Since the birth of Bitcoin, cryptocurrencies have come a long way. Their popularity has soared, and the technology has matured greatly behind –the scenes. It is easy to get caught up in crypto’s meteoric rise, but harder to comprehend what drives this asset class.
To understand what cryptocurrency is, it is first important to understand that the term cryptocurrency is a portmanteau of its two components: cryptography and currency.
Cryptography is the study of communication through secure means in a way that prevents unwanted parties from accessing messages. Historically, this related to the encrypted communications like those used by clandestine services during wartime. However, cryptography as it pertains to cryptocurrencies, assures provenance of assets (proving you own what you own), secures networks against double-spending (so that your coins can’t be spent twice by you or anyone else), and guarantees the validity of transactions.
Currency is a standardized medium of exchange that can be used more broadly to pay for goods and services. The most common examples of currencies are issued by sovereign governments, like the US Dollar or the Euro. These fiat currencies tend to have value because of their government backing, and not because of intrinsic value (like gold).
Combining these definitions, cryptocurrencies are standardized, exchangeable digital assets that are secured by cryptographic computer programming and can be used to transact between individual parties.
Finally, it is important to note that not every digital asset is a cryptocurrency. For instance, central bank digital currencies (CBDCs) are more similar to fiat currencies issued by governments, and they are not necessarily cryptographically secured. Non-fungible tokens (NFTs) are not cryptocurrencies either; although they are cryptographically secured, they are not designed for use in a financial system or to pay for goods and services.
- Cryptocurrencies are digital assets that are secured by cryptography and can be used to transact between individuals and, in some cases, smart contracts.
- Cryptocurrencies vary in their use of distributed ledger technology (which includes blockchain) and consensus mechanisms (which includes proof of work and proof of stake). These variations define the differences among projects in the crypto space.
- There are many types of cryptocurrencies including: currencies, smart contract coins, stablecoins, DeFi tokens, memecoins, privacy coins, and exchange-based tokens.
What is the history of cryptocurrency?
The idea of a cryptographically secured digital money predated Bitcoin by at least 20 years—long before blockchain technology was ever conceived. In 1990, computer scientist David Chaum and cryptographer Stefan Brands introduced Digicash (previously eCash) as an anonymous way of transferring funds between individuals. Although this garnered some interest in the tech world, the company folded in 1998.
That same year, computer scientist Wei Dai introduced b-money, which he described as an “anonymous, distributed electronic cash system.” Although b-money never came to fruition, its architect’s imprint was left on the community. Now, gwei refers to the smallest unit of ether and dai is the name for MakerDAO’s stablecoin.
Nick Szabo also first proposed bit gold in 1998. Szabo described bit gold as having “minimal dependence on third parties” and “based on computing a string of bits from a string of challenge bits,” using functions called “client puzzle function” or “proof of work function.” However, his vision, like Dai’s, was also never fully realized.
Satoshi Nakamoto, the pseudonymous inventor of Bitcoin, published the Bitcoin whitepaper in October 2008. They called for the creation of a digital currency that did not rely on trust in traditional financial institutions. This was at least in part related to the public’s frustration with the ongoing global financial crisis at the time. The Bitcoin network launched the next year, with Satoshi mining the first block that contained the embedded message “The Times Jan/03/2009 Chancellor on brink of second bailout for banks.”
Between 2009 and 2013, a number of notable cryptocurrencies were created including Litecoin (LTC), Ripple (XRP), and Dogecoin (DOGE). And then, in 2014, a new crypto sought to become more than just currency.
That year, co-founder of Bitcoin Magazine and software developer Vitalik Buterin published the Ethereum whitepaper, outlining a blockchain with smart contract functionality. Buterin’s original whitepaper discussed using on-blockchain digital assets in various ways including custom financial instruments, decentralized exchanges, financial derivatives, and even non-fungible assets.
Other cryptocurrencies—inspired by Bitcoin and Ethereum, or built entirely anew—followed, and cryptocurrency became an asset class that could not be ignored.
How does cryptocurrency work?
