What is cryptocurrency and how does it work?

What is cryptocurrency?

Before we begin, it’s worth noting that this is a simplified overview – the full explanation would consume several books.

Cryptocurrency is a type of digital currency that uses cryptography for security. Unlike traditional fiat currencies issued by governments and central banks, cryptocurrencies operate on decentralised networks based on blockchain technology. 

The primary use cases for cryptocurrency include peer-to-peer transactions, investment and trading, powering decentralised applications (dApps) such as smart contracts, DeFi (decentralised finance) and NFTs (non-fungible tokens).

Cryptocurrency as a financial concept was launched with the first coin ever – Bitcoin – in 2009. Created by the anonymous individual or group under the pseudonym Satoshi Nakamoto (whose origin remains a debated mystery), Bitcoin marked the beginning of a global financial innovation phenomenon, inspiring thousands of alternative cryptocurrencies and the development of the broader blockchain ecosystem.

How does cryptocurrency work?

Cryptocurrency works on a type of technology called distributed ledger technology (DLT) – blockchain as one of the most famous types – remains the foundational infrastructure behind virtually all cryptocurrencies. 

For context, a blockchain is a distributed digital ledger that records all transactions across a network of computers (nodes). Each transaction is grouped into a ‘block,’ and these blocks are linked together in chronological (time from creation) order to form a continuous chain – hence the name blockchain.

When a cryptocurrency transaction is made, it is broadcast to the network where it awaits verification, which ensures that the transaction is legitimate. Once verified, the transaction is added to a block, which is then appended to the existing blockchain – this process creates a permanent and tamper-proof record of all transactions.

Public and private keys are the way to access your crypto assets. A public key acts like a digital address that others use to send you cryptocurrency, while your private key is a secret code that allows you to access and control your funds. Keeping your private key safe is critical, as just as any password, anyone with access to it can control your cryptocurrency.

To maintain the integrity and security of their blockchain, cryptocurrencies rely on consensus mechanisms. The two most common consensus mechanisms are:

• Proof of Work (PoW) – where miners compete to solve complex mathematical puzzles using their computational power. The first to solve the puzzle builds the block and is rewarded with coins. This method secures the network, including for Bitcoin, but requires a significant amount of energy. Because it relies on objective computational effort to secure the network, many view it as harder to manipulate and more battle-tested against attacks than PoS.
• Proof of Stake (PoS) – where validators are chosen to create new blocks based on the number of coins they ‘stake’ as collateral. PoS is more energy-efficient than PoW, offers faster transaction processing and is potentially easier to scale while still maintaining strong network security. It’s used by several networks, including Ethereum post-Merge.

What is the blockchain?

A blockchain is a type of distributed ledger technology that records transactions in a secure, transparent and unchangeable way. A blockchain distributes copies of the ledger across a network of computers known as nodes.

Here’s how it works:

• Distributed ledger of transactions – every transaction made on the blockchain is grouped into a ‘block’. Each node in the network holds a copy of the entire blockchain, ensuring that all participants have access to the same transaction history.
• Linked and secured blocks – blocks are linked together chronologically through cryptographic hashes (a unique digital fingerprint of the data in the block). Each block contains the hash of the previous block, creating a secure chain that prevents tampering. If someone alters a transaction, the hashes no longer match, alerting everyone in the network to the fraud
• Nodes and validators – nodes maintain the blockchain by storing and sharing its data. Some nodes, called validators (or miners in Proof of Work systems), verify new transactions and add new blocks to the chain by reaching consensus through Proof of Work or Proof of Stake mechanisms. This process means that the blockchain should stay accurate.
• Real-world applications – beyond cryptocurrencies, blockchain technology is also used in supply chain management, healthcare records, voting systems, identity verification and decentralised finance (DeFi). Its ability to provide transparent, secure and tamper-proof records is revolutionising many industries outside of pure crypto use cases.

What are the key characteristics of crypto?

There are four core features of cryptocurrency:

1. Decentralisation
2. Transparency
3. Immutability
4. Security

1. Decentralisation

Cryptocurrencies from the public blockchains operate without a central authority or intermediary, instead relying on a geographically disparate network of computers to manage and verify transactions, which reduces the risk of control or manipulation by any single entity.

