Even if you’re not a financial expert, you’ve probably heard a lot about Bitcoin and other kinds of cryptocurrency. But what exactly are cryptocurrencies, and how do they actually work?
To begin, it helps to think briefly about cryptography, the secure communication of sensitive information, protected from potential adversaries. It’s the kind of technology we use regularly with our online passwords, or the chip in our credit and debit cards.
Cryptocurrency is Internet-based money, a digital asset, one of several kinds of virtual currencies that exist. Protected by strong cryptography, it’s essentially a secure, online wallet that can be used for purchases and cash transfers. Each user’s wallet has a public key, basically their account number, and a private key, which is basically a digital signature.
Bitcoin, which debuted in 2009, was the world’s first cryptocurrency and remains the most widely used. The next most popular is Ethereum, just one of the more than 7,000 cryptocurrencies created since Bitcoin. Together, those cryptocurrencies have a combined total value of more than $200 billion USD, about two thirds of which is held in Bitcoin.
Bitcoin is not anonymous, but other cryptocurrency transactions are, which some users certainly like: money laundering and tax evasion, and purchases of illegal items such as drugs are among the nefarious activities facilitated by cryptocurrencies. In addition, there are concerns the technology used to power cryptocurrencies will disrupt important industries such as finance and law.
How do cryptocurrencies work?
Bitcoin and other cryptocurrencies rely on something called blockchain technology. Blockchain is a database that stores vast chunks of information and chains each chunk together in chronological order. This makes it especially useful as a financial ledger, a secure record of digital purchases and transfers.
The blockchain database most cryptocurrencies use is decentralized and public, meaning no one person has control over the whole network. Instead, identical copies of the ledger are stored on computers all over the world, with each version checked against the others to make sure everything is accurate and up to date. Entries in the ledger can’t be deleted, and any attempt to change one version of the ledger will be caught out by the countless other accurate versions, preventing forgery and boosting security for all users.
Bitcoins are created when computers called mining machines are connected to the cryptocurrency network. The miners verify Bitcoin transactions in exchange for small amounts of the currency. Interested users can also purchase cryptocurrencies through brokers.
To maximize their earnings, some miners connect whole rooms of computers to the network. Massive amounts of energy are required to power all these machines and keep them cool. Research from the University of Cambridge has shown that Bitcoin uses more energy each year than the entire population of Switzerland. The currency may be virtual, but the carbon footprint it creates is real.
Should I invest in cryptocurrency?
Cryptocurrency units do not trade at a fixed price. Instead, their value changes based on supply and demand of units. As a result, the value of a unit of cryptocurrency can fluctuate wildly, making it a volatile investment – you might win big, but you might get burned.
About three years ago, for example, a single Bitcoin was worth almost $20,000 USD. Less than a year later, the value had plummeted to $3,400 USD. The price has risen, fallen, and mostly risen again since, and currently sits around $16,000 USD.
Besides volatility, the threat of hacking is another concern. Although the blockchain database is highly secure, personal wallets are less so, and several instances have seen hackers steal millions of dollars worth of virtual currency from unfortunate users. Worryingly, there is little recourse in an environment that is not subject to extensive government regulation.
Finally, be aware that your virtual holdings could be wiped out if your private key details are lost or erased by a hard drive crashing or being corrupted by a virus, and no backup existing elsewhere.
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