What is Cryptocurrency, and How Does it Work?

Cryptocurrencies have gained much attention in the media, online forums, and possibly even in dinnertime conversations. Despite the hype, many people still need clarification about what crypto really means.

Unlike traditional currencies, cryptocurrency is decentralized, which means it is not issued or backed by a central authority such as the government. Instead, they are distributed throughout a computer network.

This article comprehensively explains the concept of cryptocurrency — how it operates, its benefits, and its drawbacks.

Let’s start from the very beginning, shall we? People started out with the barter system of exchanging items, followed by the use of coins, then paper notes. And over the last decades, transactions have been cashless with the use of credit cards and mobile transfers.

And now, things have gone more digital with cryptocurrencies. Cryptocurrency is simply decentralized digital money built on blockchain technology—a distributed ledger enforced by a network of computers — making counterfeiting or double-spending nearly impossible.

The fact that cryptocurrencies are generally not issued by any central authority makes them immune to government interference or manipulation. So yeah, you need not worry about intermediaries for your financial transactions, as everything is decentralized.

To cap up how enthralling cryptos are, cryptocurrency transactions are swift and seamless. It’s only a matter of time before people ditch traditional banking systems.

Although most retailers are yet to accept cryptocurrency payments fully, the increasing value of cryptos has made them popular as trading instruments. To a lesser extent, they are also utilized for cross-border transactions.

We all know banks and financial institutions control how money transactions are made. But now, cryptocurrency has brought about a change as it operates outside the banking system. Crypto transactions are recorded on a block of interconnected computer nodes called the blockchain.

Here is a breakdown of the process involved in creating cryptos and how they work.

Cryptocurrencies are created through a process known as “mining.” Mining is a challenging and complex technique. To be rewarded with bitcoins, miners must solve mathematical riddles on specially equipped computer systems.

In the real world, one bitcoin could be mined in 10 minutes, but this digital process is predicted to take 30 days.

Users can now purchase and sell cryptocurrencies from centralized exchanges, brokers, and individuals. The most straightforward way to purchase or sell cryptocurrencies is through exchanges or websites like Coinbase.

Once purchased, cryptocurrencies can be held in digital wallets. Digital wallets are either “hot” or “cold.” When a wallet is hot, it is connected to the internet, making transactions easier but exposing it to theft and fraud. On the other hand, cold storage is safer but more complicated to transact with.

Bitcoins, for example, can be easily transferred from one digital wallet to another using only a smartphone. Once you have an amount of Bitcoin, you have the option to:

a) Use them to buy goods or services

b) Trade with them

c) Exchange them for cash

The simplest way to use Bitcoin for purchases is through debit-card-type transactions. These debit cards can also be used to withdraw cash, just like an ATM. It is also possible to convert cryptocurrency to cash using banking accounts or peer-to-peer transactions.

There are currently thousands of cryptocurrencies available. Major cryptocurrencies terms include:

Bitcoin was the world’s first recognized accepted type of cryptocurrency. Bitcoin is so well-known that the term “cryptocurrency” was formerly synonymous with it. However, prospective investors should be cautioned that bitcoins have become incredibly expensive. One Bitcoin was sold for $68,000 in 2021. The good news is that you don’t always have to purchase an entire bitcoin; you can buy smaller fractions called “satoshis.”

Altcoin refers to any alternative digital currency to Bitcoin and, most times, Ethereum is recognized as the first altcoin. There are a variety of other altcoins on the market today, including Tron, Solana, Decentraland, Shiba Inu, Terra, etc.

While cryptocurrency coins imitate conventional money, cryptocurrency tokens behave more like assets or deeds. An ownership stake in a digital good, NFT, or even a tangible item can all be represented by a cryptocurrency token. Although cryptocurrency tokens can be purchased, sold, and traded much like coins, they are not used as payment.

The difference between crypto coins and tokens can be confusing. Although they appear identical at first glance, they have numerous distinctions. Crypto coins are the native currencies of blockchains. Ether is the native coin of the Ethereum blockchain.

On the other hand, Tokens are native currencies of protocols supported by other blockchains. ARB is the native token of Arbitrum.  Arbitrum is a protocol built on the Ethereum blockchain.  

Here are also ways coins and tokens differ:

• Tokens cannot be mined, but coins can.
• Tokens are not directly linked to blockchains, but coins are.
• In terms of utility, they differ in the type of product or service that people can buy.

The goal of cryptocurrencies is to transform the financial system, making it more global and less central. But as with any revolution, there are setbacks. In the current stage of cryptocurrency development, there are several gaps between the theoretical idea of a decentralized system and its actual implementation.

The benefits and drawbacks of cryptocurrencies are listed below:

1. Cryptocurrencies are a new type of decentralized money. In this system, centralized intermediaries such as banks and monetary organizations are not required to enforce trust and police transactions between two parties. As a result, a cryptocurrency-based system avoids the prospect of a single point of failure, such as a huge bank, creating a worldwide crisis, such as the one that occurred in 2008 due to the failure of institutions in the United States.

2. Cryptocurrencies claim to make it easier to move funds directly between two parties, eliminating the requirement for a trusted third party such as a bank or credit card firm. Using public and private keys and various incentive schemes such as “proof of labor” or “proof of stake” protects such decentralized transfers.

3. Because there are no third-party intermediaries, cryptocurrency transactions between two transacting parties are faster than traditional money transfers. Flash loans are a good example of decentralized transfers in decentralized finance. These loans, which do not require collateral, can be made in seconds and used in trading.

4. The remittance industry is one of cryptocurrency’s most visible use cases. Cryptocurrencies such as Bitcoin are currently used as intermediary currencies to allow cross-border money transfers. As a result, a national currency is changed to Bitcoin (or another cryptocurrency), transmitted across borders, and then converted back to the destination national currency. This technology streamlines and lowers the cost of money transfers.

1. Cryptocurrencies cannot be tracked despite their claim to be used for anonymous transactions. Authorities like the Federal Bureau of Investigation can examine the digital trail they leave behind — making it possible for governments or federal agencies to monitor the financial activities of ordinary citizens.

2. The idea that everyone with a computer and an Internet connection can mine bitcoins is one of the common myths around them. On the other hand, mining well-known cryptocurrencies consume a lot of energy, often as much as whole nations do. Because of high energy costs and uncertainties, mining has been concentrated among huge companies with billions of dollars in revenue. According to MIT research, 10% of miners account for 90% of mining capacity.

3. Criminals use cryptocurrency more frequently for unlawful purposes, like money laundering and shady transactions. One well-known example is Dread Pirate Roberts, who ran a drug business on the dark web. A growing number of hackers are using cryptocurrencies to launch criminal activities.

4. The blockchain-based decentralized nature of cryptocurrencies allows wealth to be distributed among many parties. In reality, it is highly concentrated ownership. MIT researchers found that only 10,000 individuals controlled over one-third of Bitcoin’s rising value.

While the buzz seems to be very high, cryptocurrency is still in its infancy and is regarded as highly speculative. Be ready for challenges while investing in something new. Do your homework and start investing prudently if you intend to join the bandwagon riding in the evolution of money.