How Cryptocurrency Works for Dummies: History and Facts

Hearing the word “cryptocurrency”, many people immediately think of Bitcoin. And indeed, Bitcoin is the oldest and most famous of the cryptocurrencies available on the market. But this is hardly the first form of digital money or even the first blockchain. Let’s dive in and review some history and facts about cryptocurrencies and other  blockchain-based assets  . 

What is cryptocurrency?

Banks offer a digital version of fiat money. We meet them whenever we transfer money or pay by card, but these are not considered cryptocurrencies. According to the definition  added to the Merriam-Webster dictionary only in 2018, cryptocurrency is any form of currency that exists only in digital form and has no central governance or issuing body, for example, a government or a central bank. Instead, decentralized systems and cryptography are used to issue new cryptocurrencies, record transactions, and prevent fraud and counterfeiting. 

History of  Digital Cash

In 1982, David Chaum, a famous cryptographer, conceptualized what he called electronic money, where digital money obtained from banks could be spent without central oversight. He then executed his ideas as  DigiCash  which survived until 1989. His research was invaluable for what we think of today as cryptocurrency. He also became a mainstay of the Cypherpunk movement, which came to life in the late 80s and 90s. 

Cypherpunks were a group of people actively interested in cryptography, privacy, and independence from centralized systems and governments. The group converged around an anonymous mailing list where they exchanged ideas for advancing research in the areas of privacy technology and cryptography. It is widely believed that their conversations and experiences gave birth to the concept of blockchain and Bitcoin currency   as we know it today. 

Bitcoin from yesterday to today

In 2008, a famous Bitcoin white paper was published by an entity or group calling themselves Satoshi Nakamoto. The white paper described new technology and the ideology behind cryptocurrency. Bitcoin was formed as a bank and government independent “peer-to-peer electronic payment system” operated by a decentralized network of computers called nodes. Anyone can configure a node by downloading specific software and joining the network. Over the next 11 years, Bitcoin reached a market cap of $ 147 billion . At its peak value in December 2017, each Bitcoin was worth over $ 20,000. Currently in a bear market the value is hovering around $ 8.2k, but many believe the coin is just starting to rise. 

Source: Coinmarketcap

How cryptocurrencies work

According to definitions, cryptocurrencies require decentralized systems and cryptography to play the role usually reserved for banks and governing bodies. The system is designed to control and encourage the execution of valid payment transactions and the issuance of new coins. There may be different ways to create such a system. Most, but not all, cryptocurrencies rely on the underlying blockchain technology. A distributed peer-2-peer node network executes the payments and places the coin’s ownership records on the blockchain. Bitcoin, Ethereum, or EOS are examples of blockchain-based cryptocurrencies. There are also cryptocurrencies that do not use the blockchain, for example IOTA. 

Blockchain in brief

Most cryptocurrencies, including Bitcoin, are based on blockchain technology. Blockchain is essentially a chain of digital blocks, linked to each other in a specific sequence. Like a folder in a database, each block contains data. For the use case of cryptocurrency, the blockchain contains records of financial transactions and proof of ownership of the crypto-coins or other assets. This is one of the reasons why blockchain is often referred to as a digital book. 

Distributed ledger technology

Blockchain technology is often referred to as DLT for distributed ledger technology. Financial records contain proof of ownership and transaction information. Traditionally, they have to be validated by central authorities, which is both expensive and time consuming. They can also be falsified and subject to human error. Records stored on the blockchain are more secure from both outside and inside influence because they are immutable, time-stamped and distributed. 

  • The advantages and methods for time stamping digital documents were first described by Haber and Stornetta in a  groundbreaking  1991 document . Accurate time stamping is vital for financial documents. It allows us to track the ownership history of the asset. 
  • Immutability means that no one can modify the records stored in blocks. Thanks to the hashing algorithms used in cryptography, each new block in the chain contains a digital fingerprint called a hash. Each block also bears the digital imprint of a previous block. Any change in the data in a block would produce a completely different hash and the modified block would break off the chain. 
  • Finally, the digital blockchain ledgers are distributed, which means that a copy of the records is stored on many computers around the world (on a distributed peer-2-peer network). It secures data against cyber attacks and data loss, which happens for centralized systems with simple points of failure. This is why we often call the DLT (Distributed Ledger Technology) blockchain technology. 

Who makes crypto work?

Blockchain technology allows us to easily send money to our peers. But if the banks are not involved, who checks to see if the payments are correct? Who puts the records on the blockchain?

The validation of transactions is done through the so-called consensus mechanism. Before a transaction ends up in the block, the majority of nodes must agree that the payment is correct and valid. Each blockchain uses a different method to achieve such consensus. Various game theory principles and incentives are used to get network participants to play by the rules and agree on the truth. 

The Bitcoin and most other crypto    currencies using the proof work (PoW). In PoW, nodes use software and computing power to solve complex mathematical problems. The work they do allows them to validate transactions and add new blocks to the chain in exchange for fees. Some cryptocurrencies test alternative consensus algorithms, such as proof of stake and / or   decentralized voting mechanisms, to make sure the records are correct. Either way, the technology, together with predefined algorithms and social engineering, helps the network stay functional. 

Issuance of coins and tokens 

Source: Coinmarketcap

Depending on the case, the total number of pieces can be set by the creators from the start, or it can be unlimited. The total number of Bitcoin has been capped at 21 million coins, and the “new” coins are discovered during mining through Proof-of-Work. The total Ethereum supply has not been capped, so in theory the new coins could be minted indefinitely. In each situation, the rules and methods for introducing new coins into the system are defined by the technology and its governance. 

It is worth mentioning that the crypto-currencies or parts cryptocurrency are not the same as the crypto-chips. Tokens are  digital assets  that can be issued through smart contracts on blockchains suitable for issuing tokens, such as Ethereum and Neo. Tokens typically represent a value  such as a public service, private capital, a real world asset, a security token,  or a financial instrument. Successful tokens have large market caps and are traded on cryptocurrency exchanges alongside coins.