Cryptocurrencies: What Are They and How do they Work?
Cryptocurrencies are quickly breaching the national consciousness. News reports of Bitcoin turning early investors into overnight millionaires are now commonplace, and a wide range of similar stories featuring newer cryptocurrencies like Ethereum seem to pop up on a regular basis.
But if you're like most people without a deeply technical background, you're probably wondering just what these currencies are made of. Are they real money? What are they based on?
First – A Short History of Money
To understand cryptocurrency, it's important to understand money in an abstract way first. Money is a store of value used to purchase goods and services – everyone knows this.
However, for most of human history, money has been backed by some tangible commodity. For most societies and civilizations, this commodity was gold.
This commodity-based system had a number of problems. For one thing, moving gold about is both difficult and dangerous – for this reason, piracy was a common danger for merchants in the 17th and 18th centuries.
From the 19th century onwards, governments began experimenting with the idea to print paper money that referenced gold so they could simply print banknotes. These could be carried from place to place much more securely – a system called the Gold Standard.
Following World War II, the United States set up an intermediary standard by which the value of every country's national currency was pegged to the United States Dollar, which was then pegged to the value of gold. This was called the Bretton Woods System. The United States could do this because at that point, nearly every country in the world owed it money.
It wasn't until 1971 that the United States completely severed its dependence on gold as a store of value, floating currency – the value of which is based purely on the economy of the country it represents. Since the United States Dollar was still the international reserve currency, almost all national currencies became de facto floating currencies – called fiat money.
The important thing to realize here is that money doesn't need to be tied to a specific value in order to be valuable. It needs only to be accepted as payment for goods or services that have value.
So How Does Cryptocurrency Store Value?
Cryptocurrency fulfills all the functions of fiat money – it stores reliably stores value between parties who wish to exchange goods or services. However, unlike floating currencies that gain value by representing the power of their respective national economies, cryptocurrencies like Bitcoin and Ethereum gain value directly through the actions of the currency holders.
In this sense, cryptocurrencies are much like gold – but much easier to carry around, and much harder to steal.
Global cryptocurrency networks are focused on exchanges. It can be tempting to think of these exchanges as cryptocurrency banks, but they are not. They are more like stock market exchanges – a place where individuals can buy and sell various currencies according to their current agreed-upon value. Exchanges like Coinbase, Bittrex, and Poloniex simply provide the platform that makes transactions possible.
So how do exchanges agree upon a specific cryptocurrency value? This is done through the actual technology underlying cryptocurrencies.
Introducing the Blockchain
In a physical sense, cryptocurrencies are made up of code. An individual Bitcoin is simply a unique string of code that represents a value within the cryptocurrency system. However, you can't just "write your own" Bitcoins because each transaction is verified through the Bitcoin network using what is called blockchain technology.
For example, imagine that you are a bank. You keep careful records of each and every transaction that you make in a ledger. At the end of the day, you can look through that ledger to determine how solvent your bank is, and determine the value the bank's activities represent.
In a fiat currency system, you are obliged to show that ledger to the government. The government exerts the authority to check your ledger and make sure you are banking honestly – if you attempt to write transactions that don't exist, you're committing fraud, which the government will punish you for.
With cryptocurrencies, that ledger is embedded in every transaction throughout the system. The blockchain is simply a running record of every transaction made on a specific cryptocurrency platform. In order for a transaction to occur, it must be verified throughout the blockchain.
This way, if you attempt to commit fraud by giving yourself a million Bitcoins, the open ledger system will immediately see that there is no record of such a transaction occurring. You would have to hack every Bitcoin wallet in the world to do this.
Blockchain technology is what makes cryptocurrency secure. It's much easier to rob a bank than to pilfer a Bitcoin wallet.
Why Are Cryptocurrencies So Valuable?
The blockchain system offers users some very useful benefits:
Unlike fiat currencies held in traditional banks, it is possible to hold currencies anonymously. No government has jurisdiction over the blockchain system. With a little bit of work, you can hold, store, and transact value in a completely private, anonymous way. This eliminates the possibility of identity theft – a common problem for credit card holders using fiat money.
While Bitcoin is simply a currency, next-generation currencies like Ethereum offer even greater advantages in transaction automation. Ethereum has the capacity to run smart contracts, which ensure that certain tasks are carried out once certain conditions are met – this can revolutionise the way the Internet works.
Large purchases tend to take time. Escrows, lawyers, notaries, banks, clearinghouses all need to work to make sure that funds travel from one account to another successfully. The blockchain accomplishes these things automatically – and nearly instantly.
As the cryptocurrency industry moves forward, more and more people will see the value that it represents. The future economy of the world may be one in which each person issues their own personal currency tied to the value of their work – becoming, in a sense, their own bank.