It’s fairly common knowledge that cryptocurrency is a decentralized digital medium of exchange that isn’t issued by a government or bank. Most people are probably familiar with Bitcoin by now, and you might have heard of Ethereum, too. But those are just two of the more than 5,000 cryptocurrencies vying to be the next big thing.
With that many out there, you might be wondering where they all come from?
No bank and no government means no printing and no minting — but none is needed. Although you can spend it like regular money, cryptocurrency is born from an entirely different process altogether.
All Cryptocurrency Is Software
Many cryptocurrencies, like Bitcoin and Ethereum, are “mined.” Others are not. More on that in a moment.
No matter the origination process, all cryptocurrency is software that is created by code. That code determines absolutely every function associated with the cryptocurrency, from the way data are stored and how transactions are recorded to the distribution of mining rewards and the maximum supply of tokens to be produced.
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In almost all cases, the code is public and the software used to generate a given cryptocurrency is decentralized, just like the cryptocurrency itself. That public, decentralized software is hosted on individual computers all over the world instead of on a central server.
Algorithms, Cryptography and Blockchain Are at the Heart of It All
When cryptocurrencies are designed to be used as money, transactions are stored on a special kind of secure database called a blockchain, which serves as a ledger of all coded transactions. Think of it as a checkbook for cryptocurrency.
Once entered into the blockchain, no one can ever change an entry in the database without meeting specific conditions. Everyone involved can see the public record of all transitions.
Blockchain technology, therefore, allows cryptocurrency to achieve its three most important defining features:
The part of the code that represents what end-users know as “tokens” or “coins” is just a string of numbers stored on a blockchain. Cryptocurrencies are generated by algorithms, and those algorithms rely on cryptography — hence the name cryptocurrency.
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Most Cryptocurrency Is Mined
In most cases, the algorithms that fuel the cryptocurrency factory are written to award tokens to computers that add transactions to the blockchain. That process is known as mining. Miners use special hardware and the cryptocurrency’s public, decentralized software to add transactions to blockchains.
In exchange for providing that critical blockchain maintenance, miners get paid in new cryptocurrency tokens. Most cryptocurrency coins or tokens are created this way.
Technically, anyone can be a miner, but it’s a largely fruitless endeavor for most. It’s complicated, competitive, expensive if you fail — which is highly likely — and it gobbles up an enormous amount of power.
But Some Is Not
Some cryptocurrency was never designed to replace fiat currency like the dollar. In other words, it was never meant to be used as money. This kind of non-mineable, unspendable cryptocurrency is usually generated to reward early investors in a new cryptocurrency launch, called an ICO (initial coin offering).
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In other cases, a new cryptocurrency can be created through a deviation in a blockchain called a hard fork. Hard forks occur when blockchain protocols change so significantly that a new, unique branch is formed on the chain that is incompatible with the old chain. Bitcoin Cash, for example, was formed through a hard fork on the original Bitcoin blockchain.
Proof of Work and Proof of Stake
Verification is at the core of crypto. Unlike fiat currency, the value of cryptocurrency is not based on trust. It’s based on one of two verification techniques: proof of work and proof of stake.
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Most transactions are verified through proof of work. Algorithms create complex math problems that miners race to solve using special hardware. By solving the puzzle, a miner verifies a group of transactions called a block, which is then added to the larger blockchain ledger. The miner who pulls it off first is rewarded with cryptocurrency.
Proof of stake was developed to reduce the amount of power needed to verify transactions. With this method, someone has to prove they have skin in the game in order to check transactions and compete for rewards. Users have to “stake” their own existing cryptocurrency by locking it up in a communal vault to be allowed to verify transactions. The more you stake, the more transactions you’re allowed to verify and the more cryptocurrency you can earn.
This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.
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