Explainer: Cryptocurrency and how it works
El Salvador became the first country to designate cryptocurrency as legal tender - but what is crypto?
Earlier this year, El Salvador announced plans to create a smart city based fully on the use of Bitcoin - the world's first cryptocurrency city.
As the country also becomes the first to designate Bitcoin as legal tender, many are left wondering: What is cryptocurrency, and how does it work?
Cryptocurrency is any form of currency that exists digitally, using cryptography - a technique to secure each unit, ensuring it can’t be copied. It’s also decentralized, meaning it can circulate without the need for a central authority, such as a bank, unlike most standardized currencies like the US dollar or the Israeli shekel.
Decentralized currency aims to eliminate the middlemen from transactions, where no one owns the data and everyone owns the data. Additionally, as the number of members of the network increase, so does the security, as the information is spread out among more people.
In a centralized system, there is a single point of failure, where that is not the case in a decentralized system.
Nobody is in charge, it is run by the people who use it.
The most well-known cryptocurrency - crypto for short - is Bitcoin, the first one developed that changed the way people thought about money. However, Bitcoin isn’t the only form of crypto. There are thousands of different cryptocurrencies available today.
One cryptocurrency is Ethereum, better for carrying out complex transactions such as buying NFTs - non-fungible tokens that are anything digital, such as artwork, songs, or even social media posts. Non-fungible simply means it can not be substituted for anything else. For example, while one bitcoin could be exchanged for another bitcoin and no value would be lost or added, an NFT is unique in all properties.
Blockchains and mining
Bitcoin, and several other forms of cryptocurrency, exist on a blockchain, a system of recording information on the decentralized system. What makes Bitcoin possible compared to other attempts to start digital currency is that a blockchain makes the information difficult or impossible to change or hack.
As new data comes in, it is entered into a fresh block which is then "chained" onto the previous block. This means the data is chained together in chronological order. Transactions are permanently recorded and viewable to anyone.
A blockchain guarantees the security of the data, allowing for trust in the decentralized system. All blocks on the chain can be viewed by the public, allowing people who do not necessarily trust each other to do business. Each member in the network has a copy of the exact same data.
Most cryptocurrencies, including Bitcoin, are created through a process known as "mining," an energy-intensive process that uses sophisticated hardware that solves a complex computational math problem.
The mining process is painstaking, costly, environmentally impactful and rarely rewarding. Other forms of creating cryptocurrency exist and many have a significantly lighter environmental impact.
Crypto is a rapidly growing market that comes with downsides - including incredible volatility. Elon Musk notably first rose the value of “Dogecoin” by 20 percent by tweeting “One word: Doge” in early 2021. He has continued to manipulate the value of the once “joke” cryptocurrency through his fanbase.
Value can fluctuate rapidly, and while influencers and media hype can cause a rise, it can also cause a rapid fall. Bitcoin has its value determined by supply and demand. Because of the finite supply of Bitcoin governed by software, when demand goes up, so do prices.
The 2021 volatility average - measuring how much the price fluctuated on average - for Bitcoin was at 4.56 percent, slightly better than the 2020 average of 5.17 percent.
There are many ways to buy cryptocurrency, with the most accessible being a centralized exchange. These exchanges sell the currency at market rates and allow the seller to make money through fees on various aspects of the service. Several online brokers offer access to cryptocurrencies as well as stocks.
Once someone owns the currency, a person has the choice to leave the crypto on the wallet attached to the exchange or move it to a hot or cold wallet.
A hot wallet is connected to the internet, while more convenient, is at a higher risk of theft. A cold wallet isn't connected to the internet, making them more secure, but if you lose it, it's gone forever.