Understand what cryptocurrencies are and how they work
Understand what cryptocurrencies are and how they work
Most people first heard about cryptocurrencies in late 2017 when Bitcoin and other cryptocurrencies experienced a phenomenal price increase. Suddenly, all mainstream media outlets wanted a piece of the action. Without much to go on, they started using terms like cryptocurrency, digital cash, or token interchangeably, not understanding how confusing it all was to the average viewer. But what is a cryptocurrency? Now that the mania has calmed down, we have time to improve our understanding of this space.
Despite the scepticism of some established business leaders like Bill Gates or Warren Buffett, cryptocurrencies are here to stay, and we’d be foolish to ignore them purely on the advice of those they threaten. In this article, we’ll define what a cryptocurrency is, look at the technology that supports it, and identify the different types of cryptocurrencies out there.
A cryptocurrency is a digital currency that uses cryptography to secure and verify its transactions, recording them in a decentralised and immutable ledger known as blockchain. They can be used as a medium of exchange or a store of value, and are traded in many exchanges around the world.
They can be viewed as an alternative to standard national currencies, and they have value and are traded in a similar way on exchanges. Cryptocurrencies however have no physical form that you can take out of cash machines, for example, and exist only in the digital space. Digital cryptocurrency “coins” can be bought, sold, and converted back to fiat money on specialised cryptocurrency exchanges.
Cryptocurrencies operate independently from banks and act as an alternative form of payment to cash and credit cards. As such, it’s becoming increasingly popular in countries where banking institutions are unstable, as people would rather have full control of their money in a digital space rather than rely on the banks to keep their money safe. Another common example is using cyrptocurrencies to send money abroad to avoid large processing fees from banks.
Because cryptocurrency is still maturing however, the markets are much more volatile than standard foreign exchange markets, and so cryptocurrencies are currently more often used for investment purposes.
Cryptocurrencies first emerged with Satoshi Nakamoto’s Bitcoin whitepaper at the start of 2009. Although it was quite technical, this outlined a clear vision of a “purely peer-to-peer version of electronic cash (allowing) online payments to be sent directly from one party to another without going through a financial institution”.
In the last nine years, over 2,500 cryptocurrencies have appeared—a number which will inevitably increase over the coming years.
Cryptocurrencies can be divided into two categories: those that are supported by their own blockchains, like Ethereum and Bitcoin, and those built on top of other blockchains, also known as tokens.
When talking about cryptocurrencies and what is a cryptocurrency, it’s important to understand the concept of blockchain technology. Blockchain is the underlying technology powering cryptocurrencies. It’s used to create, update, and maintain a decentralised, trusted ledger of transactions which occur within a network. This network is made up of independently-owned nodes that use a cryptographic protocol to validate transactions in a cryptocurrency.
The protocol rewards accuracy in a way that ensures the data entered into the ledger cannot be wrong or subject to changes. It is immutable, secure, and completely transparent. Blockchain technology makes it possible to trust the information kept on that ledger without having to rely on a central institution like a bank. A lot of the hype surrounding cryptos comes mostly from the fact that virtually our entire economy does, in fact, rely on centralised institutions which guarantee trust in the whole system.
Analysts look at cryptos and recognise in them the potential to revolutionise the banking and finance industries. However, it’s important to remember these sectors have existed for centuries. In that time, banks have changed, but they’ve primarily remained in control of their destiny. To this end, large financial institutions have been keen to understand blockchain-powered cryptocurrencies. They have poured millions into research and development to understand and integrate the underlying technology, hoping this will allow them to stay ahead of the curve.
While Ethereum is an independent cryptocurrency with its own native token, Ether (ETH), ERC20 tokens such as OMG, JNT, or 0x are tokens that would not exist without Ethereum’s platform.
A token is merely a unit of value issued by an organisation, accepted by a community, and supported by an existing blockchain. That organisation sets it up within a particular business model to incentivise user interaction by distributing rewards among its network’s participants. These tokens have more uses but are most commonly divided into security tokens and utility tokens.
Security tokens are similar to traditional company shares since they derive their value from a tradable external asset. A utility token grants access to a company’s future product or service before it can be delivered, much like when a bookstore lets customers pre-order a book that hasn’t come out.
The best method of identifying the difference between an independent cryptocurrency and a token is to ask the question: Is this crypto independent from other platforms or does a pre-existing blockchain support it?
An independent cryptocurrency uses its own blockchain while a token is merely a cryptocurrency built on top of another pre-existing blockchain. Tokens are a subset of all cryptocurrencies. Within the independent ones, there is another difference. They can either be Bitcoin-based blockchains such as Dash or Litecoin, or they can have their own native blockchains like Ripple or Ethereum.
We will cover this topic in a future guide, but all cryptos in these two categories can also be called alternative coins. Altcoins get their name from being alternatives to the original cryptocurrency: Bitcoin.
We hope you enjoyed reading this guide ‘What is a Cryptocurrency’ – find more of our guides about cryptocurrencies here.