How does cryptocurrency work?
A cryptocurrency is a digital coin that operates on a blockchain network. It uses cryptography to secure transactions, control the supply, and verify transfers.
Blockchains act as digital databases, storing cryptocurrency transactions in blocks. These blocks require complex mathematical calculations for their recording and verification.
Cryptocurrency coins and tokens are stored in digital wallets or on exchanges, and are secured using a unique public-private key pairing that verifies the ownership of the currency. Cryptocurrencies enable the use of applications and services on a blockchain, facilitate the payment for goods and services, and can be traded.
The story of cryptocurrency began in 2009 with the launch of Bitcoin (BTC), the first decentralized cryptocurrency, created by an individual or group under the pseudonym Satoshi Nakamoto. Cryptocurrencies have since become popular among traders and are now recognized as an asset class. The Bitcoin White Papaer explains how Bitcoin works.
The success of Bitcoin inspired the creation of many other alternative cryptocurrencies, known as altcoins. These seek to address some of Bitcoin’s perceived shortcomings, such as its energy-intensive mining process and high transaction costs, by reducing fees and fostering competition.
Key Features of Cryptocurrencies:
Decentralized: Cryptocurrencies have no central authority, differentiating them from fiat currencies, which are controlled by governments and central banks. Instead, cryptocurrency transactions are processed and validated by an open and distributed network.
Immutable and Irreversible: The immutability of cryptocurrencies is based on several principles: it should be impossible for anyone but the holder of a private key to move crypto assets. All transactions are recorded on the blockchain, and its consensus mechanism should prevent any transaction from being hidden or altered.
Anonymous: Typically, cryptocurrency holders do not need to identify themselves when making transactions. They use their digital identities and digital wallets to authenticate transactions securely. It is important to note that blockchain wallet addresses are not completely anonymous—they are pseudonymous, meaning they act as placeholders for the wallet owner’s identity.
Scarcity or Limited Supply: Unlike fiat currencies, which have an unlimited supply and can be manipulated through monetary policy, many cryptocurrencies have a limited and predefined supply coded into their underlying algorithms, potentially making them deflationary. Some of the most popular cryptocurrencies, like Bitcoin, have a fixed or capped maximum supply, while others might increase their supply on a predetermined schedule or have the option to add new supply in the future as the project develops.
Types of Cryptocurrencies:
Bitcoin: As the first cryptocurrency, Bitcoin remains the world's leading cryptocurrency by market capitalization. It operates as a global peer-to-peer digital payment system that allows parties to transact directly without the need for intermediaries such as banks. Often referred to as a digital alternative to fiat currencies and gold.
Altcoins: Defined as alternative cryptocurrencies to Bitcoin, altcoins can vary from Bitcoin in several ways. Some may feature different economic models, while others might utilize unique underlying algorithms or block sizes. Altcoins cover a wide array of uses. For instance, Ethereum, the world's first programmable blockchain, enables developers to build and deploy decentralized applications (dApps) and smart contracts.
Tokens:
Unlike Bitcoin and altcoins, tokens do not operate on their own blockchains. Instead, they are built on top of existing cryptocurrency blockchains. The Ethereum blockchain, for instance, hosts a significant number of tokens, including Chainlink (LINK) and Basic Attention Token (BAT).
Stablecoins:
Stablecoins aim to maintain a stable value and are typically pegged 1:1 to fiat currencies or other assets. Major stablecoins, such as Tether (USDT) and USD Coin (USDC), are pegged to the US dollar. They can be backed by fiat or cryptocurrency reserves or controlled by algorithms, though events like the depegging of TerraUSD in 2022 have shown that algorithmic backing may not always be reliable.
Exchange Tokens:
Exchange tokens are cryptocurrencies created by crypto exchanges for use primarily within their own platforms for trading and paying for services. Examples include Binance Coin (BNB), Huobi Token (HT), and KuCoin Shares (KCS).
Central Bank Digital Currencies (CBDCs):
CBDCs are digital currencies issued or backed by a central bank. The People’s Bank of China, for example, is developing its digital yuan. The Bank of England has also explored the idea of a digital pound, humorously suggesting the nickname Britcoin.
References:
[1] Nakamoto, Satoshi. A Peer-to-Peer Electronic Cash System, bitcoin.org/bitcoin.pdf.
[2] Bylund, Anders. “What Is Blockchain Technology?” The Motley Fool, 30 Nov. 2023, www.fool.com/terms/b/blockchain/#:~:text=Each%20block%20consists%20of%20a,any%20of%20the%20blockchain’s%20data.
[3] Ethereum: ethereum.org/en/
[4] Seth, Shobhit. “What Is a Central Bank Digital Currency (CBDC)?” Investopedia, Investopedia, www.investopedia.com/terms/c/central-bank-digital-currency-cbdc.asp.
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