How Do Cryptocurrencies Work?
The what, whys and hows of cryptocurrencies.
Everything You Ever Wanted to Know About Cryptocurrency
They say that money changes everything. Most people trade 40 hours of their time every week for an allotment of it. The lure of getting rich spurred thousands of adventurous speculators to travel clear across the United States to stake their claim in the California Gold Rush. Investment markets nervously await the news from the Federal Reserve meetings.
And then there is the latest money craze – Bitcoin. While Bitcoin steals most of the headlines, it is just one of many digital currencies, also referred to as cryptocurrencies, out there today. In this article we will take a closer look at what cryptocurrencies are, how they are produced and what you can do with them.
What is a Cryptocurrency?
Before we talk about cryptocurrency, let’s backtrack a bit and define what currency is in general. Most people associate a currency with a system of money that is accepted by a particular country (or in the case of the euro, group of countries.) Dollars and euros in the form of paper or coins are prime examples. This is called fiat currency.
In actuality, a currency doesn’t require a government to guarantee it. A currency is simply a medium of exchange for goods or services. As long as the buyer and the seller accept a designated form of payment, you have a currency. The extent to which a currency is widely accepted and retains a stable value are two primary characteristics of its success.
Cryptocurrency is a decentralized digital currency. It does not exist in physical form like traditional money so you can’t carry it in your pocket or purse. It is made up of blocks of encrypted data and is exchanged through a secure peer-to-peer file transfer system. Its supply and value are depended upon the activities of the users themselves along with complex protocols built into the coding system that provides the governing structure that cannot be easily modified.
It is decentralized in that it operates without any government oversight or intervention. Because of this, cryptocurrencies don’t have banks, nor are they backed by anything like the Federal Deposit Insurance Corporation (FDIC) which backs the U.S. dollar. There isn’t a traditional mint creating these currencies either. In fact, cryptocurrencies are created by independent miners who are rewarded for their efforts.
So you can’t hold these currencies, you can’t physically see them and they aren’t affiliated with any governmental body. Yet, it seems that millions of people want access to these modern day currencies and will pay a mint to obtain them. Bitcoin and other cryptocurrencies are a phenomenon that has swept the cyber world.
What is Cryptocurrency Mining?
In order to create dollar bills, you need some type of printer. In order to generate cryptocurrency, you need a computer. We commonly use the term, “coin” when talking cryptocurrency denomination, but it is a relative term.
New coins are generated, or “mined” by a network node each time it solves a specific and difficult mathematical problem. The involved equations become more complex as more coins are mined. In technical terms, mining involves calculating the hash of a block header. This header includes a reference to the previous block, a hash of a set of transactions and a unique 32-bit value called a “nonce”. The creation of the coins is recorded in a ledger called a blockchain.
If you want to be a cryptocurrency miner, be prepared to spend some money. Any traditional mining project, whether it be gold or some other mineral requires considerable investment. Cryptomining is no different. For a popular cryptocurrency such as Bitcoin, the days of mining it on your home PC are long gone. It takes a lot of computing power to mine these coins today.
It also takes a lot of energy to not only power the mining hardware but also cool down these large servers with industrial grade cooling systems. The cost of electricity alone is a big reason why it is difficult to actually make money anymore mining Bitcoin. For this reason, the majority of mining takes place in countries such as China where electricity is inexpensive and where large "farms" of high end computers operate around the clock. (Read also: Energy (In)Efficiency in Bitcoin Mining Operations.)
A more unscrupulous mining method involves cryptocurrency mining malware. Dishonest miners distribute malware throughout the world to infect unsuspecting users. Once a device is infected with the malicious code, it begins using the CPU and memory resources of its hardware host to collectively mine a designated cryptocurrency.
While a single client device has nowhere near the capacity to mine cryptocurrency to any reasonable degree, the collective effort of thousands of devices can. A compromised computer is called a zombie. Hackers who control these zombie armies of miners are ringing in profits on the backs of others. The proliferation of crypto mining malware fluctuates with the price of the currencies.
Blockchain and Cryptocurrencies
Any discussion concerning cryptocurrencies eventually involves the blockchain. A blockchain is a database in which the data is stored in blocks that are linked or "chained" together. Once a block is completed, new data is stored in a fresh block. Because a cryptocurrency such as Bitcoin is decentralized, the blockchain is not contained by a single entity, nor is it hosted at a single location. It is dispersed across participating nodes across the world and each node contains identical copies of the blockchain are contained within each node, preventing data from being manipulated or lost.
