Cryptocurrency (Like Bitcoin) Explained Simply
We explain “how cryptocurrency works.” The goal of this guide is to teach beginners about blockchain and digital currencies (like Bitcoin).
Below we simplify things to make a somewhat complex system easier to understand. Do a site search, Google search, or see the links below to learn more about specific concepts.
What a new user needs to know: Cryptocurrency is roughly the equivalent of using PayPal or a Debit Card, except the numbers on the screen represent cryptocurrency instead of a fiat currency like a dollar. All a new user really needs to do is set up a coinbase account. With Coinbase users can buy/sell/store Bitcoin, Ether, and/or Litecoin and send and receive cryptocurrency.
The basic concepts: To use cryptocurrency, you don’t need to understand it (any more than you need to understand the monetary system to use a credit card). However, if you want to understand cryptocurrency you need to understand the concept of digital currency, the concept of blockchain (both a ledger of transactions and a technology), and the concept of cryptography. After-all, cryptocurrency is a digital currency, where transactions are recorded on a digital ledger called a blockchain, and every process along the way is secured by cryptography. The goal of this page will to show you how to understand these terms and how they connect.
The basics of cryptocurrency in simple terms: Cryptocurrency works a lot like bank credit on a debit card. In both cases a complex system that issues currency and records transactions and balances works behind the scenes to allow people to send and receive currency electronically. The main difference between cryptocurrency and bank credit is that instead of a banks and governments issuing the currency and keeping ledgers, an algorithm does.
What is cryptocurrency? Cryptocurrency is best thought of as digital currency (it only exists on computers). It is transferred between peers (there is no middleman like a bank). Transactions are is recorded on a digital public ledger (called a blockchain). Transactions and the ledger are encrypted using cryptography (why it is called “crypto” “currency”). It is also decentralized, meaning it is controlled by users and a computer algorithm and not a central government. Bitcoin is one of many cryptocurrencies, other cryptocurrencies have names like “Ether,” “Ripple,” and “Litecoin.”
How does cryptocurrency work? Transactions are sent between peers from “cryptocurrency wallets” by matching up public codes which relate back to user-held private passwords (AKA cryptographic “keys”). Transactions made between peers are recorded on a public ledger of transactions called a “blockchain.” All users of a given cryptocurrency have access to the ledger if they choose to download a “full node” wallet (as opposed to holding their coins in a third party wallet like Coinbase). The transaction amounts are public, but who sent the transaction is encrypted. Each transaction leads back to a digital “cryptocurrency wallet.” Whoever owns the password (or key) to the wallet, owns the amount of cryptocurrency denoted on the ledger. When someone sends or receives cryptocurrency, when they send from one wallet to another wallet using a set of private and public passwords, that transaction is queued up to be added to the ledger. Many transactions are added to a ledger at once. These “blocks” of transactions are added sequentially. That is why the ledger and the technology behind it is called “block” “chain” it is a “chain” of “blocks” of transactions.
How does blockchain work? When a peer-to-peer cryptocurrency transaction is made, that transaction is sent out to all users with “full node” wallets. Specific types of users called miners then try to solve a cryptographic puzzle (using software) which lets them add a “block” of transactions to the ledger. Whoever solves the puzzle first gets a few “newly mined” coins as a reward. Sometimes miners pool computing power and share the new coins. The algorithm relies on consensus. If the majority of users trying to solve the puzzle all submit the same transaction data, then it confirms that the transactions are correct.
What is cryptocurrency mining? People who are running software and hardware aimed at confirming transactions to the digital ledger are cryptocurrency miners. Solving cryptographic puzzles (via software) to add transactions to the ledger (the block chain) in the hope of getting coins as a reward is cryptocurrency mining.
TIP: Like anything else in life, there are tax implications to cryptocurrency. Make sure you understand the tax implications. In short, you’ll owe money on profits (capital gains) and may owe sales tax or other taxes when applicable. Learn more about cryptocurrency and taxes.
To summarize the above:
- Cryptocurrency can be thought of as a digital currency like PayPal or bank credit (what you use with your credit or debt card).
- There are many other cryptocurrencies beyond Bitcoin (some of which are better defined as digital assets).
- Unlike bank credit, which represents a centrally controlled and issued fiat currency (like the US dollar), cryptocurrency is decentralized and not thus not centrally controlled.
- Instead of a central powering controlling cryptocurrency, an algorithm and users themselves control cryptocurrency. The algorithm dictates how transactions work and how new coins are created, users create peer-to-peer transactions (which are recorded on an a public digital ledger).
- Those who confirm transactions by breaking cryptographic codes are called miners. Mining is how new coins are created.
- Of course, you don’t need to know any of that. All you really need to do is set up a coinbase account and use that to buy/sell Bitcoin, Ether, or Litecoin and to send/receive cryptocurrency… just remember to pay your taxes.