How Does Cryptocurrency Work?

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Includes: BTC-USD, ETH-USD, XRP-USD
by: The Freedonia Cooperative
Summary

Cryptocurrency is a word gaining more popularity; but many still do not understand the innovative technology.

Cryptocurrency started with Bitcoin, which developed technologies for a decentralized digital asset.

Bitcoin and other cryptos use their network and the blockchain to record transactions in a trusted and consistent manner.

Cryptocurrency is a term many are familiar with but few understand fully, especially the differences among various cryptocurrencies. While many have now heard of Bitcoin, the world’s first and most famous cryptocurrency, there are thousands of other coins that function differently. What they have in common is their use of the blockchain, another often misunderstood word and concept. This article will explain how cryptocurrency works, Bitcoin and beyond, and what that has to do with blockchain technology.

What Is A Cryptocurrency?

A cryptocurrency is a digital asset. It typically does not exist in physical form (like paper money) and is typically not issued by a central authority like a bank that would track, confirm and secure its own assets.

Since it is not issued by a central authority, tasks like security require the use of other means. Often, these means use cryptography -- the use of complex codes and algorithms -- to create the security needed to backup a tradable asset.

The blockchain, a term often associated with cryptocurrencies but that is not synonymous, is a method of creating this security. It’s important to know how a blockchain works in understanding cryptocurrency because it was the technological breakthrough that allowed for these digital assets.

The blockchain is a type of ledger or kept record. It records events in ‘blocks’ that are then chained together by information linking past blocks and again with future blocks. This makes the blockchain theoretically ‘immutable’ or unchangeable, and represents a new kind of record keeping that may not need to rely on a singular point of trust for confirmation.

Since cryptocurrencies don’t have main authority or record keepers, having the blockchain to record transactions, trades, newly created coins, and wallet amounts allowed the technology to blossom.

Today, there are thousands of different types of cryptocurrencies.

Bitcoin

Of course, before there were thousands, there was one: Bitcoin. Bitcoin was created from the publishing of a “white paper” by an anonymous figure known as Satoshi Nakamoto in 2008.

The paper laid out the idea of a digital cryptocurrency called Bitcoin, which could be mined, developed, tracked and traded using the blockchain.

In the paper, Satoshi outlined the idea of Bitcoin and how it could be a “peer-to-peer” digital currency that was used in transactions of value.

But its breakthrough was using cryptographic techniques from previous decades to be able to do this without issues that others had found with digital currencies.

Two of those issues that Satoshi was able to solve were the double-spend problem and Bitcoin mining, which is how blocks on the Bitcoin blockchain are confirmed and recorded.

bitcoin with mining equipment from Asus

The double-spend problem is simply being able to prevent digital currency holders from spending their money twice. If you have $200 in a bank account and withdraw $100 of it, it’s up to your bank to confirm that you now have $100 in your account. This is done consistently because the bank has a vested interest in keeping its records perfect, since it’s the holder of that money.

But cryptocurrencies don’t have a central bank, so there are alternative ways to confirm transactions. For instance, if you hold two Bitcoins and send one to a friend, your wallet must show that you have one and he or she has one. The alternative way for this to happen in a trusted manner was a breakthrough in the Bitcoin paper still used today.

Bitcoin And Cryptocurrency Mining

The answer was to have a network that could confirm these transactions itself, as well as to use highly secure and difficult cryptographic calculations to do this. This is what is called “mining” that creates new blocks which hold records of all transactions and ensure a solution to the double-spend problem.

For the computational work done by processing power, miners are rewarded for the work in creating these blocks with Bitcoin. This provides extrinsic incentive for miners to take part in the network, since they’ll reap rewards for the work done.

While mining and block creation and security isn’t vital to understanding the day-to-day use of Bitcoin or cryptocurrencies, it is a huge unlock in self-regulating networks that has been one reason for Bitcoin’s rise to prominence and fame.

bitcoin litecoin ethereum

Cryptocurrency Differences: Beyond Bitcoin

Bitcoin is just one kind of cryptocurrency. It was developed to be a peer-to-peer cashless system and has a network that upholds that purpose.

Other cryptocurrencies vary from that purpose and the path of development, maintenance, security, and use cases. One example of a different kind of cryptocurrency is Ethereum (ETH-USD)—generally considered the number two or number three biggest coin in the market.

Ethereum is a platform that allows other projects to build on top of its blockchain technology and use case. It offers the use of “smart contracts”—self-executing code that delivers on a designated purpose. In this way, it is different than Bitcoin which was designed to be a cash replacement currency.

However, like Bitcoin, Ethereum can be traded, bought, sold, or exchanged and has a value as an asset that’s produced by market economics. Ethereum, like Bitcoin, is mined and confirmed. However, Ethereum does not have the hard cap like Bitcoin of total coins that will ever exist and the Ethereum team is exploring a way to uphold the network without mining. Notably, they’ve looked into what’s called ‘staking’.

Another major cryptocurrency is Ripple (XRP-USD), which provides cross-border payments through its blockchain protocol. Both Ripple and Ethereum have economic incentives for cryptocurrency owners that drive the value of the coin up -- though neither might be considered a ‘currency’ in the classic sense.

This is just the tip of the diversity in the cryptocurrency space. At this time, there are thousands of cryptocurrencies available for trading and using, and there are likely more to come.

Getting Cryptocurrency

Because cryptocurrencies are digital assets, you can buy, sell, and trade for coins on online “exchanges”. This guide will explain the basics of cryptocurrency trading for those interested in this new and emerging technology. Binance is considered to be a safe and user-friendly exchange for new time crypto buyers and traders. Always do your own research before buying.

To learn more, you can follow Seeking Alpha’s Cryptocurrency feed that offers news and analysis across the whole industry for investors, traders and technologists.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.