What is the idea of cryptocurrency, and how does it work?

A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.

Understanding Cryptocurrencies

Cryptocurrencies are systems that allow for the secure payments online which are denominated in terms of virtual "tokens," which are represented by ledger entries internal to the system. "Crypto" refers to the various encryption algorithms and cryptographic techniques that safeguard these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions.

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Types of Cryptocurrency

The first blockchain-based cryptocurrency was Bitcoin, which still remains the most popular and most valuable. Today, there are thousands of alternate cryptocurrencies with various functions and specifications. Some of these are clones or forks of Bitcoin, while others are new currencies that were built from scratch.

Bitcoin was launched in 2009 by an individual or group known by the pseudonym "Satoshi Nakamoto." As of Nov. 2019, there were over 18 million bitcoins in circulation with a total market value of around $146 billion.

Some of the competing cryptocurrencies spawned by Bitcoin’s success, known as "altcoins," include Litecoin, Peercoin, and Namecoin, as well as Ethereum, Cardano, and EOS. Today, the aggregate value of all the cryptocurrencies in existence is around $214 billion—Bitcoin currently represents more than 68% of the total value.

How Cryptocurrency Works: a Step-by-Step Guide

So, how does this all work? Whilst much of the language of cryptocurrency can be somewhat alienating, it’s not all as tricky as it might seem. To explain it simply, we can break down the cryptocurrency process into a three-stage cycle – involving a transaction, the blockchain, and a process known as “mining”.

Here, we’ll take a look at this process in a little more detail. However, know that, given the sheer number of different cryptocurrencies, not all of them work in the same way. Whilst this process is true of Bitcoin and Bitcoin Cash, say, it is not true of Ripple (XRP).

Start with a Transaction

Let’s start with the cryptocurrency basics: the transaction itself. Nothing happens at all unless someone transfers some coins to someone else.

So, x sends money to y, through a digital wallet that stores the cryptocurrency. Unlike conventional currency, however, that payment is not facilitated by a central bank, clearinghouse, or system like SWIFT. Rather, it is transferred directly from person to person – or, in the language of crypto, from peer to peer. In this way, crypto transactions tend to be quicker and cheaper than transfers in conventional currency.

But how does this happen? Enter the blockchain.

The Blockchain

As we said above, the blockchain is the technology that enables cryptocurrency to function in a decentralized manner. In its simplest terms, it is a record or ledger in which the details of transactions are recorded – yet, it does have some specific features.

The technology gets its name from the fact that “blocks” of information are linked together in a “chain”. This is crucial for crypto’s security, as the information recorded in a given block is dependent on the information in the prior block, and so on. This way, you cannot change the information in one block without changing the entire chain – making hacking extremely difficult.

If x gives money to y, this transaction will be recorded in a block: the sender and recipient, the sum, and a timestamp. What also needs to be included is a cryptographic proof – a complex mathematical problem requiring serious computer power to solve – that verifies that this transaction happened and that determines the block’s place in the chain. We’ll come to how this is produced in a moment.

Crucially, though, the blockchain is not located in any one specific place. Rather, it is “decentralized”, or held on multiple servers across the world. All of these different versions are updated simultaneously: change one and you have to change them all.