What is a Cryptocurrency?

William Wolff

published July 3, 2021

~ 6 min read

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Abstract

Cryptocurrencies are merely an application that runs on top of a blockchain. A cryptocurrency is a digital payment system, which does not rely on middlemen to verify transactions. They are a medium of exchange, which is purely digital, encrypted and decentralized.
Unlike the US Dollar, Euro, or Chinese Yuan, there is no central authority that manages and maintains the value of a given cryptocurrency. This also implies that there is no central authority capable of changing the money supply at will. Hence, cryptocurrencies are seen as a first alternative to the traditional banking system as they come with major advantages over today’s means of payment.

artist:@chained2block

Similarities to Cash

Cryptocurrencies are an open, peer-to-peer system based on blockchain, which allows for two parties to exchange value directly - with no trusted middlemen such as a bank. In the past, this was only feasible if both parties were geographically situated in the same place - by exchanging cash. Hence, cryptocurrencies are a digital equivalent to cash payments, disregarding a few exceptions.

Differences to Cash

Cryptocurrencies are not backed by any government. Moreover, they are encrypted, which means every transaction is digitally, cryptographically signed, therefore drastically reducing the chance of theft down to human error.

Unlike traditional cash transactions, any transaction using cryptocurrencies is recorded in a distributed ledger. A ledger is a book of transactions for account keeping. For most cryptocurrencies, this ledger is represented by a blockchain.

The recording of each transaction in a decentralized setup is necessary in order to prevent anyone from creating coins out of thin air or avoid double-spending their coins with different parties. Thus, the ledger keeping a record of all transactions is fundamental to the security of the entire system.

Criticism of Cryptocurrencies

A predominant concern is that cryptocurrencies, such as Bitcoin, are not rooted in any material goods. However, the production of a Bitcoin requires electrical energy in the form of computing power which is directly related to its market price.

Market prices are based on supply and demand. The rate at which one cryptocurrency can be exchanged for another currency is prone to fluctuations. This is attributed to the design of many cryptocurrencies to ensure high scarcity.

Bitcoin and other cryptocurrencies using computing power resources as they scale are called Proof of Work (PoW) cryptocurrencies. They require an increasingly large amount of energy as the network of actors sending and receiving Bitcoin grows. This energy consumption is seen by many as unsustainable for continued future growth. However, there are other cryptocurrencies, which solved this problem by implementing a different type of consensus mechanism, for example, Proof of Stake (PoS).

Lastly, holding a cryptocurrency without a custodial third party requires you to create your own, personal digital wallet. Every wallet is kept safe using something called asymmetric encryption, which comes with a public and a private key. In short, a public key can be used to send coins to your wallet, therefore you can safely publish it. A private key allows you to spend coins from your wallet.

The problem arises from people either having lost or forgotten their private keys in the past. There is no private company that can help you with any sort of “Reset my password/ private key” option when it comes to cryptocurrencies. You are fully responsible for yourself to safely store your private key - preferably offline.

Value of Cryptocurrencies

Value is defined subjectively, depending on the individual needs of the beholder. Cryptocurrencies come with vastly different properties compared to traditional fiat currencies, such as the US Dollar and Euro. The immutability of blockchain-based cryptocurrencies is an aspect often highlighted by many supporters.

Moreover, the transparency and auditability of such cryptocurrencies is something valued by many people, as it prevents political abuse or financial fraud of certain elites. In addition, some see certain cryptocurrencies, for example, Bitcoin, as a store of value - serving as an inflation hedge for diversifying into an asset, which may not lose value as governments increase their money supply.

Overall, many supporters of cryptocurrencies joined the space looking for alternatives for solving major problems of our current global financial system, which does not offer the same access nor opportunities such as credit, financial history or insurance to everyone.

In fact, there are estimates of 2 billion people worldwide whose quality of life is undermined by financial exclusion. Hence, banking the unbanked is a major goal for some cryptocurrencies as the only requirements for these people in order to participate in the global economy via cryptocurrencies would be an Internet connection and a mobile phone.