What Is Cryptocurrency?

A Step-by-Step Guide to Blockchain-based Money

By: Rahul Nambiampurath Loading...

What Is Cryptocurrency?

The 21st century arguably changed course with the advent of blockchain technology. One of its key features, of course, is cryptocurrency, the digital money powered by blockchain’s peer-to-peer (P2P) mechanics.

Thirteen years after the introduction of Bitcoin, these digital assets reached a turning point in 2021 in terms of adoption. According to a survey by Gemini, 41% of new crypto owners bought their first coins in 2021.

Crypto-curious — people who don’t own cryptocurrency, but are interested, continue to rise, at 41% globally. Source: Gemini 2022 State of Crypto Report

Will we see a future in which cryptocurrency replaces fiat money? To find unpack that question let’s discuss money.

What Is Currency?

Modern currencies managed by central banks government officials. This is why money is called fiat (decree) currency. The central bank operates by decree from the state, and in tandem with policymakers, central bankers help set the value of money by using interest rates and regulating the printing of currency by national mints.

In times of crisis such as the 2008 subprime mortgage crash or the Covid-19 pandemic in 2020, central banks may take emergency actions to support economic stability.

In the second and third quarters of 2020, for example, the Federal Reserve increased its balance sheet by $4.5T to mitigate the economic contraction after the U.S. went into a series of lockdowns to stop the spread of Covid. (Lawmakers also flooded the economy with cash by distributing stimulus payments directly to companies and households, a policy that directly led to the boom in cryptocurrency valuations through 2021).

From one financial crisis to the next, the Fed skyrockets its total balance sheet, making it difficult to discern true value. Source: Board of Governors of the Federal Reserve System (US)

There are consequences to creating more money, though. The Fed made each banknote less valuable. This triggered the worst bout of consumer price inflation in 40 years and prompted the Fed to raise interest rates. As a result, investors shifted en masse from risk assets such as equities and cryptocurrencies into cash.

Previous Digital Money Attempts

Satoshi Nakamoto, the mysterious creator of Bitcoin, designed his invention to circumvent the central bank system by using the internet. Yet there were earlier attempts to create digital currencies. In 1990, DigiCash issued electronic money called eCash. It used cryptography to encrypt sending and receiving data, which allowed for private transactions.

Still, as a company DigiCash was centralized. In 1998, it went bankrupt, and eCash perished with it.

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Another attempt was made in 1996 by Dr. Douglas Jackson and Barry Downey. They created e-gold, in which electronic money is pegged to the precious metal. Instead of trading physical gold, users could trade a synthetic version of gold online. These two attempts failed because they weren’t decentralized.

In 1998, computer scientist Nick Szabo developed the concept of cryptocurrency as we know it. His take was called Bit Gold and it used mining, cryptography, a public ledger, and a peer-to-peer network. Some argue this paved the way for the first true cryptocurrency — Bitcoin.

Cryptocurrency Explained

The “crypto” part in cryptocurrency means that all transactions are encrypted. While this entails financial privacy, it exists as long as one’s wallet address is not linked to a real identity.

A digital wallet manages encryption, and is unlocked with a private key. As a result, digital wallets are called non-custodial, in contrast to custodial wallets which are cryptocurrency exchange accounts at Binance or Coinbase.

Digital wallets unlock access to a blockchain network. For example, a user called Stefan Thomas lost access to 7,002 Bitcoins he bought early on, losing hundreds of millions of dollars.

That’s because he no longer has the key to access the blockchain network or more precisely, to unlock the part of the ledger that recorded his transaction.

How Do Cryptocurrencies Work

In technical terms, cryptocurrency is a software program and part of a digital network. The cryptocurrency architecture consists of:

  • Source code: It sets the cryptocurrency’s total coin supply and the schedule with which new coins are released.
  • Mining or validation: Whether it is Proof of Work (mining) or Proof of Stake (validation), these consensus algorithms ensure there is no double-spending. The latter is the difficulty with which someone can duplicate crypto coins or spend them at more than one instance.

A blockchain network consists of nodes — the computers that maintain it. Each blockchain full node keeps a copy of the entire transaction ledger, which is continually updated by miners/validators.

Solving the double-spending problem is the key that unlocks cryptocurrency value. For example, if you spend $5 on an ice cream, you cannot revert that transaction without physically sneaking in and stealing the banknote back. With digital currencies, we are dealing with intangible code.

A blockchain network such as Bitcoin uses miners to verify each transaction and add thousands of them to the ledger as a new data block.

Source: Bitfeed

Each data block is time-stamped and forms a continuous chronological chain. In other words, if someone were to tamper with it, they would have to branch off a new blockchain with the fraudulent transaction as the Genesis block — the starting point of a new ledger. This is why the Bitcoin blockchain is immutable.

Without this immutability provided by miners, as they exert their cryptographic hash power, cryptocurrency could be easily subverted and rendered worthless.

Moreover, there needs to be a cost involved in the subversion itself. In the case of Proof of Work cryptocurrencies like Bitcoin, this cost is enormous because miners use energy-intensive ASIC machines to verify transactions and add blocks.

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Then, they generate a hash as their Proof of Work. An entire nation-state would have to coordinate and produce enough hash rate power to attempt such subversion. And even then, it would fail because other miners would coordinate to kick them out.

Cryptocurrencies are self-maintaining because miners receive rewards to process transfers. This gives them a powerful incentive to maintain the network in good faith.

Every time someone pays a fee to transfer cryptocurrencies, this fee goes to miners/validators. Because of this, a cryptocurrency like Bitcoin doesn’t need to have any owners, CEOs, accounting department, or customer support.

Without these central points of failure, cryptocurrency maintains itself, and it monetizes itself. This is why it gains value as a decentralized, trustless asset that cannot be subverted. One should keep this in mind when valuing thousands of other cryptocurrencies.

Series Disclaimer:

This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.