Chances are you’ve heard of cryptocurrency: Bitcoin, Ethereum and Dogecoin have all become words we hear on the news or read online. But what is cryptocurrency exactly, and how does it work?
Cryptocurrency vs. Regular Currency
Right now, you hopefully have some money in your pocket in the form of dollars, euros, or rupees, depending on what your country gives out as currency. This money is given value by a delicate system operated in part by governments, as well as certain market mechanisms that are too involved to get into here. This article from The Balance serves as a solid primer, though.
Cryptocurrency is different from this, and radically. Instead of having a physical presence—the notes and coins in your pocket—it exists entirely digitally, without the power of a government to back it. Rather, it relies on free-market mechanisms to determine its value: what people are willing to pay for it determines what it’s worth.
Of course, without a central issuing authority inflation could become a real issue: anybody could just claim at any time that they have a thousand or a million cryptobucks, and there’s nothing anybody could do to stop them. If you create your own U.S. dollars, you’ll get arrested for counterfeiting. If you create cryptocurrency out of thin air, nothing will happen.
The Cryptocurrency Blockchain
This problem was one of the biggest issues surrounding cryptocurrencies until Satoshi Nakamoto—likely a pseudonym for a person or group, nobody knows for sure except Satoshi—came up with the blockchain. It’s a pretty complicated piece of technology, but it boils down to being an online ledger that anybody can view, but not everybody can edit.
Much like the ledger that an old-school accountant would keep (that book Ebenezer Scrooge is hunched over is a ledger, for example), the blockchain records how many there are of any given cryptocurrency and who owns and spends them. It does so in so-called blocks, hence the name “blockchain.” Below is one example of a ledger in action.
The ledger keeps track of how much of any given cryptocurrency is spent (Bitcoin in the above example), when it’s spent, and also who spent it. Though your identity is protected by a pseudonym—random numbers and letters called a hash—when using most cryptocurrencies, none except for a few exceptions are truly anonymous. Even Bitcoin isn’t “anonymous” in the way many people think it is.
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Putting the Crypto in Cryptocurrency
The ledger is only one side of the equation. While it’s very nice to have a record of the cryptocoins going in or out, ledgers can be easily tampered with. In the old days, you’d use an eraser or some white-out to make expenses disappear, now you can do much the same with some advanced tools.
One way to guard against these issues is the openness of blockchain technology: if everybody can see what’s going on at any time, it should be easy to quickly figure out if something hinky is going on. The other way is to harness the power of cryptography, or encoding the data of entries and then decoding them as needed.
In the case of cryptocurrencies, this is usually done by using passwords to make sure a user is who they say they are, or rather that their wallet—where cryptocurrencies are stored—is the one that belongs to them. Since the username of a wallet is usually hashed, as we saw before, it’s important to make sure that users remember their passwords.
There are several examples of people forgetting their passwords and locking themselves out of their cryptofortune.
Buying and Mining Cryptocurrencies
With the theory of cryptocurrencies out of the way, let’s take a look at how they work in practice. To get started with cryptocurrencies, you’re going to have to go to an exchange like Coinbase or Kraken to buy your cryptocurrency of choice using regular money. We have a guide on how to buy Bitcoin if you’d like to know more; the guide also applies to other cryptocurrencies.
There are other ways to get your hand on most cryptocurrencies, namely through what’s called mining. This isn’t anything like swinging a pickaxe, though: instead, a computer is verifying whether new blocks of existing cryptocurrencies are real or fake. Payment for this service is then in that same currency. It’s the only way to release new units of a cryptocurrency and thus the best way to get more of it.
However, considering the insane amount of computing power that’s needed to process the data necessary for verifying the new blocks, there’s a chance your custom-built gaming rig will have smoke billowing out of it before you mine even the equivalent of a few bucks. There’s so much processing power needed, in fact, that mining is no longer the field of enthusiasts, but rather of whole companies. Even criminal gangs are getting in on the action—and making millions.
Storing and Spending Bitcoin
Assuming you just bought your cryptocurrency of choice, you still need a place to store it: unlike cash money, Bitcoin and Ethereum can’t be sewn into your mattress. For this, you’ll need a wallet. These come in software and hardware form and can store your particular blockchain information for you.
A software wallet is often offered by exchanges—though you can subscribe to a seperate one, the Bitcoin site has a selection—and is simply an online service where Bitcoin can be stored. Many of them have good security, though they have been falling prey to hackers more and more often.
The alternative is a hardware wallet, which is pretty much just a special USB stick that keeps track of the blockchain for you. Examples include Trezor and Ledger. They’re pretty nifty, though again, if you lose or forget your password your crypto is gone.
Once you’ve settled on a wallet, then all you really need to do is decide what to spend it on. Many online services will let you pay in cryptocurrency, and doing so is pretty easy: just click the right buttons and you should be okay. Alternatively, you could just let it sit in your wallet and watch as the price of it goes higher and higher (or plummets completely).
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