What is a cryptocurrency? Explaining in simple terms

Main

• Cryptocurrencies are virtual assets, the functioning of which is provided by a network of decentralized computer nodes (nodes). Most of them are built on the basis of the blockchain – a database of transactions in a chain of related blocks.
• Cryptocurrencies are mainly used for settlements between network users, payment of commissions for transfers, as well as for storing capital. However, they may have many other features and limitations. In some blockchains, you can issue an unlimited number of cryptocurrencies.
• Depending on the functions and scope, there are different types of cryptocurrencies, including stablecoins, NFTs, governance tokens, and wrapped assets.
• Blockchain allows you to interact directly and without restrictions with cryptocurrencies. Decentralization and lack of control of any country or organization eliminates the possibility of blocking funds and other risks.

When did cryptocurrencies appear

Proposals for the creation of cryptocurrencies were made even before the advent of the Internet. The first algorithms aimed at transferring value over the Internet were proposed by the American cryptographer David Chaum. In the late 80s, he founded a related project called DigiCash. However, that ended in failure.

One of the projects close to modern cryptocurrencies is b-money. The project was founded by programmer Wei Dai. In b-money, he first proposed a Proof-of-Work (PoW) consensus mechanism for finalizing transactions and a distributed database for storing information about transfers.

Bitcoin, created by an anonymous user named Satoshi Nakamoto, was the first successful cryptocurrency to be widely adopted. The algorithm of the blockchain of the same name is largely based on the ideas of Wei Dai and, in a broader sense, the cypherpunk movement.

The next step in the development of virtual assets was the Ethereum smart contract platform, which was founded by Vitalik Buterin. The launch of the main network took place in 2015. Thanks to smart contracts, the Ethereum blockchain made it possible to issue an unlimited number of crypto assets and program their functions.

Cryptocurrencies and blockchain: differences from traditional finance and money

The reliability of the blockchain and the data protection mechanisms embedded in it have made cryptocurrencies a worthy alternative to the traditional monetary system. Transfers of digital assets can be made directly between users, and the network protocol represented by many independent nodes is responsible for their verification and confirmation. Once a transaction has been sent and verified, it cannot be undone.

Information about transfers is stored in an open database. Blockchain is the key technology that allows you to interact with virtual assets. The cryptographic methods used in it exclude the possibility of changing data on completed transfers.

Thanks to decentralization in the blockchain, it was possible to solve the problem single point of failure in databases and payment systems, providing universal protection from censorship. Virtual assets in public blockchains are not subject to the influence of regulatory authorities and external manipulations. The third party does not have the ability to freeze the funds or cancel the transaction.

Cryptocurrencies may not be under the control of any one entity, allowing them to be used in any jurisdiction. Bitcoin is the most famous example of such an asset. New virtual assets are released during the operation of the blockchain. The algorithm of operation of a particular digital asset includes such parameters as the total emission and the rate of issuance of new coins.

The user can create an unlimited number of addresses. The latter usually do not allow you to get information about him. Only specialized blockchain analysis tools make it possible to track the movement of funds and determine the sources of their receipt.

How Cryptocurrency Works: key features

Blockchain

Most cryptocurrencies use a technology called blockchain. The latter is a sequence of hierarchically linked blocks. It contains a database of all conducted transactions. New transactions are recorded in blocks that are created by node operators. Each of the computer nodes stores its own copy of the blockchain and, in the course of reaching a consensus, confirms new blocks, passing the result to other nodes. Based on this information, user balances are changed.

Hashing

Cryptocurrencies are widely used hash functions. The latter allows you to “collapse” an arbitrary array of data into one line – a hash. The blockchain is a single whole, since each subsequent block includes the hash of the previous one. The use of other data leads to a significant change in this line. The algorithm excludes the possibility of canceling a transaction without changing all subsequent blocks.

Consensus Algorithm

The consensus algorithm is responsible for confirming transactions and verifying all blockchain data, in which network members, nodes, participate. The most popular consensus algorithms are the already mentioned Proof-of-Work (used in Bitcoin) and Proof-of-Stake.

In order to confirm transactions, the nodes consume processing power or block their own funds, which act as a guarantee of data validity. After adding a new block, it is no longer possible to re-spend the funds spent at the current stage. In the process of reaching the algorithm, its participants receive new cryptocurrencies (both in PoW and PoS). Thus, these mechanisms serve as a way to issue a new cryptocurrency.

Addresses

Blockchain addresses where cryptocurrencies are stored are built on the basis of two keys – public and private. The first is used for the “open” part of the address, the second is used for signing transactions and accessing the address. The private key is only for the owner of the address. Existing computer power does not allow hacking a blockchain address, in particular, “guessing” a private key by brute force. Blockchain addresses can be created and managed in a special application – a wallet.

Transactions

To transfer cryptocurrency, the user sends an “instruction” to the network, which contains information about the amount of the transfer and the addressee. Transfer data is automatically verified by an electronic signature using a private key. After the message enters the network, it is included in one of the following blocks, which is “extracted” by the blockchain nodes. Any node can verify the signature of each translation using the public key. This algorithm guarantees the safety of funds and the impossibility of transactions by third parties.

