Crypto­cur­ren­cies: What’s behind these digital currency systems?

In 2008, an unknown in­di­vidu­al or group published the white­pa­per for Bitcoin under the pseudonym Satoshi Nakamoto, thereby paving the way for crypto­cur­ren­cies. To this day, it is still unclear who’s behind the pseudonym and the idea for this re­volu­tion­ary, digital payment in­stru­ment. For many people today, it’s just as unclear what exactly a crypto­cur­rency is – despite the fact that, one decade after the invention of Bitcoin, there are now more than 2,000 different providers of these digital payment systems, as the im­press­ive list on the web portal Coin­Mar­ket­Cap shows.

A crypto­cur­rency (or cryptoasset) is a digital means of payment, typically based on block­chain tech­no­logy and cryp­to­graph­ic processes such as hash functions and digital sig­na­tures. Unlike con­ven­tion­al cur­ren­cies, crypto­cur­ren­cies do not involve physical coins or notes. All units of the currency are ex­clus­ively digital. These asym­met­ric­ally encrypted units of currency are usually generated col­lab­or­at­ively by the whole system, although in most cases, a pre­de­ter­mined quantity of units is defined at the launch of a crypto­cur­rency. The term “mining” was coined for the process of gen­er­at­ing units, which is why people talk about “mining crypto­cur­ren­cies”.

Most crypto­cur­rency systems are char­ac­ter­ised by a de­cent­ral­ised nature: Not only the gen­er­a­tion of new currency units, but also the in­di­vidu­al trans­ac­tions are typically executed col­lect­ively, as multiple par­ti­cipants verify and coun­ter­sign them in the re­spect­ive system. Com­mu­nic­a­tion normally occurs in a peer-to-peer network in which all nodes operate as equals. In contrast to money printed by central banks, classic crypto­cur­ren­cies have no “single point of failure” – i.e. there is no in­di­vidu­al point in the network that can jeop­ard­ise or dominate the func­tion­ing or trading of the currency system. An exception can be found in crypto­cur­ren­cies like Ripple, which are run by private companies that perform most of the unit gen­er­a­tion process them­selves and dis­trib­ute them according to their own rules.

As a result of the hyper­in­fla­tion of the bolívar fuerte, Venezuela not only in­tro­duced the new currency, the bolívar soberano, but also tied it to the Petro cryptosys­tem. Even though the Venezuelan gov­ern­ment proclaims it to be the “first national crypto­cur­rency”, the Petro lacks key char­ac­ter­ist­ics of a crypto­cur­rency precisely due to its state gov­ernance, such as the de­cent­ral­ity of the system or the equality of all par­ti­cipants. Similar con­tro­versy surrounds the privately managed systems already mentioned, like Ripple.

A closer look at the three ele­ment­ary com­pon­ents of a crypto­cur­rency reveals that, although private and state-run systems fulfil the “crypto” aspect, they have little to do with the classic principle of Bitcoin.

Cryp­to­graphy not only gives these cur­ren­cies their name, it is also a critical dis­cip­line for the security of crypto­cur­ren­cies. The term “cryp­to­graphy” refers to the science behind en­cryp­tion and the general pro­tec­tion of data and in­form­a­tion. Both are vital for a cashless and fully digital payment system that, as standard, operates without a central reg­u­lat­ory body. Crypto­cur­ren­cies primarily use two cryp­to­graph­ic processes:

• Hash functions
• Digital sig­na­tures

Hash functions represent the ele­ment­ary pieces of the puzzle for checking the integrity of the data and encoding the account addresses and trans­ac­tions of par­ti­cipants. They also provide the basis for the block­chain and block mining. Digital sig­na­tures enable the status of encrypted in­form­a­tion to be verified without dis­clos­ure. This tech­no­logy is employed, for example, in order to protect the content of e-mails. In the case of crypto­cur­ren­cies, it is used to sign trans­ac­tions and com­mu­nic­ate to the network that a trans­ac­tion has been approved.

Block­chain refers to the de­cent­ral­ised ledger of a crypto­cur­rency that records all trans­ac­tions in what are known as blocks. The recording of the in­di­vidu­al blocks takes place in fragments and in chro­no­lo­gic­al order, so that a (mostly) public, immutable and veri­fi­able record emerges over time. It is main­tained by the par­ti­cipants of the un­der­ly­ing peer-to-peer network, who follow a defined protocol in order to validate new trans­ac­tions. In this process, all nodes auto­mat­ic­ally download a complete copy of the block­chain, dis­pens­ing with the need for a central authority to inspect executed trans­ac­tions.

A data record based on block­chain tech­no­logy cannot be altered without the consent of the other network par­ti­cipants.

