Cryptocurrency is a type of digital currency that uses cryptography to secure transactions and generate new units of currency. Cryptocurrency is decentralized, meaning it isn't subject to government or financial institution control.
This sounds less complicated once you realize it's nothing new. For instance, your phone, email provider, and almost every secure website already use cryptography in the background, and the idea behind cryptocurrency is rooted in proven economic principles. We've broken down the basics of popular virtual currencies, so let's dive in.
What is cryptocurrency?
A cryptocurrency, like Bitcoin, Ethereum, Litecoin, Dogecoin, or any number of alternatives, is a type of digital currency. A good way to think about it is to imagine a bank – although some of the assets in the vault will be physical items, like gold, fine art, or cash, others are more representational – like stock certificates or bond notes.
Cryptocurrency is designed to act as a digital stand-in for abstract forms of value. The idea of computerized money isn't so new, either: Services like credit card processors have been leveraging these concepts since the 1970s when the first magnetic-stripe credit cards hit the market.
Most cryptocurrency takes the form of software specifically geared towards monetary activities. Unlike tools like PayPal or your banking app, however, this form of digital technology doesn't just replace your trip to the teller's counter. Having a digital wallet or access to a cryptocurrency exchange negates the need for physical currency and traditional banking networks themselves!
How does cryptocurrency work?
Cryptocurrency's potential as a secure medium of exchange revolves around its use of cryptography (that's where cryptocurrency gets the name!) Cryptography is a catch-all term for techniques that use mathematical algorithms to encode and decode data. It plays a critical role in protecting information from unauthorized access.
The classic example of cryptography in action is that of the cipher. Imagine that you wanted to send someone a secret message and replaced all of the As with 1s, the Bs with 2s, and so on. As long as your recipient knew how the cipher worked – the A=1, B=2, etc. – they’d be able to decipher your message.
Real ciphers, like the ones that power cryptocurrency transactions and blockchain technology, take this idea to the extreme. They replace simple substitutions with long-running math problems to generate private keys. Since it’s just math, it’s easy to verify when someone has the right key to unlock the message, but hackers and other bad actors would need massive amounts of computing power to break through.
Cryptocurrency uses cryptography for multiple purposes, such as
- Securing transactions just like shopping websites do daily
- Controlling the creation of additional units of currency – new blocks on the blockchain – to moderate value and avoid inflation
- Verifying the creation and transfer of assets via proof-of-work or proof-of-stake algorithms.
Cryptocurrencies are also decentralized – they use blockchain technology to build distributed ledgers that serve as a public record of transactions.
Decentralized blockchain ledgers aren't subject to control by financial institutions or any other central authority. This makes them appealing alternatives for paying employees, transacting with international partners using smart contracts, and even accessing startup funding.
What are the main types of cryptocurrency?
There are thousands of popular cryptocurrencies with unique purposes. Most of these assets fall into one of four categories:
Transactional cryptocurrencies are cryptocurrencies that are used to facilitate transactions, such as payments or transfers. A good example is Bitcoin (BTC), arguably the first cryptocurrency, which was created in 2009. Other popular transaction-oriented cryptocurrencies (commonly known as altcoins due to Bitcoin’s dominance) include Ethereum (ETH) and Litecoin (LTC).
Entertainment tokens are cryptocurrencies that are used to purchase goods and services within a specific industry or niche.
Stablecoins are digital currencies that are pegged to a stable asset, such as gold or the US dollar, to reduce price volatility. These cryptocurrencies are commonly used as a store of value.
Infrastructure cryptocurrencies are cryptocurrencies used to build or maintain blockchain infrastructures.
Is cryptocurrency legal?
Cryptocurrencies like Bitcoin once operated in a legal gray zone. They've been heavily regulated since first hitting the scene, however.
Today, multiple international governments have enacted laws on everything from transfers to capital gains tax reporting, and less than ten ban it. Many of the rules also target cryptocurrency exchanges – trading and speculation platforms such as Binance or Coinbase – as opposed to Bitcoin, Litecoin, or any other digital currency itself.
The trend toward regulation may actually work better for investors and companies. Regulated cryptocurrency assets, like stablecoins, tend to fluctuate in value less. This makes them more appropriate solutions for payrolls, purchases at physical and online retailers, and other business use cases.
It's also worth noting that increased regulation often adds legitimacy to cryptocurrencies. When the laws are clearer, institutional adoption of digital assets increases, stabilizing the value of cryptocurrencies and enhancing their viability as good investments.
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