What Is Cryptocurrency? How do Cryptocurrencies Work?

What is Cryptocurrency?

A cryptocurrency is a digital or virtual currency secured by cryptography (the practice of encrypting and decrypting information).

Cryptocurrencies are typically traded on decentralised computer networks among individuals with digital wallets. These transactions are publicly recorded on distributed, tamper-proof ledgers called blockchains. This transparent framework prevents duplication of coins and eliminates the necessity for a central authority to validate transactions.

Bitcoin was the first cryptocurrency created and is now the most prominent coin. It was launched in January 2009 by the pseudonymous software engineer Satoshi Nakamoto. Over recent years, numerous other coins have emerged, each with different characteristics, consensus mechanisms, and utilities.

Types of Cryptocurrencies

Each sort of cryptocurrencies serves different purposes. Consequently, there are several types of cryptocurrencies, and this number is rising rapidly. However, these digital currencies can be divided into two main categories: crypto coins and tokens.

Crypto coins

What is a crypto coin?
The initial concept of decentralised payment solutions is a distributed ledger system that records transactions’ details using a native cryptographic asset. This asset is referred to as a coin and is the only one supported by the blockchain. They are the only recognised means of exchange for those who use these blockchains. For example, the Bitcoin blockchain only supports BTC, and Ethereum only endorses ETH.

Consequently, each coin resembles and embodies the technological abilities and the financial structure of their parent blockchain.

Coins’ practical uses
When Bitcoin was created, its purpose was to serve as an alternative to conventional fiat currencies. Like other cryptocurrencies, it was designed to work in the same ways as paper money and metal coins. This means that these coins can be used for several “daily purposes” similar to US dollars or euros. Some use cases are:

1. Store of value:
   Coins could be considered as a means of preserving wealth over time. Unlike fiat currencies which are subject to inflation and often lose purchasing power over time, many cryptocurrencies have a capped supply, which means that they might resist inflationary pressures.
   For instance, Bitcoin works as a store of value because only 21 million coins can be in circulation. The provable scarcity of BTC makes it a reliable store of value and is the reason why Bitcoin is often referred to as digital gold.
2. Medium of exchange:
   Coins offer a simplified and cost-effective way of transferring money across borders. This can be particularly beneficial to migrant workers sending remittance back to their families. Companies like Circle and other P2P payments technology companies support blockchain-based remittances by developing applications that enable people everywhere to receive cryptocurrency and convert that crypto into local money.
   Coins can also facilitate microtransactions, which are typically impossible in traditional payment systems.
3. Paying for goods and services:
   Online shopping and e-commerce platforms are steadily exploring cryptocurrencies. Coins can now be used for e-commerce through digital wallets. Merchants may choose to accept cryptocurrencies either directly or indirectly through a service provider.
   One big benefit of this practice is that coins can add an extra layer of security for both customers and merchants. They protect customers from identity theft since transactions do not ask for personal information. On the other hand, merchants are safeguarded from fraudulent chargebacks.
   The use of smart contracts of many cryptocurrencies can automate all e-commerce processes, including payment, refunds, and dispute resolution without the need for intermediaries.

Crypto tokens

What is a crypto token?
Tokens are built on pre-existing blockchains, which already had their coins. Take the relationship between Uniswap and Ethereum as an example. Uniswap’s native digital token is UNI, and since UNI is built on Ethereum, a pre-existing blockchain, it qualifies as a token.

Crypto tokens are more like a kind of digital asset. The digital asset feature of blockchains enables the creation of unique digital assets that utilise the blockchain’s infrastructure to function, as seen in Ethereum’s ERC-20 token standard. These assets can represent a share of ownership in a DAO, a digital product or NFT, or even a physical object. They can be bought, sold, and traded between users. However, fees for these transactions are paid in the blockchain’s native coin and not these digital assets.

Tokens’ practical uses

Most tokens are designed to be circulated within a blockchain project or a decentralised app (Dapp). They are, however, not mined, but are created and distributed by the project developers. Once tokens are in circulation, they can serve several purposes as intended.

