What are cryptocurrencies and how do they work?

Discover what cryptocurrencies are and how the underlying technology – including the blockchain – works. 

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What are cryptocurrencies?

Cryptocurrencies are digital currencies that use cryptography – complex mathematics and computer science – to secure and verify transactions. 

They operate in a very different way to traditional (‘fiat’) currencies, because they are not issued or backed by a central authority such as a government. Instead, cryptocurrencies are decentralised and run across a network of computers.

This means there is no ‘trusted third party’ to underwrite transactions or confirm that the cryptocurrency has value. Instead, cryptocurrency users place their trust in the underlying technology – the blockchain. This is a permanent record of transactions that cannot be altered without the consensus of the network. Users trust blockchain technology to record ownership and verify transactions, which is what enables cryptocurrencies to store value.

Learn more about how cryptocurrencies work.

Fiat currencies vs cryptocurrencies

Fiat currencies Cryptocurrencies
Physical.

Digital.

Aligned with a particular nation or group of nations.

Global.

Issued by governments.

Released through mining.

Supply is mediated by central banks.

Supply is mediated by miners and mining software.

Must be injected into the economy through bonds and other securities.

Injected directly into the cryptocurrency market.

Heavily influenced by inflation and interest rates.

Largely uninfluenced by monetary policy. 


Currency or commodity?

Cryptocurrencies may be known as an ‘alternative’ to traditional currencies, but they were nonetheless conceived as a wholly conventional payment solution. Already, a number of outlets accept cryptocurrencies as a form of payment.
But while it’s true that its legitimacy as a form of payment is central to its value, cryptocurrencies often bear more resemblance to commodities like gold than they do forex. Like commodities:
 
  • The value of a cryptocurrency isn’t tied exclusively to the performance of a particular economy
  • Interest rate changes and increased monetary supplies only have an indirect bearing on their value
  • Cryptocurrencies are only valuable because people agree they will retain their value when converted back to fiat currencies
This means, at least for now, cryptocurrencies are primarily treated as a commodity: an investment whose return comes from speculating on their rising and falling value.

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How do cryptocurrencies work?

Unlike traditional currencies, cryptocurrencies exist only as a shared digital record of ownership stored on a blockchain. When a user wants to send cryptocurrency units to another user, they send it to that user’s digital wallet. The transaction isn’t considered final until it has been verified and added to the blockchain through a process called mining. This is also how new cryptocurrency tokens are usually created.

What is a blockchain?

A blockchain is a shared digital ledger which records data. For cryptocurrencies, this is the transaction history for each and every unit of the cryptocurrency, which shows how ownership has changed over time. Transactions are recorded in ‘blocks’, with new blocks added at the front of the chain. 

Unlike other types of computer file, blockchain technology can be trusted to store value because of two key security features:

Cryptography: blocks are linked together by cryptography – complex mathematics and computer science – so any attempt to alter data disrupts the cryptographic links and can quickly be identified as fraudulent.

Network consensus: a blockchain file is always stored on multiple computers across a network – rather than in a single location – and is readable by everyone within the network. This makes it both transparent and very difficult to alter, with no one weak point vulnerable to hacks, or human or software error.

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These features mean that:
 
  • Once data has been verified, it cannot be retroactively edited without the computing power and will of the network majority
  • New blocks must be approved by a network majority, and linked to previous data cryptographically. This is controlled through a process known as mining

What is cryptocurrency mining?

Mining is the process by which recent cryptocurrency transactions are checked and new blocks are added to the blockchain. Here’s a quick rundown of how both functions work.

Checking transactions

Mining computers select a set of pending transactions from a pool and check each one carefully to ensure that the transaction is valid. 

A first check confirms that the sender has sufficient funds to complete the transaction. This involves checking the transaction details against the transaction history stored in the blockchain. A second check confirms that the sender has authorised the transfer of funds. 

When sending funds, a user must sign the transaction using a private key, which is then combined cryptographically with the transaction data to form a unique digital signature. Because of the mathematics involved, miners can use this digital signature to verify that the sender had access to the wallet’s private key – and therefore the funds contained within it – without the sender having to reveal their private key. 

Creating a new block

Mining computers compile valid transactions into a new block and attempt to generate the cryptographic link to the previous block by finding a solution to a complex algorithm. 

When a computer succeeds in generating the link, it adds the block to its version of the blockchain file and broadcasts the update across the network. Once a majority of machines in the network have verified that the new block is genuine and updated their copies of the blockchain file, the computer that mined the block is rewarded – either with some newly ‘mined’ cryptocurrency tokens (eg bitcoins), or transaction fees.

The difficulty of the algorithm can be – and is – regularly adjusted, with the aim of keeping block discovery constant, even as computing power improves. This means it resembles the rate at which commodities like gold hit the market – hence the name ‘mining’.

The miner consolidates recent cryptocurrency transactions into a 'block'. 

The block is cryptographically secured and linked to the existing blockchain. 

The miner earns a block reward, which they can inject directly back into the market.

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FAQs

What is an ICO?

An ICO is an initial coin offering. It is a way for founders of a new cryptocurrency to raise capital for their project, in exchange for their currency’s tokens. The project may solely be devoted to their new cryptocurrency, or may span multiple blockchain applications.

ICOs are quickly becoming the preferred way to launch a new cryptocurrency onto the market. Investors hope that the new cryptocurrency will turn out to be the next big thing and rise in value. However, ICOs are very risky ventures: unlike companies which float on the stock market, new cryptocurrencies are unproven in the marketplace, and don’t confer any rights of ownership. This makes investments almost wholly speculative.

Likewise, ICOs are unregulated. To avoid getting tangled up in legal implications, they present themselves as ‘presale tokens’ – not unlike a Kickstarter campaign which offers benefits to early supporters.

What is a cryptocurrency fork?

A ‘fork’ is the process by which one blockchain – or transaction ledger – splits into two. It occurs when the software used among miners becomes misaligned. Cryptocurrency miners must then decide which version of the blockchain to accept as valid, and which to discard.

Can you short cryptocurrencies?

Yes. When you trade cryptocurrencies, you can take a position as it falls in value, not just when it rises.

Could cryptocurrencies replace cash?

It’s not impossible, but unlikely to happen any time soon. There are a number of reasons why it will take some time, including:

  • Cryptocurrencies still lack widespread adoption, among both individuals and businesses
  • They are too volatile: vendors would currently have to revise their prices every day to cater for swings in value
  • A digital currency would mean a complete revision of existing economic infrastructure
  • The transition would need to be worked out, to prevent the redundancy of fiat currencies and the loss of assets

Still, there are a number of benefits to the idea:

  • They can’t be manipulated like fiat currencies, as a result of the public blockchain
  • Without a middle-man, they cut the costs and reduce the obstacles of global transactions
  • They lend themselves to a universal basic income

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