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What Is Cryptocurrency – How It Works, History & Bitcoin Alternatives

Cryptocurrencies, or virtual currencies, are digital means of exchange created and used by private individuals or groups.

Because most cryptocurrencies aren’t regulated by national governments, they’re considered alternative currencies — mediums of financial exchange that exist outside the bounds of state monetary policy.

Bitcoin (BTC) is the preeminent cryptocurrency and the first to be used widely. However, hundreds of cryptocurrencies exist, and more spring into being every month.

Non-Bitcoin cryptocurrencies are collectively known as “altcoins” to distinguish them from the original.

What Is Cryptocurrency? An Introduction to Crypto

Functionally, most cryptocurrencies are variations on Bitcoin, the first widely used cryptocurrency.

Like traditional currencies, cryptocurrencies express value in units — for instance, you can say “I have 2.5 Bitcoin,” just as you’d say, “I have $2.50.”

Due to their political independence and essentially impenetrable data security, cryptocurrency users enjoy benefits not available to users of traditional fiat currencies, such as the U.S. dollar, and the financial systems that those currencies support.

For instance, whereas a government can easily freeze or even seize a bank account located in its jurisdiction, it’s very difficult for it to do the same with funds held in cryptocurrency — even if the holder is a citizen or legal resident.

On the other hand, cryptocurrencies come with a host of risks and drawbacks, such as illiquidity and value volatility, that don’t affect many fiat currencies.

Additionally, cryptocurrencies are frequently used to facilitate gray and black market transactions, so many countries view them with distrust or outright animosity.

And while proponents tout cryptocurrencies as potentially lucrative alternative investments, few serious financial professionals view most coins — with the important exception of Bitcoin and a few others — as suitable for anything other than pure speculation.

Pro tip: Are you planning to start investing in Bitcoin or another cryptocurrency? Coinbase is one of the largest platforms to buy and sell Bitcoin and many other altcoins.


How Cryptocurrencies Work

It’s true that the source codes and technical controls that support and secure cryptocurrencies are highly complex. However, laypeople are more than capable of understanding the basic concepts and becoming informed cryptocurrency users.

Several concepts govern cryptocurrencies’ values, security, and integrity.

Cryptography

Cryptocurrencies use cryptographic protocols, or extremely complex code systems that encrypt sensitive data transfers, to secure their units of exchange.

Cryptocurrency developers build these protocols on advanced mathematics and computer engineering principles that render them virtually impossible to break, and thus to duplicate or counterfeit the protected currencies.

These protocols also mask the identities of cryptocurrency users, making transactions and fund flows difficult to attribute to specific individuals or groups.

Blockchain Technology

A cryptocurrency’s blockchain is the master public ledger that records and stores all prior transactions and activity, validating ownership of all units of the currency at any given point in time.

As the record of a cryptocurrency’s entire transaction history to date, a blockchain has a finite length — containing a finite number of transactions — that increases over time.

Identical copies of the blockchain are stored in every node of the cryptocurrency’s software network — the network of decentralized server farms, run by computer-savvy individuals or groups of individuals known as miners, that continually record and authenticate cryptocurrency transactions.

A cryptocurrency transaction technically isn’t finalized until it’s added to the blockchain, which usually occurs within minutes. Once the transaction is finalized, it’s usually irreversible.

Unlike traditional payment processors, such as PayPal and credit cards, most cryptocurrencies have no built-in refund or chargeback functions, although some newer cryptocurrencies have rudimentary refund features.

During the lag time between the transaction’s initiation and finalization, the units aren’t available for use by either party. Instead, they’re held in a sort of escrow — limbo, for all intents and purposes.

The blockchain thus prevents double-spending, or the manipulation of cryptocurrency code to allow the same currency units to be duplicated and sent to multiple recipients.

Decentralized Control

Inherent in blockchain technology is the principle of decentralized control.

Cryptocurrencies’ supply and value are controlled by the activities of their users and highly complex protocols built into their governing codes, not the conscious decisions of central banks or other regulatory authorities.

In particular, the activities of miners — cryptocurrency users who leverage vast amounts of computing power to record transactions, receiving newly created cryptocurrency units and transaction fees paid by other users in return — are critical to currencies’ stability and smooth function.

Private Keys

Every cryptocurrency holder has a private key that authenticates their identity and allows them to exchange units. Users can make up their own private keys, which are formatted as whole numbers up to 78 digits long, or use a random number generator to create one.

