The History Of Cryptocurrency

What Is Cryptocurrency – How It Works, History & Bitcoin Alternatives

Cryptocurrencies, or virtual currencies, are digital means of exchange created and used by private individuals or groups. Because most cryptocurrencies aren’t regulated by national governments, they’re considered alternative currencies – mediums of financial exchange that exist outside the bounds of state monetary policy.

Bitcoin is the preeminent cryptocurrency and first to be used widely. However, hundreds of cryptocurrencies exist, and more spring into being every month.

What Is Cryptocurrency?

Cryptocurrencies use cryptographic protocols, or extremely complex code systems that encrypt sensitive data transfers, to secure their units of exchange. Cryptocurrency developers build these protocols on advanced mathematics and computer engineering principles that render them virtually impossible to break, and thus to duplicate or counterfeit the protected currencies. These protocols also mask the identities of cryptocurrency users, making transactions and fund flows difficult to attribute to specific individuals or groups.

Cryptocurrencies are also marked by decentralized control. Cryptocurrencies’ supply and value are controlled by the activities of their users and highly complex protocols built into their governing codes, not the conscious decisions of central banks or other regulatory authorities. In particular, the activities of miners – cryptocurrency users who leverage vast amounts of computing power to record transactions, receiving newly created cryptocurrency units and transaction fees paid by other users in return – are critical to currencies’ stability and smooth function.

Importantly, cryptocurrencies can be exchanged for fiat currencies in special online markets, meaning each has a variable exchange rate with major world currencies (such as the U.S. dollar, British pound, European euro, and Japanese yen). Cryptocurrency exchanges are somewhat vulnerable to hacking and represent the most common venue for digital currency theft.

Most, but not all, cryptocurrencies are characterized by finite supply. Their source codes contain instructions outlining the precise number of units that can and will ever exist. Over time, it becomes more difficult for miners to produce cryptocurrency units, until the upper limit is reached and new currency ceases to be minted altogether. Cryptocurrencies’ finite supply makes them inherently deflationary, more akin to gold and other precious metals – of which there are finite supplies – than fiat currencies, which central banks can, in theory, produce unlimited supplies of.

Due to their political independence and essentially impenetrable data security, cryptocurrency users enjoy benefits not available to users of traditional fiat currencies, such as the U.S. dollar, and the financial systems that those currencies support. For instance, whereas a government can easily freeze or even seize a bank account located in its jurisdiction, it’s very difficult for it to do the same with funds held in cryptocurrency – even if the holder is a citizen or legal resident.

On the other hand, cryptocurrencies come with a host of risks and drawbacks, such as illiquidity and value volatility, that don’t affect many fiat currencies. Additionally, cryptocurrencies are frequently used to facilitate gray and black market transactions, so many countries view them with distrust or outright animosity. And while some proponents tout cryptocurrencies as potentially lucrative alternative investments, few (if any) serious financial professionals view them as suitable for anything other than pure speculation.

How Cryptocurrencies Work
The source codes and technical controls that support and secure cryptocurrencies are highly complex. However, laypeople are more than capable of understanding the basic concepts and becoming informed cryptocurrency users.

Functionally, most cryptocurrencies are variations on Bitcoin, the first widely used cryptocurrency. Like traditional currencies, cryptocurrencies’ express value in units – for instance, you can say “I have 2.5 Bitcoin,” just as you’d say, “I have $2.50.”

Several concepts govern cryptocurrencies’ values, security, and integrity.

Block Chain
A cryptocurrency’s block chain is the master ledger that records and stores all prior transactions and activity, validating ownership of all units of the currency at any given point in time. As the record of a cryptocurrency’s entire transaction history to date, a block chain has a finite length – containing a finite number of transactions – that increases over time.

Identical copies of the block chain are stored in every node of the cryptocurrency’s software network – the network of decentralized server farms, run by computer-savvy individuals or groups of individuals known as miners, that continually record and authenticate cryptocurrency transactions.

A cryptocurrency transaction technically isn’t finalized until it’s added to the block chain, which usually occurs within minutes. Once the transaction is finalized, it’s usually irreversible – unlike traditional payment processors, such as PayPal and credit cards, most cryptocurrencies have no built-in refund or chargeback functions, though some newer cryptocurrencies have rudimentary refund features.

During the lag time between the transaction’s initiation and finalization, the units aren’t available for use by either party. The block chain thus prevents double-spending, or the manipulation of cryptocurrency code to allow the same currency units to be duplicated and sent to multiple recipients.

