EXPLAINER: How Cryptocurrencies Work (and How They Don’t)
The first and most popular cryptocurrency, bitcoin, was launched over a decade ago. Yet, despite all the incessant buzz, relatively few are familiar with cryptocurrencies or blockchain, the technology on which they are built.
Despite evangelism and the rising profile of some investors, a 2021 poll by the Pew Research Center found that only 16% of Americans said they had ever invested in cryptocurrencies. This widened to 31% between the ages of 18 and 29 and 43% of men in this age range.
If you are not one of these percentages, you might view these currencies with skepticism and avoid trying to understand the jargon or technology.
But as cryptocurrencies and related technologies enter politics, intertwine with the broader economy, and impact the environment, everyone can get an idea of what they are, how they work, their pitfalls and their potential.
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I WANT TO SPEAK INTELLIGENT. IS IT “BLOCKCHAIN” OR “THE BLOCKCHAIN?”
It depends on the usage. “Blockchain technology” is acceptable to refer to the computer code that records cryptocurrency transactions (and can be used for other things; stick with us). Alone, just call it the blockchain – even if there are several (don’t worry, we’ll explain below).
WHAT IS THE RELATION BETWEEN CRYPTOCURRENCIES AND BLOCKCHAIN?
Blockchains record cryptocurrency transactions in encrypted digital records that reside on servers around the world. Some blockchains allow developers to integrate applications and program contracts.
Also note: different cryptocurrencies are built on different blockchains. Bitcoin is built on the bitcoin blockchain; Ether is built on the Ethereum blockchain. There are now cryptocurrencies or tokens that are essentially built on top of other cryptocurrencies – but at the most basic level, all cryptocurrencies back to a blockchain.
Blockchains can also be used to record other types of information, such as ownership records or the origin of a food.
I HAVE A HEADACHE. IS THERE AN EASIER WAY TO THINK OF IT?
Basically, cryptocurrencies are digital money. The blockchain is a database for recording transactions of said digital currency. This digital currency is not backed by any government or institution.
HOW ARE CRYPTOCURRENCIES CREATED?
Different cryptocurrencies have different digital architectures (code), so how they work varies. As an example, let’s take bitcoin, which is “mined”.
In the physical world, here’s how mining works: a specialized computer processor runs on electricity and produces an astonishing amount of noise and heat. In the digital world, this processor is competing to solve a mathematical puzzle. The computer that solves the puzzle first wins newly created bitcoins. This design is part of the open source code created by the anonymous entity that launched Bitcoin in 2009.
Mining serves another purpose: during the solving of the puzzle, the most recent bitcoin transactions – the sending and receiving of currency – are recorded on the blockchain. The design of the system encourages participants to expend resources (in this case, money and electricity) to help keep a record of who owns which bitcoins.
Those with more computing power are more likely to win – so the design favors well-resourced groups who can assemble large numbers of these specialized computers and supply them with electricity at the best possible price.
As a kind of verification, the system is also designed to increase the difficulty of solving the mathematical puzzle as more and more computers compete to do so. At the same time, the amount of bitcoins that miners manage to earn decreases automatically at predetermined intervals. Together, this means that entities that got into mining early enough earned more bitcoin in exchange for lower spending.
I THINK I REALLY GOT THIS. NOW WHAT ABOUT DECENTRALIZATION?
An additional feature of the blockchain design is that the transaction record is kept on many computers which together form a global network. These computers – or nodes – constantly check each other to confirm the accuracy of their records. Replicating these records across the network is part of what prevents an incorrect or bogus transaction from being logged.
Together, the decentralized and open source nature of the blockchain means that no one or any institution can control it. But actors like governments and large corporations can still limit access in certain circumstances. China banned the trading of cryptocurrencies in September 2021 over fears they could weaken control over the financial system and facilitate crime. More recently, a major cryptocurrency exchange, Binance, stopped processing purchases made with certain Russian-issued credit cards during its invasion of Ukraine.
