Cryptocurrency is a digital currency that uses encryption (cryptography) to generate money and to verify transactions. Transactions are added to a public ledger – also called a Transaction Block Chain – and new coins are created through a process known as mining.
As of 2017, cryptocurrency has been used as a decentralized alternative to traditional fiat currencies (which are usually backed by some central government) such as the US dollar (USD).
For the average person using cryptocurrency is as easy as:
• Get a digital wallet to store the currency.
• Use the wallet to create unique “public addresses” to receive currency.
• Transfer funds in or out of your wallet using public addresses.
What is a cryptocurrency address? A public address is a unique string of characters used to receive cryptocurrency. Each public address has a matching private address that can be used to prove ownership of the public address. With Bitcoin the address is called a Bitcoin address. Think of it like a unique email address that people can send currency to as opposed to emails.
The first decentralized digital cryptocurrency can be traced back to “Bit Gold”, which was worked on by Nick Szabo between 1998 and 2005. Bit gold is considered the first precursor to bitcoin. In 2008, Satoshi Nakamoto (an anonymous person and/or group) released a paper detailing what would become Bitcoin.
Bitcoin became the first decentralized digital coin when it was created in 2008. It then went public in 2009. As of 2015, Bitcoin is the most commonly known cryptocurrency. Given the popularity of Bitcoin as well as its history, the term “altcoin” is sometimes used to describe alternative cryptocurrencies to bitcoin.
As of mid-2017, there were over 800 different types of cryptocurrencies – or altcoins – for trade in online markets and about 10 of them have market capitalizations of more than $1 Billion USD. At the time of writing this, the total market capitalization of all cryptocurrencies has eclipsed $70 billion!
In other words, cryptocurrency isn’t just a fad, it is likely a growing market that (despite its pros and cons) is likely here for the long haul.
Public Ledgers: All confirmed transactions from the start of a cryptocurrency’s creation are stored in a public ledger. The identities of the coin owners are encrypted, and the system uses other cryptographic techniques to ensure the legitimacy of record keeping. The ledger ensures that corresponding “digital wallets” can calculate an accurate spendable balance. Also, new transactions can be checked to ensure that each transaction uses only coins currently owned by the spender. Bitcoin calls this public ledger a “transaction block chain“.
Transactions: A transfer of funds between two digital wallets is called a transaction. That transaction gets submitted to a public ledger and awaits confirmation. When a transaction is made, wallets use an encrypted electronic signature (an encrypted piece of data called a cryptographic signature) to provide a mathematical proof that the transaction is coming from the owner of the wallet. The confirmation process takes a bit of time (ten minutes for bitcoin) while “miners” mine (ie. confirm transactions and add them to the public ledger).
Mining: In simple terms, mining is the process of confirming transactions and adding them to a public ledger. In order to add a transaction to the ledger, the “miner” must solve an increasingly complex computational problem (sort of like a mathematical puzzle). Mining is open source, so anyone can confirm the transaction. The first “miner” to solve the puzzle adds a “block” of transactions to the ledger. The way in which transactions, blocks, and the public blockchain ledger work together ensures that no one individual can easily add or change a block at will. Once a block is added to the ledger, all correlating transactions are permanent and a small transaction fee is added to the miner’s wallet (along with newly created coins). The mining process is what gives value to the coins and is known as a proof-of-work system.
Although there can be exceptions to the rule, there are a number of factors (beyond the basics above) that make cryptocurrency so different from the financial systems of the past:
Adaptive Scaling: Adaptive scaling essentially means that cryptocurrencies are built with a number of measures to ensure that they will work well in both large or small scales.
Adaptive Scaling Example: Bitcoin is programmed to allow for one transaction block to be mined every ten minutes. The algorithm adjusts after every 2016 blocks (theoretically, that’s every two weeks) to get easier or harder based on how long it actually took for those 2016 blocks to be mined. So if it only took 13 days for the network to mine 2016 blocks, that means it’s too easy to mine, so the difficulty increases. However, if it takes 15 days for the network to mine 2016 blocks, that shows that it’s too hard to mind, so the difficulty decreases.
A number of other measures are included in digital coins to allow for adaptive scaling including limiting the supply overtime (to create scarcity) and reducing the reward for mining as more total coins are mined.
Cryptographic: Cryptocurrency uses a system of cryptography (AKA encryption) to control the creation of coins and to verify transactions.
Decentralized: Most currencies in circulation are controlled by a centralized government, and thus their creation can be regulated by a third party. Cryptocurrency’s creation and transactions are open source, controlled by code, and rely on “peer-to-peer” networks. There is no single entity that can affect the currency.
Digital: Traditional currency is defined by a physical object (USD representing gold for example), but cryptocurrency is all digital. Digital coins are stored in digital wallets and transferred digitally to other peoples’ digital wallets. No physical object ever exists.
Open Source: Cryptocurrencies are typically open source. That means that developers can create APIs without paying a fee and anyone can use or join the network.
Proof-of-work: Most cryptocurrencies use a proof-of-work system. A proof-of-work scheme uses a hard-to-compute but easy-to-verify computational puzzle to limit exploitation of cryptocurrency mining. Essentially, it’s like a really hard to solve “catpcha” that requires lots of computing power.
Pseudonymity: Owners of cryptocurrency keep their digital coins in an encrypted digital wallet. A coin-holder’s identification is stored in an encrypted address that they have control over – it is not attached to a person’s identity. The connection between you and your coins is pseudonymous rather than anonymous as ledgers are open to the public (and thus, the ledgers could be used to glean information about groups of individuals in the network).
Value: For something to be an effective currency, it has to have value. The US dollar used to represent actual gold. The gold was scarce and required work to mine and refine, so the scarcity and work gave the gold value. This, in turn, gave the US dollar value.
Cryptocurrency works with a similar concept. In cryptocurrency, “coins” (which are nothing more than publicly agreed on records of ownership) are generated or produced by “miners”. These miners are people who run programs on specialized hardware made specifically to solve proof-of-work puzzles. The work behind mining coins gives them value, while scarcity of coins and demand thereof causes their value to fluctuate. The idea of work giving value to currency is called a “proof-of-work” system. The other method for validating coins is called proof-of-stake. Value is also created when transactions are added to public ledgers as creating a verified “transaction block” takes work as well.