1. Asset Tokenisation:
   Tokens have been used to represent rare metals, real estate properties, and more through a process called tokenisation.
   Let’s take a real-life example: Assets can be created that are tethered to the price of real world assets such as gold. Tokens like Gold Standard tokenise Gold and give individuals an easier way to get into a market that may have been difficult to enter otherwise.
2. Utility Tokens:
   The development of Ethereum Virtual Machine (EVM) has opened the door to a range of new blockchain-based applications. Dapps such as decentralised finance (DeFi) platforms, gaming systems, and artificial intelligence (AI) applications leverage smart contracts to issue tokens which give their holders privileges while using these apps.
   In some cases, the core functionalities of an app are accessible only to token holders. These tokens are known as utility tokens. For example, some metaverse platforms and NFTs can only be purchased using a designated token only.
3. Governance Tokens:
   Decentralised Autonomous Organisation (DAO) are an organised collective with a ‘flat’ hierarchical structure centred around a shared cause or mission. Crypto projects which aim for true decentralisation often embrace the DAO model for governance.
   In DAOs, participation rights are tokenised, and every token holder is considered a member of the DAO. Through voting portals, DAO members can vote on proposals and submit their suggestions to be considered by the rest of the collective.
   Some projects implement a dual-token system. They issue governance tokens and utility ones separately. Holders of the governance tokens hold the right and duty of voting on improvement proposals, while the second token serves as a means for interacting with the app.
4. Staking rewards:
   Staking is a program that lets investors earn by simply locking up their tokens in a smart contract. Holders then can benefit from the token distribution process.
   This is quite different from the practice seen in Proof-of-Stake coins.
   In single-side staking programs, investors lock up a specific asset in a staking pool and earn rewards accordingly. Additionally, DeFi platforms offer liquidity mining and yield farming programs. In liquidity mining, holders stake their liquidity pool (LP) tokens to earn rewards.

How are cryptocurrencies created?

You might find many sources saying that cryptocurrencies are created through a process called “mining”. This is right, but not the whole explanation. In fact, cryptocurrencies are generated through the process of validating transactions using a consensus mechanism. Different blockchains employ different consensus algorithms. For example, Proof-of-Work requires validators (those performing the validation) to solve complex puzzles to validate transactions, called mining. Meanwhile, Proof-of-Stake asks nodes to lock up native coins to participate in the validation process.

However, not all cryptocurrencies come from transaction validation. Some tokens are created and distributed to holders based on projects, as mentioned above. Developers can also create new currency through a hard fork. A hard fork creates a new chain in the original blockchain. One fork follows the new path, and the other sticks with the old. As each chain needs a native currency, a new coin will then be derived.

How do Cryptocurrencies Work?

Cryptocurrencies run on a distributed public ledger called a blockchain, a record of all transactions updated and held by currency holders.

Transactions of cryptocurrencies occur through messages carrying the transactions’ details that are sent to the entire network. Each message includes the addresses of the parties involved, the quantity of currency to be traded, and a time stamp.

Say Alice wants to transfer 0.5 ETH to Bob. Alice initiates the transaction by sending a request to the network, where all users can see the information included in that order (addresses, amount of coin, and a timestamp). Alice's transaction is then grouped with other recent transactions waiting to be compiled into a block. The information from the block is turned into a cryptographic code called the hash, and validators compete to verify transactions in that block and add the new block of transactions to the blockchain.

Once a validator successfully verifies the transactions, other users of the network check the verification and reach an agreement whether those transactions are valid. If they are, the new block of transactions is added to the end of the blockchain, and that 0.5 ETH Alice has sent was transferred to Bob, impossible to reverse.

