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What Is Cryptocurrency?
By James F. Trumm MONEY RESEARCH COLLECTIVE
Cryptocurrency is digital money that uses a distributed ledger known as a blockchain to make, record and secure financial transactions. But beyond that definition lies a world of rapidly evolving ideas that threaten to upend our notion of what money is and to render obsolete the banks, brokers, and financial institutions that mediate transactions between buyers and sellers.
How does cryptocurrency work?
Let’s start with the word itself. “Crypto” is a prefix applied to something that’s private, secret, or coded. And of course “currency” is just money – a medium of exchange or a store of value. So cryptocurrency is an encoded form of virtual currency that can be acquired, transferred and used to buy things.
Like all currencies, crypto may also be a store of value. And just as foreign exchange (forex) traders attempt to predict which foreign currencies will gain value and which will lose it, so cryptocurrency traders try to predict which types of cryptocurrencies will appreciate or depreciate against other currencies.
When you buy digital currencies using U.S. dollars, pounds, yen or euros, you’re exchanging what’s called fiat currency for cryptocurrency. Fiat currency (not to be confused with the money you use to buy an Italian car) is money that’s issued by the government.
To summarize a widely-cited paper authored by Jan Lansky, Ph.D. of the University of Finance and Administration in Prague, cryptocurrency has six defining characteristics:
- It doesn’t require a central authority
- It keeps a record of cryptocurrency units and who owns them
- It defines whether and how new cryptocurrency units can be created and how to determine who owns them
- Ownership of cryptocurrency units can be proven cryptographically
- Transactions can be performed in which ownership of cryptocurrency is changed, but a transaction statement can only be issued by someone who can prove the current ownership of that crypto.
- If two different instructions for changing the ownership of the same cryptocurrency are simultaneously entered, only one of them (at most) is performed.
What is a blockchain?
All cryptocurrency transactions are recorded in a digital ledger called a blockchain. Groups of crypto transactions are lumped together in “blocks” in a way that makes it impossible to secretly alter the records of a transaction without it being immediately obvious. Blockchains don’t reside on any one computer but on many machines that are linked in peer-to-peer networks. The blockchain itself can be downloaded, inspected, and validated by anyone, and transactions on it are recorded only by number, not by name.
Proof of work
Proof of work is one of two systems used to govern how new cryptocoins are created. In effect, proof of work is a race between computers to see which one can be the first to solve a complex mathematical puzzle. The results obtained by the winner of this race can then form a new block on the blockchain. The operator of that computer is then rewarded for its “work” with new cryptocoins. This process is known as mining.
Proof of stake
Like proof of work, proof of stake is a way of determining who can create new cryptocoins. Those who want to create new coins must purchase some of that cryptocurrency first. This gives them the right to validate transactions on that currency’s blockchain and earn more coins for doing so.
How to buy cryptocurrency
The easiest way for a newcomer to buy cryptocurrency is to open an account with a crypto exchange. Exchanges are services that make it possible for you to convert your fiat currency – that is, the paper money in your wallet or the balance in your bank account – into crypto. Some of the best-known exchanges include Coinbase, Binance, BlockFi, and Bisq.
How to trade cryptocurrency
Once you own some crypto, you can choose how to trade it for other cryptocurrencies. You can continue to use an exchange, which makes it easy to convert one kind of crypto into another. But you can also set up a digital crypto wallet to store and trade your crypto. Using wallets requires more technical skill but provides an extra layer of security since the keys to your crypto are held directly by you rather than by an exchange. Trading from your wallet puts you in direct (but anonymous) contact with your partner in the trade.
Where to store cryptocurrency
While we’re on the subject of wallets, if you follow a “hodl” strategy of cryptocurrency investing (the word comes from an accidental inversion of the last two letters) and intend to keep your crypto for a while, it might make sense for you to store your crypto assets in a cold wallet. Your digital assets will be safer from hackers that way, since cold wallets aren’t connected to the internet.
The pros and cons of cryptocurrency
Proponents of cryptocurrency cite its numerous advantages over fiat currency:
- Crypto can be held by and sent directly to anyone with an internet connection. Transactions are secure and private, are maintained anonymously on a public ledger, and don’t involve intermediaries (such as banks or money transfer services) that charge transaction fees and maintain records of the identities of the parties to each transaction.
- Crypto’s value isn’t directly subject to government control. While governments can (and do) devalue their currency – or even do away with it altogether and replace it with another currency – crypto’s value is determined solely by the cryptocurrency market and isn’t subject to control by a central bank or any other authority.
- In theory, some types of crypto – those that have a finite (or at least predictable) supply – may be better stores of value and hedges against inflation than traditional currencies whose supply can be expanded by the government.
Crypto critics, however, claim that crypto has some serious shortcomings:
- Crypto is not yet a generally viable means of transacting business. It’s still next to impossible to use cryptocurrency to buy groceries, fill your tank with gasoline, or pay your mortgage. Part of this is due to the technical limitations of the blockchain itself. Credit card companies can process many more transactions per second than the Bitcoin blockchain technology can. Even faster blockchains, such as Ethereum’s, are still orders of magnitude slower than Visa’s and Mastercard’s transaction processing systems.
- Because crypto can be stored and spent anonymously, criminals can and do use it as a way to hide their assets and transactions from law enforcement authorities.
- Proof-of-work coins, such as Bitcoin, are highly energy-intensive and ecologically destructive. It can take a great deal of electricity to mine cryptocurrency. The carbon footprint of the Bitcoin mining industry today is equivalent to that of the electricity providers for the entire state of Washington.
How many cryptocurrencies are there?
