What Is Cryptocurrency And How Does It Work?

cryptocurrency is a virtual or digital currency that can be used to buy goods and services; which implies there’s no physical coin or bill used and all the transactions take place online. It used an online ledger with strong cryptography to ensure that online transactions are completely secure. Here, we have included all the details pertaining to cryptocurrency such as types, how it works, uses, how to buy and store it.

What is Cryptocurrency?

It is a purely virtual line of currency that runs on the system of cryptography. It functions as a decentralized medium of exchange where cryptography is used to verify and facilitate each transaction. Cryptography also underlines the creation of units of different cryptocurrencies.

This mode of exchange primarily runs on the blockchain technology – that which lends cryptocurrencies decentralized status. It is a shared public ledger that contains all the transactions that have ever taken place within a network. Therefore, everyone on the network can see each transaction that takes place and also view others balances.

The Blockchain technology addresses one of the primary concerns with digital payment platforms, i.e. double-spending while ensuring there is no monopoly of authority. That is because, in blockchain technology, parties to a transaction themselves verify and facilitate every such activity.

How was the Idea of Cryptocurrency Conceived?

The concept of digital currency gained considerable traction in the 90s tech boom. Multiple organizations and programmers ventured to create a parallel line of currency that would be out of any central authority’s reach. However, ironically, the companies that tried to create this digital currency themselves assumed the authority of verifying and facilitating transactions.

It not only defeated the purpose but founded the venture as well. Moreover, the digital currencies back then were riddled with frauds and other financial challenges. For a long time since then, this idea of digital currency was considered a lost cause. This idea was falsified when Satoshi Nakamoto – a programmer or a group of programmers – introduced and explained what Bitcoin is in 2009, the first-ever cryptocurrency.

How Does Cryptocurrency Work?

According to Satoshi Nakamoto, the founding father of Bitcoin, it is a peer-to-peer electronic cash system. In that, it is much similar to peer-to-peer file transactions, where there is no involvement of any central authority or regulator.

Ergo, cryptocurrencies are mere transactions or entries in a shared ledger that can only be changed upon meeting certain prerequisites. Typically, in a blockchain technology like the Bitcoin network, each transaction consists of the involved parties’ – sender and receiver – wallet addresses or public keys and the amount of such transaction.

What attributes the safety net in such a network to avoid fraud is that the sender needs to confirm a transaction with their private key. After confirmation, the transaction is reflected in the shared ledger or database.

However, only miners are authorized to confirm transactions within a cryptocurrency network. They need to solve cryptographic puzzles to confirm any specific transaction. In exchange for their service, they receive a transaction fee in that particular type of cryptocurrency and a reward.

Once miners confirm a transaction, they spread it to the network, and every node in that automatically updates its ledger accordingly. Furthermore, once a miner confirms a particular transaction, it becomes irreversible and non-modifiable.

However, there is a crucial catch in mining. It is that as a particular type of cryptocurrency gains popularity and more and more miners join the bandwagon, the miners’ fees and reward per transaction go down. For instance, initially, miners could get 50 bitcoins (BTC) as a reward for mining; however, due to the recent halving in May 2020, miners’ rewards have gone down to 6.25 BTC.

What is the Use of Cryptocurrency?

It is worth wondering if the popularity that cryptocurrency has garnered over the years is hollow or not. However, even though it is still nowhere near to replacing institutionalized cash, cryptocurrency, especially Bitcoin, has found wide acceptance across the world.

  • As a mode of payment

Initially, Bitcoin had little value as a mode of payment to merchants. However, with time, several merchants worldwide like restaurants, flights, jewelers, and apps have come to accept it as a viable payment medium.

One of the most notable acceptors of cryptocurrency as a viable medium of payment is Apple Inc. It allows 10 types of cryptocurrencies for carrying out transactions in the App Store.

However, India, as an economy is still to explore cryptocurrency as a viable payment mode extensively. Nevertheless, with big companies like Apple and Facebook hoisting its cause, it is expected that cryptocurrency will gain traction in India soon.

  • Investment

Cryptocurrencies, especially Bitcoin, is one of the most lucrative investment options currently present. Its value appreciation is supremely dynamic and can prove to be an excellent avenue for capital expansion.

However, individuals must also note the volatility of this investment avenue. Bitcoin, the most popular cryptocurrency with the largest market share, has experienced some of the most erratic price changes as an asset. For instance, in December 2017, Bitcoin’s value plunged from $19000 per BTC to $7000 per BTC.

Since cryptocurrency is not rooted in any material change but a change in popularity and fad, such price fluctuation is natural.

What is the Price of Cryptocurrencies?

The following table illustrates the top 10 cryptocurrency list currently trading and their market prices as of January 2021.

Name Market Cap (in USD) Per Token Value (in $)
Bitcoin $319.59B 0.001161
Ethereum $146.21B $1,220.80
Tether $66,241B $1.021
XRP $0.3427 $27.937
Bitcoin cash $1,867,486,940 $96.64
Bitcoin SV $795,984,070 $41.17
Litecoin $376.09M $71.26
Binance Coin $39.27B $244.06
EOSA $927,945,490 $1.37
Tezos $0.7315 $0.72

What are the Different Types of Cryptocurrencies?

