What is Cryptocurrency and How Does it Work?

Cryptocurrency, often abbreviated as “crypto,” is a virtual currency that can be exchanged without a middleman.

Today, monetary transactions that occur digitally are not a new concept if you consider the invention of debit or credit cards.

With these pieces of plastic, users can pay for things without ever holding a physical bill or coin.

The difference between this form of digital payment and cryptocurrencies is that there is no intermediary.

Instead, money is transferred directly from the payee to the payer, from point A to point B, from sender to receiver. 

Since no intermediary manages these transactions, cryptocurrencies are built using cryptographic technology, hence the name “cryptocurrency.”

Based on this short introduction alone, you probably have several questions about how this can possibly be feasible or why we would need something like a cryptocurrency when we have a credit card.

To help answer these questions, we will explore the in-depth answer to what a cryptocurrency is and how these virtual currencies work.

How Does Cryptocurrency Work?

Cryptocurrencies are often mined into existence (more to come) and made available for purchase through a cryptocurrency exchange (broker, directly through another cryptocurrency holder or through a specialized ATM (for Bitcoin).

Once coins are in a user’s possession, they, like other types of money, are stored in a wallet.

However, since cryptocurrencies are digital, there is nothing physical for a wallet to hold.

Therefore, cryptocurrency wallets exist as a software that can be accessed through a password known as a private key.

The private key then becomes the single point of verification that assures a coin belongs to you.

When a cryptocurrency holder is ready to buy or sell something, coins will be transacted on a technology known as the blockchain, a database for transactions.

Unlike a traditional database however, the blockchain is decentralized, meaning nobody owns it or manages it centrally. 

What is Blockchain Technology?

Since the blockchain is the underpinning of cryptocurrency in general, let’s explore this topic in more detail, starting with its purpose. 

With physical money, we can quickly tell when it has been spent.

When we give a cashier a $5 bill for our coffee, the money is no longer in our possession.

For this reason, this same $5 bill can’t be spent to buy a notebook since we do not have it.

We may photocopy a bill with a really good scanner, but that copy will not hold the same value as our $5 bill.

Of course, this example is a little more complex with a digital currency.

Consider that a virtual five-dollar bill is more like a photo that can be duplicated and, in theory, spent multiple times, a problem known as double spend.

As a result, digital money needs a third party to monitor the flow of money and ensure a currency isn’t spent twice.

In the case of cryptocurrencies, the double-spend problem is solved by technology, and more specifically, the blockchain.

The blockchain solves this problem as a central record, database or ledger of all the transactions, which is updated and held by the users of a digital currency.

Since no one central party holds access to this record, we can say that the ledger is decentralized, being distributed across all the devices on a given network.

To ensure that transactions are accurate, the network is completely transparent, meaning anyone can see it.

While this would theoretically bring rise to security concerns, the blockchain disguises the transaction details, so although you can see money went from point A to point B, nobody would know who point A or point B is.

Cryptocurrency owners are kept anonymous through an encryption key which is a random string of letters and numbers.

Proof of Stake vs Proof of Work

Based on the description above, you likely noticed two things.

First, the blockchain is decentralized and second; operations are peer-to-peer.

With no intermediary, the logical question that might come to mind is, “how does the blockchain ensure the same money isn’t spent twice? Does every device need to look at every anonymous transaction to confirm this isn’t the case?”

The answer is no because of what we know as a consensus algorithm.

At its core, a consensus algorithm is a method of securing the cryptocurrency ledger and ensuring every computer within the network is able to agree that a transaction is legitimate.

It is also worth noting that the network could easily fall victim to attack or theft without these algorithms.

At present, there is more than one method to do so.

Proof of Work (PoW) is common in older cryptocurrencies like Bitcoin and the first generation of Ethereum and Proof of Stake (PoS) being seen in Cardano and the second generation of Ethereum, in addition to several new cryptocurrencies.

While these methods are similar in their ability to take a distributed network of participants and get them to agree on which new block of transactions is added, their differences are apparent in how they achieve this.

Proof of Work

Proof of Work validates transactions by using processing power to secure and verify a block of transactions before adding it to the rest of the chain (this is where the name blockchain comes from).

To add a new block to the chain, each set of transactions must undergo a hashing function, similar to a fingerprint or another form of one-of-a-kind ID, to stamp the data input.

The thing is, this hash can’t be generated at random; instead, it requires the user who is creating the block (also known as a miner) to take computing power and generate the answer to a complex mathematical power.

The miner who is successful is then granted the opportunity to update the blockchain.

Miners are incentivized to do this because their success results in cryptocurrency rewards.

Bitcoin still relies on Proof of Work, proving this method as successful.

For the rest of the world, Bitcoin demonstrates that hashes proved difficult enough to ensure that there were no network attacks and simple enough that miners could verify transactions promptly.

The only caveat is that as the value of cryptocurrency grows, mining requires more energy.

Looking back to the example of Bitcoin, you might notice that not just any individual can mine due to the amount of computational power that is needed.