The short answer: no one knows for sure. After Bitcoin was released and caught the public’s attention, numerous competitor coins (collectively called altcoins) were brought to the crypto market. Still other cryptocurrencies, known as stablecoins, were developed that were supposedly pegged to the value of fiat currency.
Anyone with a computer, an internet connection, and some technical chops can create his or her own cryptocurrency. Though there have been some attempts to regulate different cryptocurrencies, regulation is difficult because there’s no central clearinghouse, no governing authority, and no organization that “approves” or controls new cryptocurrencies. And that, crypto proponents argue, is one of the great things about it.
Bitcoin
Though the theoretical contours of cryptocurrency were laid out as early as 1983, it was not until January 3, 2009 that the first cryptocurrency, which was called Bitcoin (BTC) was released by someone going by the pseudonym of Satoshi Nakamoto. Bitcoin is today the most widely held and most valuable cryptocurrency in the world.
Though it was conceived as an electronic currency that could be widely used as a medium for making routine purchases, it has proved to be too volatile to be of much use for that. Rather, Bitcoin today is mostly viewed as an investment, a store of value that its owners hope will appreciate over time.
Bitcoin proponents argue that it is superior to fiat currency because its supply is regulated by the very code that created and defines it. Approximately every four years, the amount of new Bitcoin that can be “mined” is reduced by half of its previous volume. And the maximum number of Bitcoins that can ever be created is 21 million. As of January 2022, 18.9 million Bitcoins had been created, with about 2.1 million Bitcoins still to be released. It’s estimated that the last new Bitcoin will be mined sometime around 2140. Since the value of Bitcoin can’t be diluted the way fiat currency can, many Bitcoin advocates view it as a hedge against inflation. So far, however, Bitcoin’s high level of volatility has called that theory into question.
Ethereum
Ethereum (ETH) was released on July 30, 2015. (Technically, Ethereum is not the name of a cryptocurrency; it’s the name of a blockchain and the native currency that’s used on it is called Ether. But today many people use the word “Ethereum” to denote both.) Since that time, it has grown to become the world’s second-largest cryptocurrency in terms of its total value. Ethereum is commonly thought to provide a more practical platform for a truly crypto-based economy due to its ability to handle more transactions per second than other blockchains.
Unlike the Bitcoin blockchain, the Ethereum blockchain can host and run decentralized applications, execute smart contracts, and store NFTs (non-fungible tokens). Another difference between Ethereum and Bitcoin is that there is no absolute limit on the number of Ethereum coins that can be created. However, Ethereum’s protocol regularly makes it more and more difficult to solve those puzzles, thus constricting the supply of new coins.
Ethereum is created by a proof-of-work model under which banks of computers are tasked with solving intricate mathematical puzzles in order to create new Ethereum. This method has come under fire from environmentalists, who point to the huge amount of electricity needed to run those computer banks and keep them cool. In response, Ethereum is moving toward a proof-of-stake model called Ethereum 2, which uses far less electricity.
Dogecoin
Dogecoin began as a joke. It claimed to be the first dog coin. It branded itself with the face of a Shiba Inu dog and quickly took off on Reddit as the very first “meme coin” whose popularity was fueled by its image, its social media proponents, and its irreverent attitude.
Dogecoin does have one significant advantage over other cryptocurrencies. Its network takes only a minute to confirm a transaction, while Bitcoin typically takes about 10 minutes to do so. But like other meme coins, Dogecoin is highly volatile. Its value is subject more to the vagaries of social media (and tweets by Elon Musk) than technological advancement or a track record as a store of value. There is no limit on the number of Dogecoins that can be created, which critics suggest make its value subject to dilution. Like the Litcoin platform it’s based on, Dogecoin operates on a proof-of-work model, which has been criticized by environmentalists, as noted above.
Binance Coin
Binance is the largest cryptocurrency exchange in the world. Binance Coin is the exchange’s native coin and was originally developed to enable Binance users to pay exchange fees. Since its inception, though, the coin has expanded its reach and is now used for booking travel, purchasing tickets for concerts and shows, subscribing to online services, and paying financial service fees. Today it is the fourth-largest cryptocurrency in the world, with a market cap of over $14 billion as of this writing.
Binance has run into legal problems in the US and elsewhere. The Binance exchange was banned in the US in 2019. The exchange then opened an American exchange, Binance.US, but this has now been banned in five states, including New York and Texas. The company is currently being investigated by the US Department of Justice and the IRS on suspicion of tax evasion and money laundering. In June 2021, Binance was shut down in the UK due to non-compliance with British money-laundering laws.
Cardano
Cardano is a blockchain platform whose native currency is officially called Ada. However, as with other popular cryptocurrencies (e.g., Ethereum) it is popularly referred to by the name of the blockchain rather than the name of its cryptocurrency.
Cardano is significant for two reasons. First, it was developed with DeFi (decentralized finance) smart contract applications, peer-to-peer transactions, and quick processing times in mind. The Cardano blockchain also supports product authenticity verification and may soon be able to host music and associated artwork. Second, it operates on a proof-of-stake model that’s considerably “greener” than proof-of-work blockchains such as Bitcoin, Litecoin and Ethereum. Cardano co-founder Charles Hoskinson claims that one Cardano transaction uses less than 1% of the electricity that a Bitcoin transaction uses.
Litecoin
Litecoin can be thought of as a child of Bitcoin. Though its architecture is similar to that of Bitcoin, its source code has been modified to speed up transactions. While Bitcoin transactions can take 10 minutes to execute, Litecoin processes transactions in about 2.5 minutes. As with Bitcoin, there is a cap on the maximum number of Litecoins that can be produced.
Litecoin was launched in 2011. It grew and appreciated rapidly and by 2017 was the fifth-largest cryptocurrency by market cap. Today, it has dropped back on that list and now sits at number 18 by market cap.