2. Transparency

All transactions are recorded on the blockchain (public ledger), which should remain permanently accessible to anyone. This allows users to verify transactions independently.

3. Immutability

Once a transaction is added to the blockchain, it can’t be altered or deleted. This permanent record protects the integrity of the transaction history, because each block is cryptographically linked to the one before it with a hash. 

Therefore, changing a single transaction would require recalculating ancestor blocks via gaining control of the majority of the network’s computing power (in PoW) or staked tokens (in PoS).

4. Security 

Blockchain security is primarily defined by how difficult it is to alter or tamper with legitimate transactions recorded on the chain. This resilience stems from cryptographic hashing, distributed consensus mechanisms and the immutability of past blocks, all of which make unauthorised changes computationally expensive and easily detectable.

How are cryptocurrencies created?

Cryptocurrencies are created primarily through two processes – mining and staking.

• Mining – the process used by cryptocurrencies including Bitcoin that rely on Proof of Work (PoW). Miners use powerful computers to solve complex mathematical puzzles that validate and secure transactions on the blockchain. When a miner successfully solves a puzzle, they add a new block to the blockchain and are rewarded with newly created coins. Mining requires very significant amounts of both computational power and energy.
• Staking – used by cryptocurrencies that utilise Proof of Stake (PoS), staking involves holding and ‘locking up’ a certain amount of cryptocurrency in a wallet to support network operations such as validating transactions and creating new blocks. Participants who stake their coins are selected (randomly or based on other rules) to add blocks. In return, they earn rewards, typically in the form of additional cryptocurrency. Staking is more energy-efficient.

Both methods serve to secure the network, verify transactions and introduce new coins into circulation.

What is crypto mining and how does it work?

Crypto mining is the process by which transactions are validated and added to a blockchain, primarily used by cryptocurrencies that rely on the Proof of Work (PoW) consensus mechanism, like Bitcoin.

Here’s how it works:

1. When users make cryptocurrency transactions, these are broadcast to a network of nodes (computers participate in the Bitcoin network). Miners collect pending transactions and bundle them into a ‘block’, validating the transaction.
2. To add this block to the blockchain, miners compete to solve a complex cryptographic puzzle (the process that requires powerful computers and significant computational effort). This puzzle is designed to be difficult to solve but easy for the network to verify once completed.
3. The first miner to solve the puzzle broadcasts the solution to the network. Other miners verify the solution, and if valid, the new block is added to the blockchain. This confirms the transactions in that block.
4. Once recorded on the blockchain and confirmed by sufficient subsequent blocks, the transaction becomes a permanent part of the Bitcoin open-distributed ledger and is accepted as valid by all participants.
5. As an incentive for their work and to secure the network, the successful miner receives a reward, typically a combination of newly minted cryptocurrency (the ‘block reward’) and transaction fees from the validated transactions.

While this point has been made several times, it’s really important to hammer it home. Mining requires immense computational power and energy, as miners run high-performance hardware continuously to solve very complicated puzzles. 

This energy-intensive process has raised environmental concerns, leading to growing interest in alternative consensus mechanisms like Proof of Stake that are more energy-efficient – though again, detractors view this mechanism as less secure.

What is staking and how does it work?

Staking is the process used by cryptocurrencies that operate on the Proof of Stake (PoS) mechanism. Instead of relying on energy-intensive mining, staking involves holding and ‘locking up’ a certain amount of cryptocurrency in an address to support the network’s operations.

When you stake your coins (and while there are further complications) you essentially commit them as collateral to help validate new transactions and create new blocks on the blockchain. Validators are chosen to confirm transactions and add blocks based on the amount they already have staked and other factors like the length of time held. For Ethereum, however, validators are chosen at random.

In return for staking, participants earn rewards, which are usually additional coins. These rewards incentivise users to contribute to the network’s security, efficiency and growth. Staking is usually more energy-efficient than mining and can generate passive income for long-term holders, making it an attractive option for many cryptocurrency investors.

