What is cryptocurrency?
Cryptocurrency is a digital or virtual medium of exchange that uses cryptography to verify transactions. In early 2018 there were estimated to be more than 1,300 cryptocurrencies, including well-known examples such as Bitcoin, Ethereum and Litecoin. Understanding how they work requires a brief explanation of how traditional – or ‘fiat’ – currency works.
All forms of currency, such as coins and notes, are simply tokens. They have no value in themselves, but they work as forms of exchange because buyers and sellers accept that they have value. The system is usually underwritten by a government or central bank which guarantees that, if nobody is willing to exchange your token, you will always be able to take it to a bank and exchange it there.
Sometimes payments can be taken with no token changing hands, for example in direct debit payments by card. Here, the store reports the transaction to the bank which removes the amount from the buyer’s account, records the transaction in a ledger and sends the money to the seller’s bank.
Various attempts at creating a digital or virtual currency have foundered in the past because without a trusted third party or a central authority, like the bank to verify the transaction, the system is prone to fraud. Someone could, for example, copy their own digital payment information and spend the same ‘money’ with two vendors at once.
The current generation of cryptocurrency owes its origins to Bitcoin, which emerged in 2009, and uses a technology called the blockchain to create a decentralised network in which every node keeps a copy of the transaction ledger.
Every transaction on a blockchain network has its own timestamp and is part of a block. Each block is used to create the next one, forming a chain that makes it almost impossible to alter a transaction, which helps to prevent fraud.
The network includes computers acting as ‘miners’. These machines are trying to solve complex cryptography problems. As soon as a miner solves the problem it notifies the network, which checks the solution and the transactions in the block, before adding the block to the chain. In return for their effort, which for a mature cryptocurrency can mean a lot of computing power and electricity, miners receive a transaction fee and a reward payment.
On the user end, each transaction is secured by public key encryption, a well-established cryptography method that involves pairs of keys – one public and one private – to send secure information. To make a cryptocurrency transaction a sender uses their private key to create a ‘digital signature’.
The public key, which is available to the whole network, can then be used to verify that the private key used to make the signature was the one associated with the sender’s account. The private key itself, however, is not visible to the network and thus keeps the sender’s account secure.
The resulting system removes the middle man in currency transactions allowing for a faster and cheaper payment system.