Key points
- Cryptocurrencies are virtual assets powered by a network of decentralised computer nodes. Most are built on a blockchain—a database of transactions arranged in a chain of linked blocks.
- They are used mainly for peer-to-peer payments, to pay transaction fees and to store capital. They can, however, have many other functions and constraints. Some blockchains allow an unlimited number of cryptocurrencies to be issued.
- Depending on function and use-case, there are various types of cryptocurrencies, including stablecoins, NFTs, governance tokens and wrapped assets.
- Blockchains allow users to interact with cryptocurrencies directly and without gatekeepers. Decentralisation and the absence of control by any state or organisation remove the risk of funds being frozen, among other hazards.
When cryptocurrencies emerged
Ideas for creating digital money were floated even before the internet. The first algorithms for transmitting value online were proposed by the American cryptographer David Chaum. In the late 1980s he founded DigiCash, which ultimately failed.
One project close to modern cryptocurrencies is b-money, created by programmer Wei Dai. In it he first proposed a Proof-of-Work (PoW) consensus mechanism to finalise transactions and a distributed database to store transfer information.
Bitcoin, created by an anonymous user under the pseudonym Satoshi Nakamoto, became the first successful cryptocurrency to gain wide adoption. The eponymous blockchain’s design drew heavily on the ideas of Wei Dai and, more broadly, the cypherpunk movement.
The next step in the evolution of virtual assets was the smart-contract platform Ethereum, founded by Vitalik Buterin. Its mainnet launched in 2015. Smart contracts allowed the Ethereum blockchain to issue unlimited cryptoassets and to program their functions.
Cryptocurrencies and blockchains: how they differ from traditional finance and money
The reliability of blockchains and their built-in data-protection mechanisms have made cryptocurrencies a credible alternative to the traditional monetary system. Transfers of digital assets can be made directly between users; verification and confirmation are handled by the network protocol, represented by many independent nodes. Once a transaction is sent and verified, it cannot be reversed.
Information about transfers is stored in a public database. The key technology that enables interaction with virtual assets is the blockchain. The cryptographic methods it employs make it impossible to alter data about completed transfers.
Thanks to decentralisation, blockchains solve the problem of a single point of failure in databases and payment systems, providing broad protection against censorship. Virtual assets on public blockchains are not subject to the influence of regulators or external manipulation. Third parties cannot block funds or reverse transactions.
Cryptocurrencies may be outside the control of any single organisation, allowing them to be used in any jurisdiction. Bitcoin is the best-known example. New virtual assets are minted as the blockchain operates. Parameters such as total supply and the rate of issuance are hard-coded into each digital asset’s protocol.
A user can create an unlimited number of addresses, which typically do not reveal their identity. Only specialised blockchain-analytics tools can trace fund flows and determine their sources.
How cryptocurrency works: key features
Blockchain
Most cryptocurrencies use a technology called blockchain: a sequence of hierarchically linked blocks containing a database of all past transactions. New transactions are recorded in blocks created by operators of nodes. Each node stores its own copy of the blockchain and, through consensus, validates new blocks and broadcasts the result to other nodes. Balances are updated based on this information.
Hashing
Cryptocurrencies make extensive use of the hash function. It “compresses” an arbitrary data set into a single string—a hash. A blockchain is cohesive because each block contains the previous block’s hash. Different input data produce a vastly different string. The design prevents any transaction from being reversed without altering all subsequent blocks.
Consensus algorithm
Transaction confirmation and verification of all blockchain data are handled by a consensus algorithm in which network members—nodes—participate. The most popular algorithms are the aforementioned Proof-of-Work (used in Bitcoin) and Proof-of-Stake.
To confirm transactions, nodes expend computing power or lock up their own funds as a guarantee of data validity. Once a new block is added, funds spent in it cannot be double‑spent. During consensus, participants receive newly minted cryptocurrencies (in both PoW and PoS). These mechanisms thus also serve as issuance.
Addresses
Blockchain addresses, where cryptocurrencies are held, are built on two keys: a public key and a private key. The former is used for the “open” part of an address; the latter is used to sign transactions and access the address. The private key is for the owner only. With current computing power it is infeasible to “guess” a private key by brute force. Addresses can be created and managed in a wallet.
Transactions
To transfer cryptocurrency, a user sends an instruction to the network containing the amount and the recipient. The transfer is automatically verified by a digital signature using the private key. Once broadcast, the message is included in one of the next blocks “mined” by blockchain nodes. Any node can verify the signature of each transfer using the public key. This guarantees the safety of funds and prevents third parties from initiating transactions.
