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Cryptocurrency is similar to using PayPal or a Debit Card, except the numbers on the screen represent cryptocurrency instead of dollars. All a new user needs to do is set up a Coinbase account or download a Crypto Wallet App, such as Binance, to get started. Users can buy, sell, send, receive, and store Bitcoin, Bitcoin Cash, Ethereum, Ripple and many other “Alt-coins”.
To use cryptocurrency, you don’t need to understand it (any more than you need to understand the monetary system to use a debit card). However, if you want to understand cryptocurrency you need to understand the concepts of digital currency, blockchain (both as a public ledger of transactions and a technology), and the concept of cryptography. Cryptocurrency is solely digital, where transactions are recorded on a public digital ledger called a blockchain, and every process along the way is secured by cryptography. By the end of this article, you should have a much better understanding of how each of these fit together.
Cryptocurrency works a lot like bank credit on a debit card, where a complex system issues currency, records transactions and balances, allowing people to send and receive currency electronically. Just like with traditional banking, online platforms can be used to manage accounts and move balances. The main difference between cryptocurrency and bank credit is that instead of banks and governments issuing the currency and keeping ledgers, an algorithm does instead.
Cryptocurrency is best thought of as digital currency (it only exists on computers). It is transferred directly between peers, removing the role of a bank. Transactions are recorded on a digital public ledger, known as a “blockchain”. Transaction data and the ledger are encrypted using cryptography. This is what gave this concept the name “crypto-currency”. It is decentralised, meaning it is controlled by users and computer algorithms and not a central government. It is distributed, meaning the blockchain is hosted on many computers across the globe. Meanwhile, cryptocurrencies are traded on online cryptocurrency exchanges, like stock exchanges. Bitcoin (BTC) is one of many cryptocurrencies; other popular cryptocurrencies are Ethereum (ETH), Ripple (XRP), and Litecoin (LTC). Alternatives to Bitcoin are called “alt-coins.”
Transactions are sent between peers using software called “cryptocurrency wallets.” The person who creates the transaction will use the wallet software to transfer balances from one account, known as a public address, to another. To transfer funds, knowledge of a password, called a “private key”, associated with the account is needed. Transactions made between peers are encrypted and then broadcast to the cryptocurrency’s network, ready to be added to the public ledger. Transactions are then recorded on the public ledger via a process called “mining”. All users of a given cryptocurrency have access to the ledger if they choose to access it, for example by downloading and running a copy of the software called a “full node” wallet. These operate slightly differently from a third party wallet like Binance, where coins can be held. The transaction amounts are public, but who sent the transaction is encrypted, thus making them anonymous. Each transaction leads back to a unique set of keys. Whoever owns a set of keys, owns the amount of cryptocurrency associated with those keys. This concept works similarly to traditional banking, in that whoever owns the bank account owns the money in it. Many transactions are added to a ledger at once. These “blocks” of transactions are added sequentially by miners. That is why the ledger and the technology behind it are called “block-chain.” It is a “chain” of “blocks” of transactions.
The blockchain is like a decentralised bank ledger, where a record of transactions and balances are stored. When a cryptocurrency transaction is made, that transaction is sent out to all users hosting a copy of the blockchain. Specific types of users, called miners, use software to try to solve a cryptographic puzzle which lets them add a “block” of transactions to the ledger. Whoever solves the puzzle first gets a few “newly mined” coins as a reward, in addition to transaction fees paid by those who created the transactions. Sometimes miners pool computing power and share the new coins. The algorithm relies on consensus. If the majority of users trying to solve the puzzle all submit the same transaction data, then it confirms that the transactions are correct. The security of the blockchain relies heavily on cryptography. Each block is connected to the data in the last block via one-way cryptographic codes called hashes which are designed to make tampering with the blockchain very difficult. Offering new coins as rewards, the difficulty of cracking the cryptographic puzzles, and the amount of effort it would take to add incorrect data to the blockchain by faking consensus or tampering with the blockchain, helps to ensure against bad users.
People who are running software and hardware aimed at confirming and adding transactions to the digital ledger are cryptocurrency miners. Solving cryptographic puzzles, via software, to add transactions to the ledger (the blockchain), with the aim of earning coins as a reward is cryptocurrency mining.
The keys that move balances around the blockchain utilise a type of one-way cryptography called public-key cryptography. The one-way cryptographic codes that tie together blocks on the blockchain are known as “hashes”. These use a similar type of cryptography. Transaction data sent and stored on the blockchain is tokenised. Tokenisation is a type of one-way cryptography that points to data but doesn’t contain all the original data. The key to understanding these layers of encryption which ensure a system like Bitcoin’s is found in one-way cryptographic functions. Cryptographic hash functions, cryptographic tokens, and public-key cryptography are all names for different, but related, types of one-way cryptographic functions. The main idea is that cryptocurrency uses a type of cryptography that is easy to compute one way, but hard to compute the other way without a “key”. It is worth noting that some other crypto coins work in a slightly different way.
Cryptocurrency can be bought most of the same ways other types of currencies can. You can exchange goods and services for cryptocurrency, you can buy cryptocurrencies with traditional money, or you can trade cryptocurrencies for other cryptocurrencies. Trading is generally done via brokers and exchanges. Brokers are third parties that buy/sell cryptocurrency, exchanges are like online stock exchanges for cryptocurrency. You can also trade cryptocurrencies directly between peers. Peer-to-peer exchanges can sometimes be mediated by a third party. It is important to be aware that cryptocurrency prices can often be fairly volatile. It’s wise to ease into cryptocurrency investing and trading, and be prepared to lose everything you have invested. Although it is unlikely you will lose your whole investment, price crashes happen with relative frequency. The risk is especially high if you choose to invest in or trade alternative coins with lower market caps.
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