Private Keys
Every cryptocurrency holder has a private key that authenticates their identity and allows them to exchange units. Users can make up their own private keys, which are formatted as whole numbers between 1 and 78 digits long, or use a random number generator to create one. Once they have a key, they can obtain and spend cryptocurrency. Without the key, the holder can’t spend or convert their cryptocurrency – rendering their holdings worthless unless and until the key is recovered.

While this is a critical security feature that reduces theft and unauthorized use, it’s also draconian – losing your private key is the digital equivalent of throwing a wad of cash into a trash incinerator. While you can create another private key and start accumulating cryptocurrency again, you can’t recover the holdings protected by your old, lost key.

Wallets
Cryptocurrency users have “wallets” with unique information that confirms them as the temporary owners of their units. Whereas private keys confirm the authenticity of a cryptocurrency transaction, wallets lessen the risk of theft for units that aren’t being used. Wallets used by cryptocurrency exchanges are somewhat vulnerable to hacking – for instance, Japan-based Bitcoin exchange Mt. Gox shut down and declared bankruptcy after hackers systematically relieved it of more than $450 million in Bitcoin exchanged over its servers.

Wallets can be stored on the cloud, an internal hard drive, or an external storage device. Regardless of how a wallet is stored, at least one backup is strongly recommended. Note that backing up a wallet doesn’t duplicate the actual cryptocurrency units, merely the record of their existence and current ownership.

Miners
Miners serve as record-keepers for cryptocurrency communities, and indirect arbiters of the currencies’ value. Using vast amounts of computing power, often manifested in private server farms owned by mining collectives comprised of dozens of individuals, miners use highly technical methods to verify the completeness, accuracy, and security of currencies’ block chains. The scope of the operation is not unlike the search for new prime numbers, which also requires tremendous amounts of computing power.

Miners’ work periodically creates new copies of the block chain, adding recent, previously unverified transactions that aren’t included in any previous block chain copy – effectively completing those transactions. Each addition is known as a block. Blocks consist of all transactions executed since the last new copy of the block chain was created, usually a few minutes prior.

The term “miners” relates to the fact that miners’ work literally creates wealth in the form of brand-new cryptocurrency units. In fact, every newly created block chain copy comes with a two-part monetary reward: a fixed number of newly minted (“mined”) cryptocurrency units, and a variable number of existing units collected from optional transaction fees (typically less than 1% of the transaction value) paid by buyers. Thus, cryptocurrency mining is a potentially lucrative side business for those with the resources to invest in power- and hardware-intensive mining operations.

Though transaction fees don’t accrue to sellers, miners are permitted to prioritize fee-loaded transactions ahead of fee-free transactions when creating new block chains, even if the fee-free transactions came first. This gives sellers an incentive to charge transaction fees, since they get paid faster by doing so, and so it’s fairly common for transactions to come with fees. While it’s theoretically possible for a new block chain copy’s previously unverified transactions to be entirely fee-free, this almost never happens in practice.

Through instructions in their source codes, cryptocurrencies automatically adjust to the amount of mining power working to create new block chain copies – copies become more difficult to create as mining power increases, and easier to create as mining power decreases. The goal is to keep the average interval between new block chain creations steady at a predetermined level – for instance, Bitcoin’s is 10 minutes.

Finite Supply
Although mining periodically produces new cryptocurrency units, most cryptocurrencies are designed to have a finite supply. Generally, this means that miners receive fewer new units per new block chain as time goes on. Eventually, miners only receive transaction fees for their work.

This has yet to happen with any extant cryptocurrency, but observers predict that the last Bitcoin unit will be mined sometime in the mid-22nd century, if current trends continue. Finite-supply cryptocurrencies are thus more similar to precious metals, like gold, than to fiat currencies – of which, theoretically, unlimited supplies exist.

Cryptocurrency Exchanges
Many lesser-used cryptocurrencies can only be exchanged through private, peer-to-peer transfers, meaning they’re not very liquid and are hard to value relative to other currencies – both crypto- and fiat.

More popular cryptocurrencies, such as Bitcoin and Ripple, trade on special secondary exchanges similar to forex exchanges for fiat currencies. (The now-defunct Mt. Gox is one example.) These platforms allow holders to exchange their cryptocurrency holdings for major fiat currencies, such as the U.S. dollar and euro, and other cryptocurrencies (including less-popular currencies). In return for their services, they take a small cut of each transaction’s value – usually less than 1%.

