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The Skinny on Cryptocurrency

Attempting to understand cryptocurrencies can lead down a very deep rabbit hole. But it starts with an idea you’re probably already familiar with. If you’ve used a debit or credit card, you’ve used digital money, which means you’re one step closer to understanding cryptocurrency—a kind of digital currency.

Both digital currency and cryptocurrency represent a monetary value but only in digital form. (You don’t actually hold a $10 bill when you pay for $10 worth of groceries at the store using a debit card.) Both make transactions between people who are far away easy, like when you buy a pair of shoes online from a seller in a different country. Transactions are instantaneous and borderless and are conducted on computer systems, usually linked via the Internet. However, where they differ is digital currency is regulated by a financial institution and usually represents bank money held on computers, while cryptocurrency does not. Cryptocurrency is a type of virtual currency.

One more step down the rabbit hole.

Virtual currency is a digital representation of value not issued by a bank, credit institution, or other financial authority that can sometimes be used as an alternative to money. A great example is coupons or forms of buyer rewards (think frequent flyer miles). Coupons are created, controlled, and given value by the company that issues them, not a bank, and you use them as a means of payment. Virtual currency can be transferred, stored, and traded electronically between people and doesn’t need to go through the middleman of a bank. Cryptocurrency is a type of virtual currency because it is decentralized (not issued or regulated by a bank) and can only be exchanged over the Internet.

One step further.

Cryptocurrency (or crypto currency), like the popular Bitcoin, is, at its core, a representation of the idea of money, generated and verified by computer coding, called cryptography. Back in 2009, Bitcoin was created by someone (or a group of someones, no one’s really sure) named Satoshi Nakamoto. Since 2009, over a thousand other kinds of cryptocurrency have been introduced, among them Etherium, Zcash, Litecoin, and Quarkcoin, but can be generally referred to as “altcoins.” As the first decentralized cryptocurrency (again, meaning it isn’t backed or supported by a bank and only exists digitally), Bitcoin allowed for an unregulated peer-to-peer global economy, where participants trade goods and services between each other using the cryptocurrency without needing to use a bank or worry about exchange rates with foreign currency. This peer-to-peer network makes each holder of a cryptocurrency part of the larger “bank,” storing some of the currency. But what exactly is each person in this economy “holding,” so to speak?

Each Bitcoin is represented by a unique binary format—the ones and zeros of computer programming and memory. This digital identity of the coin is encrypted—meaning the data of its identity is scrambled to protect it from people manipulating it. The cryptography that describes the identify of each coin and protects it also controls the creation of more Bitcoins and verifies the transfer of coins. Most cryptocurrencies are designed to gradually decrease production of currency, mimicking a limited resource, like precious metals. The cryptography for Bitcoin dictates that no more than 21 million Bitcoins will ever be created—and we haven’t hit that number in virtual circulation yet. This helps protect the value of the coins and prevent inflation.

In order to purchase, access, store, exchange, and track cryptocurrencies, you’ll need a digital wallet. Makes sense, right? It’s a digital safety deposit box that exits as a file or app on your computer or phone. To access your digital wallet, you’ll be given a digital key (sometimes called a master or private key) in the form of a hexadecimal code—a combination of 16 digits (letters and numbers both). Your wallet can tell you what types of cryptocurrencies you own, their value, and how and when you’ve spent them. But who else is keeping track of these exchanges to avoid fraud, especially since a centralized entity like a bank isn’t in charge?

Encoded onto each altcoin is a block chain, which is a record (also called a ledger) of who has ever owned it and who has exchanged it with whom. This block chain is logged and verified by multiple computers to prevent the coin from being copied or spent twice by the same person (called double spending). This multiple entity participation in verification of coin usage is a self-sufficient accountability that enables each coin to continue to hold value.

We are still in the early days of cryptocurrencies and the growing peer-to-peer economy they are establishing. Traditional financial institutions, governments, and businesses are still defining their relationships with these currencies, but it’s safe to say altcoins are expanding the options for commerce and investing.