Once they have a key, they can obtain and spend cryptocurrency. Without the key, the holder can’t spend or convert their cryptocurrency — rendering their holdings worthless unless and until the key is recovered.

While this is a critical security feature that reduces theft and unauthorized use, it’s also draconian. Losing your private key is the digital asset equivalent of throwing a wad of cash into a trash incinerator.

Although you can create another private key and start accumulating cryptocurrency again, you can’t recover the holdings protected by your old, lost key.

Savvy cryptocurrency users are therefore maniacally protective of their private keys, typically storing them in multiple digital locations — although generally not Internet-connected, for security purposes — and on paper or in other physical form.

Cryptocurrency Wallets

Cryptocurrency users have wallets with unique information that confirms them as the owners of their units.

Whereas private keys confirm the authenticity of a cryptocurrency transaction, wallets lessen the risk of theft for units that aren’t being used.

Wallets used by cryptocurrency exchanges are somewhat vulnerable to hacking. For instance, Japan-based Bitcoin exchange Mt. Gox shut down and declared bankruptcy a few years back after hackers systematically relieved it of more than $450 million in Bitcoin exchanged over its servers.

Wallets can be stored on the cloud, an internal hard drive, or an external storage device. Regardless of how a wallet is stored, at least one backup is strongly recommended.

Note that backing up a wallet doesn’t duplicate the actual cryptocurrency units, merely the record of their existence and current ownership.

Miners

Miners serve as record-keepers for cryptocurrency communities, and indirect arbiters of the currencies’ value.

Using vast amounts of computing power, often manifested in private server farms owned by mining collectives that comprise dozens of individuals, miners use highly technical methods to verify the completeness, accuracy, and security of currencies’ blockchains.

The scope of the operation is not unlike the search for new prime numbers, which also requires tremendous amounts of computing power.

Miners’ work periodically creates new copies of the blockchain, adding recent, previously unverified transactions that aren’t included in any previous blockchain copy — effectively completing those transactions.

Each addition is known as a block. Blocks consist of all transactions executed since the last new copy of the blockchain was created.

The term “miners” relates to the fact that miners’ work literally creates wealth in the form of brand-new cryptocurrency units.

In fact, every newly created blockchain copy comes with a two-part monetary reward: a fixed number of newly minted (“mined”) cryptocurrency units, and a variable number of existing units collected from optional transaction fees — typically less than 1% of the transaction value — paid by buyers.

Worth noting: Once upon a time, cryptocurrency mining was a potentially lucrative side business for those with the resources to invest in power- and hardware-intensive mining operations.

Today, it’s impractical for hobbyists without thousands of dollars to invest in professional-grade mining equipment. If your aim is simply to supplement your regular income, plenty of freelance gigs offer better returns.

Although transaction fees don’t accrue to sellers, miners are permitted to prioritize fee-loaded transactions ahead of fee-free transactions when creating new blocks, even if the fee-free transactions came first in time.

This gives sellers an incentive to charge transaction fees, since they get paid faster by doing so, and so it’s fairly common for cryptocurrency transactions to come with fees.

Although it’s theoretically possible for a new blockchain copy’s previously unverified transactions to be entirely fee-free, this almost never happens in practice.

Through instructions in their source codes, cryptocurrencies automatically adjust to the amount of mining power working to create new blockchain copies — copies become more difficult to create as mining power increases and easier to create as mining power decreases.

The goal is to keep the average interval between new blockchain creations steady at a predetermined level. Bitcoin’s is 10 minutes, for instance.

Finite Supply

Although mining periodically produces new cryptocurrency units, most cryptocurrencies are designed to have a finite supply — a key guarantor of value.

Generally, this means miners receive fewer new units per new block as time goes on. Eventually, miners will only receive transaction fees for their work, although this has yet to happen in practice and may not for some time.

If current trends continue, observers predict that the last Bitcoin unit will be mined sometime in the mid-22nd century, for instance — not exactly around the corner.

Cryptocurrencies’ finite supply makes them inherently deflationary, more akin to gold and other precious metals — of which there are finite supplies — than fiat currencies that central banks can, in theory, produce unlimited supplies of.

Cryptocurrency Exchanges

Many lesser-used cryptocurrencies can only be exchanged through private, peer-to-peer transfers, meaning they’re not very liquid and are hard to value relative to other currencies — both crypto- and fiat.

