How Does Cryptocurrency Work?

Cryptocurrency is a next-generation financial instrument that uses decentralized networks and a blockchain protocol to establish a global medium of exchange between peers.

In the last decade, a digital ecosystem for financial trading and consumer purchases emerged thanks to trends in internet connectivity, advanced cryptographic protocols, and computing power. Last month, cryptocurrencies amounted to more than $2 trillion in global valuation as the digital currency’s credibility grows and governments consider further regulation.

A picture of paper currency lying behind a handful of gold and silver coins with cryptocurrency symbols like Bitcoin. Cryptocurrency is a growing method for storing digital assets, consumer purchases, and long-term investment.

Given the complexity and freshness of cryptocurrency technology, vendors have been slow to adopt it as a medium for payment. However, initial analysis shows that offering the payment medium brings in new customers and higher valued purchases for those who do. As traditional financial institutions and governments start to consider, if not allocate, investment funds in the emerging market, this poses well for new and existing crypto investors and traders.

This article starts with a refresher on how the crypto ecosystem operates before diving into how cryptocurrency works and the options presented to consumers and investors.

How the Cryptocurrency Ecosystem Works

  • Global connectivity via the internet enables individuals to participate in the trading or mining of cryptocurrency. Cryptocurrency can provide investors and traders more access to global markets than their native currency.
  • Advanced encryption is a staple of cryptocurrency protocols providing for asymmetric and symmetric encryption cartography, public-private keys, and hashing to enumerate, timestamp, and validate new transactions on blocks.
  • High-powered machines known as rigs or nodes are responsible for compiling, validating, and storing blocks. For their efforts, miner nodes receive a fraction of a coin’s value, referred to as the proof of work protocol. 
  • Miners are specialized nodes that participate individually or by pooled computing power to validate transactions submitted and ensure the fair distribution of coins.
  • Traders and investors rely on nodes and miners, but they also are responsible for cryptocurrency’s success and fuel its credibility as a modern financial instrument.

Read more on participating in blockchain validation with How to Mine Cryptocurrency.

How To Use Cryptocurrency

Though crypto assets are a complex and growing segment of the digital economy, cryptocurrency has long had two primary uses: 1) as monetary value for consumers buying products or services, and 2) an instrument for financial trading and investments.

For Payments

In May 2010, a programmer purchased two Papa John’s pizzas for 10,000 bitcoins. Millions of transactions later, this is just one example of how cryptocurrency gets used as a payment form. Vendors continue to roll out options for crypto payments for goods and services, but at large, options for consumers hoping to pay with cryptocurrency are lacking globally. Digital companies and video game developers are two organization types finding the most success integrating cryptocurrencies and utility tokens into their platform.

For Investments

Fast-forward to 2021, that 10,000 bitcoin used to buy pizza is worth over half of $1 billion. The fluctuating yet gradually rising value of cryptocurrency and the lack of vendor payment options leave consumers with few options. Cryptocurrency as an investment rather than paying for goods and services is a popular reason for buying-in. Investors only need to purchase and hold cryptocurrency to reap the benefits of potential growth. As a speculative market, investing large sums of money into cryptocurrency with plans to sell fast or trade often translates to higher risk.

Read more: Best Financial Services Software for 2021

How Do Crypto Transactions Work?

Cryptocurrency transactions are a process where digital traders can buy and sell crypto assets. Investors can load funds for use through a marketplace platform, submit trade requests, and manage their cryptocurrency portfolio.

1. Investor Opens Crypto Wallet

Through a web browser or device application, investors can open an exchange platform account capable of storing and trading crypto. Once registered, the user can transfer funds from their traditional financial institution to their online account. Trading platforms vary in their features but typically collect fees on trades and provide for prompt withdrawals.

2. Investor Submits Trade Request

From their account, investors can open wallets for specific coins and submit requests that pull funds from their deposited location. Requests for trades contain data specifying the type of coin, valued amount at that time, time of the request, buy/sell order, and requestor. 

3. Exchange Connects Buyer and Seller

The trading platform, serving as a broker for the specific coin’s marketplace, connects buy and sell requests for processing. While the transaction request flies across the decentralized network, a mining period separates the investors from completing and transferring funds.

4. Nodes and Miners Execute the Trade

The underlying network of nodes initially receives transaction requests before mining devices latch onto verifying the transaction. Miners validate the agreement using data from both parties’ requests and often bundle several transactions together into a single, immutable block.

5. Transaction Finalized and Validated

The miner’s validation sets the transaction in stone on the blockchain, and funds move to their respective accounts. The network undergoes a similar process for receiving and verifying the transaction before executing the funds’ transfer for every request.

Crypto Transaction Process in Action

Keeping the above transaction process in mind, individuals and organizations can use blockchain technology to purchase crypto using real-world currency or purchase goods and services using their crypto holdings.

For Purchasing Crypto

Once registered for a wallet and address with accessible funds, individuals can purchase a specific cryptocurrency. As a divisible asset, users can request a bid that meets their expectations without purchasing an entire token and diversify holdings online across several tokens. The wallet’s exchange platform uses the request to connect the buyer to a seller, where the transaction process occurs, ending with the transfer of monetary value for cryptocurrency. 

For Payments to Vendor

Individuals already holding cryptocurrency are free to spend it wherever vendors accept crypto. Companies who want to offer cryptocurrency payment options can create an account just like an individual trader. The transaction proceeds using buyer and seller information like any online payment, a withdrawal of funds from the buyer’s wallet, and a digital receipt for purchase items. Exchange platforms continue to increase offerings for commercial accounts.

Heard of the newest digital collectible? Check out eSecurity Planet’s coverage on non-fungible tokens (NFTs).

How Does Crypto Gain or Lose Value?

Cryptocurrency represents real-world value investors can use to exchange for fiat currency (physical paper and coins) backed by a central authority. Cryptocurrency shows it can compete with traditional fiat currencies in scarcity, divisibility, transportability, durability.

Supply and Demand

Like physical currencies, the value of an individual coin fluctuates based on the supply and demand of traders. Coin prices are often a direct reflection of trader behavior – meaning prices move up when more money moves into the market and moves down with the sale of holdings.

Investor Participation and Public Opinion

Though the technology underpinning some cryptocurrencies like Ethereum goes beyond just monetary value, other coins have little to no tangible value yet continue to be famous for trading. Though the whole market arguably suffers from inflation, passionate investor participation by some has pushed coins higher in value than ever intended.

Though cryptocurrency outlasted the scrutiny of the last decade, public opinion remains a top influencer of cryptocurrency price points.

Read more: The State of Blockchain Applications in Cybersecurity


Disclosure: This article is not financial advice. We strongly encourage any readers interested in cryptocurrency to learn more and talk with your financial advisor for more information.
Sam Ingalls
Sam Ingalls is a content writer and researcher covering enterprise technology, IT trends, and network security for eSecurityPlanet.com, Webopedia.com, ChannelInsider.com, and ServerWatch.com.

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