What is Cryptocurrency And How Does it Work

by Sandip Das from
What is Cryptocurrency And How Does it Work

Since cryptocurrencies are becoming increasingly popular, it is important to know what is cryptocurrency and how does it work. It is very likely, that when we hear the term crypto, the first thing that comes to mind is Bitcoin.

Yes, Bitcoin is a cryptocurrency. But, it’s in no way synonymous with the word ‘cryptocurrency’. Bitcoin was the first cryptocurrency ever, and it still is the most valued cryptocurrency. But do you know there are more than 23,000 cryptocurrencies in the world?

Crypto came into existence only in the last 15 years. So, why is there such an overwhelming growth in this novel cryptocurrency technology? What is driving crypto value? Is there any fundamental rationale behind the popularity of cryptocurrencies or is it just a crypto hype? In general, what is a cryptocurrency, and how does crypto work?

1. A Short Detour: From Barter System to Paper-based Currencies

A currency is something that has an exchange value. So, we can use it to purchase goods or services or make any type of payment. In ancient times, when we didn’t have modern paper currencies or banknotes, people used agricultural commodities (like wheat, barley, or corn) or precious metals (gold and silver) to exchange value or buy other goods or services.

In the ancient barter system, one good was exchanged for another good. If you had surplus wheat, and you needed to buy meat, you had to find a person who had surplus meat and was in need of wheat. This system continued for centuries. However, as you can imagine, the barter system was full of difficulties. There needed to be a double coincidence of needs. This means you couldn’t exchange your what for meat until there was someone who wanted to sell meat for wheat.

Going forward, this problem was resolved to a great extent through commodity money like gold or silver coins. However, there needed to be ample gold or silver to mint such coins. Also, it was a hassle to carry them.

There was also an issue of keeping the value of commodity money fixed. The precious metals or the commodity used in such currencies had their own intrinsic value. For example, people want to buy gold to make jewellery. So, the value of commodity money fluctuates.

Next came paper-based currencies issued by government agencies. Unlike commodity money, paper currencies have no intrinsic value. The government guarantees their purchasing power. Paper currencies solve many of the problems associated with the barter system or even commodity money.

However, paper currencies are not durable and they can be forged. Moreover, as we have recently experienced, excessive printing of paper money leads to high inflation. In 2021-2022, many major global economies have experienced multi-decade high inflation.

2. What is a Cryptocurrency

The simplest answer is that a cryptocurrency, also called crypto (plural: cryptos), is a type of digital currency. The term ‘crypto’ in ‘cryptocurrency’ comes from ‘cryptography’. It’s a computer-related concept in which information is made secure with the help of mathematics and algorithms (a set of instructions).

So, cryptocurrency is a form of highly secure digital currency that works on the basis of an algorithm or a set of programmed rules. These currencies are created, used, and stored based on computer algorithms. Also, cryptocurrency transactions are secure and transparent. When you are ready to buy and trade crypto, we suggest using our BTSE referral code for an exclusive bonus at one of our favourite crypto exchanges.

3. How do Cryptocurrencies Work

When you have a cryptocurrency in your crypto wallet, let’s say 1 Bitcoin, you don't own any physical object or currency. Rather, you get a crypto private key using which you can assess your cryptos and use them (making payments or sending them to someone). Your cryptos are stored in crypto wallets, which are digital addresses protected by private keys. It is extremely important to know how to safely store your crypto.

The value of cryptos is digitally stored in a decentralized database. This crypto database is called ‘decentralized’ because it’s not owned by any authority (like the government or the central bank). Rather, it’s validated and maintained by millions of network participants who are members of the public. So, if you are willing to devote your computing power, you can also be one of the cryptocurrency validators of this decentralized crypto database.

One of the most important aspects of cryptocurrencies is that they don't need any banks or financial intermediaries. So, when you want to send some money to your cousin on his birthday, you don't need to transact through your bank. You can just directly send him the money using the crypto network.

4. What is a Blockchain

Cryptos are fundamentally based on the concept of blockchains. A blockchain is basically a distributed ledger consisting of an ever-growing number of blocks. In a blockchain, transaction information is permanently stored in blocks. In addition to transaction information, these blocks also contain time stamps indicating when these transactions occurred. These blocks are then connected in chronological order.