More popular cryptocurrencies, such as Bitcoin and Ripple, trade on special secondary exchanges similar to forex exchanges for fiat currencies. (The now-defunct Mt. Gox is one example of an exchange.)

These platforms allow holders to exchange their cryptocurrency holdings for major fiat currencies like the U.S. dollar and euro, and for other cryptocurrencies, including less-popular currencies.

In return for their services, they take a small cut of each transaction’s value — usually less than 1%.

Importantly, cryptocurrencies can be exchanged for fiat currencies in special online markets, meaning each has a variable exchange rate with major world currencies, such as the U.S. dollar, British pound, European euro, and Japanese yen.

Cryptocurrency exchanges play a valuable role in creating liquid markets for popular cryptocurrencies and setting their value relative to traditional currencies. You can even trade cryptocurrency derivatives on certain crypto exchanges or track broad-based cryptocurrency portfolios in crypto indexes.

However, exchange pricing can still be extremely volatile. For example, Bitcoin’s U.S. dollar exchange rate fell by more than 50% in the wake of Mt. Gox’s collapse, then increased roughly tenfold during 2017 as cryptocurrency demand exploded.

And cryptocurrency exchanges are somewhat vulnerable to hacking, representing the most common venue for digital currency theft by hackers and cybercriminals like those responsible for taking down Mt. Gox.


History of Cryptocurrency

Cryptocurrency existed as a theoretical construct long before the first digital alternative currencies debuted.

Early cryptocurrency proponents shared the goal of applying cutting-edge mathematical and computer science principles to solve what they perceived as practical and political shortcomings of “traditional” fiat currencies.

Before Bitcoin

Cryptocurrency’s technical foundations date back to the early 1980s when an American cryptographer named David Chaum invented a “blinding” algorithm that remains central to modern web-based encryption.

The algorithm allowed for secure, unalterable information exchanges between parties, laying the groundwork for future electronic currency transfers.

About 15 years later, an accomplished software engineer named Wei Dai published a white paper on b-money, a virtual currency architecture that included many of the basic components of modern cryptocurrencies, such as complex anonymity protections and decentralization.

However, b-money was never deployed as a means of exchange.

The late 1990s and early 2000s saw the rise of more conventional digital finance intermediaries.

Chief among them was PayPal, which made Tesla founder and noted cryptocurrency advocate Elon Musk’s first fortune and proved to be a harbinger of today’s mobile payment technologies that have exploded in popularity over the past 10 years.

But no true cryptocurrency emerged until the late 2000s when Bitcoin came onto the scene.

Bitcoin and the Modern Cryptocurrency Boom

Bitcoin is widely regarded as the first modern cryptocurrency — the first publicly used means of exchange to combine decentralized control, user anonymity, record-keeping via a blockchain, and built-in scarcity.

It was first outlined in a 2008 white paper published by Satoshi Nakamoto, a pseudonymous person or group.

In early 2009, Nakamoto released Bitcoin to the public, and a group of enthusiastic supporters began exchanging and mining the currency.

By late 2010, the first of what would eventually be dozens of similar cryptocurrencies — including popular alternatives like Litecoin — began appearing. The first public Bitcoin exchanges appeared around this time as well.

In late 2012, WordPress became the first major merchant to accept payment in Bitcoin. Others, including online electronics retailer Newegg.com, Expedia, Microsoft, and Tesla followed. Countless merchants now view the world’s most popular cryptocurrency as a legitimate payment method.

And new cryptocurrency applications take root with impressive frequency — Cryptomaniaks has a great look at the fast-growing world of cryptocurrency sports betting sites as just one example.

Although few cryptocurrencies other than Bitcoin are widely accepted for merchant payments, increasingly active exchanges allow holders to exchange them for Bitcoin or fiat currencies — providing critical liquidity and flexibility. Since the late 2010s, big business and institutional investors have closely watched what they call the “crypto space” too.

Facebook’s closely guarded Libra project could be the first true cryptocurrency alternative to fiat currencies, although its growing pains suggest that true parity remains well in the future.


Cryptocurrency Examples

Cryptocurrency usage has exploded since Bitcoin’s release.

Although exact active currency numbers fluctuate and individual currencies’ values are highly volatile, the overall market value of all active cryptocurrencies is generally trending upward. At any given time, hundreds of cryptocurrencies trade actively.

