What are cryptocurrencies?

CMC Markets

A cryptocurrency is a type of digital currency created from code. They function, outside of traditional banking and government systems.

Cryptocurrencies use cryptography to secure transactions and regulate the creation of additional units. Bitcoin, the original and by far most well-known cryptocurrency, was launched in January 2009. Today there are over 1,500 cryptocurrencies available online.

Cryptocurrencies differ significantly from traditional currencies as they use blockchain technology to create a distributed ledger. Nonetheless, you can still buy and sell them like any other currency and can also trade on the price movements of various cryptocurrencies via CFDs. 

Cryptocurrencies fall under the banner of digital currencies, alternative currencies and virtual currencies. They were initially designed to provide an alternative payment method for online transactions. However, cryptocurrencies are not yet widely accepted for all transactions as some consider them too volatile to be suitable as methods of payment. As a decentralised currency, it was developed to be free from government oversight or influence, and the cryptocurrency markets are instead monitored by peer-to-peer internet protocol. 

Bitcoin is credited with being the first decentralised cryptocurrency. Like all cryptocurrencies, it’s controlled through a blockchain transaction database, which functions as a distributed public ledger. Bitcoin was created by Satoshi Nakamoto – whether the name refers to an individual or a group is unknown. 

A feature of most cryptocurrencies is that they have been designed to slowly reduce production and some have an absolute limit on supply. Consequently, in some cases only a limited number of units of the currency will ever be in circulation. For example, the number of bitcoins is not expected to exceed 21 million. Cryptocurrencies such as ethereum, on the other hand, work slightly differently. Issuance is capped at 18 million ethereum tokens per year, which equals 25% of the initial supply. Limiting the number gives it higher value. 

Key features of cryptocurrencies

There are a number of key principles that govern cryptocurrency use, exchange and transactions.

Cryptography

Cryptocurrencies use advanced cryptography in a number of ways. In today’s digital world it’s based primarily on computer science and mathematical theory. It also draws from communication science, physics and electrical engineering. 

Two main elements of cryptography apply to cryptocurrencies – hashing and digital signatures:

  • Hashing verifies data integrity, maintains the structure of the blockchain and encodes people’s account details and transactions. It also generates the cryptographic puzzles that makes block mining possible.
  • Digital signatures allow an individual to own a piece of encrypted information without revealing that information. With cryptocurrencies, this technology is used to sign monetary transactions and demonstrates ownership.

Blockchain technology

A blockchain is the decentralised, public ledger or list of a cryptocurrency’s transactions. Completed blocks, comprised of the latest transactions, are recorded and added to the blockchain. They are stored in chronological order as an open, permanent and verifiable record. An ever evolving network of market participants manage blockchains, and they follow a set protocol for validating new blocks. Each ‘node’ or computer connected to the network automatically downloads a copy of the blockchain. This allows everyone to track transactions without the need for central record keeping. 

Blockchain technology creates a record that can’t be changed without the agreement of the rest of the network. The blockchain concept is attributed to bitcoin’s founder, Satoshi Nakamoto. This concept has been the inspiration for other applications beyond digital cash and currency.   

Block mining

Coin mining is the process of attaching new transaction records as blocks to the blockchain. In the process – using bitcoin as an example – new bitcoins are credited to the miners, adding to the total number of coins in circulation. Mining requires a specific piece of software that is used to solve mathematical puzzles, and this validates the legitimate transactions which make up blocks. These blocks get added to the public ledger (blockchain) at regular intervals. As the software solves transactions the miner is rewarded with a set amount of bitcoins. The faster a miner’s hardware can process the mathematical problem, the more likely it is to validate a transaction and earn the bitcoin reward.       

The main cryptocurrencies

Bitcoin

Bitcoin is credited as the original and most well-known cryptocurrency. Satoshi Nakamoto, a person or group of people under the name created it in 2009. As of December 2017, there were around 16.7 million bitcoins in circulation (there may be a finite number of 21 million available). Traders can purchase bitcoin through an exchange and speculate on its price movements via CFDs. Learn more about bitcoin.

Ethereum

Ethereum is relatively new in the cryptocurrency world. It launched in 2015 and at the time of writing is currently the second largest digital currency network. It operates in a similar way to the bitcoin network, allowing people to send and receive tokens representing value via an open network. The tokens are called ether, and this is what is used as payment on the network. Ethereum’s primary use, however, is to operate as smart contracts rather than as a form of payment. Smart contracts are scripts of code which can be deployed in the ethereum blockchain. The limit on ether also works slightly differently to bitcoin. Yearly issuance is capped at 18 million ether which equals 25% of the initial supply. Learn more about ethereum.

Bitcoin cash

Bitcoin cash (BCH) is a cryptocurrency and payment network created as a result of a hard fork with Bitcoin in December 2017. A hard fork occurs when members of the cryptocurrency community have a disagreement, usually regarding improvements to the software used within the network. In this case it was a disagreement around a proposal to increase the block size. After a fork, the blockchain splits in two and it is left to the miners and the wider community to decide which cryptocurrency to align themselves with. When the bitcoin hard fork took place, one bitcoin cash token was typically awarded for every bitcoin held (although some exchanges chose not to recognise bitcoin cash).

Litecoin 

Litecoin (LTC) is a peer-to-peer cryptocurrency that was set up by Charlie Lee (a former Google employee) in 2011. It was an early bitcoin spinoff, or ‘altcoin’ and initially intended for smaller value transactions than those made using bitcoin. Technically speaking it was created to be almost identical to bitcoin, but it has some notable differences. For example, litecoin can process blocks up to four times quicker than bitcoin. It also requires more sophisticated technology to mine, but the total number of coins available has a much larger cap – it is currently set to 84 million, which is four times greater than bitcoin.

Ripple

Ripple (XRP) is a network that allows the transfer of any currency (including both  established currencies and cryptocurrencies) around the world. It aims to ensure secure, fast and low cost transfers across the network, with no risk of fraud or chargeback. The network is considerably faster than bitcoin – it is able to settle transactions in just a few seconds. The minimum transaction cost is also much lower, which is one of the reasons that ripple has been increasingly adopted by banks for settlement. Ripple is also the name given to the native cryptocurrency (XRP) used on the ripple network.

Summary

Bitcoin and other cryptocurrencies can best be described as alternative currencies. As noted above, they are not yet widely accepted today as a medium of exchange. The outlook for cryptocurrencies is binary – it’s likely they’ll either fail or take over the world. This is some of the factors that drives the higher risk and higher potential reward nature of cryptocurrency market.


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