What Is Cryptocurrency?

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Cryptocurrency went mainstream in 2017 as the price of bitcoin, the most popular cryptocurrency, soared over 13-fold during the year.

It's often called "digital gold," as some of the characteristics of bitcoin and other cryptocurrencies are similar to the precious metal often used as a store of value. But that comparison doesn't do it justice.

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Cryptocurrency is an electronic cash system that doesn't rely on central banks or trusted third parties to verify transactions and create new units. Instead, it uses cryptography to confirm transactions on a publicly distributed ledger called the blockchain, enabling direct peer-to-peer payments.

That definition might seem downright cryptographic right now, but by the end of this overview, you won't need a decryption key to understand crypto.

Today we'll cover:

  1. The creation of bitcoin and the blockchain, the underlying technology of all decentralized cryptocurrency.
  2. How the blockchain solves the problems associated with prior virtual currencies.
  3. How cryptocurrency transactions work without central banks.
  4. The function of cryptocurrency "miners."
  5. How to buy cryptocurrency.

The early history of cryptocurrency

In 2009, a programmer using the pseudonym Satoshi Nakamoto created bitcoin, the first ever cryptocurrency. Satoshi also created the blockchain technology, which makes all decentralized cryptocurrencies possible.

The blockchain was created as a solution to the "double-spending problem," which arises in virtual currencies because it's easy to duplicate digital information. A person could make a copy of his or her digital currency information and send both the original and the copy to separate parties.

Before bitcoin and blockchain, virtual currency relied on trusted third parties to prevent double spending. But Satoshi wanted to develop a decentralized currency, which meant finding a way for the network of bitcoin users to verify transactions.

"The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work," Satoshi wrote in the abstract of the white paper announcing bitcoin. This was the earliest description of the blockchain.

Why is it called a blockchain?

A block is a collection of transaction data on the cryptocurrency network. It basically says Person A sent this much to Person B, and Person X sent this much to Person Y.

It also includes important information that allows the rest of the network to verify the validity of the block -- such as the solution to a complex math problem -- called a proof-of-work. While the math problem is hard to solve, it's very easy for others to verify a valid solution. New blocks cannot be amended to the blockchain without a valid solution.

A block also includes a reference to the block that immediately precedes it. Thus, the blocks create a chain linking one to another through those references.

The reference to the preceding block is accomplished through something called a cryptographic hash function. A hash function takes a set of data and maps it to a string of letters and numbers called a digest. If anything in the data changes, the resulting hash digest will change as well.

Chaining blocks together by using a hash function to reference the preceding block adds a great level of security to the system. To change a block in the ledger, a hacker would have to reproduce the entire chain of blocks following it, since it would create a chain of invalid hash values referencing the previous block.

As more computing power joins the network, the blockchain grows longer, and as the amount of calculation required to solve the math problem and add a block increases, it becomes increasingly difficult to change data in the blockchain. A hacker would require a majority of computing power on the network to effectively alter transactions.

How does a cryptocurrency transaction work?

Cryptocurrency is used for direct peer-to-peer payments anywhere in the world. The speed of transactions varies based on currency and confirmation requirements, but it's generally very fast compared with traditional banking systems. Where banks can take days to transfer money, cryptocurrency transfers happen in minutes.

In general, cryptocurrency transactions go through the following steps before they get added to the blockchain.

  1. A person requests a transaction, and the request is sent to the entire network.
  2. Each computer on the network collects all concurrent transactions into a block, along with a timestamp for each transaction.
  3. Each computer works on solving the difficult math problem to add the block to the blockchain. This process is called "mining."
  4. Once a computer finds a valid solution, it broadcasts the block to the rest of the network.
  5. The network checks the solution as well as compares transactions in the block against the current blockchain to prevent double spending.
  6. The block is added to the chain, showing the transaction was completed.

Once a block is added to the chain, that block gets hashed and is used to create the next block. The process continually repeats itself.

As such, transactions are practically irreversible, much the same way as if you give someone cash (hence calling it an electronic cash system). As mentioned, the chaining of one block to another means someone would have to edit the entire chain of blocks to change a transaction.

Since blocks are continually added to a chain, it's extremely unlikely someone will be able to propagate an updated chain of blocks to the network before the rest of the network produces the next block and extends the chain further.

Every transaction needs a signature

Just as credit cards use your signature to verify you authorized a purchase, cryptocurrency uses a signature as well -- a digital signature.

