We have all heard of - and perhaps invested in - Bitcoin, Ethereum, or other cryptocurrencies. These cryptocurrencies have created a lot of excitement throughout the world, and they have had a huge impact on the socioeconomic and political state of the world. They are entirely digital and not issued by a government or central bank, but in fact use a clever alternative system. The technology behind their existence and popularity has evidently been momentous - both in terms of the way we think about what money is or can be, and how we practically carry out transactions. Traditional (physical) money is markedly different, and thus many find cryptocurrencies intriguing and very exciting, causing much ‘hype’ around it. But how does it really work and what's going on behind the scenes?
 
You have probably heard of the 'blockchain' but this word likely has no significance or meaning to you - yet! In fact, blockchain is the underlying system on which the vast majority of cryptocurrencies operate. The functionality of most mainstream cryptocurrencies relies on blockchain technology, which provides the integrity and foundations for these virtual and digital currencies (such as BTC or ETH) to work with just the same success as traditional or physical ones (such as the USD or GBP) can. For example, crypto is a medium of exchange which is electronically stored in blockchains. Given that cryptocurrencies are virtual assets which often take the form of digital files, you might think that it would be very simple to replicate or reproduce them - thus gaining 'free' money. However, what prevents people from doing this is blockchain. Blockchain acts as a digital record or ledger, which can verify transactions; such as to ensure that the sender actually has the money to make the payment or that the same crypto coins aren’t being spent more than once. Crypto owners possess their own private keys to prove that they do own the crypto that they spend – a verification process, which is used to validate any transaction.
 
However, certain transactions may reveal very private or confidential information, so cryptocurrencies utilise techniques of encryption from cryptography to stay secure. Indeed, ‘crypto’ is Greek for ‘secret’. One example of cryptographical methods used in cryptocurrencies is public-private key encryption. As mentioned, all users have a private key and a public key. In order to make a payment to someone, only their public key is required. However, in order to access the funds in someone’s virtual wallet, the private key is also required. Furthermore, crypto networks employ decentralised peer-to-peer arrangements, which means that individuals can transact directly. This feature skips the step of intermediation by a ‘trusted intermediary’, such as a central bank or government. Buyers and sellers (peers) can interact tête-à-tête – peer-to-peer – via such a service. Decentralisation is one of the most fundamental ideas, underpinning the uniqueness and innovation of cryptocurrencies. It is a revolutionary difference between physical currencies and digital ones.
 
Cryptographical techniques, encoded into the blockchain, are used to validate payments and verify the authenticity of a transaction in a peer-to-peer system – there is no central authority to do this. These encryption methods render the system so secure that new features that have never previously existed can be made possible. For example, payments can be pseudonymous. You do not need to know anything about a person to pay or be paid by them: not their address, current location, or even real name. This anonymisation can provide an additional desired layer of confidentiality and security. Not only that, but this allows much more safety to avoid hacks and online theft or piracy. Hence, it is extremely complex, and virtually impossible, to change or alter past activity recorded on the ledger. The kind of encryption used in many cases is 256-bit. What is meant by this is that 2²⁵⁶ different values can be represented with this kind of encryption. Say, to guess the data of a transaction would be unfathomably difficult. To contextualise this figure, it is approximated that the number of atoms in the entire universe is roughly 2²⁵⁶. It is evident that cryptocurrencies can be very secure and that it is extremely difficult to corrupt or change the record of a ledger. But what happens after a transaction is verified or validated and what does the blockchain actually have anything to do with this process?
 
Blockchain has been compared to a ledger several times as they can serve very similar purposes and behave in very similar ways. More specifically, computers involved in crypto networks are subject to Distributed Ledger Technology. Blockchains (of course there are several, owing to their decentralised nature) operate concurrently on a network of many independent computers, called ‘nodes’. In this way, our ledger (blockchain) is distributed to many nodes. So once a transaction has been verified as valid and legitimate, the data surrounding the transaction is collated. Once combined (and successfully cryptographically secured), a block is created. Yes, as indicated by its name, the blockchain is a collection of linked ‘blocks’, which represent payments. Together, they make up the blockchain, and it is for this reason that it is said to resemble a ledger. This new block of data is appended to the ledger, in a permanent and unchangeable way. The transaction is completed. Despite this process, which seems simple and yet so effective, how has the receiver actually gained any ‘money’ and how the sender has lost any ‘money’?
 
It is necessary to make the distinction between value and money. Nobody loses or gains money in a cryptocurrency transaction, but crypto coins which hold value are transferred. The fact that they are virtual assets does not mean that they are not real or that they are worthless. In fact, they do not have intrinsic value, but instead an agreed upon worth per unit. This is dictated by how much a buyer is willing to pay and fluctuates greatly in the case of cryptocurrencies. It may admittedly be rather puzzling, because unlike non-crypto currencies, cryptocurrencies are not redeemable for any other product or commodity. Therefore, it is difficult to attribute any physical price to them as they do not inherently have worth. Crypto can be thought of as and compared to stocks, in this respect.
 
Cryptocurrencies have caused a tsunami of razzmatazz over the last decade or so. Namely, cryptocurrencies have reinvented what it means to pay someone and the technology we use to perform these payments and transactions. In fact, El Salvador has even begun to accept Bitcoin as legal tender! These ideas have certainly transformed our economic outlook – but will crypto dominate our future and is it here to stay?