Data immutability

Once a block is added to the chain, all its transactions are considered confirmed and irreversible. Verification of all transactions, including past ones, takes place every cycle of achieving network consensus. Unreliable data can only get into the blockchain if an attacker can decrypt the hash of blocks or controls a significant proportion of all network nodes. For example, in the case of Bitcoin, this threshold is 51%. As of October 13, 2022, worldwide over 15,000 nodeswhich makes an attack on bitcoin almost impossible.

Classification of cryptocurrencies: coins and tokens

To create and carry out transactions with cryptocurrency, a blockchain is needed, which requires infrastructure and economic incentives.

The main virtual crypto asset that ensures the functioning of the block chain is called native. The latter is used to pay transaction fees and pay rewards to nodes. On platforms that allow you to run smart contracts, native cryptocurrency is used to pay for their execution. For Bitcoin and Ethereum, the native coin bears the same name as the project and trades under the tickers BTC and ETH, respectively.

Various crypto assets may appear as a result of a hard fork. These include, for example, Bitcoin Cash and Ethereum Classic.

Today, cryptocurrencies no longer necessarily require a separate blockchain: many crypto assets are created for use in various applications running on the same network. Such cryptocurrencies are called tokens. CryptoSlate portal monitors quotes about 1300 tokensissued on the Ethereum network.

The release of tokens was made possible thanks to smart contracts, which became popular after the launch of Ethereum. Any user with programming skills can create their own cryptocurrency. The most well-known token standard is ERC-20.

What are the tokens

Virtual assets that are used for settlements and other purposes in projects and decentralized applications are called utility tokens.

Often, tokens are used to manage a project. The community of asset owners can make decisions about the future direction of the project. Owners have the opportunity to put proposals to the vote and take part in polls. The weight of the vote is proportional to the number of coins.

Coins may provide certain rights or privileges. Tokens are used to raise funds in the Initial Coin Offering (ICO). In some projects, virtual assets provide the right to a portion of the project’s profits. Tokens that have a set of functions within an application or network are also called utility tokens.

Cryptocurrencies officially recognized as securities are called security tokens. As of October 2022, there are at least A few dozens such crypto assets.

Stablecoins are implemented on the basis of blockchains. The value of these tokens is pegged to the price of a certain asset, such as the US dollar. Most often they are used for settlements and accumulation of savings. Their issuers keep an appropriate amount of currency in reserves, which guarantees price stability and safety of funds.

Smart contract platforms allow the issuance of wrapped tokens. The latter are tied in value to a cryptocurrency from another blockchain. For example, in order to use bitcoin on the Ethereum network, a token was issued WBTC. The binding is implemented due to the fact that the issuance of a token requires the locking of the corresponding amount of cryptocurrency, which acts as collateral. To unlock virtual assets, wrapped tokens are burned.

Modern networks issue non-fungible tokens (NFTs). These are unique coins that represent certain digital objects (images, audio and video files). NFTs have become collectibles. The first non-fungible tokens are rarities and have a high value (for example, CryptoPunks). NFTs can also perform other functions, such as being used as avatars or tickets to certain events.

There are cryptocurrencies that are derivative financial instruments. On the basis of such tokens, in particular, liquid staking is built. Unlike stablecoins, their price is regulated by market mechanisms. Some trading platforms issue leveraged tokens.

How the value of cryptocurrency is formed

When creating a blockchain, developers decide what the tokenomics of the project will be. The latter determines the issuance algorithm and the distribution of coins between users. Issue is the number of coins in circulation. In some projects, the initial output is zero, such as in Bitcoin. In such cases, the cryptocurrency can be issued continuously or periodically. A number of projects have a permanent emission.

The distribution of the initial issue of coins between users is determined by the developers. Usually part of the assets remains with the project team. Funds are reserved for advertising, development and development of the project. Some of the coins are used to attract investments. They can be bought by large investors within one or more rounds. Many projects use a public token sale to sell virtual assets to everyone. In other cases, they practice the distribution of coins between active users – airdrop.

Cryptocurrency algorithms may require blocking of some coins (for example, when staking). Since some of the assets are deposited in smart contracts, a certain amount of funds is not available. As a rule, the release of a cryptocurrency is limited to a maximum issue. For projects that constantly generate coins, their total number will never exceed this value. For example, the maximum supply of BTC is 21 million.

Halving affects the value of the cryptocurrency. The mechanism is used in cryptocurrencies that pay a fixed block reward. Halving occurs periodically and leads to a decrease in this amount. The event reduces inflation, and if there is demand for the asset, it stimulates the growth of its value.

The price of a cryptocurrency is affected by the burning of coins. The latter involves the withdrawal from circulation of a certain amount of assets. To destroy the coins, the owners send them to special addresses or smart contracts. At the same time, an abrupt increase in the value of the cryptocurrency is possible, and periodic burning increases its scarcity.

Cryptocurrencies, unlike fiat money, are not controlled by a specific organization or state. As a result, virtual assets are characterized by high volatility. Their value is determined primarily by market mechanisms. The value of a cryptocurrency depends on the relationship between supply and demand. If a significant amount of coins is sold on the market, and there are few people who want to buy, the value drops. When demand exceeds supply, the price rises.

The main indicator of the demand for a virtual asset is the market capitalization. The latter is equal to the product of the volume of coins in circulation by the unit cost. At the time of writing BTC capitalization exceeds $374 billion. The latter is calculated based on the issue of more than 19 million coins worth $19,513 each.