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By the end of this article you will understand:
1. What cryptocurrency is
2. The difference between cryptocurrencies like Bitcoin and government-issued currencies (fiat)
3. The distinction between cryptocurrency and blockchain
4. In simple terms how cryptocurrencies work
What is cryptocurrency?
A cryptocurrency is a new form of digital value secured by cryptography rather than the authority of a central bank. Cryptography is a method of protecting information through codes to ensure only the intended recipient can access it. This explains the root of the word ‘cryptocurrency’: a combination of cryptography and currency.
Cryptocurrency transactions are recorded in digital ledgers called blockchains and shared across a network of computers rather than in one central bank database, a quality described as decentralised.
The independence from manipulation that decentralisation lends cryptocurrencies is one of their defining features. We’ll explore all the benefits of cryptocurrency below, along with their limitations and the difficulty of assessing their potential value.
Bitcoin: the first cryptocurrency
Bitcoin was the first cryptocurrency. It was created by a person or group of people going by the pseudonym Satoshi Nakamoto. Satoshi published the Bitcoin Whitepaper explaining how it worksin October 2008.
Bitcoin is also the name of the blockchain-based system that creates and supports bitcoin, its cryptocurrency.
The distinction between the digital money units and the blockchain that supports it is often lumped together under the term cryptocurrency or ‘crypto’ for short. Crypto is also used as a catchall reference to the growing ecosystem of businesses and services in this space.
In this article, we’ll explain how the two components – cryptocurrency units and blockchains – work together to give cryptocurrencies their unique characteristics. We’ll also explore where the value of cryptocurrencies comes from.
Comparing cryptocurrencies to existing money
To explain how cryptocurrencies work, let’s compare Alice using her bank to send Bob £20 vs the same process using a cryptocurrency like bitcoin.
How banking transactions work
Alice will likely use a banking app on her smartphone to create a transaction using the details Bob provides, some of them personal, that identify his bank account.
Both Alice and Bob’s banks will then run checks to ensure the transaction is valid and no rules have been broken. This process can take time and apply costs, especially if Alice and Bob are in different countries.
Alice could use alternative payment methods to her bank to send Bob that £20, but the process happening in the background is essentially the same, with specific restrictions, rules, and centralised control.
That centralised system is known as fiat money,referring to the powergovernments have to control the supply of money as well as how it can be used.
How cryptocurrency transactions work
Alice could also use cryptocurrency to send Bob the equivalent of £20 in digital value by following a similar set of steps. But the process happening in the background is different.
Using Bitcoin as an example, Alice can also use an app on her phone described as a bitcoin wallet. After opening her bitcoin wallet, Alice will enter Bob’s bitcoin address – a long string of letters and numbers –rather than his bank account details.
For Alice’s bitcoin to reach Bob, it isn’t cleared by a central system; instead, a network of independent users all agree on how much bitcoin Alice has sent Bob, and their new balances are recorded into a shared ledger called a blockchain.
This process of reaching the agreement that Alice sent Bob £20 worth of bitcoin requires the network to follow a set of rules on how the Bitcoin network should function.
These rules are defined in a piece of software called the Bitcoin Protocol. Decentralisation protects the Bitcoin Protocol from changes except by majority agreement.
The Bitcoin Protocol requires Alice to provide a valid cryptographic key (like a password) to prove she controls a bitcoin address with enough units to send to Bob.
The job of the network members (Nodes) is to listen for new transactions, like the one from Alice to Bob, bundle them together in blocks and agree that Alice followed the rules and provided the correct key. The new block is then added to the existing chain of blocks.
This agreement process is known as a consensus mechanism. Consensus mechanisms differ between blockchains, giving unique characteristics to the cryptocurrency that each support. This partly explains why there are so many cryptocurrencies and, as we’ll explain below, why their values differ.
Examples of consensus mechanism
Bitcoin’s consensus mechanism is called proof-of-work because it relies on specific types of Nodes, called miners. Miners must prove they have done sufficient work to earn the right to update the details of new transactions, like the one between Alice and Bob, then add them to the blockchain.
Mining doesn’t involve digging, as the name might suggest. Instead, it’s about finding a solution to a complex maths puzzle. The work that goes into solving the puzzle maintains the accuracy and integrity of transactions and, in return, miners receive a reward of new bitcoin.
Mining is the only way the system generates new bitcoin; a key differentiator with the fiat money system, where central bank committees make decisions on the money supply.
There are many different types of blockchain. Each type takes a different approach to reaching consensus, but all are focused on doing this without a central point of failure.
Another example is Proof-of-Stake, the consensus mechanism used by Ethereum. Proof-of-Stake offers use cases beyond sending digital payments, which is why the definition of cryptocurrency in our introduction refers to sending digital value, not just money.
Ethereum & different cryptocurrency use cases
Launched in 2015, Ethereum supports a cryptocurrency called ether. Ether can be used as digital money but also to pay for renting decentralised computer power from Ethereum (a bit like using a remote cloud server such as Amazon Web Services).
Ethereum’s computing power (described as the Ethereum Virtual Machine or EVM) can support any service that can be coded into an instruction called a Smart Contract.
The beauty of Ethereum is that, unlike Amazon, Google or Apple, it isn’t a gated service. The decentralised applications it supports, often abbreviated to dApps, can include:
- Creating and exchanging non-fungible tokens (NFTs)
- DeFi applications for lending or borrowing cryptocurrency
- Gaming, metaverse or gambling services
In these use cases, ether is the unit of currency within that application, with transactions settled on the Ethereum blockchain.
One of the clever features Ethereum supports is the creation of distinct cryptocurrencies with separate identities and supplies. So long as these cryptocurrencies follow a set of agreed standards, Ethereum will act as the settlement layer, charging fees for processing transactions. An example is Shiba Inu, a dog themed cryptocurrency built on Ethereum.
Ethereum is just one type of blockchain offering this facility; there are many more such as Solana, Avalanche or the Binance Smart Chain. Each supports their native cryptocurrency to pay for computing power but also custom currencies and dApps.
What is cryptocurrency? A recap
A cryptocurrency is a new form of digital value secured by cryptography rather than the authority of a central bank.
Transactions are recorded in shared digital ledgers called blockchains via a network of computers, a quality described as decentralised.
Bitcoin was the first cryptocurrency. Launched in 2009, it follows a set of rules called the Bitcoin Protocol. Making a bitcoin transaction requires a cryptographic key, like a password.
Successful transactions are recorded in data blocks, which make up the bitcoin blockchain.
For its network to be decentralised but agree about the accurate state of bitcoin balances, special participants called Miners follow a consensus method called proof-of-work. Miners expend computing power to compete in a lottery, run every ten minutes, where the winner is rewarded with bitcoin.
Ethereum was launched in 2015 and supports a cryptocurrency called ether. Ether can be used as digital money but equally as a way to pay for renting decentralised computer power from Ethereum.
Ethereum supports decentralised applications (dApps). You can use dApps in a range of areas including:
- Creating & exchanging non-fungible tokens (NFTs)
- Lending or borrowing cryptocurrency
- Gaming and gambling in the metaverse
Ethereum also supports the creation of distinct cryptocurrencies with separate identities and supplies. These cryptocurrencies must follow a set of agreed standards called ERC-20.