Cryptocurrencies: How They Work

The virtual currencies that have gotten the most attention are cryptocurrencies, which are used to transact business directly between two parties without going through a banking system.

Using a cryptocurrency is very different from paying with traditional currency. It’s a process with its own unique digital features, a distinctive underlying technology, and a highly specialized vocabulary.

To understand how cryptocurrency works, let’s look at a situation where it may be used.

Let’s assume you are selling a mountain bike to your cousin, using Bitcoin for the transaction. Each of you would each have a digital wallet that contains your private key—an alpha-numeric code of at least 16 characters (punctuation marks are encouraged!) that is far more comprehensive than a PIN. The private key, which should be kept entirely secure, enables you spend the Bitcoins allocated to your account.

Assuming your cousin agrees to the purchase, that transaction is added to a list, or block, that is automatically recorded by all the computers on the Bitcoin network. The block contains all the cryptocurrency’s recent transactions. In the case of Bitcoin, this means all the transactions that have occurred during the last 10 minutes or so. The block becomes part of a chain, or blockchain, which is also what the underlying technology is called.

Mining. To authenticate the transaction, specially designed super-computers compete to solve an extremely complex mathematical problem, called a hash. In this process, known as mining — think of it as virtually panning for Bitcoin—specially designed hardware with high-powered microchips tests a staggering number of possible solutions—called the hash rate—until the problem is solved. At that point, all the computers on the network simultaneously add the new block to their own copy of the blockchain.

The computer that first comes up with the solution receives 12.5 new bitcoins. The fiat value of those bitcoins will vary with the current exchange rate. But remember, mining itself comes with a cost, both for the hardware and for the massive amounts of power consumed to solve the mathematical problem.

Because the winning computer already put in the work needed to create and new block and authenticate the transaction, the transaction fees paid by the seller are significantly reduced. In fact, the fees are far less than merchants would pay when accepting a credit card charge, which is one of the major benefits of cryptocurrency often cited by its advocates. 

Decentralized record-keeping. Once the transaction has been authenticated and added to the blockchain, the bitcoin value of the purchase is entered in your wallet and deducted from your cousin’s wallet. There is no way to reverse the process. Even if your cousin didn’t like the bike, or it turned out to be defective in some way, there’s no way to undo the transaction. That’s unlike most credit card charges, where you can usually get your purchase refunded if the merchandise is damaged or defective, or not what you ordered.

The blockchain itself shows all the Bitcoin transactions that have taken place—regardless of who made them or when—since the initial transaction was recorded. Each of the computers on the network has its own copy of the entire blockchain. As a result, the record-keeping is decentralized and, proponents believe, is less susceptible to manipulation or hacking. Rather than being stored in one master database provided by intermediaries who determine the access, the blockchain serves as a distributed ledger, or shared public ledger, which is essentially an enormous, publicly accessible database.

Next up: How money is raised in Initial Coin Offerings and the regulatory scheme governing cryptocurrency offerings.


The Investor's Guide to Cryptocurrency Offerings was funded by a grant from the Investor Protection Trust and written in collaboration with Lightbulb Press