Instead, the blockchain is dispersed across thousands of computers in different geographic locations across the world. Besides the fact that all of the data in the blockchain is encrypted, the dispersing of this digital ledger adds to the security of the currency. The blockchain also contains identical copies data copies, preventing data from being manipulated or lost.
The blockchain contains the record of every coin that is mined and when it was created. It also contains every transaction involving the currency. Bitcoins for instance are cryptographically signed each time they are exchanged, which requires that each Unlike
The blockchain contains the record of every coin that is mined and when it was created. It also contains every transaction involving the currency. Bitcoins for instance are cryptographically signed each time they are exchanged, which requires that each Bitcoin user have both a public key and unique private key. Every cryptocurrency holder has a private key that authenticates their identity and allows them to then exchange currency. While this vastly strengthens the security of transactions versus regular cash currency, it opens up the disturbing possibility that if you lose your key, your cryptocurrency holdings become worthless until the key is properly recovered.
Bitcoin and other widely recognized cryptocurrencies allow broad transparency, making it possible to view any past transaction. This isn’t always the case however as some cryptocurrencies are used on the dark web and are built around anonymity in order to protect the identities of those involved in the transaction. Unlike fintech applications such as PayPal, a transaction is finalized once it is recorded within the blockchain, making refund or chargeback functions impossible, at least for now.
Blockchain isn't limited to the world of cryptocurrency though—It is also possible for blockchains to host legal contracts and other types of sensitive data. Many large companies are looking into how to incorporate blockchain technology into their recording processes. (Read also: An Introduction to Blockchain Technology.)
How Are Cryptocurrencies Worth Real Money?
A cryptocurrency are like any asset. It is worth what someone is willing to pay for it. Unlike a national currency, the value of cryptocurrency fluctuates constantly and is highly volatile at times. While a $1 bill is worth a dollar regardless of when you receive it or spend it, the price of Bitcoin and other digital currencies is all over the map. While the value of a single Bitcoin had dipped in April of 2020 to around $5,000, it surged to over $40,000 in January 2021.
Bitcoin was created back in 2009 at which you could have purchased a single Bitcoin for pennies. The cryptocurrency skyrocketed in value to over $20,000 per coin in 2017 and then crashed downward. This extreme volatility serves as an inhibitor in its acceptance as a feasible currency.
Advocates of cryptocurrencies believe that Bitcoin and other currencies are a great inflation hedge in the same way that gold is. National currencies such as the U.S. dollar were once backed up by gold or some other type of commodity, but that is no longer the case.
Most fiat currencies are backed by nothing other than the reputation of the country that issues it. This means that governments can print as much of a currency as it wants in order to support high deficit spending. The expansion of a currency can lead to high inflation as the value of a dollar is weakened over time. This means that the purchasing power of Fiat currencies diminishes over time.
In some aspects, cryptocurrencies are deemed more secure than traditional money. Unlike paper currency, it is extremely difficult, if not impossible, to create a counterfeit digital currency. This fact enhances the faith that people have in the currency. (Read also: Hacking Cryptocurrencies.)
Unlike fiat currencies, cryptocurrencies such as Bitcoin have a defined cap as to how many can be mined. This finite number is referred to as the key guarantor of value. The Bitcoin model allows for a total of 21 million coins to be mined. As of now, there are about 18.5 million bitcoin in circulation. Once the cap number is reached, the planet’s supply will be maxed out and mining operations will cease permanently.
Ethereum, the second most widely held digital coin, will tap out at 72 million coins. Besides having a hard cap number, the production rate for these digital currencies diminishes over time as the mathematical equations take longer and longer to compute. In the case of Bitcoin, the mining rate drops by roughly 50% every four years. For these reasons, many advocates of cryptocurrencies argue that Bitcoin and other digital currencies will hold their value better than their fiat predecessors. Skeptics point out that there is no guarantee that the formula that mandates the mining process of Bitcoin or other cryptocurrencies won’t be changed once the caps are reached.
How Can You Get Cryptocurrencies?
While not just anyone can mine cryptocurrencies, anyone can purchase them through the Internet. Buying cryptocurrencies is done through a cryptocurrency trading exchange. One of the most popular ones is Coinbase.
Different exchanges deal in different cryptocurrencies. To purchase one you must create an account with the exchange, who will then issue you a digital wallet to hold your coins. You don’t have to purchase an entire coin, which is a good thing as many of us do not have tens of thousands of dollars on hand to purchase one. While you can purchase some cryptocurrencies with U.S. dollars, others require Bitcoins or other cryptocurrencies, complicating the purchase process.
Why Use a Cryptocurrency?
Besides the allure of getting rich off of cryptocurrency investment and speculation, there are a number of good reasons to use cryptocurrencies to buy and sell goods and services.
