Money can be defined as a social institution that serves as a unit of account, medium of exchange and store of value. This is the starting point for understanding what cryptocurrencies are and how they work. Cryptos are trying to represent a new form of currency that is digital, privately issued and exchangeable from peer-to-peer. It works thanks to the support of decentralised ledger technology (DLT).
Historically, currencies only fulfil their main functions when their value is stable and their network of users is sufficiently large. To date, cryptocurrencies have failed to meet these criteria because they have a relatively high amount of volatility and they are used by a niche of users. Looking at crypto on a technical level, beyond prices and current adoption, we might discover potential similar to fiat currencies. Thus, as an alternative instrument to traditional finance.
What are cryptocurrencies? A brief history
The history of crypto begins further back than you may think. In 1983, David Chaum, an American cryptographer, was the first to conceive the idea of an electronic currency based on cryptography and oriented towards anonymity. He gave his idea the name “ecash”. The idea was taken up during the 1990s by developers such as Wei Dai, who came up with a similar concept and called it “b-money”.
Shortly afterwards, another well-known figure in the crypto scene today, Nick Szabo, formulated his theory of operation for what he called “bit gold”. 2008 was crucial for the history of the industry. It was the year Bitcoin, the first real cryptocurrency, was created. Its anonymous developer chose the pseudonym Satoshi Nakamoto while creating the first decentralised system for exchanging currencies.
Litecoin, the second crypto in history, was created in 2011 from a hard fork of Bitcoin’s blockchain. Since then, thousands of cryptocurrencies have been created, offering different solutions and projects
What are Altcoins?
Over the years, computer scientists and developers have worked to understand and improve blockchain technology, resulting in all the cryptocurrencies we know today. All those other than Bitcoin are called ‘alternative coins’, which is abbreviated to ‘altcoins‘.
The value of cryptos on the market is influenced by the law of supply and demand, but utility is certainly a feature that distinguishes them individually, even in terms of price.
There are tens of thousands of tokens and coins, but most transactions involve the Bitcoin and Ethereum ecosystems. As of December 2022, BTC and ETH make up almost 60 percent of crypto’s total market cap, which amounts in total to approximately $820 billion. In comparison, the total value of physical money in the world in the form of coins and banknotes, amounts to 8 trillion (eight trillion), according to an estimate by visual capitalists from the end of 2022.
The Classification of Money: Where do Cryptocurrencies fit?
To understand how cryptocurrencies fit into the financial system and into the history of money more generally, it is necessary to describe them according to the three criteria by which fiat currencies are classified:
- the issuer: governmental or autonomous
- the form: physical or digital
- how transactions are validated: centralised or decentralised
Cryptos would thus represent a form of money that had already been theorised in financial taxonomy, but only came into being in 2009 with Bitcoin.
In particular, to really understand what cryptocurrencies are, we need to consider their fundamental characteristics:
1) They are issued and programmed independently
Cryptocurrencies are not issued by a government or a central bank, but can be programmed by anyone who can. Thus, there are no monetary policies, but tokenomics. It is an algorithm that defines how cryptocurrencies work, particularly with regard to issuance and circulation. With Bitcoin for example, it is the halving mechanism that manages the distribution of new coins. Mathematical control over issuance is what makes tokens and coins what they are, because it is a prerequisite for their transparency and the predictability of their monetary policy.
Similarly to electronic money issued by central and commercial banks, cryptocurrencies are also fiduciary. In simple terms, this means that they have no intrinsic value, as long as no one considers the technological value of the blockchain.
Just like digital currencies, cryptos are not tangible, you cannot physically withdraw them at ATMs. Even Bitcoin ATMs actually distribute fiat currencies, converting the coins you hold into banknotes. Therefore, BTC and ETH are exchanged in different ways than traditional money.
Fiat currencies are both physical and digital, but in the latter form they cannot be considered cryptocurrencies. Bitcoins are based on a different technology (the blockchain). The visible balance on some payment apps or on your internet banking could be confusing, but it is simply fiat money in digital form, not cryptocurrencies.
Fiat money is physically present in wallets or virtually in bank accounts, while tokens and coins need a wallet to be stored and used.
Cryptocurrencies can be sent directly between two users (peer-to-peer), without going through intermediaries, thanks to wallets. These exchanges have minimal transaction costs, compared to the high fees charged by many traditional financial institutions.
The absence of a link to a particular jurisdiction, nation or authoritarian third party allows the crypto system to be truly global and easily accessible, so that it can facilitate global trade and the inclusion of people who do not yet have access to financial services. Because of the way they work, cryptos can therefore benefit countries where there is a major economic crisis and unreliable centralised financial systems.
To sum up, cryptos have advantages over fiat currencies because:
- They are free of intermediaries
- They secure circulation thanks to the blockchain
- They are independent of governments and borders
- They are an alternative resource
How do cryptocurrencies work?
The ‘crypto’ prefix gives us a clue for the answer: ‘cryptography‘. It is the mechanism that protects ownership and verifies cryptocurrency transactions through complex algorithmic calculations. Since it is based on mathematical functions, the crypto system is more secure than systems based on human control. In particular, cryptography ensures that:
- users cannot spend the same amount of cryptocurrency twice (double spending problem)
- users can exchange tokens and coins without compromising their privacy
- the entire ecosystem is safe
In order to access the network, users must have a set of private and public keys. Let’s briefly describe the role of these two elements in order to learn more about how cryptocurrencies work.
A private key is a kind of password that gives access to the blockchain. The essential difference is that it cannot be changed or recovered if lost. From a private key, it is possible to generate a public key and a wallet address. These are used to receive crypto, as if they were a bank account and an iban respectively. It is impossible to trace a public key or address back to the private key that generated them.This system, called public key cryptography, is what makes cryptocurrency ownership secure and virtually inviolable by third parties. No one can block your wallet or prevent you from moving its contents. Furthermore, it is very easy to prove to the network of nodes in charge of verifying transactions that you have a right to spend the cryptos you own.
The future of crypto: innovation and regulation
Cryptocurrencies like Bitcoin seem to have highlighted a problem in the global banking system. It only works 8 hours a day and 5 days a week. The current infrastructure does not seem very practical, especially in the age of the Internet. Bitcoin’s system, on the other hand, is always active and no central authority can ‘turn it off’, because it is composed of a network of some 15,000 nodes of equal power (as bitnodes attest), that are constantly incentivised to participate. In fact, mining nodes are constantly competing to validate transactions, as each block created by mining entitles them to a reward. This makes the blockchain decentralised, immune to censorship and always operational.
History and characteristics can only partly explain what cryptocurrencies are. Their potential usefulness goes beyond the concept of a currency, as they are based on a constantly evolving technology. The blockchain is largely composed of open source software, thus it is modifiable by anyone who wants to create new applications. This exponentially accelerates the development of decentralised finance, opening up various possibilities for the economy in general. Time will surely produce new solutions for the management and use of money.
Although no centralised authority can control the Bitcoin system, it is possible that governments will enact laws to regulate all cryptocurrencies. This does not limit progress, on the contrary, it could promote it. Regulating the use of cryptos is an essential process to support adoption, because it could resolve scepticism and create a climate of trust around Bitcoin and the like. This process has already begun in Europe: the European Parliament has approved MiCA, a system of laws aimed at regulating cryptocurrencies in the interest of consumers.