The cryptocurrencies described here are marked by stable adoption, robust user activity, and relatively high market capitalization (greater than $10 million, in most cases, although valuations are of course subject to change):

1. Bitcoin

Bitcoin is the world’s most widely used cryptocurrency and is generally credited with bringing the movement into the mainstream.

Its market cap and individual unit value consistently dwarf (by a factor of 10 or more) that of the next most popular cryptocurrency. Bitcoin has a programmed supply limit of 21 million Bitcoin.

Bitcoin is increasingly viewed as a legitimate means of exchange. Many well-known companies accept Bitcoin payments, although most partner with an exchange to convert Bitcoin into U.S. dollars before receiving their funds.

2. Ethereum

Launched in 2015, Ethereum (ETH) is the second most popular cryptocurrency and, on most days, the second most valuable after Bitcoin.

Ethereum makes some noteworthy improvements to Bitcoin’s basic architecture. In particular, it utilizes “smart contracts” that enforce the performance of a given transaction, compel parties not to renege on their agreements, and contain mechanisms for refunds should one party violate the agreement.

Although “smart contracts” represent an important move toward addressing the lack of chargebacks and refunds in cryptocurrencies, it remains to be seen whether they’re enough to solve the problem completely. Still, they’re at least partly responsible for Ethereum’s success.

3. Litecoin

Released in 2011, Litecoin (LTC) uses the same basic structure as Bitcoin. Key differences include a higher programmed supply limit (84 million units) and a shorter target blockchain creation time (2.5 minutes).

The encryption algorithm is slightly different as well. Litecoin is often the second- or third-most popular cryptocurrency by market capitalization.

4. Ripple

Released in 2012, Ripple (XRP) is noted for a “consensus ledger” system that dramatically speeds up transaction confirmation and blockchain creation times — there’s no formal target time, but the average is every few seconds.

Ripple is also more easily converted than other cryptocurrencies with an in-house currency exchange that can convert Ripple units into U.S. dollars, yen, euros, and other common currencies.

However, critics have noted that Ripple’s network and code are more susceptible to manipulation by sophisticated hackers and may not offer the same anonymity protections as Bitcoin-derived cryptocurrencies.

5. Dogecoin

Dogecoin (DOGE), denoted by its immediately recognizable Shiba Inu mascot, is a variation on Litecoin.

It has a shorter blockchain creation time (one minute) and a vastly greater number of coins in circulation — the creators’ target of 100 billion units mined by July 2015 was met, and there’s a supply limit of 5.2 billion units mined every year thereafter, with no known supply limit.

Dogecoin is thus notable as an experiment in “inflationary cryptocurrency,” and experts are watching it closely to see how its long-term value trajectory differs from that of other cryptocurrencies.

6. Coinye

Coinye, a semi-defunct cryptocurrency, is worth mentioning solely for its bizarre backstory.

Coinye was developed under the original moniker “Coinye West” in 2013, and identified by an unmistakable likeness of hip-hop superstar Kanye West. Shortly before Coinye’s release, in early 2014, West’s legal team caught wind of the currency’s existence and sent its creators a cease-and-desist letter.

To avoid legal action, the creators dropped “West” from the name, changed the logo to a “half man, half fish hybrid” that resembles West — a biting reference to a “South Park” episode that pokes fun at West’s massive ego — and released Coinye as planned.

Given the hype and ironic humor around its release, the currency attracted a cult following among cryptocurrency enthusiasts. Undaunted, West’s legal team filed suit, compelling the creators to sell their holdings and shut down Coinye’s website.

Although Coinye’s peer-to-peer network remains active and it’s still technically possible to mine the currency, person-to-person transfers and mining activity have collapsed to the point that Coinye is basically worthless.


Final Word

Cryptocurrency is an exciting concept with the power to fundamentally alter global finance for the better.

But while it’s based on sound, democratic principles, cryptocurrency remains a technological and practical work in progress. For the foreseeable future, nation-states’ near-monopoly on currency production and monetary policy appears secure.

In the meantime, cryptocurrency users (and nonusers intrigued by cryptocurrency’s promise) need to remain ever-mindful of the concept’s practical limitations.

Any claims that a particular cryptocurrency confers total anonymity or immunity from legal accountability are worthy of deep skepticism, as are claims that individual cryptocurrencies represent foolproof investment opportunities or inflation hedges.

After all, gold is often touted as the ultimate inflation hedge, yet it’s still subject to wild volatility — more so than many developed countries’ fiat currencies.

Brian Martucci
Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.

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