What Is Cryptocurrency?

What Is Cryptocurrency in Simple Words?

In short, cryptocurrencies are a type of digital money that circulates in decentralized (distributed) networks. The advantage of Bitcoin and similar assets is the absence of a single controlling server. Cryptocurrencies are used not only as a means of payment, but also as a tool for speculative trading and investment.

The first electronic payment services were centralized, that is, managed by one administrator. This did not suit users for the following reasons:

Risk of hacking or server failure.

Government restrictions.

Identification procedure for opening an account.

To get rid of these shortcomings, the developers came up with a new way to transfer money between users: peer-to-peer decentralized networks. Each member of this community is assigned a unique address (wallet). Computers connected to a peer-to-peer network "communicate" with each other using cryptographic algorithms. As a result, each wallet owner participates in the work of the community and can see the transactions of all users.

To describe the functions and capabilities of cryptocurrency in simple terms, it is enough to compare it with a game of chess or checkers:

Each participant in the party sees the arrangement of pieces and can write down all the moves.

Players have the same rights, no one controls their actions. They change the situation on the board on their own (make moves).

The result of each game is determined according to the rules (algorithms) known to its participants in advance.

Cryptocurrency works in a similar way. Computers connected to the network process the transactions of other users and enter them into a common virtual notebook (blockchain). With the help of special algorithms, transactions are protected from outside interference.

The author of the first digital currency is considered to be a person using the pseudonym Satoshi Nakamoto. His real name is still unknown. In 2009, Nakamoto announced the launch of Bitcoin, a decentralized network in which cryptographic methods make it possible to receive and transfer "electronic cash".

The term "cryptocurrency" was used later in an article published by Forbes magazine. Then this word began to be used to refer to any virtual assets that are transferred through decentralized networks and used as a means of payment. The term cryptocurrency means digital money that circulates in peer-to-peer decentralized networks. This happens in the following sequence:

The same software is installed on all computers in the network (algorithms that support identical methods of encryption and data transfer).

Information about transfers is sent to several devices, which, using cryptographic methods, verify the authenticity of the transaction.

After calculations on one of the computers connected to the network, a block is generated (mined) – data on the latest transactions.

All records are added to a single chain called blockchain. This supports the security and decentralization of cryptocurrency operations.Using the blockchain, each member of the network can verify information about transfers received from different sources.

The main disadvantage of conventional electronic currencies is centralization. Users of such payment systems run the risk of losing money due to blocking by the administration of the resource or hacking the server. A centralized payment system (for example, a bank) may be closed by decision of the state authorities.

Digital assets provide complete autonomy of users from legal structures, regulators and financial companies. Cryptocurrencies have the following differences from fiat:

Decentralization. Digital projects are managed by the users themselves.

Immutability. A confirmed transaction cannot be removed from the block chain.

Confidence. Cryptocurrency networks operate on the principle of open source code. Each participant sees the "rules of the game" and understands that his savings cannot be confiscated due to the arbitrariness of the administration. This increases the level of trust in decentralized networks.

Transparency. All transaction information is publicly available.

Safety. To transfer money, the user confirms the transaction with an electronic key. A special encryption mechanism protects cryptocurrency wallets from hacking.

Commissions. The fees for executing a transaction are different in different cryptocurrency projects. But in general, when working with digital assets, you can find networks in which the commission will be lower than in banks and conventional payment systems.

Decentralization. Each cryptocurrency is an independent project. The processes of issuing and confirming transactions are not regulated by states. Many cryptocurrency networks provide for the participation of users in decision-making: holders of digital money participate in voting, which determine the development of the project.

Immutability. Traditional financial systems have a chargeback problem. By decision of the administrator or security service, the transaction can be canceled, and the money can be written off or transferred to another user. This is not possible in decentralized networks. Each transaction is entered into the blockchain and cannot be replaced or deleted.

Confidence. Confirmation of transactions is carried out automatically using reliable cryptographic algorithms. Counterparties know for sure that the transaction will be processed and entered into the block chain.

Transparency. All transactions are public and can be viewed by any visitor. At the same time, many blockchains hide information about the sender and recipient of the payment. This ensures a balance between the protection of personal data and the transparency of transfers. The owner of the wallet can check that the network works as it is written in the source code.

Safety. Each new block in encrypted form is written to the chain over the previous ones. Information in the blockchain cannot be deleted or corrected. There is no risk that someone will hack the server and credit all the money to a personal wallet. Exceptions are possible in such cases:

Attack 51%. Confirmation of operations in many cryptocurrencies is carried out according to the Proof-of-Work or Proof-of-Stake method. An attacker can replace information by obtaining 51% of the blocks of computing power used in mining or coins used to verify transactions. But it is difficult to carry out such an attack in large crypto networks.

Theft of keys to confirm transactions on behalf of the user. Although decentralized networks do not have a single server, attackers can hack into the personal computer of an ordinary crypto trader and withdraw money from his wallet.