Types of cryptocurrency

There are many different ways to group cryptocurrency varieties, but some of the most popular include:

Bitcoin

Bitcoin is cryptocurrency’s trailblazer and inarguably the most famous coin – many use the terms ‘crypto’ and ‘Bitcoin’ interchangeably. Introduced in 2009 by Satoshi Nakamoto, it serves primarily as a digital store of value and a medium of exchange. Bitcoin’s decentralised nature and limited supply have made it a significant player in the crypto market and it’s often referred to as ‘digital gold’.

Altcoins

Altcoins are all cryptocurrencies other than Bitcoin – for example, Ethereum and XRP. Many altcoins offer features or use cases that differ from Bitcoin, such as faster transaction speeds, smart contract functionality (Ethereum) or different consensus mechanisms. New altcoins are continuously being created in a constant evolutionary battle for use case value.

Stablecoins

Stablecoins are cryptocurrencies designed to maintain a stable value by pegging to assets like the US dollar or other fiat currencies. Unlike Bitcoin and most altcoins, stablecoins aim to reduce volatility, making them useful for everyday transactions and as a more stable option during market swings. Common examples include Tether (USDT) and USD Coin (USDC).

Utility Tokens

Utility tokens provide holders access to a product or service within a specific blockchain ecosystem. Unlike Bitcoin, utility tokens are not primarily designed as a currency for medium of exchange but rather to fuel decentralised applications and platforms. Examples include Chainlink and Uniswap.

Central Bank Digital Currencies (CBDCs)

CBDCs are digital currencies issued and regulated by governments or central banks. Unlike decentralised cryptocurrencies, CBDCs are centralised and serve as a digital form of a country’s fiat currency. Examples include China’s Digital Yuan and the Digital Euro under development in the EU.

Why buy and invest in cryptocurrencies?

There are many reasons to consider diversifying into cryptocurrency. Note that this is not investment advice.

Cryptocurrency benefits

• Potential for high returns – many major cryptocurrencies, especially Bitcoin and Ethereum, have historically delivered significant returns in certain times, often attracting investors seeking significant growth in good times (though past performance is not an indicator of future results).
• Diversification – including cryptocurrencies in your investment portfolio can provide diversity, as they have historically reflected asymmetric risk and return profiles compared to traditional assets like stocks and bonds.
• Innovation – investing in cryptocurrency allows you to invest in cutting-edge technologies such as blockchain, decentralised finance (DeFi), which are reshaping financial systems alongside many other industries.
• Accessibility – cryptocurrency markets operate 24/7, unlike traditional stock markets, and often have lower barriers to entry; therefore, anyone with an internet connection should be able to buy, sell or trade digital assets at any time.

How to store cryptocurrencies

Many investors value the convenience of crypto exchanges like us, though you can also hold coins in your own self-custodied wallet.

Crypto exchanges

Many people store their cryptocurrencies on centralised exchange platforms where they purchase them. This method is useful because it means you can quickly trade or sell your assets. However, keeping funds on exchanges does carry some risk – including hacking, platform insolvency or restricted access during outages. Users don’t have full control over their private keys via centralised exchange platforms, which means they rely on the centralised exchange’s security. 

Crypto.com holds all customer crypto assets on a 1:1 backing basis, meaning every user deposit is matched by equivalent assets held in custody. These holdings are publicly verifiable via our independently attested Proof of Reserves page.

Fiat currency deposits are held with regulated banking partners in line with applicable regional regulations and Crypto.com’s custodial standards.

Self-custodial/non-custodial wallets

For greater control and security, many users store cryptocurrencies in self-custodial wallets outside the centralised exchanges. These include both hot wallets and cold wallets.

Hot wallets are connected to the internet, making them easy to use for frequent transactions and quick access. Examples include mobile apps, desktop wallets and browser extensions. However, because they’re online, they are also vulnerable to hacking and malware attacks – and can be vulnerable.

Cold wallets store your cryptocurrency offline, such as in hardware wallets like a Trezor, or paper wallets (where you physically write down your public and private keys on a piece of paper). Cold wallets usually offer much higher security but also suffer the risk of losing the private key, and are significantly less convenient for trading.

Cryptocurrency vs fiat money: What is the difference?

