What Are Cryptocurrencies And How Do They Work

Bitcoin was launched more than a decade ago, introducing the digital ledger known simply as blockchain. Bitcoin, the first cryptocurrency ever created is still the most widely used and most valuable cryptocurrency. But even with all the relentless buzz surrounding bitcoin, ethereum and other digital coins, cryptocurrencies and the revolutionary blockchain technology on which they're built remain a mystery to most.

Despite the evangelizing by crypto investors, including some celebrities, a 2021 poll by Pew Research Center found that just 16% of Americans said they have ever invested in cryptocurrencies. The percentage of people who have ever invested in cryptocurrencies grew to 31% between the ages 18 and 29. It also increased to 43% among men that age, compared to 19% in the same age bracket.

For those who are not in the top 10%, it could be that they have a healthy skepticism about digital currencies which has prevented them from trying to understand the terminology or the technology.

But as cryptocurrencies and related technologies reach into politics, intertwine with the larger economy, impact the environment, and are increasingly targeted by scammers, it behooves most to have a general sense of what cryptocurrencies are, how they work and what their pitfalls and potential are. Here's a quick overview of blockchain technology and cryptocurrency for those who aren't familiar.

Is it "blockchain", "the blockchain"?

It's either, depending on usage. A blockchain is a type of database. Different cryptocurrencies use different blockchains. Bitcoin is built on top of the bitcoin blockchain, while ether is built upon the ethereum Blockchain. Some cryptocurrencies and tokens can be built on top of other cryptocurrency Blockchains. For instance, many new tokens are built on the ethereum blockchain - but at the most basic level, all cryptocurrencies are supported by a blockchain.

"Blockchain" is the preferred term for the technology. The public ledger system in its entirety is called "the blockchain."

Blockchains keep track of cryptocurrency transactions in encrypted, digital records that can be accessed from anywhere on the planet. Some blockchains permit developers to create programs and applications. Blockchains can also record other information such as property records and the origins of food items.

NFTs, also known as nonfungible tokens (or digital items like images or videos), are the latest buzz-generating trend in blockchain technology. These tokens are stored on the blockchain and secured to ensure that each item or asset is unique and unchangeable.

Is there an easier way to look at this?

Fundamentally, cryptocurrencies are digital money. The blockchain is a database, or digital ledger, for recording transactions of said digital money. This digital money isn't backed by any government or institution.

How are cryptocurrencies created?

Different cryptocurrencies use different digital architectures (code), which means that their working methods vary. As an example, let's use bitcoin, which is "mined."

Here's how crypto mining works: networks of specialized computer processors running on vast amounts of electricity and producing an astonishing amount of noise and heat, compete to solve a mathematical puzzle - calculations required to verify the most recent bitcoin transactions, record them on the blockchain and ensure the blockchain is secure. The first computer to solve this puzzle wins the newly minted bitcoin. This design is part a source code open-source created by Satoshi Nakamoto (an anonymous entity that launched bitcoin in 2009).

The mining system design encourages users to spend resources, in this case money or electricity, to help keep track of who owns which Bitcoins. Read more about it here.

What is all this about decentralization, you ask?

The blockchain's design also includes a public record of transactions on many computers that make up a global network. These computers, also called nodes, continuously check each other's information to verify that their records are accurate. These records are replicated across the network to prevent any fraudulent or incorrect transactions from being logged.

The open source nature and decentralized nature of blockchain means that it is not possible for any one person or institution to control it. However governments and large corporations may be able to limit access to certain digital tokens under certain circumstances. China banned cryptocurrency trading in September 2021, citing concerns that cryptocurrencies might weaken the government’s control over the financial sector and facilitate crime. Binance, a major cryptocurrency exchange stopped processing transactions made with certain Russian credit cards due to its invasion of Ukraine.

How secure can blockchain be?

Cryptocurrency enthusiasts find blockchain extremely difficult to hack. That's part of its appeal. How secure a particular blockchain is will depend on what platform you are talking about.

Although the bitcoin blockchain is unhacked, the second-largest cryptocurrency and blockchain, ethereum, suffered a major crisis due to a software flaw in 2016. Although the ethereum blockchain was not compromised, $50 million worth of ether was stolen.

Many cryptocurrency-related services and technologies have been hacked or simply exploited by their designers to deceive and steal from participants.

Multiple breaches of cryptocurrency exchanges (where people can trade cryptocurrency for traditional currencies) have occurred. Digital bank robbers were able to clear out the accounts. It is notable that the CEO of a cryptocurrency platform died in 2018 without providing a passcode. This effectively locked out customers of millions of dollars worth cryptocurrencies.

Whether they're a victim of a scam or security breach or have simply forgotten their digital wallet's password, consumers have few recovery options. The preprogrammed decentralized system does not provide insurance or a means to reset passwords.

In short, the investments are backed by few protections. Although U.S. prosecutors pursue criminal behavior like false advertising and stealing, if the value a new cryptocurrency token drops, it is considered lost. Even the value of bitcoin, which some proponents call "digital gold," is extremely volatile.

Last thought: Cryptocurrencies continue to be criminals' preferred payment option. Illegal drugs or other barred commodities are often exchanged for cryptocurrency, which can be transferred across distances more easily than cash and can be harder for prosecutors to trace. The public record of who is the owner of most cryptocurrencies is visible. This makes it difficult for criminals and law-breakers to hide their identities in order to launder cryptocurrencies they have stolen, swindled, or ransomware attacked.

Where is the "value" in cryptocurrencies?

This age-old question: Who decides how much a buck is worth to you? - is further complicated with cryptocurrencies. Unlike traditional currencies that are backed by central banks or governments, cryptocurrencies do not have a physical backing.

Instead, their values are determined by people's faith and market conditions. Backers hope that more and more people will want a digital currency that is relatively free from government oversight - and that, as people sink resources into cryptocurrencies, their value will increase over time. Explorer

Some cryptocurrencies can be used as both an investment and as a unit of exchange, which is a departure from traditional currencies. Some consumers buy bitcoin hoping they can eventually sell it for a profit. Others might use a fraction of a bitcoin to get a firecracker pork burrito at New Hampshire's Taco Beyondo - one of a growing list of businesses that accepts bitcoin as payment.

What about the environmental impact?

Crypto mining uses a lot of energy, as mentioned. According to the U.S Energy Information Administration, a peer-reviewed study found that bitcoin's annual electricity consumption was 45.8 terawatts. This is comparable to Hong Kong's net electricity usage in 2019. That doesn't even take into account energy consumed by other cryptocurrencies.

Also, bitcoin's energy consumption has increased annually: The Bitcoin Mining Council estimated the cryptocurrency consumed 220 terawatt hours of energy in 2021.

When judging the environmental impacts of cryptocurrencies, it's important to consider the electricity's source. Crypto miners want electricity at the lowest possible cost. This often leads them towards high-polluting resources like coal. Sometimes, logistical constraints force them to seek out renewable energy sources like hydroelectric dams that offer the lowest prices. These variables should be taken into account when calculating cryptocurrency's exact energy consumption and environmental impact.