Cryptocurrencies: What’s behind these digital currency systems?

In 2008, an unknown individual or group published the whitepaper for Bitcoin under the pseudonym Satoshi Nakamoto, thereby paving the way for cryptocurrencies. To this day, it is still unclear who’s behind the pseudonym and the idea for this revolutionary, digital payment instrument. For many people today, it’s just as unclear what exactly a cryptocurrency is – despite the fact that, one decade after the invention of Bitcoin, there are now more than 2,000 different providers of these digital payment systems, as the impressive list on the web portal CoinMarketCap shows.

A cryptocurrency (or cryptoasset) is a digital means of payment, typically based on blockchain technology and cryptographic processes such as hash functions and digital signatures. Unlike conventional currencies, cryptocurrencies do not involve physical coins or notes. All units of the currency are exclusively digital. These asymmetrically encrypted units of currency are usually generated collaboratively by the whole system, although in most cases, a predetermined quantity of units is defined at the launch of a cryptocurrency. The term “mining” was coined for the process of generating units, which is why people talk about “mining cryptocurrencies”.

Most cryptocurrency systems are characterized by a decentralized nature: Not only the generation of new currency units, but also the individual transactions are typically executed collectively, as multiple participants verify and countersign them in the respective system. Communication normally occurs in a peer-to-peer network in which all nodes operate as equals. In contrast to money printed by central banks, classic cryptocurrencies have no “single point of failure” – i.e. there is no individual point in the network that can jeopardize or dominate the functioning or trading of the currency system. An exception can be found in cryptocurrencies like Ripple, which are run by private companies that perform most of the unit generation process themselves and distribute them according to their own rules.

As a result of the hyperinflation of the bolívar fuerte, Venezuela not only introduced the new currency, the bolívar soberano, but also tied it to the Petro cryptosystem. Even though the Venezuelan government proclaims it to be the “first national cryptocurrency”, the Petro lacks key characteristics of a cryptocurrency precisely due to its state governance, such as the decentrality of the system or the equality of all participants. Similar controversy surrounds the privately managed systems already mentioned, like Ripple.

A closer look at the three elementary components of a cryptocurrency reveals that, although private and state-run systems fulfill the “crypto” aspect, they have little to do with the classic principle of Bitcoin.

Cryptography not only gives these currencies their name, it is also a critical discipline for the security of cryptocurrencies. The term “cryptography” refers to the science behind encryption and the general protection of data and information. Both are vital for a cashless and fully digital payment system that, as standard, operates without a central regulatory body. Cryptocurrencies primarily use two cryptographic processes:

• Hash functions
• Digital signatures

Hash functions represent the elementary pieces of the puzzle for checking the integrity of the data and encoding the account addresses and transactions of participants. They also provide the basis for the blockchain and block mining. Digital signatures enable the status of encrypted information to be verified without disclosure. This technology is employed, for example, in order to protect the content of e-mails. In the case of cryptocurrencies, it is used to sign transactions and communicate to the network that a transaction has been approved.

Blockchain refers to the decentralized ledger of a cryptocurrency that records all transactions in what are known as blocks. The recording of the individual blocks takes place in fragments and in chronological order, so that a (mostly) public, immutable and verifiable record emerges over time. It is maintained by the participants of the underlying peer-to-peer network, who follow a defined protocol in order to validate new transactions. In this process, all nodes automatically download a complete copy of the blockchain, dispensing with the need for a central authority to inspect executed transactions.

A data record based on blockchain technology cannot be altered without the consent of the other network participants.

The third important pillar of cryptocurrencies is known as block mining. This refers to the process necessary in order to append new transactions in the cryptosystem as blocks to the blockchain. Mining requires certain software that can solve mathematical problems and thereby find the underlying hash functions. All network participants can attempt to solve each mathematical problem for validating a new block of transactions. This procedure is also known as the “Proof of Work” that has to be produced. Once a block is correctly mined and the output of the hash function is guaranteed, all network participants can check whether the solution is correct.

However, the reward for successful mining is only received by the miner whose computer solved the problem first. Typically, a block reward – as this type of reward is called – is a set number of currency units as well as all transaction fees associated with the newly added block.

They're called cryptocurrencies for a reason: their similarity to real currencies with notes and coins, as well as the fact that users of Bitcoin or similar influential alternatives like Ethereum, IOTA or Monero possess an exchange value (demand and use) have brought the digital currency systems into discussion as the potential means of payment of the future. Bitcoin in particular is already in use in this respect. Various online sales platforms such as Overstock have adopted Bitcoin payments into their repertoire of available payment methods. But even the top cryptocurrency has not yet established itself as a means of payment, primarily due to the significant fluctuations in value.

Cryptocurrencies are also being used for other purposes especially in the start-up sector:

So long as the units of a cryptocurrency have a certain exchange value that can be converted to a central bank currency like the dollar, cryptocurrency can in principle be used as a means of payment. But to actually pay with digital money, the vendor must also accept the cryptocurrency. In order to execute a payment, a pair of keys is required, comprising a public and private key.

The public key is visible to anyone and essentially has the same role as a bank account number: it serves as the sender’s address from which a user carries out a payment with the respective cryptocurrency. Conversely, the private key is used for verifying a transaction, a bit like a password or PIN. It should only be visible to the owner of the crypto address used to sign a transaction. In the case of the latter, this is usually automatically performed by a wallet, the virtual account that stores a cryptocurrency. In other words, users only have to enter the amount and the target address, i.e. the public key, of the payee when making a payment.

Ever since Bitcoin’s spectacular price boom in 2017, cryptocurrencies have been a popular speculative investment. In just a short space of time, interest in investing in the cryptocurrency sector has risen considerably. And there are some different ways to invest in one of the currencies available on the market.

Like foreign exchange trading, cryptocurrencies can also be used as a tradable commodity, with the aim of exploiting price swings in order to increase the investor’s capital. The difference with cryptocurrencies is that there are no central banks, financial supervisory bodies or government regulatory authorities to monitor the monetary supply and step in when the market overheats. Units of various cryptocurrencies can be bought, sold and exchanged on trading platforms like CoinSwitch, which always display the most up-to-date prices. Alternatively, it’s also possible to invest indirectly in cryptocurrencies via conventional exchanges, by betting on price fluctuations or purchasing the shares of companies involved in the cryptocurrency sector.

Due to the fact that there are more than 2,000 different cryptocurrencies worldwide, it’s no wonder that even recognized experts are not familiar with all the different providers and their models. Anyone who wishes to invest in cryptocurrency has no choice but to monitor the market closely and seek out suitable solutions. Especially for newer or more unknown currencies, there is always the risk of falling victim to fraud or the system completely collapsing. The following list contains some of the established cryptocurrencies characterized by a high market capitalization (a high value of total shares in circulation):

Cryptocurrencies offer key opportunities and possibilities that conventional currencies lack. In particular, blockchain technology has so far offered compelling potential in a variety of sectors, which is why it is also being used in numerous projects beyond the financial industry. The lack of a central authority anchored in most cryptosystems also generally represents a promising innovation. The associated freedom from market regulation, however, also poses one of the greatest problems with cryptocurrencies. Since there is also a lack of a consistent exchange value, the prices of cryptocurrencies are subject to severe fluctuations and the ever-present risk of a total system crash.

The pros and cons of cryptocurrencies compared to conventional monetary and currency systems are summarized in the following table:

Please note the legal disclaimer relating to this article.