What is cryptocurrency and how does it work?

  • Jonathan Rowe
  • 21.03.2024

Cryptocurrency, also known as digital currency, refers to any type of currency that exists solely in digital or virtual form and uses cryptography to secure transactions. Unlike traditional currencies, cryptocurrencies operate without a central authority to issue or regulate them, relying on a decentralized network to validate transactions and generate new units.

What is a cryptocurrency?

Cryptocurrency works as a digital payment system that does not rely on banks to verify transactions. It operates on a peer-to-peer network, facilitating payments between parties around the world. Unlike physical currency exchanged in the real world, cryptocurrency transactions are purely digital records in an online database. When cryptocurrency funds are transferred, these transactions are recorded in a public ledger and the currency itself is stored in digital wallets.

The term "cryptocurrency" comes from the use of encryption to validate transactions, which involves complex coding to store and transfer data between wallets and public ledgers. Encryption serves the primary purpose of securing and protecting transactions.

The first cryptocurrency was bitcoin, which was founded in 2009 and remains the best known to date. Much of the intrigue surrounding cryptocurrencies involves trading for profit, and speculators often cause significant price fluctuations.

How does cryptocurrency work?

Cryptocurrencies operate on a decentralized public ledger known as the blockchain, which serves as a comprehensive record of all transactions maintained and updated by currency holders.

Cryptocurrency creation occurs through a process called mining, where computing power is used to solve complex mathematical problems, resulting in the generation of coins. Alternatively, users can purchase currencies from brokers and manage them using crypto wallets for storage and spending.

Cryptocurrency ownership does not imply tangible ownership. Instead, it entitles the holder to a key that allows a record or unit of value to be transferred from one party to another without the involvement of a trusted intermediary.

Although bitcoin was created in 2009, cryptocurrencies and the application of blockchain technology continue to evolve in the financial context, and further progress is expected. In the future, this technology may facilitate transactions involving various financial assets.

Is cryptocurrency secure?

Cryptocurrencies typically utilize blockchain technology, which describes the process of recording transactions into time-stamped "blocks." While this process is complex and technical, it creates a digital log of cryptocurrency transactions that is highly resistant to hacking by hackers.

In addition, cryptocurrency transactions often utilize a two-factor authentication mechanism. For example, users may be required to enter a username and password to initiate a transaction, followed by an authentication code sent as a text message to their personal cell phone.

Despite these security measures, cryptocurrencies are not immune to hacking attempts. Several high-profile incidents, such as the $534 million Coincheck hack and the $195 million BitGrail hack in 2018, highlight the vulnerability of cryptocurrency startups to significant financial losses due to cyberattacks.

Unlike traditional fiat currencies backed by governments, the value of virtual currencies is determined solely by supply and demand dynamics. Consequently, this can lead to dramatic price fluctuations, resulting in significant gains or losses for investors. In addition, cryptocurrency investments are subject to fewer regulatory safeguards than conventional financial instruments such as stocks, bonds and mutual funds.

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