Immutability
After a block is added to the chain, all of its transactions are considered confirmed and irreversible. All transactions, including past ones, are re-verified each consensus cycle. False data could enter the blockchain only if an attacker could break the block hashes or control a substantial share of all network nodes—for Bitcoin, this threshold is 51%. As of 13 October 2022, more than 15,000 nodes operate worldwide, making an attack on Bitcoin practically impossible.
Classifying cryptocurrencies: coins and tokens
Creating and operating a cryptocurrency requires a blockchain, which in turn needs infrastructure and economic incentives.
The primary cryptoasset that powers a blockchain is called the native coin. It is used to pay transaction fees and reward nodes. On platforms that run smart contracts, the native cryptocurrency is used to pay for their execution. Bitcoin and Ethereum both have native coins named after their networks, trading under the tickers BTC and ETH, respectively.
Different cryptoassets can arise via a hard fork. Examples include Bitcoin Cash and Ethereum Classic.
Today a cryptocurrency does not need its own blockchain: many cryptoassets are issued for use in various applications running on the same network. Such cryptocurrencies are called tokens. CryptoSlate tracks prices for about 1,300 tokens issued on Ethereum.
Token issuance is enabled by smart contracts, which surged in popularity after Ethereum launched. Anyone with programming skills can create a cryptocurrency. The best-known token standard is ERC-20.
Types of tokens
Virtual assets used for payments and other purposes in projects and decentralised applications are called utility tokens.
Tokens are often used for project governance. A community of holders can decide on future development. Holders may submit proposals and vote; voting power is proportional to the number of coins held.
Tokens may grant certain rights or privileges. They are used to raise funds in an initial coin offering (ICO). In some projects, virtual assets confer a right to a share of profits. Tokens that provide functions within an application or network are also called utility tokens.
Cryptocurrencies officially recognised as securities are called security tokens. As of October 2022 there are at least several dozen such cryptoassets.
Blockchains also host stablecoins. Their value is pegged to an asset such as the US dollar. They are most often used for payments and saving. Issuers hold corresponding currency reserves, which help maintain a stable price and safeguard funds.
Smart-contract platforms allow the issuance of wrapped tokens. These are pegged to a cryptocurrency on another blockchain. For example, to use bitcoin on Ethereum, the token WBTC exists. The peg is maintained because issuing the token requires locking an equivalent amount of cryptocurrency as collateral; wrapped tokens are burned to unlock the underlying asset.
Modern networks issue non-fungible tokens (NFTs). These are unique tokens that represent specific digital objects (images, audio and video files). NFTs have become collectibles. Early non-fungible tokens are rarities and command high prices (for example, CryptoPunks). NFTs can also serve other functions, such as avatars or tickets to certain events.
Some cryptocurrencies are structured as derivatives. Liquid staking is built on such tokens. Unlike stablecoins, their prices are set by market forces. Some trading platforms issue leveraged tokens.
What gives a cryptocurrency its value
When creating a blockchain, developers decide on the project’s tokenomics: the issuance algorithm and the distribution of coins among users. Emission is the number of coins in circulation. In some projects the initial supply is zero, as in Bitcoin. In such cases a cryptocurrency may be issued continuously or periodically. Some projects have constant issuance.
The distribution of the initial supply is determined by the developers. A portion typically remains with the team. Funds are reserved for marketing, development and growth. Some coins are used to attract investment, sold to large investors in one or more rounds. Many projects hold a public token sale to offer assets to anyone interested. Others distribute coins to active users via an airdrop.
Some protocols require coins to be locked (for example, in staking). With assets deposited in smart contracts, a portion of the supply is inaccessible. As a rule, issuance is capped by a maximum supply. For projects that mint continuously, the total number of coins will never exceed this cap. For example, BTC’s maximum supply is 21m.
Prices can be affected by a halving. This mechanism, used by cryptocurrencies that pay a fixed block reward, periodically cuts that reward. Halvings reduce inflation and, if demand persists, can support price increases.
Prices are also influenced by coin burns, which remove some assets from circulation. To destroy coins, holders send them to special addresses or smart contracts. Burns can trigger sharp price moves; regular burns increase scarcity.
Unlike fiat money, cryptocurrencies are not controlled by any single organisation or state. As a result they are highly volatile. Their prices are determined mainly by market forces. Value depends on supply and demand: if a large volume of coins is offered for sale and there are few buyers, prices fall; when demand exceeds supply, prices rise.
The main measure of a virtual asset’s popularity is its market capitalisation, equal to the circulating supply multiplied by the unit price. At the time of writing, BTC’s market capitalisation exceeds $374bn, based on an issuance of more than 19m coins at $19,513 each.