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What Is Cryptocurrency and How Does It Work?

What Is Cryptocurrency and How Does It Work?

Beginner
გამოქვეყნებული Apr 3, 2023განახლებული Aug 17, 2023
10m

TL;DR

  • Cryptocurrency is a digital currency based on blockchain technology that enables peer-to-peer (P2P) transactions.

  • Bitcoin, ether, BNB, and USDT are notable examples of the top cryptocurrencies by market capitalization.

  • Cryptocurrencies are accessed through crypto wallets or exchanges. Though people often say they are “stored” in wallets, they are actually stored on a blockchain.

  • They have specific characteristics, including decentralization, transparency, and immutability.

What Is A Cryptocurrency?

Cryptocurrency is a decentralized digital currency that uses cryptography for security. It can operate independently of intermediaries such as banks and payment processors.

This decentralized nature facilitates peer-to-peer (P2P) transactions directly between individuals. But instead of physical wallets and bank accounts, people access their cryptocurrency through unique crypto wallets or crypto exchanges.

You may have heard people saying that crypto is “stored” in wallets. However, cryptocurrencies don't actually exist in crypto wallets or exchanges — in reality, they always remain on the blockchain. In the case of a crypto exchange, it holds the private keys that allow users to access those funds.

The first and most well-known cryptocurrency is Bitcoin, which was created in 2009 by an individual or group under the pseudonym Satoshi Nakamoto. Since then, thousands of cryptocurrencies have emerged, each with unique characteristics and purposes.

Like traditional fiat currencies, cryptocurrencies can be used as a medium of exchange. However, the use cases for cryptocurrencies have expanded significantly over the years to include smart contracts, decentralized finance (DeFi), stores of value, governance, and non-fungible tokens (NFTs). 

How Does Cryptocurrency Work?

We’ve mentioned that cryptocurrency uses cryptography for security purposes, but what does that really mean? Simply put, cryptocurrencies use advanced mathematical algorithms to secure transactions and protect data from unauthorized access or manipulation. These algorithms serve two primary functions: maintaining the privacy of user identities and verifying the authenticity of transactions.

Blockchain transactions are public and addresses (public keys) are pseudonymous, though not completely anonymous. In other words, while transactions are visible on the blockchain, the users behind them are not easily identifiable. Cryptocurrencies achieve this through the use of cryptographic techniques such as hash functions and digital signatures.

Cryptocurrency achieves autonomy through a distributed network of computers collectively known as a blockchain, which is essentially a decentralized digital ledger that stores transaction data across many specialized computers on the network.

Each of these computers — also called nodes — maintains a copy of the ledger, and a consensus algorithm preserves the blockchain’s by ensuring fake or inconsistent copies are rejected. This distributed architecture increases the network’s security because there is no single point of failure, such as a bank vault, for malicious actors to exploit.

Cryptocurrencies allow individuals to transfer funds directly to one another. In a typical cryptocurrency transaction, the sender initiates the transfer by creating a digital signature using their private key. The transaction is then sent to the network, where nodes validate it by verifying the digital signature and ensuring the sender has sufficient funds.

Once verified, the transaction is added to a new block, which is then added to the existing blockchain. While this may sound complicated, miners take care of these steps so the user doesn't have to worry about them.

What Makes Cryptocurrency Unique?

Cryptocurrencies have impacted various ecosystems, from finance to technology, by introducing innovative features that distinguish them from traditional protocols and currencies. Some of the unique aspects of cryptocurrencies include:

1. Decentralization

Cryptocurrency's decentralized architecture eliminates the need for a central authority. This allows for greater autonomy, as well as less vulnerability to manipulation or control by a single entity.

2. Transparency and immutability

Blockchain technology records all transactions on a transparent and tamper-proof ledger. Therefore, once a transaction is added to the blockchain, it can be viewed by anyone and cannot be altered or deleted.

3. Programmability

Many cryptocurrencies, such as ETH, are programmable, allowing developers to deploy smart contracts to create decentralized applications (DApps) and other innovative solutions on top of blockchains. Additionally, because permissionless blockchains are open-source, anyone can start deploying code on top of a blockchain and create their own DApps.

4. Borderless

Cryptocurrencies are easily transferred and exchanged globally, allowing people to use them for international transactions and remittances.

5. Predefined supply of coins

Many cryptocurrencies have a limited supply of coins, meaning the teams behind them will only ever create a finite number of coins. This deflationary aspect of cryptocurrencies can potentially be positive over time, as scarcity drives demand.

In contrast, fiat currencies are often inflationary because central banks can print more money. However, with a limited supply, crypto inflation can be better controlled because the total number of coins is predetermined. 

Types of Cryptocurrency

Among the myriad cryptocurrencies, four notable examples include Bitcoin (BTC) and popular altcoins ether (ETH), Binance Coin (BNB), and Tether (USDT).

Bitcoin (BTC)

BTC is the most popular cryptocurrency. It uses a consensus mechanism called proof-of-work (PoW), where miners compete to validate transactions and keep the network running. In addition, BTC’s limited supply of 21 million coins makes it relatively scarce and helps maintain its value over time.

Ether (ETH)

ETH is the second most popular cryptocurrency, launched in 2015 by Vitalik Buterin and his team. In addition to transfers of value, it enables programmability through smart contracts. 

