The term cryptocurrency denotes a medium of exchange on a blockchain network. A cryptocurrency is made of units of trade which are appropriately known as coins. Unlike fiat currencies – the units of which are created by a central bank or monetary authority – coins are created automatically by the blockchain network through a process known as mining.
Unlike other blockchain applications, such as security tokens, cryptocurrencies are meant to be used as a medium of trade. A cryptocurrency may have a dedicated blockchain (as is the case with bitcoin), or it may be just one of many applications performed by a blockchain (as is the case with Ethereum).
Cryptocurrencies can be non-proprietary (bitcoin and Monero are examples of this) or proprietary (Ethereum and Ripple are examples of this).
How do cryptocurrencies work?
Like other blockchain applications, cryptocurrencies make use of encryption and a distributed ledger (database) to secure transactions. In order for a transaction to be performed, a complex decryption process must be completed by a node (computer) on the blockchain network. Transactions are assigned to nodes automatically based on either a proof of work, proof of stake, proof of capacity or proof of importance model.
A majority of the nodes making up the blockchain network must confirm that a transaction is correct as per their ledgers in order for the transaction can occur. This process is known as consensus. Once this consensus has (automatically) been reached by the network’s nodes, the transaction is automatically recorded on each ledger of each node.
New coins are created by the decryption process required to perform transactions. These newly-generated coins are automatically assigned to the blockchain wallet of the node which performs the decryption process for a successful transaction. This mining process gives entities an incentive to provide the computers (nodes) required for the network to operate.
All ledgers across the blockchain network record identical information. If the data on one ledger does not match that of the other ledgers on the network, it is rejected. This means that if someone tampers with data on one or more ledgers (such as increasing the number of coins in a blockchain wallet), this data will be overwritten by the data recorded on the majority of other nodes on the network.
The distributed ledger system enables cryptocurrencies to function automatically, without the need for a person or other entity ensuring that the data is correct.
The process required for the creation of cryptocurrency units sets cryptocurrencies apart from book money. Book money is made of account balances which represent debt claims against financial services providers, and is created when a financial services provider enters figures into its proprietary ledger. All fiat currency which is not base money is book money. Units of cryptocurrency, on the other hand, are effectively base money because each coin is generated individually and represents a unique monetary unit.
Another key differentiator between cryptocurrencies and book money is the distributed ledger technology which ensures the integrity of data. Book money, on the other hand, must be actively managed by financial services providers and legal measures are required to ensure that financial services providers maintain the integrity of data.
What gives a cryptocurrency value?
Like other mediums of exchange, cryptocurrencies are a service which facilitates trade and functions as a store of value. As with other currencies, a cryptocurrency’s value is determined by demand for the services it provides. Their value fluctuates in keeping with supply and demand.
Unlike book money, the supply of cryptocurrency is limited because new coins can only be created as transactions are made. This means that the creation of new units of a cryptocurrency is directly linked with the use of a cryptocurrency for transactions. The number of units which can be mined is typically set when the blockchain is created. Because supply of cryptocurrency units is limited, demand for existing coins climbs along with demand for the service.
In the case of proprietary cryptocurrencies, value is largely a reflection of the service providers which own them. Service providers can create demand for their cryptocurrencies through strong marketing strategies or customer networks. Proprietary cryptocurrencies may also have a fixed value in relation to other currencies determined by their owners. These are known as stablecoins.
More on this topic:
Buying and using bitcoin in Switzerland
Popular cryptocurrencies compared
Alternative currencies in Switzerland