When it comes to the variants of cryptocurrencies, most are forks of Bitcoin, while others were built from scratch. However, there are only 3 broad types of cryptocurrencies currently in existence. These are –

  • Bitcoin

It is the first cryptocurrency that was ever introduced and is considered the “digital gold”. It currently holds a market capitalization of $172.76 billion, the largest of any other variant of cryptocurrency. A unit of Bitcoin can be broken down into Satoshis, which is equivalent to the relationship of rupees and paise.

Furthermore, the Bitcoin network is so designed that it can only have 21 million units of Bitcoin circulation at any point in time. This limited availability is a primary component that drives its market price.

  • Altcoins

This category primarily involves forks and alternate versions of Bitcoin, thus, the name. However, some Altcoins are exponentially different from Bitcoin and use varying algorithms. For instance, Ethereum, which is an altcoin, is not a currency but a platform where entities can make their apps based on blockchain.

Currently, there are more than a thousand altcoins. Some of the notable altcoins are Ethereum, Factom, Litecoin, NEO, etc.

  • Tokens

These are products of altcoins like Ethereum and NEO. These cryptocurrencies do not have a separate blockchain but instead run on the decentralized apps created via such altcoins. However, tokens carry supremely low value compared to the other two types mentioned above, because it can only be used to purchase items from such decentralized apps or dApps.

How to Buy Cryptocurrency?

Compared to other variants of cryptocurrency, units of Bitcoin can be purchased more conveniently owing to a large number of options. Individuals can choose to purchase it from cryptocurrency exchanges, using gift cards, via investment trusts.

How to Store Cryptocurrency?

Entities can hold units of cryptocurrencies in wallets – offline and online. Each such wallet holds a public key, i.e. the wallet address and a private key (used to sign off payments). In any case, it is not exactly the units of cryptocurrency that one holds but the private key.

Nevertheless, entities can select from a wide range of crypto wallets, each catering to a different purpose. Online wallets largely serve the purpose of regular transactions. Apple, as well as J.P. Morgan Chase, Visa, and Facebook, have introduced online crypto-wallets. Conversely, offline or cold wallets are stored in a person’s hard drive and serve the purpose of security of cryptocurrency.

Cryptocurrency Advantages and Disadvantages

The Merits Associated with Cryptocurrency

a) Protection Against Inflation: Inflation has led several currencies to lose value over time. The amount of any coin is specified in the source code. As demand grows, its value rises, keeping pace with the market and, in the long term, preventing inflation.

b) Privacy: Cryptocurrency privacy and security have long been key concerns. The blockchain ledger is built on many mathematical problems that are difficult to decode. As a result, bitcoin transactions are more secure than standard electronic transactions. To improve security and privacy, cryptocurrency uses pseudonyms that are unrelated to any user, account, or stored data that may be traced to a profile.

c) Self-Governed: The governance and upkeep of any currency are critical to its development. Developers/miners hold cryptocurrency transactions on their hardware and receive the transaction fee as a reward. Since miners are compensated for their efforts, they keep transaction records accurate and up to date, preserving the cryptocurrency’s integrity and keeping records decentralized.

d) Decentralization: One important advantage of cryptocurrency is that it is mostly decentralized. Many cryptocurrencies are controlled by the developers who use them and people who own a large amount of the coin or by a firm that develops it before it is given to the market. Decentralization serves to keep the currency monopoly free and in check by ensuring that no single entity determines the flow and value of the coin, which, in turn, keeps it stable and secure, not like fiat currencies, which are controlled by the government.

e) Easy Transfer: Cryptocurrencies have traditionally been seen as the best option for transactions. Cryptocurrency transactions, whether international or domestic, are lightning fast. Because there are minimal barriers to overcome, the verification takes extremely little time to complete.

Demerits Associated with Cryptocurrency

a) Some coins cannot be obtained in other fiat currencies: Some cryptocurrencies are only available in a single or a few fiat currencies. This forces the user to first convert these currencies into one of the major currencies, such as Bitcoin or Ethereum, and then to their desired currency via other exchanges. This only applies to a few cryptocurrencies. This results in the addition of superfluous transaction fees to the process.

b) Hacks: Although cryptocurrencies are extremely secure, exchanges are not. Most exchanges save user wallet info in order to correctly operate their user ID. Hackers can steal this information and get access to a large number of accounts. These hackers can quickly move funds from those accounts once they have gained access.

Some exchanges, including Bitfinex and Mt Gox, have been hacked in recent years, and Bitcoin worth thousands and millions of dollars has been stolen. Most exchanges are now highly secure, but there is always the possibility of another hack.

c) No refunds or Cancels: If there is a disagreement between the parties involved or if funds are sent to the wrong wallet address by mistake, the sender cannot retrieve the coin. Many people can utilize this to defraud others for their money. Because there are no refunds, one can simply be formed for a transaction for which they never received the product or services.

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