What is Cryptocurrency and How Does It Work?

Since the bitcoin boom of 2017, more people than ever have become interested in cryptocurrency, going so far as to buy it as a form of investment. But cryptocurrency was not designed to be bought and sold to make profit. So, what exactly is it and how does it work?

What is Cryptocurrency?
Cryptocurrency is a digital currency, where transactions are recording on a public ledger, usually a blockchain, and every process is protected by cryptography, which is simply the practice of secure communication. Cryptography is what makes cryptocurrency different from more common forms of electronic payment, such as credit cards or PayPal. Cryptocurrency is anonymous and cannot be traced back to its sender or recipient, which makes it popular among people who want to conceal their financial activity.

Cryptocurrency is distinguished from fiat, or traditional, money in that it is decentralized and digital. Cryptocurrency is decentralized by design, so there is no intermediary like a bank to transfer cryptocurrency between people. Instead, cryptocurrency is controlled by its users and computer algorithms like a blockchain to maintain its integrity. Cryptocurrency is also completely digital, so no physical representation of its value, such as paper money, is needed.

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Without a regulatory body, there is no oversight for this digital currency, which is why a blockchain is essential. A blockchain is a large set of data that represents every transaction ever made. Blockchain technology cannot be altered retroactively without disrupting all the other records, and it prevents users from duplicating cryptocurrency as a form of fraud.

The History of Cryptocurrency
Though cryptocurrency did not take off until the late 2000s, it was first invented in 1983 by an American cryptographer, David Chaum, as an electronic currency called “ecash.” However, ecash still required that users withdraw money from traditional banks, so it was not like the cryptocurrency we know today.

It was not until 2008, when a still-anonymous person known as Satoshi Nakamoto authored a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” that the first decentralized cryptocurrency, bitcoin, was created. Bitcoin slowly grew in value until it skyrocketed toward the end of 2017, with one bitcoin (1 BTC) reaching an all-time high of $19,783.06.

As of 2019, the total dollar-denominated value of bitcoin in circulation is $64.3 billion out of a total cryptocurrency market value of almost $134 billion. Since the release of bitcoin, over 4,000 alternative forms of cryptocurrency, called altcoins, have been created.

How Cryptocurrency Works
You can acquire cryptocurrency in two ways—by mining cryptocurrency or by exchanging it.

Cryptocurrency miners are the people who maintain the blockchain. They validate all transactions by using software and hardware to solve cryptographic puzzles and receive coins as a reward. This process also creates new coins. Mining cryptocurrency requires a huge amount of computer processing power and electricity, so the costs of mining often outweigh benefits of earning cryptocurrency.

A cryptocurrency exchange is where people can trade their cryptocurrency for traditional money or other digital currencies, and this is where the “value” of various types of cryptocurrency is determined. The exchange acts as an intermediary between people who want to sell and buy cryptocurrency and charges fees to exchange cryptocurrency or takes the difference between the selling and buying prices as a transaction commission.

You can also trade cryptocurrency in a peer-to-peer exchange. Cryptocurrency is stored and transferred between cryptocurrency wallets, which all have a private key to “sign” each transaction and a public key for others to check that a transaction is valid.

Because they are in the blockchain, transaction amounts are public, but information about who sent or received a transaction is encrypted. This makes cryptocurrency a pseudo-anonymous system. It is impossible to trace transactions back to their senders or recipients because the blockchain only has a record of each user’s public key. Without knowing the private key to a user’s account, you cannot identify exactly who is behind a specific transaction.

AUTHOR’S NOTE: This is the first article in a three-part series about cryptocurrency. In our next article, we will discuss the risks of cryptocurrency and how financial institutions can protect themselves and their customers from these risks.

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