What is cryptocurrency?
A cryptocurrency is a digital currency that operates on decentralized networks without relying on central authorities (like governments) or intermediaries (like banks). Like traditional currency, cryptocurrency was designed to be exchanged in the buying and selling of goods. But because cryptocurrencies are volatile, they are not as widely accepted as traditional currency yet, and are not generally used for everyday needs.
Cryptocurrency was first introduced in 2008 with the invention of Bitcoin. Bitcoin is one of the most well-known cryptocurrencies; other well-known coins include Ether, Tether, and Binance.
Some defining characteristics of cryptocurrencies include: decentralized or peer-to-peer (P2P) networks, pseudonymity, and permanent records of transactions.
How do people use cryptocurrency?
Some merchants and individuals use cryptocurrency as payment for everyday goods and services. For example, an illustrator might accept cryptocurrency, rather than US dollars, as compensation for creating a custom image.
In addition, many people treat cryptocurrency as a speculative investment. Because cryptocurrencies are generally not backed by traditional financial institutions or governments, and often receive considerable media coverage, they have a volatile nature and fluctuate in value. Many people buy cryptocurrency in the hope that it will increase in value in the future, so they can sell it at a profit to someone else.
Cryptocurrency has also sometimes been associated with criminal activity. Attackers commonly request cryptocurrency for payment in ransomware attacks because it is more difficult to trace than traditional currency. Online marketplaces selling illicit products (such as illegal drugs) have also used cryptocurrency to promise users “anonymity.”
How does cryptocurrency work?
Cryptocurrencies are built on many different technologies, including the following:
Blockchain
A blockchain is a distributed database that acts as a ledger that records transactions. The ledger is made up of chronological “blocks'' of data that are validated and secured by the blockchain’s network of nodes (or computers).
Cryptocurrencies are generally built on public blockchains. (Public blockchains allow anyone to join, unlike private blockchains that limit who can join.) They use this technology to validate, secure, and record transactions about when currency is created and how it moves from person to person.
This ledger of activity is available to members of the blockchain, meaning every individual can see how cryptocurrency moves throughout the network.
Peer-to-peer (P2P) networks
P2P networks are made up of geographically dispersed computers that all store data and communicate with each other. This is in contrast to traditional client-server models, in which all clients connect to a server to access a service.
P2P networks remove the need for intermediaries (like banks) to facilitate cryptocurrency transactions, because the network’s nodes can interact directly. This means cryptocurrency can change hands without outside involvement, as long as the blockchain validates the transaction.
Cryptography
Cryptocurrency is also built on cryptographic technology. Cryptography refers to a variety of techniques that involve securing and validating data using codes, algorithms, and other computations. Data secured with cryptography is encrypted. Data can also be digitally signed using cryptography to ensure it is valid, just as a tamper-proof seal ensures a canister of medicine is legitimate.
The primary cryptographic technique many cryptocurrencies use is the public-private key system. A public key is like a username cryptocurrency owners share with others to facilitate transactions. It is tied to the private key which is like a password the user should not share with anyone.
When transactions happen on a blockchain, its members can see the public keys involved with the transaction. Because of this design, cryptocurrency transactions are pseudonymous (despite many claims that they are anonymous) and traceable.
That said, depending on the cryptocurrency, the public key may not have to be associated with the buyer’s name or other identifying information. Historically, some exchanges have not required buyers to share any personal information to purchase cryptocurrency. In this sense, cryptocurrencies can theoretically offer more privacy than using a credit card or traditional bank. That said, cryptocurrencies claiming to be completely anonymous should be met with skepticism.
Consensus mechanisms and mining
A consensus mechanism is how a blockchain “agrees” on the validity of new transactions before adding them to the ledger. Different cryptocurrencies use different consensus mechanisms, but two of the most common are Proof-of-Work (PoW) and Proof-of-Stake (PoS).
First pioneered by Bitcoin, PoW relies on nodes within the network competing to “mine” new blocks. Mining is how new coins are created or minted.* It involves solving complex cryptographic equations. Solving these equations is not only time-consuming but also requires a high amount of computational power and energy consumption. The energy PoW requires is one of the main reasons cryptocurrencies are criticized for their impact on the environment.
PoS blockchains, on the other hand, have nodes that are dedicated to validating transactions. Rather than solving cryptographic equations to validate transactions, PoS blockchains “stake” or give coins as a show of trust in a transaction. Because PoS transactions do not involve the kind of labor-intensive cryptographic equations that PoW blockchains do, proponents of PoS consider them more environmentally friendly.
