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What is Cryptocurrency? How does it work?

Everyone seems to be talking about cryptocurrency these days, but many are unsure how to define it and fewer still know exactly how it works. In this blog, we attempt to answer two fundamental questions.

What is cryptocurrency?

Cryptocurrency is a digital currency (it only exists on computers), where transactions are recorded on a public digital ledger called a blockchain, and every process along the way is secured by cryptography (which is why it is called 'crypto' 'currency'). It is 'distributed' meaning the blockchain is hosted on many computers across the globe. Meanwhile, cryptocurrencies are traded online on online cryptocurrency exchanges, like stock exchanges. Bitcoin (commonly traded under the symbol BTC) is one of many cryptocurrencies; others have names like 'Ether' (ETH), 'Ripple' (XRP) and 'Litecoin' (LTC).

How does cryptocurrency work?

To use cryptocurrency, a user does not need to understand it (any more than one needs to understand the monetary system to use a debit card or the internet).

Cryptocurrency is roughly the equivalent of using PayPal or a Debit Card, except the numbers on the screen represent cryptocurrency instead of pounds. It works like bank credit on a debit card. In both cases, a complex system that issues currency and records transactions and balances works behind the scenes to allow people to send and receive currency electronically. Likewise, just like banking, online platforms can be used to manage accounts and move balances. The main difference between cryptocurrency and bank credit is that instead of banks and governments issuing the currency and keeping ledgers, an algorithm does this in the case of cryptocurrency. Transactions are sent between peers (there is no middleman like a bank).

Transactions are sent between peers using software called 'cryptocurrency wallets'. The person creating the transactions uses the wallet software to transfer balances from one account (also known as a public address) to another. To transfer funds, knowledge of a password (also known as a private key) associated with the account is needed. Transactions made between peers are encrypted and then broadcast to the cryptocurrency’s network and queued up to be added to the public digital ledger (the blockchain). Transactions are then recorded on the public ledger via a process called 'mining' (to be explained in a future blog). All users of a given cryptocurrency have access to the ledger if they chose to access it or they can choose to hold their coins in a third party wallet. The transaction amounts are public but who sent the transaction is encrypted (transactions are pseudo-anonymous). Each transaction leads back to a unique set of keys. Whoever owns a set of keys, owns the amount of cryptocurrency associated with those keys (just like whoever owns a bank account owns the money in it). Many transactions are added to a ledger at once. These 'blocks' of transactions are added sequentially by miners. That is why the technology behind it is called 'block' 'chain'. It is a 'chain of blocks' of transactions.

About the author

Raymond Davidson

Raymond has been specialising in Forensic Accounting and Litigation work for over 30 years, is a Fellow of the Institute of Chartered Accounts in England and Wales and trained by the Academy of Experts to act as a Mediator.



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