A cryptocurrency is very different from other types of currency. Cryptocurrencies are digital, cryptographically secured, and based on decentralised blockchain technology. Examples include Bitcoin and Ethereum.
To begin with, cryptocurrencies are digital or virtual. This means that the currency is only found in digital form. There is no banknotes or coins, but confusingly these currencies are still talked about as ’coins‘. For example, you could buy one ‘Bitcoin’, even though it does not exist physically as a coin.
Cryptocurrencies are secured by cryptography, which makes it nearly impossible to make fake cryptocurrency. This is similar to fiat currencies (“normal” currencies like dollars and pounds), where we try to make banknotes as hard to fake as possible. But making fake cryptocurrency is a lot harder than making fake banknotes. There exist other currencies which are digital but not encrypted, and hence not cryptocurrencies.
The most important feature of most cryptocurrencies is that there is no central bank or government that controls them. There is no central ledger in a central bank and not even ledgers in smaller commercial banks. Instead, cryptocurrencies used a distributed ledger system. Cryptocurrencies are run on peer-to-peer networks. These are computer networks that have no central control. Instead, all the computers in the network talk to each other.
In a distributed ledger system, all the computers have a copy of the ledger. This means all computers know all the transactions that have been carried out using that cryptocurrency. Because of this, no one entity can control which transactions are allowed or not, as banks and central banks can for fiat currencies.
This lack of some sort of central control is a defining feature of cryptocurrencies, and in theory, means that they cannot be controlled or manipulated by governments.
Because cryptocurrencies run on computer networks, and everyone can be part of that network. Using the decentralised ledger (blockchain) technology, you can send and receive cryptocurrencies via the network. This is called a ‘payment network’. You can use the cryptocurrency in any way you would like the kinds of money you are used to, except hold them in your hand.
One of the most important problems that face any payment network is that double-spending should not be possible. What this means is that we try to spend our money twice. For example, we take some of our digital currency and buy something from one person, but also try to spend the same currency to buy something else.
This is not a problem when dealing with physical money like coins and notes, but when using digital money, for example, credit cards, we need a way of preventing people from spending the same money twice.
The way this problem is solved for fiat currencies is to have a trusted ‘third party’ (see: Middleman) – a central server with a ledger – that kept records of the balances and transactions going on in the payment network. This way, a transaction could be cancelled if deemed fraudulent. The problem with having a third party keeping the ledger is that the third party is then in control of your money and your ability to spend it. Such a third party would also have a lot of personal information about you (think about how much a bank knows about its customers).
If we want to avoid having a third party controlling the ledger, we need to instead give everyone a copy of the ledger and have everyone update it. In a decentralized payment network, everyone helps maintain the ledger. This is done thanks to a technology called a blockchain. A network using blockchain technology is called a blockchain network.
A blockchain is a public ledger of all transactions that have ever happened within the network. It is available to everyone. Everyone in the network can see each other’s account balance, but who owns that account is encrypted. But that is fine – to prevent fraudulent spending, the first thing to make sure of is that there is enough money in the account that is used to buy something.
In a blockchain network, every transaction is a computer file. That file consists of the sender’s and recipient’s public keys, which is used to identify the sender and receiver on the network. The public key is the address to the digital wallet of both sender and receiver. Also included in the file is the amount of currency transferred. In order for the transaction to be approved initially, the sender and must sign the transaction using their private key. Finally, the details of the transaction are sent to every other computer in the blockchain network. There is one more important step: in a cryptocurrency network, there are miners. A miner is simply a computer that confirms transactions by solving a cryptographic puzzle. Everyone on the network can run a miner. If you do so, you have a chance to get paid some cryptocurrency as thanks for your help. Miners check transactions and mark them as legal and spread the confirmed transaction across the network. Each computer in the network then adds the transaction to its copy of the ledger. Importantly, once a transaction is confirmed and stored in the blockchain, it can never be reversed or forgotten.
New cryptocurrency tokens are generated or released into the economy using mining. Every time a miner gets the puzzle right, they receive a small reward of cryptocurrency. In most cryptocurrencies, this is the only way that new tokens (coins) can be generated, and this controls the rate of inflation.
What all of this means is that a cryptocurrency network is based on the absolute consensus of everyone participating in the network about whether account balances and transactions are legal or not. In fiat currencies, there is no consensus but a central authority that makes this decision. The process of keeping consensus is based on various rules and is ensured by very good cryptography. This is the main reason why cryptocurrencies are called just that: cryptocurrency.
Governments, law enforcement, tax authorities, and others are not all of them happy about cryptocurrencies. There is a lot of debate about how cryptocurrencies should be implemented and used, if at all.
One common argument against cryptocurrencies is that it is possible to design them in such a way that they cannot be controlled by governments.
This is one reason for there currently being a lot of debate about how cryptocurrencies fit within all the rules and regulations around money and economies.
Another commonly voiced concern about cryptocurrencies is that they can be used almost anonymously. Some people are worried that this will make it easier for traders of illegal goods like drugs or endangered animals to trade without being caught by the police. There is also concern that cryptocurrency can be used for money laundering (when money acquired through crime is processed, so their origin is hidden) and tax evasion.
While these concerns are valid, it is worth pointing out that ‘normal money’ or fiat currencies are also used for money laundering and tax evasion. Whether cryptocurrencies make it easier or harder to conduct illegal trade is currently being debated by a lot of people, but it is worth noting that the underlying problem is money laundering rather than the currency in question.
On a final note, you might be wondering why people think cryptocurrencies like Bitcoin are valuable when they just exist as code on some networked computers. This is, however, not much different from fiat currencies, which have value only to the degree that we have faith in the government controlling them. Cryptocurrency tokens or coins become valuable if there is a community of people that believe in the purpose of the coins and the networks.
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