*Note that some currencies can only have a finite number of coins. Bitcoin, for instance, has a maximum of just under 21 million coins, not all of which are currently in circulation.
Wallets and exchanges
A cryptocurrency wallet is used to store the private keys users need to buy and sell cryptocurrency. Wallets generally take the form of applications, software, or USB drives. Wallets do not, however, store actual currency. Because cryptocurrency is fully digital, a record of the cryptocurrency itself lives on its blockchain, along with the public key of its associated owner.
An exchange is like a cryptocurrency marketplace. It is a place — typically a website or application — where people buy and sell cryptocurrency.
Visualizing cryptocurrency in a PoW blockchain
To understand how cryptocurrency works from a technical and user point of view, imagine that Sally would like to buy ABC cryptocurrency, which is built on the ABC blockchain. ABC blockchain is a large blockchain that uses PoW as a consensus mechanism.*
Sally’s public key is @sallyspublickey and they would like to buy one ABC coin. Here is what that process may look like:
Minting new ABC coins: Before Sally can buy an ABC coin, the ABC blockchain must create one. New ABC coins are created by miner nodes on the ABC blockchain who work to solve cryptographic equations. When miners solve these equations, new coins are added into circulation. Once validated, records of the creation of these new ABC coins are stored in new blocks that are added to the ABC blockchain. (Note that new coins are not necessarily minted every time someone decides to purchase a coin, it is also possible to purchase existing coins. The process of minting coins is included here for demonstration purposes.)
Cryptocurrency exchange: Sally visits a cryptocurrency exchange to purchase an ABC coin. Sally has to deposit regular currency into their exchange account to purchase an ABC coin. They will also have to share their public and private keys to make the purchase. In this scenario, Sally has purchased cryptocurrency before and owns a wallet already. If she had not, she would need to obtain a wallet and keys, most likely from a cryptocurrency exchange or application, like Coinbase.
PoW: To validate the purchase of this cryptocurrency, miner nodes once again solve cryptographic equations. Once the transactions are verified, they are recorded in a new block that gets added to the ABC blockchain. This process may take 10 minutes or so in this blockchain. (Note that the time to confirm transactions varies across cryptocurrencies and blockchains and can take significantly longer in some cases.)
Sally’s private key is now tied to one ABC coin: Sally does not receive any physical coins. Instead, their private key, which they store in their wallet, proves they own one ABC coin. Now, Sally can use that coin to purchase something from a vendor who accepts ABC coin or hold onto their one coin in the hopes it will grow in value.
Transaction details appear on ABC blockchain: Members of the ABC blockchain can now see the transaction and that @sallyspublickey is the owner of one ABC coin.
What are the pros and cons of cryptocurrency?
People choose to use and invest in cryptocurrencies for a number of reasons:
Distrust of centralized institutions: One of the primary reasons people believe in cryptocurrency is that it offers an alternative to trusting large-scale financial institutions. Many proponents of cryptocurrency also believe the P2P network design gives them more control over their money.
Blockchain security features: Blockchain has many mechanisms that prevent data tampering, theoretically making it more secure in certain ways.
Investment opportunity: As the value of cryptocurrency fluctuates often, many people choose to buy it (and encourage others to buy it) in the hopes of making money.
At the same time, these are some of the reasons people do not opt into cryptocurrency:
Security risks: There have been many high-profile attacks against some exchanges and blockchains. For example, in 2016, around $72 million of cryptocurrency was stolen from the exchange Bitfinex.
Privacy concerns: On most blockchains, cryptocurrency transactions are publicly visible. This visibility is an intentional mechanism by which blockchains preserve data integrity — but some users may not want their financial transactions exposed to the public, even with the pseudonymity provided by a cryptocurrency wallet.
Association with fraud and cyberattacks: Many criminals are attracted to cryptocurrency because of the pseudonymity it provides. In fact, the FBI arrested a couple in early 2022 who are accused of laundering billions of dollars worth of Bitcoin, in association with the Bitfinex attack. Many ransomware attackers also ask for cryptocurrency as ransom because it is more difficult to trace than traditional forms of payment.
Environmental concerns: Because many of the most widely used cryptocurrencies, including Bitcoin, use energy-intensive PoW mechanisms, there are concerns about the environmental impact cryptocurrency could have long term.
Unpredictable outlook: Because cryptocurrency is not widely adopted or regulated at the moment, many are skeptical about its longevity.
Volatility: While swings in value may be attractive to investors with a higher risk tolerance, they may be frightening to someone looking for more a long-term, stable investment.