The third important pillar of crypto­cur­ren­cies is known as block mining. This refers to the process necessary in order to append new trans­ac­tions in the cryptosys­tem as blocks to the block­chain. Mining requires certain software that can solve math­em­at­ic­al problems and thereby find the un­der­ly­ing hash functions. All network par­ti­cipants can attempt to solve each math­em­at­ic­al problem for val­id­at­ing a new block of trans­ac­tions. This procedure is also known as the “Proof of Work” that has to be produced. Once a block is correctly mined and the output of the hash function is guar­an­teed, all network par­ti­cipants can check whether the solution is correct.

However, the reward for suc­cess­ful mining is only received by the miner whose computer solved the problem first. Typically, a block reward – as this type of reward is called – is a set number of currency units as well as all trans­ac­tion fees as­so­ci­ated with the newly added block.

They're called crypto­cur­ren­cies for a reason: their sim­il­ar­ity to real cur­ren­cies with notes and coins, as well as the fact that users of Bitcoin or similar in­flu­en­tial al­tern­at­ives like Ethereum, IOTA or Monero possess an exchange value (demand and use) have brought the digital currency systems into dis­cus­sion as the potential means of payment of the future. Bitcoin in par­tic­u­lar is already in use in this respect. Various online sales platforms such as Overstock have adopted Bitcoin payments into their rep­er­toire of available payment methods. But even the top crypto­cur­rency has not yet es­tab­lished itself as a means of payment, primarily due to the sig­ni­fic­ant fluc­tu­ations in value.

Crypto­cur­ren­cies are also being used for other purposes es­pe­cially in the start-up sector:

So long as the units of a crypto­cur­rency have a certain exchange value that can be converted to a central bank currency like the pound, crypto­cur­rency can in principle be used as a means of payment. But to actually pay with digital money, the vendor must also accept the crypto­cur­rency. In order to execute a payment, a pair of keys is required, com­pris­ing a public and private key.

The public key is visible to anyone and es­sen­tially has the same role as a bank account number: it serves as the sender’s address from which a user carries out a payment with the re­spect­ive crypto­cur­rency. Con­versely, the private key is used for verifying a trans­ac­tion, a bit like a password or PIN. It should only be visible to the owner of the crypto address used to sign a trans­ac­tion. In the case of the latter, this is usually auto­mat­ic­ally performed by a wallet, the virtual account that stores a crypto­cur­rency. In other words, users only have to enter the amount and the target address, i.e. the public key, of the payee when making a payment.

Ever since Bitcoin’s spec­tac­u­lar price boom in 2017, crypto­cur­ren­cies have been a popular spec­u­lat­ive in­vest­ment. In just a short space of time, interest in investing in the crypto­cur­rency sector has risen con­sid­er­ably. And there are some different ways to invest in one of the cur­ren­cies available on the market.

Like foreign exchange trading, crypto­cur­ren­cies can also be used as a tradable commodity, with the aim of ex­ploit­ing price swings in order to increase the investor’s capital. The dif­fer­ence with crypto­cur­ren­cies is that there are no central banks, financial su­per­vis­ory bodies or gov­ern­ment reg­u­lat­ory au­thor­it­ies to monitor the monetary supply and step in when the market overheats. Units of various crypto­cur­ren­cies can be bought, sold and exchanged on trading platforms like Coin­Switch, which always display the most up-to-date prices. Al­tern­at­ively, it’s also possible to invest in­dir­ectly in crypto­cur­ren­cies via con­ven­tion­al exchanges, by betting on price fluc­tu­ations or pur­chas­ing the shares of companies involved in the crypto­cur­rency sector.

Due to the fact that there are more than 2,000 different crypto­cur­ren­cies worldwide, it’s no wonder that even re­cog­nised experts are not familiar with all the different providers and their models. Anyone who wishes to invest in crypto­cur­rency has no choice but to monitor the market closely and seek out suitable solutions. Es­pe­cially for newer or more unknown cur­ren­cies, there is always the risk of falling victim to fraud or the system com­pletely col­lapsing. The following list contains some of the es­tab­lished crypto­cur­ren­cies char­ac­ter­ised by a high market cap­it­al­isa­tion (a high value of total shares in cir­cu­la­tion):

Crypto­cur­ren­cies offer key op­por­tun­it­ies and pos­sib­il­it­ies that con­ven­tion­al cur­ren­cies lack. In par­tic­u­lar, block­chain tech­no­logy has so far offered com­pel­ling potential in a variety of sectors, which is why it is also being used in numerous projects beyond the financial industry. The lack of a central authority anchored in most cryptosys­tems also generally rep­res­ents a promising in­nov­a­tion. The as­so­ci­ated freedom from market reg­u­la­tion, however, also poses one of the greatest problems with crypto­cur­ren­cies. Since there is also a lack of a con­sist­ent exchange value, the prices of crypto­cur­ren­cies are subject to severe fluc­tu­ations and the ever-present risk of a total system crash.

The pros and cons of crypto­cur­ren­cies compared to con­ven­tion­al monetary and currency systems are sum­mar­ised in the following table:

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