Transactions are secured through a cryptography system called public key encryption. Each user has both a public key and a private key associated with his or her account.

To authorize a transaction, users must prove they know their private key by using it as an input into a cryptographic hash function similar to the one used to link blocks together in the blockchain. That's called signing the digest. The private key is used to write that "digital signature," so it's very important that the private key remains private.

The public key, which is available to all computers on the network, is used to decrypt the data and confirm that the private key associated with the account requesting the transaction was used to encrypt it. The public key, however, cannot be used to determine the private key, ensuring the security of one's cryptocurrency holdings.

What do miners do?

With no central banks deciding when to print more money, a cryptocurrency needs to define how to create new units of the currency. Many cryptocurrencies, like bitcoin, distribute new units to miners as an incentive for verifying transactions on the blockchain.

Miners work to solve the difficult math problem or other proof-of-work systems within every block of the blockchain. They also work to verify the solutions. Running all these calculations have real-world costs, including buying hardware and using electricity.

The difficulty of the math problem for bitcoin blocks is automatically adjusted such that the combined processing power of the network takes about 10 minutes to solve the problem on average.

When a miner successfully adds a block to the bitcoin blockchain, that miner also earns the right to take a reward. The winning miner's bitcoin address is recorded in the block.

The reward started at 50 bitcoins per block. That number is halved every 210,000 blocks (or about every four years). The current reward for adding a block is now 12.5 bitcoins, and that number will fall to 6.25 around June 2020.

At some point, the reward for solving a block in the bitcoin blockchain will become extremely small. By 2140, miners will have mined all 21 million bitcoins that will ever be in circulation. At that point, the incentive for miners to update and verify the blockchain will come from transaction fees. Some cryptocurrencies already rely on relatively high transaction fees to offer miners incentive.

Transaction fees are currently relatively small for bitcoin, but if transaction volume doesn't climb to compensate for the decrease in block rewards, transaction fees will have to increase to compensate miners.

How to buy cryptocurrency

It's no longer practical to use your home computer, or even a custom-built bitcoin mining computer, to mine bitcoin and most other cryptocurrencies. Most people will get a better return by buying it through a cryptocurrency exchange. A cryptocurrency exchange allows consumers to change their fiat currency, like U.S. dollars, into cryptocurrency like bitcoin.

A cryptocurrency exchange works just like any other exchange, such as a stock exchange. It matches buyers and sellers based on a book of orders. As orders are added to the book, the exchange matches buyers willing to pay the same amount (or more) than sellers are requesting.

The price of cryptocurrency is determined solely by what people are willing to buy it for. As such, the price quoted by one cryptocurrency exchange with one book of buy orders can be drastically different from the price of another exchange with another book of buy orders. Theoretically, exchanges with the highest volume of buyers and sellers will produce the most accurate price.

"What is cryptocurrency" revisited

To recap, I defined cryptocurrency as "an electronic cash system that doesn't rely on central banks or trusted third parties to verify transactions and create new units. Instead, it uses cryptography to confirm transactions on a publicly distributed ledger called the blockchain, enabling direct peer-to-peer payments."

Let's break that down.

  • "An electronic cash system": Cryptocurrency has no physical form. Ownership is determined by the digital record found in the blockchain.
  • "Uses cryptography": Transaction requests are authorized and confirmed through public key encryption. The blockchain also uses encryption to link blocks to one another.
  • "Confirm transactions": The chain of transaction data in the blocks allows the network to verify that a transaction hasn't already occurred -- the double spending problem -- and to add new transactions to the ledger.
  • "A publicly distributed ledger": The blockchain ledger is available to all the computers on the network. In fact, its publicity is essential to making the entire system work. By keeping an updated transaction ledger on every computer on the network, the system is able to protect against changes to the blockchain and verify transactions and ownership.
  • "Direct peer-to-peer payments": Payments never go through a central banking system or trusted third party but instead simply move from payer to payee. This process increases the speed of transactions and reduces the fees associated with transferring money.

Cryptocurrency is a complex new form of electronic cash. With no reliance on central banks to confirm transactions or authorize the creation of new units, it can dramatically reduce the fees and time associated with moving money around the world.

People are still coming up with new applications for blockchain technology and new cryptocurrencies every day. With this basic overview of what cryptocurrency is, you can start developing a deeper understanding of the various currencies available.

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Adam Levy owns bitcoin. The Motley Fool has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.