When we think of money, we usually think of the basic concepts we’ve known since childhood. You know, “Schoolhouse Rock”-level details: Governments decide to print money. They back it with a guarantee so people will trust it. We use our names and social security numbers to open accounts at banks that hold our money for us. That money is typically insured up to a point to maintain stability and confidence in the financial system.
Well, cryptocurrency deviates from all of that. It’s generally not controlled by a government, not held in a bank, and not tied to a person’s name. That’s why understanding crypto can feel so abstract.
What is cryptocurrency, and how does it work? The answer isn’t as simple as, say, how a dollar functions. But once you understand the basics, it’s not as complex as you might think.
So let’s get you more information. Cryptocurrency 101 is now in session.
What is cryptocurrency and how it works
A cryptocurrency is a digital asset that’s built on a network of computers connected across the world. That means there’s no single group in charge of issuing and managing the currency; it’s decentralized.
That’s one of its defining characteristics: Cryptocurrencies generally operate outside of the concept of a central authority, unlike traditional “fiat” currencies such as the American dollar and British pound. Those currencies are issued and backed by governments, which can change monetary policy or take other actions that may affect a currency’s value.
Cryptocurrencies are “backed” by cryptographic systems. For example, new cryptocurrency tokens may be created when a computer solves arbitrary math puzzles. Those tokens are stored in online wallets that can be accessed only with a crypto “key,” or password. And complex algorithms help record and secure transactions between users.
The transaction record is another major defining feature of cryptocurrencies. They’re often built on a system called the blockchain, which functions like a public online ledger. Anyone can view a record of all of the transactions in a given cryptocurrency.
A batch of transactions is recorded as a chunk of data called a block, and when those transactions are verified they’re added to the ledger—creating a chain of blocks. Every block contains information like the time and date of the transactions, usernames involved, and the value of the cryptocurrency.
Blockchain depends on that decentralized network of computers, each of which is called a node in cryptocurrency. Every node has a copy of all records. Because no single person is in control, it’s near-impossible to cheat the system—it would catch, for example, an attempt to duplicate a token.
Typically when a user wants to make a transaction their computer sends a message to the rest of the network asking for permission—and if it’s verified by the other computers, they add it as the next block in the chain. That data can’t be altered or deleted, so blockchain ensures transactions are not only transparent but also secure.
What is cryptocurrency mining?
Now you have the basics about the system that cryptocurrencies and their transactions are built upon. So let’s get into how the cryptocurrencies themselves are created and exchanged.
Launching an entirely new cryptocurrency usually involves an initial coin offering (ICO). Typically the makers of the new cryptocurrency create blockchain-based tokens and sell them to users in exchange for existing cryptos like Bitcoin. The creators can use that fundraising to build out their platform or project, and the buyers may use the tokens for accessing services, purchasing products, treating like an investment, or trading on exchanges.
Once a cryptocurrency has launched, new “coins” or tokens in that currency may be created in a few ways—often one of two so-called consensus mechanisms that help verify and secure transactions.
The first method is called proof-of-work (PoW). It’s what the No. 1 and 2 cryptocurrencies by market capitalization, Bitcoin and Ethereum, were initially built upon. Advanced computers act as “miners” for cryptocurrency, solving complex math puzzles to verify transactions on a blockchain—and they receive newly minted tokens in return. This method is very secure, but the major downside is that all of that computing work requires tons of energy usage.
The second major method is proof-of-stake (PoS), which Ethereum is transitioning to. Users are called validators, and they agree to “staking,” or holding onto, a certain amount of their tokens. The more they stake, the more likely they’ll be selected to validate transactions and earn new tokens as a reward. PoS uses vastly less energy than PoW and is often quicker. One con is that users who amass lots of tokens can have an outsize effect on the system.
What is cryptocurrency trading?
Users can buy, sell and trade tokens on cryptocurrency exchanges like Binance and Coinbase. To participate you’ll create an account and deposit funds—either cryptocurrency you own or fiat currency transferred from a bank account—and place an order to buy or sell.
The tokens are stored in programs called cryptocurrency wallets that have two main parts: A public key, which is a sort of address through which other users can send you tokens, and a private key that’s like a password kept only to yourself. Some wallets are software on your computer or phone, while others are “cold” hardware wallets that are physical devices like hard drives that are considered more secure because they don’t stay connected to the internet.
Note that the cryptocurrency market tends to be volatile, with major swings higher and lower depending on the specific token and general market sentiment. The future of cryptocurrency may be fascinating to consider—but as a pure investment, it’s not for the faint of heart or the conservative of wallet.