Proof of Stake

In contrast to Proof of Work, Proof of Stake arose as the solution to the scalability issue.

In this model, a network participant gets selected to add to the latest round of transactions and be compensated in exchange.

This process will typically differ between projects, although at its basics, participants will stake their own earnings for a chance to validate each transaction.

The participant is selected based on factors such as the amount of crypto in the pool and the length of time the money has been there; this ensures that the most dedicated participants receive rewards.

This method is less energy-intensive than Proof of Work since computers are not duplicating efforts to solve the same puzzle in a competition-based mechanism.

Instead, operations are randomized. 

Pros of Cryptocurrency

Now, understanding the ins and outs of how cryptocurrency works, it is worth considering the benefits of using and investing in digital currency.

Transactions Are Fast

Transactions between sender and receiver in the traditional financial system may take up to 3 days for a domestic transfer and up to a week or more when considering international payments.

In contrast, cryptocurrency transactions were designed to be completed in a matter of minutes from the time sent to the time these same funds are available to use, globally.

Cryptocurrencies Solve The Problem of the Unbanked

Part of the reason the world is subject to such a large unbanked population is due to a lack of ID and lack of access to traditional banking.

Cryptocurrencies aim to solve this problem by providing an alternative to the traditional system by only requiring a computer or smartphone and an internet connection to use.

Cons of Cryptocurrency

As the saying goes, not all glitter is gold and it is worth looking at some of the drawbacks this asset class faces.

Cryptocurrencies Are Volatile

Cryptocurrencies are known for their massive price swings, at times differing in hundreds or thousands of dollars overnight.

While this can make for profitable investments, it can also be difficult to transact in everyday use cases like salary payments, as a price dip may make one of two parties unhappy.

Using Cryptocurrencies Requires a Steep Learning Curve

For those unfamiliar, learning how to navigate a new financial world can be daunting, especially when real money is at risk.

This has led many to avoid adopting this technology altogether.

Fortunately, several learning materials are now being made available to provide the necessary educational background before getting involved in the greater world of digital currencies.

What Can Cryptocurrency Be Used For?

It’s true cryptocurrencies are all the rage with those that are digital forward, but they do provide significantly higher value than just being a medium for investment.

Their set up as a decentralized offering makes them ideal for several powerful use cases, a few of which we will consider below.

A Deflationary Store of Wealth

Traditionally, storing your life savings in a bank account alone is not recommended since your money is subject to inflation.

As your average investor, little can be done to prevent the devaluing of money.

In contrast, cryptocurrencies prove their utility with their deflationary nature, ensuring life savings don’t consistently lose their value.

Remittance Payments

Another use case worth calling out is remittance payments, which are often subject to slow transaction times and high fees under the traditional financial system.

Since cryptocurrencies are not restricted by borders and are lower cost in nature, users could theoretically be saving significant time and effort by sending assets directly to the recipient. 

Purchasing Products Online

Many have become skeptical about giving their credit card information when transacting digitally since these payment forms are tied directly to their identity.

In contrast, cryptocurrencies ensure privacy, eliminating a lot of the risk that comes with online credit card payments.

How to Invest in Cryptocurrency?

Now that you have use for digital assets, it’s time to get some of your own.

There are several ways to purchase cryptocurrency, the most common being a centralized cryptocurrency exchange.

Users can select from several platforms, weighing factors such as the cryptocurrencies available, fees and funding methods.

After making this decision, users will be required to add personal information such as an email and password to create their account.

As a part of this setup process, some platforms will prompt the user to add additional information to abide by Know Your Customer (KYC) protocols.

Once the account has been verified, users will be able to fund their accounts and purchase the assets of their choice.

How to Mine Cryptocurrency?

Mining cryptocurrency is done for two reasons; first, it guarantees that the network remains secure, as previously touched on.

Secondly, like the government printing money, mining is a method of issuing new cryptocurrencies.

Some cryptocurrencies are limited to finite quantities, which are monitored by increasing mining difficulty, while others are unlimited in quantity, with supply being managed in other ways.

To start mining, interested parties will first need to purchase mining equipment (such as an ASIC or GPU).

This decision will depend on what type of cryptocurrency a user decides to mine.

From there, users will need to set up a cryptocurrency wallet where mined rewards can be stored.

Again, depending on the cryptocurrency selected, there will often be a recommended choice by the asset itself.

Upon completion of wallet setup, users will receive a generated address that can be used to receive funds. 

The last step in the mining process will be the physical space itself, a step that includes downloading the correct software and ensuring a proper cooling system exists.

Mining can be very time-intensive and can result in a fire if proper considerations aren’t taken into account.

Is Crypto a Good Investment?

For those looking to gain direct exposure to the demand for digital currency, cryptocurrency has shown significant potential in its ability to meet the problems faced by traditional finance.

Despite its use cases, purchasing the asset is volatile and requires investors to exercise a certain amount of caution.

As with any other investment, by diversifying funds across different cryptocurrency projects and different markets (splitting between traditional stocks and digital assets), users will maximize their earning potential and limit the risk they are taking on.