Key Features of Cryptocurrencies

1. Intangibility:
   Keep in mind that cryptocurrencies are intangible. If you own cryptocurrency, what you actually possess is the keys allowing you to access and interact with (transfer, receive, swap, etc) that unit of measure.
2. Pseudonymity and Anonymity:
   Many people misunderstand and assume that all cryptocurrencies are anonymous, when most are inherently pseudonymous. While cryptocurrency transactions do not include personal details or IP addresses, their pseudonymous nature allows for the potential identification of the sender or receiver through the analysis of transaction data and patterns.
   Privacy coins are the only sort of cryptocurrencies that offer anonymity. They are designed to prioritise trader’s anonymity and transaction privacy by using advanced cryptographic techniques to conceal transaction details and protect participants’ identities.
3. Decentralisation:
   Cryptocurrencies are designed to be decentralised. There is no need for an intermediary like a government or a central bank to take care of processing transactions. Therefore, no single entity has control over the currency, which enhances security and the risk of manipulation.
4. Transparency:
   All cryptocurrency transactions are validated through consensus mechanisms and are fully public. Once a transaction is requested, all its information will be viewable to every user of the blockchain, which means that every transaction can be seen or tracked at any time.
5. Cryptographic Security:
   Cryptocurrencies use cryptographic techniques to secure transactions and control the creation of new units. When a transaction is verified by the blockchain consensus mechanism, it is impossible to reverse the process. Each block in the chain will contain an encrypted code called the hash from the previous block. Changing just one transaction means that you need to alter the data in the whole chain, which is undoable. This is why cryptocurrencies are immutable.
6. Accessibility:
   These digital currencies are accessible to everyone, even those without access to traditional banking. What you need are just an internet connection and a crypto wallet.
7. Lower fees and faster time:
   Using cryptocurrencies can help avoid high transaction fees as there is no need for a central processing unit. These currencies also allow fast transaction time within fractions of seconds or minutes, even for cross-border transactions.
8. Supply mechanisms:
   Some cryptocurrencies have a capped supply, such as BTC with 21 million coins, BNB with 200 million coins, or Avalanche (AVAX) with around 720 million coins. A capped supply isn’t just a strategy to utterly increase a token’s value overtime due to limited availability while the demands continue to rise. One more integral function of that mechanism is to eliminate the inflationary nature of conventional fiat currencies, which we will discuss right after this Feature section.
   However, other prominent players do not have this feature. Take Ethereum, Dogecoin, and Stellar as examples. These blockchains choose to adopt unlimited supply mechanisms to encourage more widespread use, as users are not deterred by scarcity or high prices. The price to pay is that they must implement suitable monetary policies to control inflation and maintain price stability. One typical solution is ‘coin burning’.
9. Volatility:
   The price of a coin or token can fluctuate significantly based on its utility, scarcity, adoption, and even the support of a community (which is particularly right for meme coins).
   For a cryptocurrency’s value to rise, it could choose to be scarcer by having a fixed supply and gradually cutting down rewards for validators (the Bitcoin halving, for example). Or its developers must expand the currency adoption by continuously introducing important utilities like the case of Ethereum. Or it just needs a ‘strong enough’ community to endorse the coin, such as PEPE.
10. Divisibility:
    Cryptocurrencies can be divided into very small units. For instance, Bitcoin can be divided into 100 million smaller units called sats, which is short for the word ‘satoshis’ named after the coin’s pseudonymous creator Satoshi Nakamoto.
    This characteristic is extremely useful as it allows for microtransactions (especially when a coin’s value is substantial) and greater flexibility in uses (paying for gas and brokerage fees or rewards).

How to determine whether a cryptocurrency is inflationary or deflationary?

Understanding Inflation and Deflation:

Inflation: Commonly defined, inflation is an increase in the overall level of prices. Besides, we can stick to the primary definition presented by Hazlitt: “Inflation is the increase in supply of money and credit. Each individual note and coin become less valuable because there are more of them available. Goods then rise in price not because goods are scarcer before, but because notes & coins are more abundant.

Deflation: Deflation refers to a general decrease in prices for goods and services, often linked with a reduction in the availability of money and credit within the economy. During deflation, the buying power of currency increases gradually. This phenomenon leads to a decline in the nominal expenses associated with capital, labour, goods, and services, even though their relative prices may remain unchanged.

Inflationary and Deflationary Cryptocurrency

Cryptocurrencies can be inflationary or deflationary depending on their native monetary policy and design. You would assess this by examining its supply dynamics, the demand incentives, their usage and whether they preserve value and stability.

Understanding the monetary mechanisms and supply dynamics of tokens, whether inflationary or deflationary, holds significant implications for their utility. If a cryptocurrency has a fixed supply, it tends to be deflationary. Deflationary tokens are effective at encouraging holding and discouraging spending, leading to increased scarcity and accelerated adoption of the token as a store of value. Moreover, a decreasing token supply acts as a safeguard against inflationary pressures stemming from external factors like government policies or economic events that may lead to inflation, hyperinflation, or stagnation.

By contrast, cryptocurrencies with a variable supply can be either inflationary or deflationary, depending on factors such as the rate of new coin creation and other variables. Inflationary tokens may promote spending and discourage hoarding, thereby enhancing their adoption as a medium of exchange and improving liquidity.

A notable advantage of inflationary tokens is their flexibility, allowing adjustment of the inflation rate to suit the company's requirements, such as for airdropping new tokens or other purposes specified by the tokenomics of the company.

The DeFi world

Cryptocurrencies and blockchains have created a new world of "decentralised finance" or DeFi in short. DeFi endeavours to democratise access to financial services—borrowing, lending, and trading—without reliance on traditional institutions like banks and brokerages. Instead, DeFi operates through "smart contracts," which autonomously execute transactions when predefined conditions are met.