Cryptocurrency exchanges play a valuable role in creating liquid markets for popular cryptocurrencies and setting their value relative to traditional currencies. However, exchange pricing can still be extremely volatile – Bitcoin’s U.S. dollar exchange rate fell by more than 50% in the wake of Mt. Gox’s collapse, for instance.

History of Cryptocurrency
Cryptocurrency existed as a theoretical construct long before the first digital alternative currencies debuted. Early cryptocurrency proponents shared the goal of applying cutting-edge mathematical and computer science principles to solve what they perceived as practical and political shortcomings of “traditional” fiat currencies.

Technical Foundations
Cryptocurrency’s technical foundations date back to the early 1980s, when an American cryptographer named David Chaum invented a “blinding” algorithm that remains central to modern web-based encryption. The algorithm allowed for secure, unalterable information exchanges between parties, laying the groundwork for future electronic currency transfers. This was known as “blinded money.”

By the late 1980s, Chaum enlisted a handful of other cryptocurrency enthusiasts in an attempt to commercialize the concept of blinded money. After relocating to the Netherlands, he founded DigiCash, a for-profit company that produced units of currency based on the blinding algorithm. Importantly, DigiCash’s control wasn’t decentralized, as is the case with Bitcoin and most other modern cryptocurrencies – DigiCash itself had a monopoly on supply control, similar to central banks’ monopoly on fiat currencies.

DigiCash initially dealt directly with individuals, but the Netherlands’ central bank cried foul and quashed this idea. Faced with an ultimatum, DigiCash agreed to sell only to licensed banks, seriously curtailing its market potential. Microsoft later approached DigiCash about a potentially lucrative partnership that would allow early Windows users to make purchases in its currency, but the two companies couldn’t agree on terms, and DigiCash went belly-up in the late 1990s.

Around the same time, an accomplished software engineer named Wei Dai published a white paper on b-money, a virtual currency architecture that included many of the basic components of modern cryptocurrencies, such as complex anonymity protections and decentralization. However, b-money was never deployed as a means of exchange.

Shortly thereafter, a Chaum associate named Nick Szabo developed and released a cryptocurrency called Bit Gold, which was notable for using the block chain system that underpins most modern cryptocurrencies. However, Bit Gold never gained popular traction and is no longer used as a means of exchange.

Pre-Bitcoin Virtual Currencies
After DigiCash, much of the research and investment in electronic financial transactions shifted to more conventional, though digital, intermediaries, such as PayPal. A handful of DigiCash imitators, such as Russia’s WebMoney, sprang up in other parts of the world.

In the United States, the most notable virtual currency of the late 1990s and 2000s was known as e-gold. e-gold was created and controlled by a Florida-based company of the same name. e-gold, the company, basically functioned as a digital gold buyer. Its customers, or users, sent their old jewelry, trinkets, and coins to e-gold’s warehouse, receiving digital “e-gold” – units of currency denominated in ounces of gold. e-gold users could then trade their holdings with other users, cash out for physical gold, or exchange their e-gold for U.S. dollars.

At its peak in the mid-2000s, e-gold had millions of active accounts and processed billions of dollars in transactions annually. Unfortunately, e-gold’s relatively lax security protocols made it a popular target for hackers and phishing scammers, leaving its users vulnerable to financial loss. And by the mid-2000s, much of e-gold’s transaction activity was legally dubious – its laid-back legal compliance policies made it attractive to money laundering operations and small-scale Ponzi schemes. The platform faced growing legal pressure during the mid- and late-2000s, and finally ceased to operate in 2009.

Bitcoin and the Modern Cryptocurrency Boom
Bitcoin is widely regarded as the first modern cryptocurrency – the first publicly used means of exchange to combine decentralized control, user anonymity, record-keeping via a block chain, and built-in scarcity. It was first outlined in a 2008 white paper published by Satoshi Nakamoto, a pseudonymous person or group.

In early 2009, Nakamoto released Bitcoin to the public, and a group of enthusiastic supporters began exchanging and mining the currency. By late 2010, the first of what would eventually be dozens of similar cryptocurrencies – including popular alternatives like Litecoin – began appearing. The first public Bitcoin exchanges appeared around this time as well.

In late 2012, WordPress became the first major merchant to accept payment in Bitcoin. Others, including Newegg.com (an online electronics retailer), Expedia, and Microsoft, followed. Dozens of merchants now view the world’s most popular cryptocurrency as a legitimate payment method. Though few other cryptocurrencies are widely accepted for merchant payments, increasingly active exchanges allow holders to exchange them for Bitcoin or fiat currencies – providing critical liquidity and flexibility.