Features of the work and technology of cryptocurrencies: a complete guide

Cryptocurrency is a type of decentralised digital-only cash that uses cryptography to make it difficult to counterfeit or hack.

The idea behind cryptocurrency is that people can transfer value online outside of the control of governments or central banks. Most people who buy crypto assets hope to turn a profit.

However, the collapse of cryptocurrency exchange FTX in November 2022 has highlighted the high degree of risk surrounding the asset, with investors storing their coins on the platform losing a total of around eight billion dollars. They’ve yet to recover them and may never do so.

What is cryptocurrency in simple terms?

Cryptocurrency is virtual money that is able to circulate without any input from banks.

It is a digital asset, so you can’t hold it or touch it as you would with pound coins or notes. It is an internet-based medium of exchange.

While cryptocurrencies can be used to buy items in some stores, it is more commonly traded as digital assets as a way to profit from investment returns.

The most recognisable cryptocurrency is bitcoin, which has exploded in popularity.

Bitcoin is created with an encrypted code (basically like a string of numbers and letters). Creating new cryptocurrency is known as mining. In order to “unlock” the cryptocurrency you need the equation to crack the code – it’s a sort of virtual key.

Records of cryptocurrency ownership are held on a computerised database secured by strong cryptography. As codes are used to protect information this is supposed to bring greater security.

All bitcoin transactions are recorded in a database known as a blockchain, which prevents people from spending the same coin twice.

How does cryptocurrency work?

Cryptocurrency is decentralised, meaning it’s not run by a central authority such as governments, central banks or financial institutions.

Instead it operates on a peer-to-peer network, with transactions being recorded on a public ledger using blockchain technology. (A blockchain is a decentralised database that is maintained across a computer network and can be viewed by anyone at any time; it can’t be hidden.)

This ledger allows data to be shared globally, in order to verify transactions and prevent fraudulent double spending of cryptocurrencies.

Cryptocurrency works by writing blocks and recording transactions to the ledger. Transactions can’t be faked, or overwritten.

The ledger is a database that is:

  • Public
  • Online 24/7
  • Not controlled by any central bank or government

While transactions are recorded on this public ledger, the details of the people trading cryptocurrencies are not – you remain anonymous, which can be part of their appeal.

It is nearly impossible to counterfeit cryptocurrency. All the computers that store and update copies of the blockchain technology have to “agree” on the correct version of the public ledger.

When you buy digital currency, you own a private key. This is a piece of code which authorises outgoing transactions on the blockchain network so you can spend the funds.

So if cryptocurrencies aren’t issued by banks or governments, where do they come from?

How is cryptocurrency created?

New bitcoins are created by what’s known as cryptocurrency “mining”. This is where people use computers to solve difficult mathematical puzzles. This uses a huge amount of computing power.

The crypto part refers to the fact that transactions are secured by cryptography —a form of coding —which is extremely difficult to hack or break.

Proof of work and proof of stake are two ways in which cryptocurrency miners can prove their ownership of new crypto assets. Because each equation is unique, once it is solved, the network knows that the transaction must be authentic.

The users who solve the equation win the right to sign off new blocks of transactions to the bitcoin blockchain. As a reward for keeping the blockchain working properly, they get a chunk of bitcoins. Every four years, this amount is cut in half.

Lose your private key and you lose access to your money — there is no bank to give you a replacement.

What is an example of cryptocurrency?

The best-known example is bitcoin. Created in 2009 by Satoshi Nakamoto – who lends his name to “satoshis”, the bitcoin equivalent of pence – it is now the world’s largest cryptocurrency by market cap.

Other popular cryptocurrencies include ethereum, ripple, tether and litecoin. When bitcoin climbs, other cryptocurrencies will often also rise strongly. The reverse is also true, which we saw in 2022 after bitcoin plunged below $20,000.

There are thousands of different types of cryptocurrencies in existence.

In fact, the cryptocurrency market as a whole hit $1 trillion in value at the start of 2021, led by bitcoin, which accounted for 69% of the total market. In November, the market hit over $3 trillion, according to CoinGecko.

Can I mine bitcoin at home?

In the early days, it was possible to “mine” bitcoin using a home PC but the puzzles get more complicated and harder to solve over time. Now only very specialised equipment has enough computing power to be able to run enough calculations per second to do it.

There are scores of publicly listed cryptocurrency mining companies that run vast farms of computer equipment dedicated to solving these puzzles.

For example, London-listed Argo Blockchain is planning to open a Texas mining facility capable of 200MW of mining — enough to power about 200,000 UK homes.

How is cryptocurrency stored?

When you buy cryptocurrencies, you will usually hold them in a digital wallet – in essence, an app that works like a bank account.

Here are some points about digital wallets:

  1. Access is gained through your smartphone or other device
  2. You can then use the cryptocurrency to pay for goods and services
  3. This can be done by scanning a QR code for a retailer that accepts cryptocurrency, for example.
  4. For greater security, you can also run a multi-currency or bitcoin wallet on a physical device such as a flash drive.
  5. But the security of your money can still be an issue with cryptocurrencies, even when using wallets, because the sector is largely unregulated. In the UK, for example, crypto assets are not overseen by the Financial Conduct Authority and, as such, not protected by compensation schemes if anything goes wrong.

The “crypto” element of cryptocurrencies comes from the fact that a wallet generates a unique cryptographic address that allows you to carry out transactions with the currency.

Should I use a digital wallet for cryptocurrency?

Investors who want to make money out of cryptocurrencies usually trade them on a specialist exchange such as Coinbase – and they could hold their currency there.

The alternative to doing that when you buy, say, bitcoin is to download it and hold it in digital wallets – in essence, apps that work like a bank account. The wallet generates a unique cryptographic address that allows you to carry out transactions with the currency. There are two types:

“Hot” wallets – these are digital wallets that are connected to the internet

“Cold” wallets – digital wallets that are offline, such as USB drives

So should you store cryptocurrency in a digital wallet? One consideration is security; the crypto exchanges can be vulnerable to hacking attacks, theft and collapse. For instance, when major cryptocurrency exchange FTX collapsed in November 2022, investors lost billions of dollars.

With most wallets, investors are required to create and remember a complex passphrase in order to gain access to their wallet and transfer coins in and out.

WARNING: Forget the passphrase and you are locked out of your wallet meaning access to your cryptocurrency is lost forever