This article explains how cryptocurrencies work in general terms. It is not investment advice, and it does not suggest that buying, holding or trading them is wise or unwise. Prices of many digital assets have swung sharply in the past, and anyone considering them should be prepared for the possibility of losing the money involved.
What a cryptocurrency is
A cryptocurrency is a digital asset recorded on a shared database rather than held by a single bank or company. Instead of an institution keeping the master record of who owns what, many computers keep copies of the same record and follow agreed rules for updating it. Cryptography, meaning mathematical techniques for proving identity and protecting data, is used to confirm that changes to the record are legitimate.
The first widely known example, Bitcoin, was described in a 2008 paper by a person or group using the name Satoshi Nakamoto, and its network began operating in 2009. Many others have followed, and they differ in design, purpose and reliability.
The ledger
At the center is a ledger: a list of transactions. In most cryptocurrencies, transactions are grouped into blocks, and each block refers to the one before it, forming a chain. This is why the underlying technology is called a blockchain. Changing an old entry would require changing every later block and persuading the network to accept it, which is meant to be very difficult. The broader idea is covered in our look at blockchain technology.
Because the ledger is shared, it can usually be viewed publicly. Entries typically show addresses and amounts, not names, though addresses can sometimes be connected to real identities. Cryptocurrency is therefore often better described as pseudonymous than as anonymous.
Keys and wallets
Ownership works through a pair of linked keys:
- A public key, or an address derived from it, is something you can share so others can send assets to you.
- A private key is a secret that authorizes spending. Whoever controls it controls the assets.
A wallet is software or a device that stores private keys and helps you create transactions. It does not hold coins in the way a physical wallet holds cash; the record stays on the ledger. Some wallets are managed by a service that holds the keys for you, while others leave the keys entirely in your hands. This difference matters:
- If a service holds your keys, you depend on that service’s security and honesty.
- If you hold your own keys, nobody can freeze or reverse your access, but if you lose the key or the recovery phrase, there is typically no help desk to restore it.
Those who use these tools should protect their accounts well. A password manager, two-factor authentication and careful handling of recovery information all apply. Note that digital wallets for everyday payments are a different thing from cryptocurrency wallets, though they share some ideas.
How a transaction works
In simplified terms:
- You create a transaction stating that you want to send some amount to another address, and you sign it with your private key.
- The signature lets the network confirm the transaction came from the owner without revealing the key.
- Participants on the network check that the sender has the funds and that the transaction follows the rules.
- The transaction is added to a block and recorded.
Most transactions are considered irreversible once confirmed. That differs from card payments, where a dispute process such as card chargebacks may exist. A mistake or a fraudulent payment can be very hard to undo.
Who keeps the ledger honest
Since no central authority approves entries, networks need a method for agreeing on the next block. Two broad approaches are common:
- Proof of work, where participants compete to solve a computational puzzle, often called mining. It uses significant computing power and electricity.
- Proof of stake, where participants who lock up some of their own holdings are chosen to validate blocks, with penalties designed to discourage cheating.
Each has trade-offs involving security assumptions, energy use and concentration of influence. Experts disagree about which is preferable.
Why people use them, and why others are skeptical
People are interested for different reasons: sending value across borders without traditional intermediaries, building applications on shared ledgers, or speculating on price changes. Skeptics point to volatility, high fees or slow speeds on some networks, limited consumer protections, energy use of some designs, and a history of fraud.
Compared with conventional digital payments or mobile payments, cryptocurrencies usually offer fewer safeguards if something goes wrong.
Common risks
- Volatility. Values can fall as quickly as they rise.
- Scams. Fake investment schemes, impersonation scams and fraudulent websites targeting this area are common. Be wary of anyone promising guaranteed returns or urging you to act quickly.
- Loss of keys. Lost or stolen keys are generally unrecoverable.
- Platform failure. Exchanges and other services have failed or been hacked in the past.
- Regulation and tax. Rules vary by country and can change. Taxes may apply to gains and to some transactions, and a qualified adviser can explain what applies to you.
- Technical errors. Sending to the wrong address, or on the wrong network, can result in permanent loss.
Questions worth asking
Before using any cryptocurrency service, it helps to ask who controls the keys, what happens if the company fails, what fees apply, how disputes are handled and what the legal status is where you live. If a claim sounds too good to be true, it probably is.
Understanding the mechanics helps you read news and claims more critically, whatever your view of the technology.