Attack on control centers (nodes). In some cryptocurrencies, transactions are verified not by ordinary users, but by special servers. Such networks are called pseudo-decentralized. If a node is hijacked, there is a risk of incorrect transfer records being entered into the blockchain.

What Are Different Types of Cryptocurrencies?

Decentralized

In most cryptocurrencies, there is no main server and no leaders influencing decision making on the network. Confirmed transactions cannot be reversed or reviewed, and the user cannot be locked out. Digital assets that meet these criteria are usually referred to as decentralized. These cryptocurrencies have the following advantages:

Complete user independence.

Decisions in the community are made by consensus of the majority of its members.

The emission of new units is carried out as a result of mining. Traders know in advance how many coins will be released in the future.

Each participant can confirm the transactions of other users.

Pseudo-decentralized

Certain cryptocurrency communities have a more pronounced hierarchy:

Transactions are confirmed not by ordinary visitors, but by nodes.

Managers or developers can independently decide on blocking users, changing protocols and issuing new coins.

The operation can be changed or removed from the blockchain – the basis of cryptographic money.

These features cause concern among some traders. Attackers can take over the nodes and get hold of other people's money. In addition, there is a risk of unreasonable blocking or write-off of savings. Despite criticism, pseudo-decentralized projects can also have certain advantages:

High transaction processing speed. Since transactions are verified by separate servers, there is less risk of mining power degradation.

The ability to quickly intervene developers in technical and financial processes. In the event of a drop in quotes, project owners can buy back and burn (destroy) some of the tokens, reducing the risk of inflation.

Platform Cryptocurrencies

Digital assets are used not only as a means of payment, but also as a fuel for transactions in decentralized networks. Such cryptocurrencies are needed by clients of exchanges, DeFi projects and other distributed structures. Platform tokens are like store discount cards in the real world:

The holder of these assets pays less commissions and fees.

The owners of the service often hold drawings and distribute prizes among regular participants.

Some operations are available only to members of the "club" (holders of native tokens).

At the same time, platform cryptocurrencies can be sold on exchanges as an independent investment asset and used as a means of payment.

Stablecoins

The reason why cryptocurrency is used less frequently in payments than fiat money is because of its high volatility. Most coins and tokens are not backed by anything, and their quotes depend only on the balance of supply and demand. In such conditions, both buyers and sellers fear a sharp collapse in quotations.

Stablecoins are cryptocurrencies backed by fiat, securities or commodities. Their rate is linked to the quotes of national money, gold, silver. In fact, a stablecoin is a digitized version of a regular asset. The Tether (USDT) cryptocurrency is 100% backed by the same amount of US dollars, and the token exchange rate against USD on exchanges is approximately 1:1.

Critics of digital money often claim that Bitcoin and other electronic finance are candy wrappers with no real value. This statement is erroneous. Until the beginning of the 20th century, all fiat money was backed by gold. But then the determination of exchange rates according to this system became inconvenient, the states switched to market regulation of quotations. Thus, digital currencies in most cases are not backed by real assets in the same way as fiat money.The price of the US dollar or the Swiss franc depends on the mood of traders and speculators no less than the quotes of BTC or ETH. In addition, the definition of cryptocurrency as a means of payment used in decentralized networks means that it is the same money, only invisible (electronic).

Unlike fiat, the essence of digital currencies is autonomy from government agencies. Governments learned about the new type of means of payment later than ordinary crypto traders and investors began to use it. In many countries, the concept of "electronic cash" is still not found in the legislation.

What Are Altcoins and Tokens?

The first digital currency was Bitcoin, developed in 2009. Later, many similar projects appeared on the market. As a result, beginners often confuse the terms "altcoin" (applied to all digital money except BTC) and "token" (used only in relation to units of account that do not have their own blockchain).

Any cryptocurrency works on a chain of blocks (blockchain). This is an information environment that stores all records of transactions made. But not only information about transfers can be entered into the blockchain, but also a token (a contract that indicates how many units of the asset belong to the owner of the wallet). This registry entry is not considered a coin or coin because it does not have its own chain. But tokens can also act as payment units and be used as a cryptocurrency.

How To Get Crypto Coins?

The principle of operation of the cryptocurrency (source code) can provide 2 ways to generate new digital units:

Mining (extraction of blocks).

Centralized issue.

In addition, a trader can buy coins, receive them in exchange for other crypto assets, or earn as a reward for staking (transferring currency to confirm transactions on the network).

Mining

In the Bitcoin network and its analogues, transactions are confirmed via the Proof-of-Work algorithm:

The sender specifies the address and amount of the transfer.

The application is signed with a unique cryptographic key and transferred to other community members.

Owners of ASIC farms (devices with high performance) process translation data using special algorithms. In some crypto networks, coins can be mined through a video card or a regular processor.

After the work on the calculations is completed, the next block is generated.

ASIC farm owners are rewarded for their actions in the form of new coins.

If the network is based on the Proof-of-Stake (proof of ownership) algorithm, crypto money is mined in a different way – through forging. The coin is created during the verification of transactions and distributed in proportion to the number of assets that were used for this purpose.

What Is Staking?

