How Cryptocurrency Works: A Guide

Revolut Contributor

 · August 04, 2020  · 08/04/2020

Want to know how cryptocurrency works? You’re in the right place.

Cryptocurrencies are a type of virtual currency that are processed and secured by cryptography. They’ve experienced a bit of a boom in the last decade or so – with more than five thousand cryptocurrencies having joined the party since the 2009 launch of Bitcoin.

As such, the world of crypto can be a difficult one to navigate – particularly when the technical features often take centre stage. So, what is crypto? And how does cryptocurrency work? Let’s take a look.

Firstly, What is Cryptocurrency?

A cryptocurrency is a digital, or virtual, currency that is defined by its use of cryptography – a discipline that uses mathematical concepts and techniques to secure information. Without cryptography, the cryptocurrency system could not exist in the way that it does today.

Cryptography allows cryptocurrency to take its famously “decentralized” form. Rather than relying, like conventional currencies, on the authority of any central bank or government, crypto works on a peer-to-peer basis. It is managed by a community of developers and every transaction is verified and recorded through the use of a cryptographic proof.

This has given cryptocurrencies a certain appeal – not least for their security and transparency. With every transaction recorded in a digital ledger known as the blockchain, cryptocurrency keeps all financial activity both public and secure, whilst peer-to-peer transactions mean payments are as quick as possible.

👉 Learn more in our comprehensive article What is Cryptocurrency

How Cryptocurrency Works: a Step-by-Step Guide

So, how does this all work? Whilst much of the language of cryptocurrency can be somewhat alienating, it’s not all as tricky as it might seem. To explain it simply, we can break down the cryptocurrency process into a three-stage cycle – involving a transaction, the blockchain, and a process known as “mining”.

Here, we’ll take a look at this process in a little more detail. However, know that, given the sheer number of different cryptocurrencies, not all of them work in the same way. Whilst this process is true of Bitcoin and Bitcoin Cash, say, it is not true of Ripple (XRP).

Start with a Transaction

Let’s start with the cryptocurrency basics: the transaction itself. Nothing happens at all unless someone transfers some coins to someone else.

So, x sends money to y, through a digital wallet that stores the cryptocurrency. Unlike conventional currency, however, that payment is not facilitated by a central bank, clearing house, or system. Rather, it is transferred directly from person to person – or, in the language of crypto, from peer to peer. In this way, crypto transactions tend to be quicker and cheaper than transfers in conventional currency.

But how does this happen? Enter the blockchain.

The Blockchain

As we said above, the blockchain is the technology that enables cryptocurrency to function in a decentralized manner. In its simplest terms, it is a record or ledger in which the details of transactions are recorded – yet, it does have some specific features.

The technology gets its name from the fact that “blocks” of information are linked together in a “chain”. This is crucial for crypto’s security, as the information recorded in a given block is dependent on the information in the prior block, and so on. This way, you cannot change the information in one block without changing the entire chain – making hacking extremely difficult.

If x gives money to y, this transaction will be recorded in a block: the sender and recipient, the sum, and a timestamp. What also needs to be included is a cryptographic proof – a complex mathematical problem requiring serious computer power to solve – that verifies that this transaction happened and that determines the block’s place in the chain. We’ll come to how this is produced in a moment.

Crucially, though, the blockchain is not located in any one specific place. Rather, it is “decentralized”, or held on multiple servers across the world. All of these different versions are updated simultaneously: change one and you have to change them all.

Mining: The Meaning of Crypto

Remember that cryptographic proof? That’s where mining – e.g. Bitcoin mining – comes in. This is responsible for two of crypto’s most important elements: producing the proof and allowing more coins to enter circulation.

“Mining” is the term for the process of producing the cryptographic codes that join each of the blocks to the chain. The “miners” are developers across the world with serious computer power behind them. They need this power to produce the correct 64-digit number or “hash” that is specific to that given block. The chances of finding it are apparently one in 14 trillion.

Given that this process is so difficult, the security of the blockchain is assured. Importantly, though, the miners get something out of it, too. If a miner finds the right hash, they are rewarded in Bitcoin. That’s the only way that new cryptocurrency can be minted.

Crypto as a Currency

After all this, let’s not forget that cryptocurrencies are currencies – and, as with USD or Euros, you don’t need to know all the technicalities in order to use them. These days, it’s not just techies that have an interest in crypto. Rather, currencies like Bitcoin or Ethereum have become serious stores of value.

To that end, let’s take a different look at how cryptocurrency works – not just as a technological system but as a currency.

How Does Bitcoin Have Any Value?

Unlike fiat currencies, with central banks, there is no central authority behind cryptocurrency to stabilize its value. However, cryptocurrencies maintain some value – however volatile – because people are willing to buy them and are willing to accept them as payment.

In short, cryptocurrencies like Bitcoin have value because people see them as valuable. Yet, things aren’t just that simple. This fact is determined by different factors too. Let’s take a look.

Usefulness

Crypto’s utility, firstly, gives it value. The fact that it’s a solution to a specific problem makes it sought-after and therefore valuable. Originally, Bitcoin was seen specifically as a fast (and cheap) solution for transferring money worldwide. However, as more people jumped on the bandwagon, Bitcoin’s value soared. Demand increased, while supply remained stable.

Scarcity / Quantity

How does supply and demand affect the value of a currency? Monetary policy is the series of techniques that governments and banks employ to control the amount of money in circulation. Bitcoin does this by maintaining a limit on the number of coins.

Remember that miners receive new Bitcoin for their trouble? This is the only way that new Bitcoin enters the system. But by keeping the coin reasonably scarce (Bitcoin, for example, is limited to 21 million coins), the value remains high.

Security

Finally, a currency couldn’t be used if it wasn’t believed to be secure – and it wouldn’t have any value if the same coin could be used twice simultaneously.

The cryptographic system ensures that every transaction is unique and that the currency can only be counterfeited with a huge amount of effort. As we saw above, every copy of the blockchain would need to be changed simultaneously for a fraudulent transaction to be recorded.

Similarly, whilst physical currency can be damaged, crypto has extra security in this regard. Being digital-only, cryptocurrency is theoretically permanent in its existence and non-damageable.

Is Cryptocurrency a Good Investment?

Consequently, then, is crypto something worth investing in? We’re not here to offer investment advice, so you need to judge for yourself. Indeed, there are stories of big returns – and big losses.

For example, in early 2011, Bitcoin reached parity with the dollar, meaning that you could trade one Bitcoin for one USD. If you’d stuck that investment out until December 2017, you may have received over $19,000 for that one coin which was bought six years earlier.

These days, however, there isn’t just one cryptocurrency – so for many people the question becomes which one to invest in. Bitcoin remains the front-runner as it makes up 63% of the crypto market according to CoinMarketCap, but there are other crypto options which might interest budding investors.

Conclusion: How Crypto Works

At the intersection of technology, finance, and the digital community, you can see why so many people find cryptocurrency interesting. And it’s not as complicated as it first seems.

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