Like BTC, ETH initially used a PoW consensus mechanism but has shifted to the more environmentally friendly and energy-efficient proof-of-stake (PoS) model. This shift has allowed users to validate transactions and secure the network by staking their ETH rather than through nodes using computing power.

BNB

Formerly known as Binance Coin, BNB (which stands for Build and Build) was introduced in 2017 by the cryptocurrency exchange Binance as an ERC-20 token on the Ethereum blockchain. In 2019, it migrated to its own blockchain, BNB Chain, as a BEP-2 token.

Later, Binance Smart Chain (BSC; now named BNB Smart Chain) was created and today, the BNB cryptocurrency exists on both BNB Chain as a BEP-2 token and BSC as a BEP-20 token. It’s also worth noting that BNB Chain consists of two chains: the EVM-compatible BSC, as well as BNB Beacon Chain (previously called Binance Chain), which covers governance, staking, and voting.

BNB Chain provides an environment for creating smart contracts and DApps, and features lower transaction fees and faster processing times than many other blockchains.

BNB has various use cases, some of which include paying transaction fees on BNB Chain and trading fees on Binance, participating in token sales, and staking for network validation on the BNB Chain. Binance also uses a periodic token burn mechanism, which limits the overall supply of BNB.

Tether (USDT)

USDT is a USD-pegged stablecoin launched in 2014 by Tether Limited Inc. Stablecoins are cryptocurrencies designed to maintain a consistent value relative to a reserve asset, such as a fiat currency. In the case of USDT, each token is backed by an equivalent amount of assets held in the company's reserves. As a result, USDT offers the benefits of a cryptocurrency while minimizing price fluctuations.

What Is Crypto Market Cap?

The term “crypto market cap is” short for “cryptocurrency market capitalization”, which is a metric used to determine a cryptocurrency’s relative size and value. You can calculate it simply by multiplying a coin’s current price by the total number of coins in circulation. However, you may not even need to do so as many cryptocurrency platforms calculate it for you.

Crypto market cap is often used to rank cryptocurrencies, with a higher market cap generally indicating a more stable and widely accepted cryptocurrency. Conversely, a lower market cap usually signals a more speculative or volatile asset.

Do note, however, that this is just one of the many factors to consider when evaluating a cryptocurrency's potential. Several other factors, such as technology, team, tokenomics, and use cases, should also be considered when researching cryptocurrencies.

How to Safely Invest in Crypto

Like other financial assets, investing in cryptocurrency can be risky and may result in financial loss. Here are five essential tips to make buying and selling cryptocurrency safer:

1. DYOR

The acronym DYOR stands for “do your own research”. It's important to understand the basics of blockchain technology — such as the different types of cryptocurrencies and market dynamics — before investing in any cryptocurrency.

Books, blogs, podcasts, and online courses are all good places to start. You should also learn about the projects, teams, and technology behind different cryptocurrencies in order to make informed decisions.

2. Start small and diversify

The crypto market can be volatile and unpredictable, especially when it comes to less popular coins. Therefore, starting with small investments that won’t hurt your pocket is wise. This approach enables one to gain experience and develop a better understanding of market trends without risking significant financial loss.

Diversification can also be useful when investing in cryptocurrencies. Instead of focusing on a single cryptocurrency, investing in different cryptocurrencies can reduce your overall risk and increase your holdings’ chances of long-term growth.

3. Stay involved

As the cryptocurrency landscape is ever-changing, one should stay abreast of news, technological advancements, and regulatory updates in order to be able to make timely decisions. Joining a crypto community is an excellent way to do this.

4. Choose a reputable cryptocurrency exchange

Choosing a well-known and secure cryptocurrency exchange for your crypto investments should be your top priority in terms of security measures. The right crypto exchange can be found by researching different options and comparing their fees, customer support, interface, and available cryptocurrencies.

5. Practice risk management

Before investing in any cryptocurrency, it's essential to implement some risk management techniques. For example, investors should only invest what they can afford to lose. In addition, setting stop-loss orders to limit potential losses and taking profits at predetermined levels to secure gains can make a big difference.

What Is a Crypto Whitepaper?

A crypto whitepaper is a document that explains the details and technical specifications of a blockchain project. It typically includes information such as the project's goals, how it works, the technology behind it, the team involved, the tokenomics of the project, and the roadmap for development and implementation.

Cryptocurrency whitepapers serve as a comprehensive guide to the project, explaining its purpose and potential benefits. Investors and community members often review and scrutinize whitepapers to evaluate the legitimacy and potential of a cryptocurrency project before investing or getting involved. As such, whitepapers are essential for transparency and accountability in the cryptocurrency industry.

However, there are no standards or regulations for whitepapers, and they could be misleading or inaccurate. Cryptocurrency projects can write anything they want in their whitepapers. Therefore, the responsibility to verify the truthfulness of the claims in the document falls on the users.

Conclusion

The cryptocurrency ecosystem represents a revolutionary approach to finance and technology. However, the future of cryptocurrency depends on whom you ask.

Some believe bitcoin will replace gold and disrupt the existing financial system, while others argue that cryptocurrency will always be a secondary system and niche market. There are also those who believe Ethereum will become a decentralized computer that will serve as the backbone of a new Internet.

Though there are numerous possible outcomes, it's simply too early to determine what will happen even a year from now. Still, we can't deny cryptocurrency’s already visible impact on various industries, which is likely to further develop in the coming years.

Further Reading

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