Cryptocurrency

A cryptocurrency is an electronic, non-tangible form of currency not backed by actual securities or government support, existing virtually, usually as an interconnected system of units which is protected by cryptography. A cryptocurrency is based on a blockchain technology which provides high tolerance for counterfeit. The key feature of it is its decentralization. Another crucial feature of it is that it isn’t issued by authorities, and so government has no control over it, which generates its own pros and cons.

Cryptocurrency working principles

A cryptocurrency is a form of a digital currency-like medium of exchange, designed to be used between two parties without attracting the third one to guarantee value and prove a transaction. This is achieved by using blockchains. A block is basically a separate piece of code, containing encrypted data on the transaction, and each block must be verified by other units in the network, and integrated into a list of block. This list is called a blockchain.

The abovementioned technology is based on a networking principle implemented the following way - there is a group of computers, on each of which a cryptocurrency software is installed to allow it to be a part of the group, working as a distributed ledger. The units in this system are also called nodes.

Each transaction is encrypted (the data usually includes addresses of the participants, an electronic signature, the value being transferred, and other things depending on the type of cryptocurrency), and then is sent to other units in the group for it to be verified by them and added to the list of block, i.e. it becomes a part of a blockchain. Units have no other connection with each other and are considered mutually distrustful, thus guaranteeing no interest for them to fake transactions.

An important issue of this scheme is that establishing consensus and recording transactions are complicated and costly processes, often taking huge amounts of processing power and energy. So, the nodes in cryptocurrency systems are rewarded for their participation in processing, validating and recording operations.

After the transaction is made and verified (shared and copied by all the nodes), it’s recorded in the blockchain and has its own unique digital signature. So, a blockchain is impossible to be discreetly altered or modified by its design.

Transactions are traditionally executed between two wallets, with a certain amount of a cryptocurrency being taken from one wallet and sent to the second one. 

To enable a wallet to be used for transferring a cryptocurrency, there is a pair of keys:

• a public key, which is known by others, granting them the possibility to send cryptocurrency to the wallet;
• a private key, which is known usually only by the wallet owner, providing the possibility to spend the wallet currency.

Cryptocurrency types

Since Bitcoin, the first successful and widely used cryptocurrency, was launched in 2009, a vast number of other cryptocurrencies have appeared. Some of them were in fact copies of Bitcoin, but structurally different kinds have also developed.

Nowadays, there are two main kinds of cryptocurrency, with the main difference between them lying in the process of transaction validation:

• Currencies using the Proof of work scheme, in which the data is confirmed by other members of the network as described above. This scheme is typical for many cryptocurrencies including Bitcoin, Ethereum, Monero, and some others.
• Currencies using the Proof of stake scheme, in which it’s required for users to prove their ownership of a certain amount of currency for validation. Currencies with this consensus achieving mechanism are Solana, Polkadot, and others.

Legal issues

One of the distinctive features of cryptocurrencies, and the one being promoted as a philosophy, is a fact that they are independent of the government interference. But this fact, doubled with the lack of backing by actual assets, makes it difficult for cryptocurrencies to be used legally in some countries and regions. Though it’s considered that cryptocurrencies might be utilized for ordinary daily transactions, only El Salvador allows the use of it as legal tender, while in other countries cryptocurrencies have various statuses, but generally are not legally approved to be an equivalent of actual currencies.

In Japan, for example, cryptocurrencies are treated as property, in Europe they qualify as financial instruments, while in China cryptocurrencies are banned to be used or mined within the borders. So, when operating a cryptocurrency, it’s important to understand what status it has, if that depends on the value being operated, and how those operations are taxed in the given jurisdiction.

Cryptocurrency pros and cons

As the use of cryptocurrency is a rather new option, still not fully covered by law and operating on a basis which wasn’t used before, there are a number of advantages provided.

The main advantages of cryptocurrencies are the following:

• Fastness of transactions, which opens new possibilities for traders.
• No need in the third party for establishing trust and safety, making it easier to buy and sell.
• Decentralization, which decreases the possibility of a system failure in case one of its elements fails.
• Profitability, as cryptocurrencies often significantly raise in value over time if they are popular enough.

At the same time, the same features of cryptocurrencies that generates their advantages result in less attractive issues.

The most serious disadvantages are the following:

• Energy waste and ecological issues, which are triggered by expensive and resource-consuming mining.
• Lack of full anonymity, as the digital trail of every transaction might be tracked;
• Involvement in criminal activities, as cryptocurrencies might become an easy tool for it because of the lack of government control and decentralization.
• Possible concentration of cryptocurrency value within a small pool of users, which is conditioned by the fact that mining requires specific resource.
• Cryptocurrency price changes might be difficult to predict, and they are highly volatile;
• Hacking of cryptocurrency wallets, which is possible, although most cryptocurrency systems themselves are designed to be secure.