How do cryptocurrencies work? Functionalities and effectiveness explained by Digimagg

Everything you ever wanted to know about cryptocurrency

They say money can change everything. Many people exchange 40 hours of their time every week for a portion of it. The allure of becoming wealthy drove countless adventurous speculators to journey across the United States to stake their claim in the California Gold Rush. Investment markets anxiously await news from Federal Reserve meetings.

And now, there's the latest craze in money – Bitcoin. While Bitcoin garners most of the headlines, it is just one of numerous digital currencies, also known as cryptocurrencies, available today. In this article, we will delve into what cryptocurrencies are, how they are created, and what purposes they serve.

What is a cryptocurrency?

Before delving into cryptocurrency, let's first define currency in general. Many people think of currency as a system of money accepted by a specific country (or group of countries, as in the case of the euro). Paper or coin forms of dollars and euros are common examples, known as fiat currency.However, a currency doesn't necessarily need government backing. It's simply a medium of exchange for goods or services. As long as both the buyer and seller agree on a form of payment, it functions as a currency. The widespread acceptance and stable value are key factors in its success.

Cryptocurrency, on the other hand, is a decentralized digital currency. It doesn't exist in physical form, so you can't physically carry it. Instead, it consists of encrypted data blocks exchanged through a secure peer-to-peer file transfer system. Its supply and value depend on user activities and complex protocols in the coding system, which establish a governing structure that's not easily altered.Being decentralized means it operates without government oversight. Consequently, cryptocurrencies lack banks and aren't backed by entities like the Federal Deposit Insurance Corporation (FDIC), which supports the U.S. dollar. There's also no traditional mint producing these currencies. Instead, independent miners create them and receive rewards for their efforts.

These currencies cannot be physically held or seen, and they are not connected to any government. Despite this, there is a significant demand for these modern currencies, with many people willing to pay high prices to acquire them. Bitcoin and other cryptocurrencies have become a phenomenon in the digital world.

What is cryptocurrency mining?

To produce physical dollar bills, you need a printer; to create cryptocurrency, you need a computer. Although we often refer to cryptocurrency units as "coins," this is a loose term.

New coins are generated or "mined" when a network node solves a complex mathematical problem. These equations become more challenging as more coins are mined. Mining involves calculating the hash of a block header, which includes references to the previous block, transaction hashes, and a unique 32-bit value known as a "nonce." This mining process is recorded in a ledger called a blockchain.

Cryptocurrency mining requires a significant investment, similar to traditional mining projects for minerals like gold. For popular cryptocurrencies like Bitcoin, mining on a home PC is no longer feasible due to the high computing power required. Energy consumption is also substantial, not just to power the mining hardware but also to cool the servers with industrial-grade cooling systems. The cost of electricity is a major factor, making it challenging to profit from mining Bitcoin. Consequently, most mining occurs in countries with low electricity costs, like China, where large computer farms operate continuously.

A less ethical mining approach involves the use of cryptocurrency mining malware. This malicious software is spread by dishonest miners to infect unsuspecting users worldwide. Once a device is infected, the malware utilizes the CPU and memory resources of the host hardware to collectively mine a specific cryptocurrency.

Individually, a single client device lacks the capacity to mine cryptocurrency effectively. However, when thousands of infected devices work together, the collective effort can be significant. A compromised computer is often referred to as a "zombie." Hackers who control these zombie armies of miners profit at the expense of others. The prevalence of crypto mining malware corresponds with the fluctuating prices of cryptocurrencies.

Blockchain and cryptocurrencies

Any discussion about cryptocurrencies inevitably involves the concept of blockchain. A blockchain is a database where data is stored in blocks linked or "chained" together. When a block is filled, new data is stored in a fresh block. Since cryptocurrencies like Bitcoin are decentralized, the blockchain is not controlled by a single entity or hosted in a single location. Instead, it is distributed across participating nodes worldwide, with each node containing identical copies of the blockchain. This prevents data manipulation or loss.

The blockchain is spread across thousands of computers in different geographic locations. In addition to being encrypted, this distribution enhances the currency's security. The blockchain records every coin mined and transaction made with the currency. For example, bitcoins are cryptographically signed with each exchange, requiring users to have both a public key and a unique private key. Every cryptocurrency holder has a private key that authenticates their identity and enables them to exchange currency. While this significantly boosts transaction security compared to regular cash, it also means that losing your key renders your cryptocurrency holdings worthless until the key is recovered.

Bitcoin and other well-known cryptocurrencies offer extensive transparency, allowing anyone to view past transactions. However, some cryptocurrencies, especially those used on the dark web, prioritize anonymity to protect transaction participants' identities. Unlike fintech applications like PayPal, once a transaction is recorded in the blockchain, it is final, making refund or chargeback functions impossible, at least for now.

Blockchain is not limited to cryptocurrencies; it can also host legal contracts and other sensitive data. Many large companies are exploring how to integrate blockchain technology into their record-keeping processes.

How are cryptocurrencies worth real money?

A cryptocurrency, like any asset, is valued based on what someone is willing to pay for it. Unlike national currencies, the value of cryptocurrency fluctuates constantly and can be highly volatile. While a $1 bill is always worth a dollar, the price of Bitcoin and other digital currencies can vary greatly. For example, the value of a single Bitcoin dropped to around $5,000 in April 2020 but surged to over $40,000 in January 2021.

Bitcoin, created in 2009, was initially worth only a few pennies per coin. Its value skyrocketed to over $20,000 per coin in 2017 before crashing. This extreme volatility hinders its acceptance as a stable currency.

