What is Cryptocurrency and How Does It Work?

 

What is cryptocurrency?

Cryptocurrency, or crypto, is a form of digital currency that can be used for internet-based electronic payments or as a store of value. The idea of "digital cash" isn't new—credit cards, PayPal, Venmo, and other payment methods permitting easy, traceable electronic transactions came before. But there are important differences. 

A big one is that transactions using these earlier methods were settled using traditional "fiat" currencies. Fiat currencies—such as the U.S. dollar and euro—are those issued by governments and whose supply is managed by central banks. 

In contrast, cryptocurrencies are considered a "non-fiat" medium of exchange because they function independently of any government or central bank, using unique algorithms to record transactions and determine supply. 

Cryptocurrencies have no intrinsic value, unlike a fiat currency (whose value stems from the fact that it is legal tender authorized by a government) or earlier commodity-based currencies (such as those tied to gold or silver). 

Instead, a crypto currency's price is based on the quality of the underlying technology, as well as supply and demand dynamics determined in part by technology that limits the creation of additional units and investor sentiment. Like with any traded item—think baseball cards—scarcity can influence value: The fewer units available, the higher the price potential buyers are willing to pay.

Why is it called "crypto" currency?

"Crypto" refers to the cryptography—i.e., the unique software code underpinning a virtual currency.

How does cryptocurrency work?

Cryptocurrencies are rooted in blockchain technology. A blockchain is an open-source database—essentially a public ledger—that is distributed across a decentralized computer network (in this case, the internet) and forms a permanent record of transactions between parties. Each transaction represents a "block" of data about who owns what at a given time, along with the hash (unique identifier) of the previous block. Together these blocks form a "chain" that can't be altered or counterfeited. 

Having a public ledger obviates the need for a central authority to confirm the database's accuracy or to clear transactions, as each new transaction is recorded across the entire network. 

So, you could think of a cryptocurrency transaction as a series of electronic messages that record information about the parties involved, the timing, and the quantity of currency being traded. Note that ownership of bitcoin or other cryptocurrencies is not an investment in blockchain, the technology, or its current or future uses.

While cryptocurrencies are perhaps the most famous application of this technology, blockchains have many potential uses beyond payments. They include "smart" contracts, which are executed automatically once the agreed terms and conditions are fulfilled. They can also be used to manage supply chains and provide financial services.