The main issue DeFi works to resolve is the dangers of centralisation and using intermediaries. A common example of the ideal DeFi user is the unbanked. These individuals have little opportunity or ability to benefit from financial services as their unbanked status means that traditional financial products are inaccessible. Using DeFi, these individuals could potentially take out a short-term loan with their collateral without KYC requirements, participate in market-making activities such as providing liquidity, or receive interest on their savings without the need of a bank account (yield farming).

Popular DeFi use cases

Lending/Borrowing
This allows users to borrow with collateral or lend their assets to others for a fee. Most DeFi protocols will automatically match borrowers and lenders, so that all a DeFi user needs to do is to deposit funds and choose whether to lend or borrow. Many lending and borrowing platforms also provide additional yield in the form of the project's governance token, allowing lenders and borrowers to “yield farm” in addition to using the financial service.

Stablecoins
Stablecoins are cryptocurrencies tied to specific assets. Most of them are actually ERC-20 tokens and do not have their own chains (built on existing blockchains). However, they are still called coins as their primary function is a medium of exchange.
While there are stablecoins governed by a centralised body such as Tether (USDT), a number of algorithmic and collateral-backed stablecoins have become one of the more common use cases of DeFi. These tokens are pegged to an underlying asset such as USD, EUR, gold and Bitcoin, with the method that maintains this peg varying depending on the mechanics of the project. The decentralised nature of these pegged assets has recently prompted governments worldwide to enact regulatory frameworks for their use.

Insurance
DeFi is not without risk. The biggest risk in DeFi is third-party risk. This pertains to vulnerabilities in the protocol, as a user must interact with a protocol's smart contracts and therefore be exposed to risks the protocol might have. These can range from contract risks (vulnerabilities are the coding of the smart contracts) or oracle risks (the ability for bad actors to influence the oracle information a protocol uses to generate the price of assets). Insurance protocols allow DeFi users to insure their funds within a protocol. This provides them with another level of protection unseen in other projects.

Decentralised Exchanges
Decentralised exchanges (DEXs) are exchanges that function through smart contracts. Most inceptions are automated market makers (AMM), meaning they use mathematics to initiate swaps opposed to order book mechanics on traditional exchanges. DEX's have become one of the more popular forms of DeFi with most generation 2 DeFi protocols implementing their own exchange function. As new smart contract-enabled blockchains begin to build out their ecosystem, most will have a native DEX where a user may swap tokens.

Yield Farming
Yield farming is when a user stakes their asset to generate a yield. The method in which yield is generated can vary. A user could earn yield by staking a single asset such as Ethereum on protocols like Yearn Finance or another example would be a DeFi user earning yield by providing liquidity. Generally, a protocol will define the yield APY by the relative risk of the asset being staked.

Liquidity Providing
Liquidity providing is the act of providing funds (liquidity) to market participants often for decentralised exchanges. While liquidity providing mechanics can vary, most early liquidity providers were required to provide a 50/50 split of the asset pair being added to the liquidity pool e.g. 50% Ethereum and 50% DAI would need to be added to provide liquidity for an ETH/DAI pair. It is now common for newer protocols to reward liquidity providers with their native token often in addition to fees, giving the liquidity provider better yield.

How to get started with cryptocurrencies?

1. Comprehend basic concepts
   In essence, most people are interested in cryptocurrencies for their financial benefits. And as it’s about money, you must be extremely careful.
   Understanding all fundamental concepts is the first essential step. Beginners must know what a cryptocurrency is, how it works, what creates its value, etc. Look for helpful resources that provide comprehensive introduction and detailed explanation. Don’t forget to double check all information to make sure that you are learning the true stories.
2. Choose the crypto you want to invest
   The next step is to choose which coins or tokens you want to invest in. When researching crypto, look into its creators and blockchain, the features and utilities it offers as well as its price movements. Do not hesitate to ask questions on trading groups or any experienced traders you know, as they can give you useful insights.
3. Create and fund your account
   When you have a grasp of this special type of currency, you can start investing. There are thousands of options to choose your starting point. CoinSpot has been a leading cryptocurrency exchange in Australia with 450+ cryptocurrencies accessible for trade, multiple deposit methods and competitive trading fees for instant traders, OTC and SMSF investors. CoinSpot also offers simple-to-use staking services, an in-platform NFT marketplace, and an extremely secure system. CoinSpot’ customer support team is 24/7 responsive with several finance and tech experts ready to help at any time. Read our instruction on How to buy cryptocurrency with CoinSpot to start trading now!