In Proof-of-Stake networks, the transaction is confirmed by the users with the most coins. In return, they receive new units of the crypto asset. Owners of coins in such networks transfer their savings to staking. These assets are temporarily blocked to confirm transactions. In return, the investor receives a percentage for using the coins he owns.

Tokens and some coins can be issued to the market at a time. In this case, there is no mining, and the cryptocurrency is distributed among traders at auction or as a result of an airdrop (free distribution). Also, digital money is issued before ICO (Initial Coin Offering), IDO (Initial DEX Offering), IEO (Initial Exchange Offering). These are all forms of the primary sale of coins. Such actions are similar to the public offering of shares on stock exchanges.

What Is Cryptocurrency Used For?

There is an opinion that digital finance is used only as a speculative tool. In fact, cryptocurrency can also be used as:

Payment instrument (including in stores).

Way to save capital.

A tool for obtaining a loan secured by your coins and more.

For virtual money you can pay or buy:

Information technology services (hosting, domains, advertising).

Goods from online stores.

Services of employees and freelancers.

Even if the selected service does not accept Bitcoin, you can exchange coins for fiat for payment.

Speculation. Due to the high volatility (dynamics of exchange rate fluctuations) of cryptocurrencies, holders earn on trading digital assets.

Cryptocurrency looks like a convenient asset for making money, since many exchange services allow anonymous registration. This allows you to hide from outsiders (including tax services) information about the income of the trader.

Where to Buy Cryptocurrency?

The easiest way to purchase coins and tokens is through online exchangers. These are services that allow users to buy cryptocurrency for fiat. The client sends money to the seller using a debit/credit card, bank transfer, and payment systems. From it, the user receives coins and tokens to a personal wallet.

The second way to exchange fiat money for coins is P2P services. This is an analogue of an ad site that publishes offers to buy and sell various crypto assets.

Professional traders and large investors prefer to work through exchanges – specialized platforms where you can buy not only the coins themselves, but also derivatives. Crypto platforms usually offer additional ways to earn money: lеnding and staking.

Buying cryptocurrencies from individuals takes less time, as it does not require registration and identity verification on the site. But this method has a serious drawback: the risk of fraud (non-fulfillment of obligations by the party). To avoid being scammed, it is recommended to find an exchanger with a good history, reputation, and reviews from other users. In addition, you can apply for the services of intermediaries from escrow services. These companies act as a guarantor that controls the fulfillment by the parties of the terms of the transaction.

Where to Store Coins?

Fiat money is transferred through banks and payment systems. Blockchain networks are peer-to-peer, that is, their users send and receive currencies directly through personal wallets. All cryptocurrency storages are divided into 2 types:

Hot. The device with the key to access the money is connected to the Internet. An example of a hot wallet would be a regular personal computer with a coin storage application installed. The advantages of this method are quick access to financial transactions and the ability to install on any device, including mobile.

Cold. Not connected to the network all the time. These vaults are a physical analogue of a credit or debit card: a transaction is possible if the user is at an ATM, the rest of the time there is no access to savings. Cold wallets are protected from hacking, but they require special equipment and knowledge of blockchain technologies to set them up. One of the varieties of such storages is hardware in the form of flash drives. In addition, a cold wallet can be paper: it is enough to print private keys on a sheet to transfer assets.

Many exchanges and exchange offices offer users built-in crypto storages. In this case, the client receives a digital address identical to a regular wallet.

To safely store cryptocurrency, it is recommended:

Create backup copies of private (secret) keys. Their loss will lead to the inability to dispose of funds.

Trust money only to reliable exchanges and exchangers.

Use antiviruses, complex passwords and two-factor authentication on all sites.

Is Crypto Real Money?

Crypto assets cannot be considered an absolutely safe tool for making money. Working with digital currencies carries the following risks:

Legal. In many countries, legislation regulates only transactions with fiat money. The topic of fraud is often mentioned in the media. The victim may be left unprotected because the police and other law enforcement agencies simply will not have sufficient means to find the perpetrators. In addition, some states are taking the path of limiting anonymous transfers. At any time, cryptocurrency exchanges and websites may be banned.

Technical. Novice traders and crypto-investors run the risk of losing the access key, accidentally transferring it to intruders, and transferring money to the wrong wallet. This tool is not suitable for dummies.

Financial. Cryptocurrencies are characterized by high volatility. Individual coins can rise in price or fall in price by hundreds of percent in a few days. In such conditions, there is a risk of a quick loss of the deposit.

Used in illegal operations. A crypto trader runs the risk of accidentally becoming a member of the “dirty money” laundering chain.The rapid growth of quotes of major cryptocurrencies and their market capitalization. Many digital startups turn out to be "scams" – useless and unprofitable projects.

High exchange rate volatility. A trader risks losing most of his investment if he chooses the wrong moment to enter a trade.

Slow application processing speed and other problems that prevent the implementation of crypto payments in everyday operations.

Working with digital technologies requires technical skills. You need to know the principles of the blockchain device, methods for confirming transactions, and security methods.