Supporters of cryptocurrencies argue that Bitcoin and others are excellent hedges against inflation, similar to gold. Unlike national currencies, which used to be backed by gold or another commodity, most fiat currencies today are backed only by the issuing country's reputation. This allows governments to print more currency, leading to inflation and a decrease in purchasing power over time.

Cryptocurrencies are considered more secure than traditional money in some respects. It is extremely difficult, if not impossible, to counterfeit digital currency, which increases people's trust in it.

Unlike traditional fiat currencies, cryptocurrencies like Bitcoin have a fixed limit on the total number of coins that can be mined, which is seen as a key factor in determining their value. For example, the Bitcoin protocol specifies that only 21 million bitcoins can ever be mined. Currently, there are around 18.5 million bitcoins in circulation, and once the cap is reached, mining operations will cease permanently.

Similarly, Ethereum, the second most popular cryptocurrency, has a cap of 72 million coins. Additionally, the production rate of these digital currencies decreases over time as the mathematical problems required for mining become more complex. In the case of Bitcoin, the mining rate decreases by approximately 50% every four years.

Supporters of cryptocurrencies argue that these capped supplies and decreasing production rates will help maintain their value compared to fiat currencies. However, skeptics raise concerns that there is no guarantee that the mining process for Bitcoin or other cryptocurrencies will not be altered once these caps are reached.

How can you get cryptocurrencies?

While not everyone can mine cryptocurrencies, anyone can buy them online. This is typically done through a cryptocurrency trading exchange, with Coinbase being one of the most well-known. Each exchange deals in different cryptocurrencies, and to buy them, you need to create an account and get a digital wallet from the exchange to store your coins. You don't need to buy a whole coin, which is fortunate since most people don't have tens of thousands of dollars to spend on one. Some cryptocurrencies can be purchased directly with U.S. dollars, while others require you to use Bitcoins or other cryptocurrencies, making the buying process more complex.

Why Use a Cryptocurrency?

Besides the potential for financial gain through cryptocurrency investment and speculation, there are several practical reasons to use cryptocurrencies for buying and selling goods and services.

One key advantage is the lack of association with any government, eliminating concerns about international exchange rates. This means you can trade Bitcoin with individuals worldwide as easily as with someone in your own country, essentially creating a borderless currency. However, the idea of establishing cryptocurrencies as a universal currency may face obstacles, such as India's proposed legislation in 2021 to ban private cryptocurrencies in favor of a nationalized alternative.

Another benefit is the independence from traditional banking systems. You don't need a bank account or approval from a financial institution to conduct transactions, eliminating bank fees, minimum balances, and credit score requirements. With just a smartphone or computer app, cryptocurrencies offer unparalleled mobility and accessibility.

Cryptocurrency transactions are conducted peer-to-peer, eliminating the need for intermediaries that typically charge transaction fees. Some leading peer-to-peer exchanges even operate without fees.

While Bitcoin transactions are transparent on the blockchain, personal identities are not disclosed. Unlike credit card transactions, you don't need to provide personal information like your name and address, offering a higher level of privacy, although not completely untraceable.

Digital currencies are also well-suited for online transactions. As more people shift to online shopping, cryptocurrencies offer a convenient and universal online payment method that is likely to become more widely accepted.

How Many Cryptocurrencies Are There?

While most people typically use a single currency in their daily lives, there are actually 180 currencies recognized by the United Nations worldwide. In the realm of cryptocurrencies, the exact number in circulation is unknown. While nearly 8,000 cryptocurrencies have been created, many have become obsolete over time.

It's estimated that there are currently between 4,000 and 5,000 digital currencies in circulation. Bitcoin holds the largest market share, accounting for approximately 62% of the market. Despite its dominance, the origins of Bitcoin remain shrouded in mystery, with its creation attributed to a paper released by someone using the pseudonym Satoshi Nakamoto in 2008.

The top five cryptocurrencies collectively make up about 80% of the market. Many cryptocurrencies lack value, with some being created as hobbies or jokes by individual developers. However, even these lesser-known cryptocurrencies can attract attention at times. For example, in February 2021, Dogecoin, a digital coin created in 2013, surged in value by over 800% after gaining attention on a Reddit board during the GameStop frenzy.

Some of the more popular alternative coins to Bitcoin include Ethereum, Litecoin, Bitcoin Cash, and Ripple. Ethereum, in particular, is notable for being the second most popular blockchain platform, offering more than just mining and coin transactions. It provides additional services such as contract functionality and distributed application development.

Bitcoin Cash is a type of cryptocurrency that is created as a result of a fork, which happens when users or developers decide to implement a significant change to the currency, resulting in a new blockchain.

Can Anyone Make a Cryptocurrency?

Yes, anyone can create their own cryptocurrency, which is why there are so many in existence today. However, creating a digital currency requires a significant financial investment to cover the costs of hardware and electricity. Extensive programming skills are also necessary to develop the blockchain and encryption algorithms. Additionally, strong cybersecurity measures are essential to protect against hacking threats, as cryptocurrencies are often targeted by cybercriminals. Building a supportive online community is also crucial for the success of a new cryptocurrency, which can be achieved through an initial coin offering (ICO), similar to an initial public offering (IPO) for stocks.

Crypto Has Only Just Begun

The cryptocurrency market is still in its early stages of development. Interest in blockchain technology is growing among businesses, as they explore new innovative uses for this secure and flexible platform. Many believe that cryptocurrencies will increase in value in the coming years, with some analysts predicting a price of $100,000 for Bitcoin. As global trade expands and governments continue deficit spending, there is speculation that cryptocurrencies could become the preferred currency worldwide. However, it is uncertain whether cryptocurrencies will ultimately succeed or if they are just a transitional phase to something else.