The simplest definition of “cryptocurrency” can be found in the two parts of the word itself:
“crypto” (data encryption) and “currency” (medium of exchange). Thus, a cryptocurrency –
which is a subset of a broader category of digital currencies and is often referred to simply as
“crypto” – is a medium of exchange (similar to regular money) that exists in the digital world and
employs encryption to ensure transaction security. A subset of the broader category of digital
currencies, cryptocurrencies were developed in part to address the centralization, confidentiality,
and security issues associated with traditional fiat currencies. There are now thousands of
cryptocurrencies, but the best known and most popular include Bitcoin, Ethereum, Litecoin, and
Ripple. Cryptocurrencies use a technology called “blockchain” to ensure secure transactions
and decentralization.
Differences between Cryptocurrency and Fiat Money
To understand the basis and purpose of cryptocurrency, it is helpful to examine how it compares
to government-backed legal tender or “fiat money”. As shown below, at present crypto allows for
more secure, more transparent transactions to be completed anonymously and with little to no
regulatory oversight compared to fiat money.
Fiat currency is part of a centralized financial system whereby money goes through a regulating institution such as a bank as part of an exchange of money for goods or services. The institution typically charges a fee and transactions are subject to the institution’s rules and regulations. Cryptocurrencies use a decentralized system that exists outside the purview of financial regulators and allows users to exchange money directly, avoiding additional fees and requirements set by an intermediary. The use of distributed databases and digital networks allows users to exchange money from anywhere they have access to the internet.
While crypto uses a decentralized system, an increasing number of people using cryptocurrencies are using online platforms sometimes referred to as centralized exchanges. These exchanges essentially function the same way a bank does for fiat money. The exchange platforms help users buy and sell crypto, facilitate exchanges from crypto to fiat money or from one cryptocurrency to another, and allow users to store their digital wallets. The growing popularity of exchange platforms comes from the fact that they simplify the crypto ecosystem as a whole and make it easier for average people to buy into crypto and securely
manage their investments. In India, some of the most popular platforms include WazirX, CoinSpot, Coinbase, and Binance, each of which provides a smartphone app that streamlines the exchange and use of crypto.
Truly defining cryptocurrency, however, is more complex than it may seem on the surface and policymakers around the world have been engaged in a debate over its definition as they seek to craft regulations. In short, depending on its use, crypto can be thought of as an alternative currency, a commodity, and a security. Governments and officials in different countries have sometimes chosen to define it differently based on their own tax codes and other laws.
Alternative Currency: Though its options for use vary from country to country, cryptocurrency can often be used as an alternative payment method to cash and credit cards and acts just as regular money. Though it has no physical version like banknotes or coins, cryptocurrencies are becoming accepted as a form of payment in some places and can be used to purchase goods and services online and in an increasing number of physical stores in some countries. They are transferable between accounts and can be exchanged for cash. In the USA and some European countries, cryptocurrency (mainly Bitcoin) debit cards are becoming more common as well. These allow the account holder to load a specific amount of bitcoin onto the card at a time; the card can then be used just like a regular debit card, even to withdraw cash from any ATM, with the conversion rate being calculated at the time of purchase or withdrawal.
Commodity: Cryptocurrencies may also be defined as commodities, treating them as physical
goods similar to gold or oil. Like typical commodities, cryptocurrencies can be purchased via
cash markets, used to store value, or held as assets.
Security: Cryptocurrencies may be defined as securities as well, placing them in a broad
category of financial instruments that have value and can be traded, like stocks or ETFs
(exchange-traded funds). Supporting this definition is the fact that, like an Initial Public Offering
(IPO) of company stocks, cryptocurrencies are first issued in Initial Coin Offerings (ICO). Buying
into an ICO makes an investor a shareholder of a common enterprise and grants access to
potential future profits just as does holding shares of a company.
These uses for and potential definitions of cryptocurrencies will be key to any policies and
regulations that may be implemented in the future.
What is a blockchain? A blockchain is a distributed database of digital records that are linked to one another across a network rather than to a central server. Like the decentralized exchanges of cryptocurrency, blockchains use peer-to-peer networks whereas traditional databases operate on the “Client-Server” principle, which means that all information is stored in a single location, such as a bank. This technology has several drawbacks, including the possibility of server hacking, data manipulation, and money transfer to other accounts. The additional security and validity offered by blockchain technology has led to it being very widely used in the financial industry. However, it is used not only for cryptocurrencies, but also for keeping records, digital notaries, and smart contracts. It is also actively used in research, medicine, management, politics, education, and other areas.
