How Does Cryptocurrency Work?

 

Few topics have received as much media attention as cryptocurrency over the last several months. Unfortunately, most of the reporting on the subject is incredibly biased. Advocates cite digital money systems as the inevitable future, and often refuse to listen to anyone who says otherwise. Likewise, opponents often bash the concept without even the slightest understanding of how it works. This article is intended to strike a balance, explaining how crypto works without the rose-colored glasses associated with promotional sites.

 

What A Digital Currency Is

Digital currencies such as Bitcoin (BTC) are money systems that may be exchanged for goods and services. While acceptance isn’t as ubiquitous as it is with more traditional currencies, it may be accepted as payment as long as both parties agree on its value.

Like other currencies, each crypto token’s value is in constant flux based on market conditions and several other variables. While the American dollar has an established government and the Federal Reserve system that govern the available money supply and inflation, most cryptocurrencies have no centralized regulatory authority. This means that price swings are less predictable, enticing some with no interest in spending crypto to purchase it as an investment.

How Does It Work?

Most crypto transactions are stored on a blockchain, or a public ledger. The blockchain is kind of like your account history at a bank, except that it includes every transaction for a given token instead of one consumer’s. The fact that the entire thing is public knowledge means that anybody who wants to can trace a given coin’s history through every account that it has ever been in.

The term blockchain comes from the structure of the ledger. Data is recorded electronically on “blocks” that fill up eventually, just like an SD card that you store pictures on. When one is full, the next is “chained” to it such that the information on the full block may still be accessed. This allows miners toverify that every transaction agrees with those that came before it, reducing the potential for fraud.

Every transaction on the blockchain includes three bits of information: Input, Output, and Amount. The Input is the most confusing of the three. It lists the source of the tokens transferred, not the account that is transferring them. For instance, if Kyle gives 100 BTC to Bob that he originally received from Pierre, Pierre’s Bitcoin account is listed as the input of the Kyle-to-Bob transaction. It’s somewhat counter-intuitive, but this system of public accountability makes it difficult for one party to add unauthorized coins to the blockchain. The miners mentioned above use powerful computers to verify that all the coins involved are coming out of the accounts they are supposed to be in.

The other two data points are easier to understand. The Output is the account that receives tokens in any given transaction. Finally, the Amount is how much money was transferred. Notably, Bitcoin’s blockchain is capable of processing transactions as small as 0.00000001 BTC. That’s typically much less than an American penny, allowing for microtransactions that standard currencies cannot support.

What Differentiates Tokens From Each Other?

First, each crypto token has its own dedicated blockchain with some variation. Ethereum is notable for its programmable blockchain, allowing developers to concentrate on a single platform for all of the innovations in the space. One of its coolest features is the ability to create a “smart contract,” or a conditional payment that automatically executes itself once the conditions are met.

Different blockchains also have different processing times. For example, Bitcoin’s blockchain can handle 3-7 transactions per second, depending on the mining resources available. Some in the crypto community feel that this is too slow, advocating for a switch to larger blocks to make transaction processing more efficient. These individuals were appeased on August 1, 2017, when a Hard Fork permanently split part of Bitcoin’s blockchain into Bitcoin Cash, a coin identical to Bitcoin save for faster processing times.

Finally, each coin has a different circulation. Bitcoin’s source code calls for a grand total of 21 million BTC to be released, while another token called Ripple (XRP) has a much larger planned circulation of 100,000,000,000 XRP. The greater supply might make Ripple more viable as an everyday currency, but investors tend to prefer the larger profit potential offered by Bitcoin’s scarce supply.

What Are The Downsides?

While blockchains are difficult to hack into, it’s not impossible. Many crypto holdings are stored on sites called Exchanges that facilitate the crypto-economy. In 2014, one popular platform called Mt. Gulg disclosed that hackers had been siphoning off funds deposited by their customers for years, totaling $473 million in digital assets. Most exchanges lack any kind of insurance, so you could be out of luck if this happens to you.

Some exchanges are also designed by scammers to steal from the unsuspecting public. For example, a platform called Bitconnect was shut down in January 2018 for ripping off its customers, with the masterminds behind it arrested for their crimes later that year. Individual “experts” may also purchase a cheap coin before hyping it up to inflate its market value, turning a profit at the expense of the suckers who trusted them.

In addition, crypto transactions are processed much more slowly than traditional ones. Visa can handle 24,000 transactions per second, putting any crypto to shame. Customers usually don’t want to wait, making the faster process much more popular for everyday purchases.

Parting Thoughts

Cryptocurrency is a fascinating phenomenon that only figures to grow in the public consciousness as the underlying blockchain technology improves. Many books have been written about all of the particulars, but the synopsis above should be enough for most people to decide whether crypto is right for them.

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