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To answer if cryptocurrencies are built on blockchains – yes, they are. All crypto transactions are recorded and stored in these blocks. These are miners or validators (more on these shortly) who verify these transactions and maintain the blockchain. These miners and validators are rewarded with new cryptocurrencies.

5. What are the Main Features of Cryptocurrencies

A cryptocurrency is unlike anything that has ever happened in money, banking, or finance. And for those who wonder what is cryptocurrency and how does it work, these are crypto's salient features, which make it stand apart from any other monetary instrument:

  1. It’s a decentralized currency. This means there is no central authority for issuing cryptocurrencies.
  2. Cryptocurrency transactions are highly secure as they are protected by sophisticated cryptography.
  3. Cryptocurrencies allow peer-to-peer payment and other financial transactions without intermediaries.
  4. The supply of most cryptocurrencies is limited. For example, the maximum total supply of Bitcoin is 21 million. Once this maximum supply is reached, no more Bitcoin will be created. So, cryptocurrencies can save you from inflation.
  5. Cryptocurrencies are mainly created using computer algorithms (more on this shortly).
  6. Transactions through crypto are stored in an open and decentralized network. So, these crypto transactions are open to the public and anyone can verify these. However, this doesn’t mean that there is no privacy. Even though people can see the transactions made in crypto themselves, the identity of the parties is not revealed.
  7. Cryptocurrency transactions are permanent and irreversible. This means, that once you make a payment to someone using cryptos, this transaction is permanently recorded on the database.
  8. Crypto transactions are not subject to any restrictions. Cryptos provide a secure and seamless global payment network in which anyone can send or receive money from anyone without involving any third party. So, it empowers you by giving you control of your own money.

You can clearly see that cryptocurrency payments and crypto exchange in general bring some great advantages in comparison to fiat currency. However, it is also very important to notice and remember that as there are thousands of different cryptocurrencies on the market, they all differ from each other, sometimes only slightly, but very often rather noticeably, mainly in terms of their cryptocurrency value, but also due to technicalities. Considering that, it is essential to know what is cryptocurrency and how does it work and be up-to-date with crypto news and have the latest bonus codes for crypto exchanges to maximise your own crypto income.

6. The Difference between Cryptocurrencies and Fiat

Fiat currencies are paper currencies or coins issued by the central bank. For example, a $1 bill is a fiat currency. As you can easily guess, a fiat currency has no intrinsic value of its own. It’s just a piece of paper. Today, fiat currencies are the most common form of currency (will they remain so in the next decade?).

Transactions are not always smooth using fiat currencies. It's a hassle to send someone money internationally. The transaction is processed through a number of intermediaries, banks, and clearing houses, and they are often subject to surveillance by tax authorities. Using cryptos, you can conduct peer-to-peer money transfers without involving any bank or any other financial institution. So, cryptos compared to fiat money are much more convenient.

Fiat currencies are subject to damage or theft. Currency notes in your pocket can get soiled and someone can steal your wallet. But, being virtual currencies, cryptos are never soiled while resting on the decentralized network. Also, noone can steal your cryptos unless you reveal your private keys (so never reveal your private keys to anyone).

Another crucial pain point with fiat currencies is galloping inflation. In 2022, inflation in the US reached a 4-decade high. Most other countries faced high inflation around the same time. One of the main reasons behind such an inflationary condition was indiscriminate monetary expansion. In other words, central banks printed too much money to stimulate the economy. When money supply growth is faster than real output, the result is galloping inflation.

Cryptos can save you from inflation, as the supply of most cryptos is limited. So, once the upper limit of maximum supply is reached, no new crypto can be created and put into circulation. Historically, gold has been used as a hedge against inflation. But since cryptos like Bitcoin have taken over this job, many often call Bitcoin digital gold and according to our research, Bitcoin is expected to be one of the cryptos with the biggest potential this year.

7. A Brief History of Cryptos

The term cryptocurrency was first used in the 1980s. However, there were no major developments in the field of cryptos in the next 2 decades. Modern-day cryptocurrencies have a mysterious beginning.

In October 2008, most global economies were dealing with a gruelling financial mess triggered by the subprime mortgage crisis in the US. During this time, an anonymous person named Satoshi Nakamoto mailed a paper to a cryptographic mailing list. The paper explained how a decentralized ledger can be used to create a secure payment system without any controlling authority or other financial intermediariesThis was the beginning of Bitcoin.

