What is Cryptocurrency (and How Does It Work?)

By: DailyForex.com

What is Cryptocurrency?

“Cryptocurrency” is digital currency which uses cryptography to create new units of the currency and to secure and manage all transactions. Cryptocurrency is created and managed by computer software, and has no physical existence at all. Another way to think of it is as currency used within, and created, by computer software, as opposed to having a distinct physical form. As opposed to cryptocurrency, the U.S. dollar is created by the U.S. government and used within the United States as the official means of exchange. Its creation and maintenance is regulated under license from the U.S. government in accordance with the laws of the country. The U.S. dollar is a “fiat currency”, like almost all national currencies, backed by the country’s government and national bank. In contrast, Bitcoin, currently the largest and most important cryptocurrency, is created by and used within the Bitcoin blockchain software, and is entirely regulated and managed using Bitcoin blockchain technology. There is one distinct similarity between fiat currencies and cryptocurrencies: Just as fiat currencies can be used as a currency in many cases outside their country of origin, so too, Bitcoin can be exchanged in transactions completely unrelated to use of the Bitcoin blockchain technology. What is Cryptocurrency?

There are many other cryptocurrencies besides Bitcoin. They are all created by and used within other computer software platforms that utilize similar blockchain technology. The most notable examples are, based on the market capitalization of 1st September 2017: Ethereum, Bitcoin Cash, Ripple, and Litecoin. We will look at how cryptocurrencies are created, stored and managed in detail later, but you probably have more important questions in mind that need to be answered first.

Are cryptocurrencies “real money”?

Believe it or not, the answer to this question can be both “yes” and “no”. Money, or “currency”, to use the correct term, is defined as an accepted “means of exchange”. The national currency of the country where you live is legal tender by law – providers of goods and services, with a few exceptions, must accept payment in that currency. If you have a job, you would expect to be paid by your employer in that currency. If you have a debt, or are issued with a bill, you can always pay it off with your national currency. It is truly a “means of exchange”. With cryptocurrencies, the situation is very different as most goods and services cannot be purchased with cryptocurrency. This might change in the future, but it is the case now.

In other words, if you own a cryptocurrency such as Bitcoin, you can exchange it for a fiat currency any time there is an open and accessible market but you cannot go out and spend it in most stores at your local mall or market (although there are a few stores and online retailers that DO accept the larger cryptocurrencies, such as Bitcoin, as payment). In this sense, owning a cryptocurrency is the same as owning shares or a commodity such as gold. At the time of this writing only eight major online retailers accept payment in Bitcoin:

  1. Microsoft (for Windows and Xbox)

  2. Expedia.com (for hotel bookings)

  3. Overstock.com

  4. eGifter.com (may be used to purchase gift cards valid at a wide range of outlets)

  5. Foodler

  6. Newegg (for a limited range of transactions)

  7. Shopify

  8. Dish

There is a much larger number of smaller businesses that do accept Bitcoin as payment.

Another question you may have is how cryptocurrency technology works.

National currencies are created and managed by central banks and governments that determine how much new money should be printed and what the base rate of interest should be. Sometimes central banks even intervene by buying and selling currencies in the market to influence exchange rates. It is clear who oversees currencies like the U.S. dollar or the euro. How does it work with cryptocurrencies? Very differently!

Unlike fiat currencies, and even unlike commodities such as gold which are semi-currencies with a “store of value”, the supply of each currency is theoretically finite, and usually known in advance. Blockchain technology keeps a record of every Bitcoin in existence, including who owns it (or the ownership key, to be more exact), and issues a fixed quantity of new Bitcoins approximately every 10 minutes to a computer which has successfully contributed a minimum amount of work towards maintaining the blockchain technology acting as Bitcoin’s operating system. At the current time, it is known exactly how many Bitcoins exist because every Bitcoin ever created is listed within the Bitcoin blockchain ledger. It is also known that there will never be more than 21 million Bitcoins in existence ever, because the Bitcoin blockchain technology is programmed to halt the creation of new Bitcoins at 21 million, although it is possible that Bitcoin miners could create a new offshoot of Bitcoin (from a “hard fork”) that would have a higher supply limit. The blockchain technology keeps a record of every Bitcoin in existence, including who owns it (or the ownership key, to be more exact), and issues a fixed quantity of new Bitcoins approximately every 10 minutes to a computer which has successfully contributed a minimum amount of work towards maintaining the blockchain technology acting as Bitcoin’s operating system.

I will discuss more about blockchain technology in my next article – sign up for our Android or iOS app to read these Bitcoin articles and others comfortably from any mobile device.

Adam is a Forex trader who has worked within financial markets for over 12 years, including 6 years with Merrill Lynch. He is certified in Fund Management and Investment Management by the U.K. Chartered Institute for Securities & Investment. Learn more from Adam in his free lessons at FX Academy.

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