Understanding cryptocurrencies: a simple guide

Cryptocurrencies are forms of digital or virtual money that exist entirely online, without any physical counterpart such as coins or banknotes. They are a type of digital currency that enables people to make transactions directly with each other through an online system. Unlike traditional currencies, cryptocurrencies rely on shared digital records (often called blockchains) and computer code. 

The most well-known cryptocurrency is Bitcoin, but there are thousands of others, each with unique features and purposes. While conventional money is typically a claim on a central bank or commercial bank, cryptocurrencies are generally not claims on any specific institution. This lack of a clearly identifiable issuer has traditionally made it difficult for the financial system to treat cryptocurrencies as a form of money.

Underlying technology: blockchain explained

At the core of most cryptocurrencies is blockchain technology. A blockchain is a digital ledger or database that records transactions across a network of computers. This ledger is intended to be "decentralised", meaning that, theoretically, no single person or organisation controls it. Instead, many participants work together to validate and verify transactions. 

The blockchain is also supposed to be "immutable", which means that once someone records information, no one can alter or tamper with it, creating transparency and trust. However, blockchain technology does not automatically guarantee decentralisation or immutability, as the number of individual participants and the network’s governance rules determine how well these goals can be achieved.

Examples of how cryptocurrencies can be used in a variety of ways, including:

• Buying goods and services: some businesses accept cryptocurrencies as payment.
   
• Investment: many people buy cryptocurrencies hoping their value will rise.
   
• Smart contracts and apps: blockchains like Ethereum let people create apps that run automatically on the blockchain.
   
• Transferring money between wallets: cryptocurrencies can be transferred between owners. 

Cryptography and security

The term “cryptocurrency” comes from the use of cryptography, a set of techniques for securing information and communications. Cryptography secures transactions, controls the creation of new coins (a process called “mining” in the case of some cryptocurrencies), and verifies the transfer of digital assets between users. This helps ensure that only the rightful owner can spend their cryptocurrency and that transactions can be verified as valid.

Verification algorithms for cryptocurrencies such as Bitcoin require significant processing power. Reward schemes provide incentives for “miners” who contribute computing power and help create new blocks that validate transactions.

How are cryptocurrencies different from traditional money?

Most currencies such as the US dollar, euro or Japanese yen are called “fiat currencies.” These are issued, regulated and controlled by governments and central banks. By contrast, cryptocurrencies usually operate outside the direct control of a central authority. Instead, decentralised systems and consensus algorithms (methods for computers to agree on transactions) maintain the currency's operation and integrity.

Are cryptocurrencies “real money”?

Cryptocurrencies such as Bitcoin can be exchanged for other currencies at certain online exchange platforms. There are also ATMs where owners can exchange them for traditional money. Historically, cryptocurrencies have not been considered legitimate money in the traditional financial system. However, regulation in this area is evolving, and new regulatory frameworks are helping to integrate crypto-assets more closely into the financial system.