Till now, we have no idea who Satoshi was or where he lived. The only thing we know is that Satoshi’s ideas mark the beginning of Bitcoin and the entire crypto universe. In 2009, Bitcoin was formally launched as an Open source software. Even in early 2010, Bitcoin was the only cryptocurrency to exist. In July 2010, 1 Bitcoin was trading for a paltry $0.0008.

As time passed, more and more cryptocurrencies like Litecoin, Namecoin, and Peercoin were created. Most of these new currencies closely followed Bitcoin. Ethereum, Another major cryptocurrency of today, was created in 2015. It was during 2017-18 when Cryptos had a dream run. By Jan 2018, the total market value of cryptos crossed $700 billion for the first time. Cryptos had a string bull run between 2020-21 before having a difficult year in 2022.

8. How are Cryptos Created - Proof of Work (PoW) vs. Proof of Stake (PoS)

Cryptos are created using a sophisticated algorithmic technique. New cryptos are created when a block is completed after verifying transactions. There are two major ways of verifying transactions and completing blocks. These are Proof of Work vs. Proof of Stake (PoW vs. PoS).

Under the PoW mechanism, new cryptos are created through mining. Miners are members of the public who use their computing power to solve complex mathematical problems to compete for an opportunity to verify transactions in a block. The miners who successfully verify a block are then rewarded with new cryptocurrencies which are added to the circulation.

The PoW system requires humongous computing power, which makes it extremely energy-intensive. Bitcoin runs on PoW. Currently, Bitcoin consumes 150 terawatt-hours of electricity in a year, which is higher than the annual electricity consumption of Argentina.

The PoS system requires much less energy. In this mechanism, new transactions are validated by participants who stake their cryptocurrencies on the blockchain platform. These validators verify transactions on blocks and close the blocks. Once the blocks are completed, these validators are rewarded with new cryptocurrencies. Also, the creation of new blocks leads to the release of more cryptos in circulation.

If you are interested in gaining in-depth knowledge and know exactly what is the difference between proof of stake and proof of work protocols read our article on the topic. We explain what is a blockchain, how it works, what is consensus and consensus mechanism. Furthermore, you will learn why there is a need for a voting mechanism to ensure that a block contains only correct information.

9. Where to Use Cryptocurrencies

Cryptocurrencies can be used as digital currency to buy goods and services from sellers accepting these currencies. There are companies like AT&T, AMC, Starbucks, and Microsoft which accepts certain cryptos in specific jurisdictions for purchasing their offerings.

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Cryptocurrencies can also be used as a mode of payment, an instrument for saving and investing, or even a currency for making transactions on a crypto platform. However, different countries have different rules regarding the usage of cryptos.

10. Different Types of Cryptocurrencies

There are two main types of cryptocurrencies – crypto coins and crypto tokens. It is vital to understand the difference between crypto coins and tokens is you want to know what is cryptocurrency and how does it work, therefore, here we present you a brief explanation of both:

  1. Coins: These are digital currencies native to a blockchain platform, like Bitcoin and Ethereum.
  2. Tokens: These are crypto assets specifically created for a crypto project on an existing blockchain. For example - Uniswap (UNI)

So, if crypto coins are like a major currency like the dollar or euro, a crypto token is like a Burger King Coupon that works only in Burger King. Following are some special types of crypto coins:

  • Stablecoins: A stablecoin is a type of cryptocurrency, the value of which is pegged to the value of a fiat currency like a dollar or another commodity or even another crypto. As the name says, stablecoins are designed to keep the value of crypto less volatile.
  • Meme coins: These are cryptos created mainly for the purpose of fun. For example, the extremely famous meme coin Dogecoin (DOGE) actually started as an Internet joke.

As you can see, there are quite a lot of options when it comes to cryptocurrency trading. If you want to start with crypto, and buy your first crypto coins, you should always choose the best crypto exchanges.

11. Cryptonomics - What Gives Cryptocurrency Value

The value of a cryptocurrency primarily depends on its demand. Demand for a cryptocurrency can be of different types like investment demand or transaction demand or even demand for savings.

