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What is Cryptocurrency & How it Works

What is Cryptocurrency & How it Works

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Cryptocurrency is often described as “digital money.” This description may be true, but it fails to capture what makes cryptocurrency unique and so appealing to many investors. 

What is cryptocurrency?

At its core, cryptocurrency is a system of value. When investors buy a cryptocurrency, they are betting that the value of that asset will increase in the future, just as stock market investors buy securities when they believe the company will grow and share prices will increase. 

Stock valuations boil down to discounted estimations of a company’s future cash flows. There is no comparable valuation metric for cryptocurrencies because there is no underlying company; the value of a cryptocurrency is tied only to investor appetite.

Cryptocurrency valuations boil down to one of two factors: the likelihood of other investors buying the asset or the utility of the cryptocurrency’s blockchain. 

How does it work?

Cryptocurrency runs on blockchain technology, but what exactly is a blockchain? The term has become so commonplace, its meaning and significance are often blurred. A blockchain is simply a digital ledger of transactions. This ledger (or database) is distributed across a network of computer systems. No single system controls the ledger. Instead, a decentralized network of computers keeps a  blockchain running and authenticates its transactions. 

Proponents of blockchain technology say that it can improve transparency, increase trust and bolster security of data being shared across a network. Detractors say that blockchain can be cumbersome, inefficient, expensive, and can use too much energy.         

Rational crypto investors buy a digital asset if they believe in the strength and utility of its underlying blockchain. All cryptocurrencies run on blockchain, which means crypto investors are betting (whether they know it or not) on the resiliency and attractiveness of that blockchain.

Cryptocurrency transactions are recorded in perpetuity on the underlying blockchain. Groups of transactions are added to the ‘chain’ in the form of ‘blocks,’ which validate the authenticity of the transactions and keep the network up and running. All batches of transactions are recorded on the shared ledger, which is public. Anyone can go and look at the transactions being made on the major blockchains, such as Bitcoin (BTC) and Ethereum (ETH).  

But why do people dedicate computing power to validating blockchain transactions? 

The answer is, they are remunerated with the underlying cryptocurrency. This incentive-driven system is called a proof-of-work (PoW) mechanism. The computers ‘working’ to ‘prove’ the authenticity of blockchain transactions are known as miners. In return for their energy, miners receive freshly minted crypto assets.

Investors in cryptocurrencies don’t hold their assets in traditional bank accounts. Instead, they have digital addresses. These addresses come with private and public keys — long strings of numbers and letters — that enable cryptocurrency users to send and receive funds. Private keys allow cryptocurrency to be unlocked and sent. Public keys are publicly available and enable the holder to receive cryptocurrency from any sender.  

It is fair to say that Bitcoin has changed the paradigm — there has been nothing quite like it before, and it has unleashed an entirely new technology, a new platform for investing, and a new way of thinking about money.

Cryptocurrency began as a grassroots movement with an anti-establishment ethos, but today, corporations and financial institutions are embracing cryptocurrencies for their potential to disrupt clunky legacy systems and diversify investment portfolios. As innovations continue to reshape the cryptocurrency sector, including exciting new projects like decentralized finance (“DeFi”), the meaning of cryptocurrency will continue to evolve. 

To learn more about evaluating crypto, we recommend reading this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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