This is a generic, high-level overview, but the key differences between cryptocurrency and fiat include:

• Centralisation – possibly the most important distinction. Fiat money is issued and controlled by governments and central banks, giving them authority over monetary policy and supply via interest rate setting and tools like quantitative easing. Cryptocurrencies, excluding CBDCs, instead operate on decentralised networks without a single controlling entity, relying on consensus among participants.
• Supply – on a related note, central banks can adjust the supply of fiat currency based on economic needs, which can lead to inflation or deflation. Many cryptocurrencies, like Bitcoin, have a fixed maximum supply, creating scarcity and limiting inflation.
• Inflation resistance – while fiat currencies tend to lose value over time due to inflation, some cryptocurrencies are designed to be deflationary or have predictable supply schedules, which can potentially preserve value over the long term.
• Transaction speed and costs – cryptocurrencies often allow for faster and cheaper transactions, particularly for cross-border payments, by eliminating intermediaries. Traditional fiat transactions can be slow and involve higher fees.

Cryptocurrency vs stocks: What is the difference?

Key differences between cryptocurrency and stocks include:

• Ownership – stocks are shares in a company, giving shareholders benefits including voting and/or dividend rights. Cryptocurrencies do not typically confer ownership in a company or asset.
• Regulation – stock markets are heavily regulated by government authorities to protect investors and ensure transparency and integrity of the financial system. Cryptocurrency markets are less regulated, which can lead to higher risks but also flexibility for innovation.
• Market hours – stock markets operate during specific hours on business days, usually closing on weekends and holidays (though this is starting to change). Cryptocurrency markets are open 24/7,  which can allow trading at any time worldwide.
• Volatility – cryptocurrencies tend to be much more volatile than stocks, with prices often experiencing rapid and large fluctuations, making them potentially higher-risk investments.
  

Risks of cryptocurrencies

As with all investments, crypto comes with some risks:

• Market volatility – as noted above, cryptocurrency prices can experience rapid and significant fluctuations within short periods of time, leading to potential large gains but also substantial losses.
• Regulatory uncertainty – the constantly changing legal landscape across various jurisdictions means changing regulations or government shifts can affect individual cryptocurrencies' value quickly, sometimes causing sudden price shifts.
• Security risks – cryptocurrencies are susceptible to hacking, phishing and theft, especially if private keys or exchange accounts are compromised, which can result in irreversible loss of capital.
• Scams and fraud – just like traditional investments, the crypto space has seen many fraudulent schemes, including fake Initial Coin Offerings (ICOs), Ponzi schemes and phishing attacks, making it essential for investors to exercise extra caution when considering an investment.

What is the future of cryptocurrency?

While the future remains speculative, there are several themes to consider:

• Mainstream adoption – increasing number of individuals, businesses and institutions start to embrace cryptocurrencies for payments and investments, which continue pushing crypto closer to everyday use.
• Technological advancements – continued research and development is improving blockchain scalability, speed and energy efficiency, allowing for more complex applications and greater user adoption.
• Regulatory developments – governments and regulators are working toward clear frameworks that balance investor protection with fostering innovation, which could stoke greater trust in the market.
• Integration with traditional finance – increasing collaboration between crypto platforms and traditional financial institutions is helping to bridge the gap, leading to hybrid financial products and broader acceptance across multiple sectors.

How to buy and invest in crypto

1. Choose a reputable cryptocurrency exchange you trust.
2. Create and verify your account.
3. Deposit funds using preferred payment methods.
4. Select cryptocurrencies to purchase.
5. Place your order and secure your assets.

Explore the Crypto.com Exchange for advanced trading features and tools.

Crypto disclaimer: The products offered by the Company may include assets that are volatile that you trade at your own risk. Nothing mentioned on this site is intended as or should be read as investment advice or recommendation. Cryptoassets prices can go up or down and returns cannot be guaranteed. Cryptoassets are volatile and therefore may not be suitable for you. You should undertake independent evaluation and take into account your level of experience, financial situation and risk appetite. You are solely responsible for your own investment decisions. Terms and conditions apply. For more information, please refer to our: (i) Financial Services Guide and Policy & Procedure Guide (FSG & PPG); (ii) Risk Disclosure Statement; (iii) Complaints Handling Policy.