Traditional banks need to keep track of two main things: 1) the amount of money in their clients’ accounts, and 2) the flow of value in and out of those accounts. Cryptocurrency networks are not much different. They must guarantee secure means of keeping a recorded ledger of balances and transactions, both among users and with smart contract protocols.
Distributed ledger technology
The general goal of cryptocurrencies is to decentralize financial instruments. To do so, their records are built on distributed ledger technology (DLT) designed to distribute the keeping of a network’s information across multiple parties and to record and store information about their transactions in a decentralized fashion. This is done so that no one entity needs to be trusted—and no one entity can manipulate the information without agreement from the network as a whole.
The most common DLT for cryptocurrencies is a blockchain, which assembles digital information into collections called blocks that connect with each other to build the history of all transactions and are publicly verifiable. Examples of blockchains include Bitcoin, Ethereum, and Polkadot.
Another DLT is a directed acyclic graph (DAG), which processes transactions through interconnected nodes (computers) and builds a web-like lattice structure of information, instead of a chain. Examples of DAG-based cryptocurrencies include Fantom and Nano.
To process and post transactions to a distributed ledger, nodes connected to a cryptocurrency network must reach consensus with other nodes. This ensures that the network agrees on the state of all assets on the network.
Cryptocurrencies may use one (or multiple) of a variety of consensus mechanisms for nodes to validate transactions. These nodes need to prove they have a vested (financial) interest in keeping the system operational and are granted the opportunity to collect rewards generated by the system. The two most popular consensus mechanisms are:
- Proof of work – Originally designed to counter denial-of-service attacks and spammers, proof of work requires certain users to solve cryptogenic proofs—essentially mathematical puzzles—to create new blocks on a blockchain. This process is called mining and can require a significant amount of computing power (or “work”).
- Proof of stake – Instead of mining new blocks through solving math puzzles, proof of stake nodes can earn the opportunity to validate transactions and add new blocks through locking (or staking) their own assets. Should they act maliciously, their stake will be confiscated, and they will get removed from the network.
What are the most common types of cryptocurrencies?
Cryptocurrencies can either be coins or tokens. Coins are digital assets that exist on their own native blockchain (like BTC, ETH, ADA, or SOL). Tokens are assets created on a blockchain for specific uses. For instance, DAI is a token that exists on Ethereum.
There are some common categories that most cryptocurrencies fall into. The following list highlights some important ones, but it is by no means comprehensive.
- Currencies – Cryptocurrencies generally used for payments and as a medium of exchange, much like fiat money. Bitcoin was created with this purpose, but others have followed, including Litecoin (LTC), Stellar Lumens (XLM), and Dash (DASH).
- Smart contract platform coins – Native cryptocurrencies of Turing-complete platforms that created a space for smart contracts using blockchain technology. These include Ethereum (ETH), Solana (SOL), and Polkadot (DOT).
- Stablecoins – Cryptocurrencies designed to keep a “peg” to a stable value, using a variety of methods. Many are pegged to fiat currencies like the US Dollar, but some track the price of gold or even other cryptocurrencies. These include USDT, USDC, DAI, and PAXG.
- DeFi tokens – Decentralized finance (DeFi) introduced lending/borrowing, derivatives, and interest-bearing opportunities, and many projects released their own tokens. These include Uniswap (UNI), Balancer (BAL), and Aave (AAVE).
- Memecoins – Often designed as a joke or speculative asset, memecoins originate from moments in internet popular culture, and often see notoriously high volatility. Famously, the first of these was Dogecoin (DOGE), but the category has expanded to include other cryptocurrencies like Shiba Inu (SHIB).
- Privacy coins – Cryptocurrencies that focus on shielding the senders and receivers' data such that individuals remain anonymous while still enjoying a trustless record on its blockchain. These include Monero (XMR) and Zcash (ZEC).
- Exchange-based tokens – Used by centralized cryptocurrency exchanges to offer incentives to use their services. Examples include FTX’s FTT and Crypto.com’s CRO.
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Disclosure: Bitstamp is licensed to engage in virtual currency business activity by the New York State Department of Financial Services.