As we become an increasingly digitized society, cryptocurrencies are becoming more popular and upending traditional models of banking across the globe. Many believe cryptocurrencies could replace fiat currencies and become the primary global currency within the next several years. But what does this mean? How do cryptocurrencies work, and what is the underlying “blockchain” technology?
A cryptocurrency is a piece of digital information that you can hold that is given value. As long as no one else knows that digital information, that value belongs to the holder. Essentially, cryptocurrency is cash for the internet. There are currently an estimated 1,500 types of cryptocurrencies, including Bitcoin, Ethereum, Litecoin, and Ripple. A fiat currency is paper money or coin with no intrinsic value and not convertible into gold or silver but made legal by order of a governmental body. The dollar and the euro are examples of fiat currencies.
A blockchain is a peer-to-peer digital ledger of transactions that may be publicly (or privately) distributed to all users. Blockchain is the technology that allows cryptocurrencies to exist. Blockchain is a chain of information broken up into blocks of data. Each block of data represents a transaction of cryptocurrency, and one can follow the chain to build up a picture of each transaction. In the blockchain, the block of data is protected using a public-private key encryption and can only be accessed by a person who holds the private key.
One of the main attractions of cryptocurrencies is the fact that the system is decentralized, which brings the advantages of speed and security. Transactions can be done instantaneously, as opposed to waiting for an intermediary, like a bank, to verify the transaction. In terms of security, a decentralized ledger is unlikely to be successfully hacked because, unlike a bank which has one central repository of information, cryptocurrency ledgers reside in thousands of computers. This decentralization makes it highly unlikely for hackers to simultaneously access and tamper with all of the computers in the network.
Unlike fiat currencies, no bank or government controls cryptocurrencies—it is an open network that is managed by its users. For example, let’s assume a person attends an art fair and buys a painting with a ten dollar bill. The seller knows that the purchaser can pay for the painting, and both parties physically control their desired item after the exchange—no intermediary is required. In an online sale, however, the parties must use a trusted third party (e.g., a bank) to process the transaction. Cryptocurrencies eliminate the need for the intermediary in an online transaction. Our art purchaser could buy the painting online with Bitcoins without providing any bank account information.
To ensure that the information stays private (and thus retains its value), cryptocurrencies rely on cryptography through the blockchain as the method of protection in much the same way watermarks and similar methods are used to protect fiat currency. Cryptography is the practice and technique of using encryption for secure communication and transmission of data and information. We already rely on similar technology every time we use our phones or computers to transfer money to and from our banks; it is embedded in the internet. However, in cryptocurrency, the cryptography is used through the blockchain technology, thus adding multiple layers of security that our current banking technology does not have. Moreover, for cryptocurrency, cryptography prevents users from spending funds from another user’s wallet or from corrupting the blockchain. Cryptography can also be used to encrypt a wallet so that the wallet cannot be used without a password. Since cryptocurrency exchanges are based on cryptographic proof (a common consensus validation mechanism for verifying blockchain transactions), parties can transact directly with each other without a trusted intermediary.
Cryptocurrency users can instantly send any amount of money to anyone in the world without needing a bank, an ATM, or a credit card. Governments, banks, and other financial intermediaries cannot interrupt user transactions, impose prerequisites or limits, or freeze cryptocurrency accounts. Since there is no way for third parties to identify, track, or intercept cryptocurrency transactions, sales taxes are not added onto these types of purchases. Similarly, because money is transferred directly from person to person, cryptocurrency transaction fees are substantially lower.
Cryptocurrencies also permit a degree of user anonymity. Like cash-only purchases, a user’s cryptocurrency purchases are not associated with their personal identity and cannot be traced back to the user. This greatly increases privacy when compared to traditional currency systems, where third parties potentially have access to personal financial data. Cryptocurrencies are also harder to steal than conventional currency. An online bank account, for example, only requires a few authentication details to access while a person cannot steal cryptocurrency without simultaneous access to all of the computers in the blockchain.
While there is a lot of potential for the use of cryptocurrencies and the blockchain technology, there are still many kinks to work out. Government regulators are worried about increased cybercrime due to the anonymous nature of the technology. Financial institutions are concerned that blockchain-based transactions make it more difficult to comply with anti-money laundering and know-your-customer regulations. These are just two of the many areas of concern that need to be addressed before cryptocurrencies and the blockchain technology could be widely accepted and used.