- Because popular cryptocurrencies are not associated with any government, you don’t have to worry about international exchange rates. You can exchange Bitcoin with other people on the other side of the world just as easily as you can someone who lives in your own country, making it an unofficial borderless currency. Dreams of establishing Bitcoin and other cryptocurrencies as a true universal currency may be short lived. India introduced legislation in 2021 that if passed into law, will outlaw all private cryptocurrencies other than a future nationalized one.
- You don’t need a bank account to exchange cryptocurrencies. You don’t have to obtain a banker’s permission to make a transaction. You don’t have to worry about bank fees, minimum account balances or what your credit score is. Because all you need is an app on your smartphone or computing device, cryptocurrencies are extremely mobile.
- Exchange transactions are done peer-to-peer so there is no need for a middleman or intermediary that demands a small cut of the transaction in order to process it.
- While all Bitcoin transactions are transparent within the blockchain, personal identities are not. Unlike a credit card, you do not have to supply personal information such as your name and address to complete a transaction. While not completely untraceable, cryptocurrencies offer a higher degree of privacy than other online transactions.
- Digital currencies are especially suitable for online transactions. As more and more people continue to migrate their shopping preferences to online retailers, consumers will become more receptive to a universal online currency.
How Many Cryptocurrencies Are There?
While most of us only utilize a single currency on a daily basis, there are 180 currencies across the world recognized by the United Nations. When it comes to cryptocurrencies, no one knows exactly how many are in circulation today. While nearly 8,000 have been created, many of them have faded along the way.
Estimates are that there are between 4,000 and 5,000 in digital currencies in circulation today. Bitcoin is the big kahuna in the crypto world with approximately 62% market share. Despite its dominant place in the market, its origin is somewhat of a mystery as no one knows for sure who first created it, the idea is traced to a paper released under the pseudonym Satoshi Nakamoto in 2008.
The top 5 cryptocurrencies collectively garner about 80% of the market. The vast majority of crypto coins in the world today have no value. Some were made as a hobby or joke by individual programmers. Yet, even some of these cryptocurrencies come into the spotlight from time to time. In February of 2021, a little known digital coin created in 2013 called Dogecoin saw its value surge more than 800% after appearing on a Reddit board during the GameStop frenzy.
Some of the more popular alternative coins to Bitcoin include Ethereum, Litecoin, Bitcoin Cash and Ripple. Ethereum is the second most popular blockchain platform due to its expansion beyond the mining and coin transactions. Today it offers additional services including contract functionality and distributed application development. (Read also: The Differences Between the Top 3 Cryptocurrencies.)
Bitcoin Cash is an example of a fork cryptocurrency or spinoff. Forks occur when users or developers decide to require a fundamental change for the currency. This change results in a new blockchain.
Can Anyone Make a Cryptocurrency?
The answer is yes, anyone can create their own cryptocurrency. That is a primary reason why there are so many in the world today. Of course, in order to create digital coins, you need a lot of real coins in order to finance its creation as the required hardware requires a substantial investment not to mention skyrocketing powerbills.
You also need to have extensive programming skills or know someone willing to offer their skills. That’s because you have to create a blockchain to support your personal cryptocurrency along with the hash that encrypts everything. Blockchain programmers are in high demand and don’t come cheap.
Next, you will have to implement an extensive cybersecurity system with robust defenses as cryptocurrencies are a common target for hackers. Even if your cryptocurrency venture proves successful, a serious intrusion by outside hackers can destroy its value and reputation overnight. The final quest is to garner enough interest to build a supportive online community. Only after completing these initial steps can you release an initial coin offering (ICO).
This is similar to an initial public offering (IP) of a newly traded stock. With a lot of hard work and a little bit of luck, your ICO may bring in enough funds to pay for your initial expenses.
Crypto Has Only Just Begun
The cryptocurrency market is still in its infancy, comparatively speaking; we are in the early innings of its development. Interest in blockchain technology alone is surging within the corporate community as businesses continue to strive for new innovative uses of this secure and agile platform. (Read also: Is It Time for Your Business to Accept Bitcoin?)
Many are convinced that cryptocurrencies will only accelerate in value over the coming years, with some investment analysts in 2021 forecasting a $100,000 price for Bitcoin in the not too distant future. As global trade becomes even more ubiquitous and governments across the world continue their practice of deficit spending, there is growing conjecture that cryptocurrencies will one day become the preferred currency of global consumers everywhere.
While the jury is still out as to whether these cryptocurrencies will prevail or if it is a merely transitory step to something else out there remains to be seen.