A cryptocurrency is a medium of digital currency exchange, which makes use of cryptography techniques – essentially online encryption – in order to control the creation of units and ensure that transactions are secure. Cryptocurrencies are categorised as a subset of digital currencies. However, it is important to establish that while cryptocurrencies are all digital currencies, not all digital currencies are cryptocurrencies.
Cryptocurrencies differ from electronic money systems like PayPal because they feature completely decentralised control. This system of decentralisation means that, unlike with centralised economic systems, governments and companies cannot control the supply of the currency by producing new units.
Since the emergence of the popular Bitcoin peer-to-peer payment system in 2009, cryptocurrencies have generated a lot of mainstream publicity and have been dubbed the future of currency. So what exactly is a cryptocurrency, where did cryptocurrencies come from, and are they really the future of the financial world?
Cryptocurrencies have emerged largely as a result of mistrust of current economic systems and financial institutions. Although Bitcoin is often referred to as the world’s first cryptocurrency, this is not strictly true and the origins of cryptocurrency pre-date its creation. In actual fact, the first known electronic cash system making use of digital encryption methods was created by David Chaum as far back as 1994.
A few years later, Wei Dai published a paper in which he outlined an anonymous, electronically distributed cash system, called “B-Money”. Then, between the years 1998 and 2005, cryptographer Nick Szabo devised a system of decentralised currency, making use of cryptography, which he called “Bit Gold”.
The Bit Gold system has been widely viewed as a direct precursor to the Bitcoin cryptocurrency system and some have even gone as far as to speculate that Nick Szabo is actually Satoshi Nakamoto, the anonymous person behind the creation of Bitcoin.
How Does Cryptocurrency Work?
Cryptocurrency is created collectively by the entire cryptocurrency system. The creation of currency units takes place at a set, publicly-known rate. With the majority of cryptocurrencies, production of the currency is designed to decrease gradually over time, eventually placing a cap on the total amount of currency in circulation. This system is intended to avoid hyperinflation and maintain a level of scarcity so that the currency retains value.
The ledger, or computer file for recording economic transactions, is maintained by a community of members of the general public, who use their computers to time stamp and validate transactions. Safety, security and integrity of the ledger relies upon members of this community trying to maintain it with a degree of honesty. The community is usually rewarded with units of the currency.
Existing cryptocurrencies, including Bitcoin, are currently pseudo-anonymous, protecting the privacy of users. However, in certain instances, it may be at least theoretically possible to link transactions to an individual. The vast majority of cryptocurrencies now make use of the basic technical features of Bitcoin. Cryptocurrencies descending from Bitcoin are sometimes referred to as ‘Altcoins’.
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The popular Bitcoin cryptocurrency system was created by Satoshi Nakamoto, an anonymous person or group, in 2008, and was subsequently released as open source software in 2009. In the years since its creation, its popularity has exploded and Bitcoin has emerged as an accepted, mainstream form of payment for a wide range of different products and services around the globe.
As a system of currency, Bitcoin makes use of a public ledger, called the block chain, which is maintained by a network of communicating nodes. Anyone can make use of the required software and join the network, meaning that there is no single, central authority. As a result, Bitcoin is widely recognised as a decentralised virtual currency.
Units of currency, called Bitcoins, are created as a reward for users offering their computing power to record and verify transactions. This activity of payment processing is often referred to as ‘mining’ and results in newly created Bitcoins. In addition, Bitcoins can be obtained in exchange for money, goods or services.
Pros and Cons of Cryptocurrency
Bitcoin and similar cryptocurrencies offer a number of advantages over traditional currency systems.
For example, cryptocurrencies cannot be seized by a third party, meaning that governments cannot freeze someone’s wealth. In addition, the ownership of units of cryptocurrency can only be changed by the owner. This offers protection from theft, as a thief would need physical access to another person’s computer. Merchants also have an incentive to accept Bitcoin because the transaction fees are significantly lower than with credit cards.
However, there are also a number of disadvantages to cryptocurrency use.
Unlike with more traditional currencies, Bitcoin and other cryptocurrencies do not offer much in the way of consumer protections in the unlikely event that Bitcoins are stolen or otherwise lost. In addition, cryptocurrency transactions are irreversible, potentially leaving users at risk of certain types of fraud.
Issues like data loss or damage to physical media could feasibly result in the complete loss of cryptocurrency from the market. Moreover, while cryptocurrencies are legal in all countries except Iceland, some regulators have expressed concerns in an attempt to dissuade users and a number of countries have taken steps to restrict their use.
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