Digital Currencies (Cryptocurrencies)
What is a digital currency?
A digital currency is one that only exists electronically. This means there are no tangible coins or notes you can hold onto or carry around.
Why would someone want to use a digital currency instead of normal money?
There are numerous reasons why people are turning to digital (crypto) currencies.
- Some people are dissatisfied that “real money” can just be printed by central banks and is no longer linked to a tangible asset, such as gold. This means the value of your money erodes over time as there is no theoretical limit to how much new money can be put into circulation
- Some digital currencies are created to have absolute limits to the amount of supply, for example Bitcoin is capped at 21 million Bitcoins. This stops inflation from occurring, which keeps your purchasing power strong over time
- Some people believe that currencies should be decentralised and payments should be direct (therefore not at the mercy of any banks or financial institutions)
- Some people like the potential privacy that a digital currency may allow, although this is becoming more difficult to achieve due to regulation and interference from Governments
It is worth noting that Bitcoin is currently a volatile asset with high price movements in both directions. Because of this it is currently regarded by many as a long term store of value rather than a day to day currency to be spent (e.g. if your wages were paid in Bitcoin you may find you have lost or gained some purchasing power before you even make it to the shops). Other digital currencies that are more stable in value do exist.
How are transactions made using a digital currency?
Transactions are made with digital currencies by sending coins from one digital wallet to another.
- Wallets can come in the form of apps download to your phone or computer
- Wallets have a unique address associated with each type of cryptocurrency it supports
- To send money, you need to accurately type in the person’s wallet address (which is a long string of letters and numbers)
- When you request a transaction (the movement of money), the information is broadcast to special computers (nodes) on the network and await validation
- Once validated, transactions are recorded forever on the digital ledger (the blockchain)
- The validation processes ensures that the transaction was authorised and that the person has enough funds available (to stop double spending of coins)
- A secret encryption key in your digital wallet ensures that only you can authorise the movement of your digital coins
How are transactions recorded in digital currencies?
A permanent record of transactions are recorded on the blockchain.
- Think of the blockchain as a digital ledger that keeps track of money that is sent from one digital wallet to another
- Identical and simultaneous copies of the blockchain are kept by hundreds of users, meaning it is very hard, if not impossible, to fraudulently alter the transaction records
- Before authorising a new transaction, the blockchain will be checked to make sure you are still the owner of the currency
How are digital currencies created?
Some cryptocurrencies are mined, such as Bitcoin. This means a new digital coin is created every time a “miner” is chosen to confirm a set of transactions (a block on the blockchain). This is called a proof-of-work system because confirming the transactions usually requires a significant amount of processing power and effort. The newly minted coin is your reward, plus potentially a small mining fee too.
Digital currencies can also be pre-mined and operate using a proof-of-stake system. Significant ownership of a digital currency (your initial stake) authorises you to confirm transactions on the blockchain and claim a fee for your efforts. The bigger your stake and the more reliable you are, the more you earn from fees. However, if you validate transactions incorrectly you may lose some of your stake (coins). This method doesn’t require the significant processing power and energy requirements of a mined network.
Coins in a proof-of-stake system are either:
- Pre-mined (just simply created from nowhere) and initially sold or given away, or
- Mined using a proof-of-work system that has transitioned to a proof-of-stake system
What are the pros and cons of digital currencies?
Some digital currencies are really fast whilst others can take a long time to verify and confirm a transaction, e.g. although its the most popular cryptocurrency, Bitcoin is probably the slowest, taking 10 to 30 minutes to complete a transaction. Bitcoin can only handle 4.6 transactions per second. Visa can handle 1,700 real world transactions per second.
To encourage a global decentralised network of computers to participate in the validation of transactions, each transaction usually incurs a fee. Some digital currencies have very small fees whilst others are quite large at peak times. However, most real world banks would certainly charge a significant fee if you wished to wire large amounts of money to an account in another country.
If you accidentally send digital coins to the wrong wallet address they can be lost forever – it is your own responsibility to know what you are doing and double check addresses and values. Non-digital currencies have checks in place to try and avoid these mistakes.
The ledger (blockchain) shows a permanent record of all transactions for each wallet address (but this isn’t directly linked to a name). The details of money moved between traditional banks isn’t publicly available like this.
Digital currencies are not immune from hacking and other security concerns – it is the users responsibility to keep their wallets safe and not reveal encryption keys.
Digital currencies and crime
Many people associate digital currencies with crime because they see it as a mechanism for anonymously moving the proceeds of crime around the world. Although this probably does happen, it conveniently ignores the shear volume of illegal activity that happens globally using cash. So is it actually any worse? Cash cannot be traced yet all digital transactions are visible on the blockchain.
Most digital exchanges require proof of identity to purchase or withdraw digital currencies, so illegal activity isn’t as common as we would probably expect.