WOW. SO, HOW SECURE IS BLOCKCHAIN?
Cryptocurrency enthusiasts consider it quite difficult to hack – that’s part of its appeal. Again, it depends on what platform you’re talking about.
The bitcoin blockchain has not been compromised to date, but the second largest blockchain and cryptocurrency, ethereum, faced a major crisis in 2016 resulting from a software vulnerability. Although the Ethereum blockchain itself was not hacked, some $50 million worth of Ether was stolen.
Many cryptocurrency-related services and technologies have been hacked or simply exploited by their designers to deceive and steal from participants.
Cryptocurrency exchanges – where people can exchange cryptocurrencies for traditional currencies – have been repeatedly compromised, with digital bank robbers wiping out accounts. Memorably, in 2018, the CEO of a cryptocurrency exchange died without relaying a crucial password, effectively excluding customers from millions of dollars worth of cryptocurrencies.
Consumers have few recovery options, whether they fall victim to a scam or a security breach, or simply forgot their digital wallet password. There is no password reset or insurance in the pre-programmed decentralized system.
In short, investments are backed by few protections. US prosecutors are prosecuting outright criminal behavior like false advertising or theft, but if the value of a new cryptocurrency token drops and doesn’t recover, that money is lost. Even the value of bitcoin, which some proponents call “digital gold,” is extremely volatile.
A final thought: cryptocurrencies remain the payment method of choice for criminals. Illegal drugs or other prohibited goods are often exchanged for cryptocurrency, which can be transferred over long distances more easily than cash and can be harder for prosecutors to trace. But for most cryptocurrencies, the record of who owns what is publicly visible, forcing criminals to become more savvy in order to effectively launder cryptocurrencies obtained through theft, scams, or ransomware attacks.
WHERE DOES THE “VALUE” OF CRYPTOCURRENCIES COME FROM?
This age-old question – who decides the value of a dollar? – is even more complicated with cryptocurrencies. Unlike traditional currencies, no government, central bank, or physical asset backs cryptocurrencies.
Their values are based on people’s belief in them, as determined by the market. Backers hope that more and more people will want a digital currency that is relatively free from government control – and that as people invest resources in cryptocurrencies, their value will increase over time.
Unlike traditional currencies, some cryptocurrencies function as both an investment and a potential unit of exchange. Some buy it in the hope that they can eventually resell it for a profit. Others might use a fraction of bitcoin to, say, get a firecracker pork burrito at Taco Beyondo in New Hampshire.
WHAT ABOUT ENVIRONMENTAL IMPACTS?
Cryptocurrency mining consumes a lot of energy. A peer-reviewed study calculated that in November 2018, bitcoin’s annual electricity consumption was 45.8 terawatt hours, comparable to Hong Kong’s net electricity consumption in 2019, according to the US Energy Information Administration.
This does not even take into account the energy consumed by other cryptocurrencies. And bitcoin’s energy consumption has increased every year: the Bitcoin Mining Council estimated that the cryptocurrency consumed 220 terawatt hours of energy in 2021.
When assessing the environmental impacts of cryptocurrencies, it is important to consider the source of electricity. Miners want electricity at the lowest cost, which sometimes leads them to polluting energy sources like coal. Other times can they find the cheapest energy from renewable sources like hydroelectric dams. It really depends on the location. These variables make it difficult to calculate the exact energy consumption and environmental impacts of cryptocurrencies.
Environmental impacts also include the energy used to cool computer processors, which heat up during operation, as well as electronic waste produced when miners upgrade their equipment and discard old models or broken units.
WHAT IS A NON-FUNGELLA… A NON-FUNGLEABLE… WHAT IS AN NFT?
For everyone’s sake, let’s keep it short. Non-fungible tokens are basically any digital item – like an image or video – that has been saved on the blockchain to show who it belongs to.