So, as more transactions are done using cryptos, more blocks are created and more cryptos are put into circulation. New cryptos in circulation constitute the supply of cryptos. Some cryptocurrencies like Bitcoin have a fixed supply. While cryptos like Ethereum don’t have a fixed upper limit of supply. The interaction of demand and supply creates the market value of cryptos. This interaction is also called cryptonomics.

12. Why Own or Invest in Cryptocurrencies

The main reason behind owning or investing in cryptos is the anticipation that the value of cryptos will go up in the future. So, is there any good reason to believe that cryptos, as a new asset class, would appreciate in the long term?

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The answer is that the fundamental value of cryptos depends on their applications. As more and more countries have accommodative crypto regulations and cryptos are accepted as a mode of payment, cryptos are likely to be more widely adopted and used. As cryptos become more mainstream and have more use cases, the overall value of cryptos as an asset class is expected to go up. Therefore, if this is what you are interested in following, then check our article on how to invest in crypto.

13. What are the Major Cryptocurrencies

As stated before in this text, currently there are more than 23,000 different cryptocurrencies in the market. As you are getting more and more acquainted with what is cryptocurrency and how does it work, here we present you a list of some major cryptocurrencies:

  • Bitcoin (BTC)
  • Ethereum (ETH)
  • Tether (USDT)
  • BNB (BNB)
  • USD Coin (USDC)
  • XRP (XRP)
  • Cardano (ADA)
  • Dogecoin (DOGE)
  • Polygon (MATIC)
  • Solana (SOL)

Even though there are so many various cryptos in circulation, the most valuable ones are on the top when it comes to the popularity. However, it does not mean that sooner or later some unknown currencies will start becoming more and more valuable, what, in turn, makes them a great crypto investment opportunity at the moment!

14. Why is the Crypto Price so Volatile

The main reason for cryptos volatility is because of their speculative crypto demand. In recent years, there has been significant cryptocurrency hype and interest around cryptos. Whenever the value of cryptos goes up, it attracts new investors (many of whom are first-time investors) anticipating quick returns. Also, market declines tend to create panic selling. These types of speculative trading often lead to volatility in cryptos.

Irrespective of short-term volatility, cryptos can prove to be an important emerging asset class in the long term. So, investing in crypto long term in sound crypto projects can result in significant crypto returns. However, speculative cryptocurrency trading in the short run can lead to disastrous losses.

15. Are Cryptocurrencies Legal

When you ask yourself what is cryptocurrency and how does it work, at some point you also want to know: are cryptocurrencies legal? Different countries have different rules and regulations regarding cryptos. In 2021, El Salvador became the first country to recognize Bitcoin as a legal tender. In 2022, the Central African Republic (CAR) also gave legal tender status to cryptos.

Buying or selling cryptos is legal in most developed nations like the US or UK, or most countries in Europe. Also, most Asian countries allow crypto investing and cryptocurrency transactions. However, crypto technology is constantly evolving and there is no comprehensive regulatory framework in most countries. In the coming years, we can expect to have more defined crypto norms across countries.

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16. How do I Invest in Cryptocurrencies

Investing in cryptos is straightforward, like investing in other assets like stocks and commodities. You need to register with a crypto exchange and verify your KYC to be able to buy and sell cryptos. Some of the leading crypto exchanges are:

  1. Binance
  2. Coinbase
  3. Kraken
  4. KuCoin
  5. Bybit

After registering with a crypto exchange, you can deposit fiat currency using different options like credit or debit cards. Next, you can buy cryptos available on the exchange. Once bought, you can hold or sell your cryptos through the exchange. Also, make sure to read our ByBit promo code review, where we extensively look at the promotions and offers for new users.

17. What is Cryptocurrency And How Does it Work - FAQ

17.1 🪙 What are the most popular cryptos on the market?

Currently, there are more than 23,000 different cryptos on the market, and some major cryptos are Bitcoin, Ethereum, and Tether, to name a few.

17.2 ⚖️ Are cryptos legal?

Yes – buying and selling cryptocurrencies, or paying with crypto is legal in most developed nations, and there are more and more regulatory frameworks being introduced to create more defined crypto norms across different countries.

17.3 📈 How to invest in crypto?

To make it as easy as possible, you should just register with a crypto exchange, deposit your fiat currency, and then buy cryptocurrencies of your choice. This is a very straightforward process, but for someone who just found out what is cryptocurrency and how does it work you should also consider choosing one of the leading crypto exchanges to start with.

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