Cryptocurrency is a decentralised digital currency based on blockchain technology. You may be familiar with the most popular versions, Bitcoin and Ethereum, but there are more than 9,000 different cryptocurrencies in circulation.
How do cryptocurrencies work?
A cryptocurrency is a digital, cryptocurrency and decentralised medium of exchange. Unlike the US dollar or the euro, there is no central authority that manages and maintains the value of a cryptocurrency. Instead, these tasks are widely distributed among the users of a cryptocurrency via the internet.
It is possible to use cryptocurrencies to buy normal goods and services, although most people invest in cryptocurrencies as they would with other assets, such as shares or precious metals. Although cryptocurrencies represent an exciting new asset class, buying them can be risky as a lot of research needs to be done to fully understand how each system works.
Bitcoin was the first cryptocurrency, described in principle by Satoshi Nakamoto in 2008 in a paper entitled ‘Bitcoin: A Peer-to-Peer Electronic Cash System’. Nakamoto described the project as “an electronic payment system based on cryptographic proof rather than trust”.
This cryptographic proof takes the form of verified transactions recorded on a blockchain.
What is a blockchain?
A blockchain is an open, distributed ledger that records transactions in code. In practice, it is a bit like a chequebook distributed on countless computers around the world. Transactions are recorded in ‘blocks’, which are then linked together in a ‘chain’ of previous cryptocurrency transactions.
“Imagine a book where you write down everything you spend every day,” explains Buchi Okoro, CEO and co-founder of the African cryptocurrency exchange Quidax. “Each page is like a blockchain and the whole book, a group of pages, is a blockchain.”
In a blockchain, everyone who uses a cryptocurrency has their own copy of this ledger to create a standardised transaction register. Each new transaction is recorded and each copy of the blockchain is updated simultaneously with the new information, so that all records remain identical and accurate.
To prevent fraud, each transaction is verified using a validation technique, such as Proof of Work or Proof of Stake.
Proof of Work vs. Proof of Stake
Proof of Work and Proof of Stake are the two most commonly used consensus mechanisms to verify transactions before they are added to the blockchain. Verifiers are then rewarded with cryptocurrencies for their efforts.
Proof of Work
“Proof of Work is a method of verifying transactions on a blockchain where an algorithm specifies a mathematical problem for computers to solve in a competition,” explains Simon Oxenham, Social Media Manager at Xcoins.com.
Each participating computer, often called a ‘miner’, solves a mathematical puzzle that is used to verify a group of transactions – known as a blockchain – and adds them to the blockchain’s ledger. The first computer to do so is rewarded with a small amount of cryptocurrency for its efforts. Bitcoin, for example, rewards a miner with 6.25 BTC (about 200,000 US dollars) for validating a new block.
The race to solve blockchain puzzles can require a lot of computing power and electricity. This means that miners can barely break even with the cryptocurrency they receive for validating transactions, after taking into account the cost of electricity and computing resources.
Some cryptocurrencies use a proof-of-stake verification method to reduce the amount of energy required to verify transactions. With the Proof of Stake method, the number of transactions each person can verify is limited by the amount of cryptocurrency they are willing to ‘stake’ or temporarily store in a shared vault to participate in the process.
‘It’s almost like a bank guarantee,’ Okoro explains. Any person betting cryptocurrency is eligible to verify transactions, but the chances of being selected usually increase with the amount of the bet.
“Because Proof of Stake eliminates the need to solve energy-intensive equations, it is much more efficient than Proof of Work and allows for faster transaction verification/confirmation times,” says Anton Altement, CEO of Osom Finance.
For comparison, the average transaction speed in Bitcoin is at least 10 minutes. When compared to Solana, a cryptocurrency platform that uses the proof-of-stake mechanism and averages around 3,000 transactions per second (TPS), it is much faster than Bitcoin’s slow blockchain.
The role of consensus in cryptocurrencies
Both Proof of Stake and Proof of Work rely on consensus mechanisms to verify transactions. This means that although individual users are used to verify transactions, each verified transaction must be checked and approved by a majority of the ledger holders.
How can cryptocurrencies be mined?
Mining creates new units of cryptocurrency, usually in exchange for the confirmation of transactions. Although it is theoretically possible for the average person to mine cryptocurrencies, this is becoming increasingly difficult in proof-of-work systems like Bitcoin.
“The bigger the Bitcoin network gets, the more complicated it becomes and the more computing power is required,” says Spencer Montgomery, founder of Uinta Crypto Consulting. “The average consumer used to be able to do it, but now it’s too expensive. There are too many people who have optimised their equipment and technology to compete.”
Proof-of-work cryptocurrencies also require large amounts of energy for mining. Bitcoin mining, for example, currently consumes 127 terawatt hours (TWh) of electricity per year, which is more than the entire annual electricity consumption of Norway.
While it is impractical for the average person to earn cryptocurrencies by mining in a proof-of-work system, the proof-of-stake model requires less powerful computers, as validators are randomly selected based on their stake. However, to participate, one must already own a cryptocurrency. (If you do not own a cryptocurrency, you will not be able to participate).
How can cryptocurrencies be used?
Although it is possible to buy a range of goods and services with cryptocurrencies, in particular Litecoin, Bitcoin or Ethereum, it is also possible to use cryptocurrencies as an alternative investment option to stocks and bonds.
“The best-known cryptocurrency, Bitcoin, is a secure, decentralised currency that has become a store of value like gold,” says David Zeiler, cryptocurrency expert at financial news site Money Morning. “Some are even calling it ‘digital gold’.”
How to use cryptocurrencies for secure purchases
Using cryptocurrencies for secure purchases depends on what you want to buy.
If you are looking to make a payment in cryptocurrency, you will most likely need a cryptocurrency wallet. One type of wallet is a ‘hot wallet’, a software programme that interacts with the blockchain and allows users to send and receive stored cryptocurrencies.
Keep in mind that transactions are not instantaneous, as they have to be validated by some mechanism.
Is it worth investing in cryptocurrencies?
Experts are divided on investing in cryptocurrencies. Since cryptocurrencies are a highly speculative investment that can be subject to strong price fluctuations, some financial advisors advise against investing at all.
Advantages and disadvantages of cryptocurrencies
Peter Palion, a certified financial planner (CFP) in East Norwich, New York, believes it is safer to stick with a government-backed currency, such as the US dollar.
“If you have a US dollar in your cash reserves, you know you can pay your mortgage and your electric bill,” says Palion. “If you look at the last 12 months, bitcoin is pretty much like my last EKG, whereas the US dollar index is pretty much a flat line. Something that goes down 50 per cent is not good for anything but speculation.”
For clients specifically interested in cryptocurrencies, New York-based wealth advisor Ian Harvey helps them invest in them. “The weight in a client’s portfolio should be enough for them to perceive it as significant without nullifying their long-term plan if the investment goes to zero,” says Harvey.
When it comes to deciding how much to invest, Harvey asks investors what percentage of their portfolio they are willing to lose if the investment fails. ‘It could be 1% to 5%, as much as 10%,’ he says. ‘It depends on how much they have now and what is really at stake in terms of loss’.