How do blockchains work? Records on a blockchain are structured into “blocks” of data linked by nodes along the network. When the storage capacity of a block is full, that block is closed, and the subsequent block is created as the next link in the chain. Thus, any new transaction on the blockchain necessitates the formation of a new block. Each transaction includes a digital signature, which ensures its authenticity. Each new block must be checked by the majority of system nodes before it is added to the network.
● Key data: The data stored within each block is determined by the type of blockchain. In
the structure of the bitcoin chain, for example, the block stores data about the recipient,
sender, and number of coins.
● Cryptographic Hash: A hash is a unique identifier, equivalent to a fingerprint. A
cryptographic algorithm is used to generate the hash of each block. As a result, it makes
it easier to identify each unique block in the chain. When a block is created, the hash is
automatically appended, and any changes to the data stored in the block also affect the
hash. In short, the hash provides a unique identifier for each block and records all
changes to the blocks’ data.
● Hash from the previous block: Including the hash of the previous block is the final
element in the creation of a new block. This generates a chain of blocks and is the
primary security feature of blockchain technology as it further authenticates the chain
and a block’s place on it.
● Timestamp: Each block also contains a timestamp from its creation, which verifies the
existence of the data contained within the block prior to the block’s creation.
How does the blockchain remain secure? Any attempt at hacking will change a block’s hash.
All subsequent blocks will have incorrect information as a result, rendering the entire blockchain
system invalid. In theory, all of the blocks in a chain could be reconfigured using powerful
computer processors but a security solution known as “proof of work” eliminates this possibility
and slows down the process of creating new blocks. It takes about 10 minutes in the
architecture of bitcoin chains to complete the required proof of work and add a new block to the
chain. This work is done by miners (more on mining in the following section). In short, a miner performs complex computational tasks that solve the proof of work for a new block. Every other miner on the network system must then verify the proof of work was done correctly. If everything is in order, the block is added to the chain, including each miner’s local copy Blockchain technology is the most transparent and secure form of digital record keeping in
existence today, allowing for no outside interference. It is essentially impossible to hack the
blockchain system because it would require intervening in all of its blocks as well as controlling
more than half of all nodes in the peer-to-peer network.
What is cryptocurrency mining? As mentioned above, cryptocurrency mining is the process of
verifying recent transactions and adding new blocks to the blockchain. Miners start by choosing
a pending transaction from the pool. The miner will first verify that the sender has sufficient
funds to complete the transaction. Then the miner will verify that the sender authorized the
transfer of funds by using his private key. Only after the miner completes these verification
exercises (proof of work) and their work is verified by others on the system, is a transaction
complete and a block added to the chain. In short, mining solves complex cryptographic tasks
using powerful, specialized computer hardware.
Mining is one of the ways to earn money with cryptocurrency. Each new block generates a good
reward for the miner; currently, 6.25 bitcoins are awarded per block mined. This method of
earning, however, necessitates a significant investment in time, computational skill, processing
power, and energy in addition to the funding required for such powerful computers. Furthermore,
as the complexity of mining grows over time along the length of a blockchain, the available
capacity must be continuously upgraded.
Miners make up a unique part of the crypto ecosystem. Their work is one of the most significant
differences when comparing cryptocurrencies to fiat money, which only the government can
print. In theory, anyone in the world can mine crypto and earn significant amounts of money in
doing so, though the level of skill and computer equipment needed to do so makes it a less
egalitarian prospect.
Because of crypto’s focus on privacy and security, it is impossible to know for certain where
most miners are located. However, estimates showed that the vast majority of miners were
based in China until the government’s ban on mining last year. Now at least two-thirds of mining
activity takes place in the USA, Russia, and Kazakhstan. While companies like EasyFi Network
have mining facilities in India that support the development of blockchains, there is little to no
real data on mining practices in the country. In 2017, the government banned the import of the
specialized computer hardware required for crypto mining. This ban, which was put in place
because of the vast energy requirements and an overall abundance of caution related to the
emerging crypto market as a whole, limited the amount of mining that could be done in India.
Additionally, the cost of electricity alone is likely prohibitive to the vast majority of people who
might seek to engage in crypto mining.
Benefits and Challenges of Cryptocurrency
Policymakers around the world are needing to parse the very real, significant benefits that
cryptocurrency can provide as well as the concerns and risks associated with its increasing
prevalence and mainstream usage in everyday financial exchanges.
The figure below lays out several of the key pros of cryptocurrency, which illustrates why so
many individual users and companies feel that crypto is the future of financial systems the world
over.