What is Cryptocurrency?

By Megan Herr & Thomas Dyer

I.   History of Cryptocurrency

Innovators have a tendency of identifying problems and subsequently creating a solution instead of the inverse. Great ideas do not make historic innovations; creative solutions to problems do. Cryptocurrency arose out of the identified problems contained in “traditional” fiat currencies. Transactions involving fiat currencies are often traceable by parties who should not otherwise have access to that information. Cryptocurrencies effectively address both of these problems, along with a handful of others through innovations including blind algorithms and the related blockchain technology.

II.   How Does a Cryptocurrency Ledger Work?

A cryptocurrency’s blockchain operates as a ledger which records all prior transactions and activity. This technology enables a system to validate the ownership of all units of the currency at any point in time. Copies of this chain of data are stored in every node of the currency’s software. Individuals known as “miners” volunteer their computers to authenticate each new cryptocurrency transaction. As a reward, these miners are compensated with a small amount of the currency. Traditionally, only the fastest system to verify a transaction receives the compensation. Miners have an incentive to increase the power of their computer system which enables the miner to continually verify transactions first, thereby receiving more compensation. This allows the algorithm to become more complicated, providing an additional level of security and reliability.

The product of these verifications is a chain of individual blocks which depict the history of transactions involving the currency. Once a block is added to the chain, the transaction is irreversible, unlike a credit card using fiat currency. The presence of the blockchain on a multitude of different servers further prevents fraud. If a hacker successfully defrauded the currency, the hacker would have to change the history on an extremely large number of these chains in order for the system to recognize that transaction as part of the prevailing, and accurate, history of transactions. 

III.   Is Cryptocurrency a Valid Currency?

Cryptocurrency is a digital value or virtual “currency” that operates on a Distributed Ledger Technology (DLT), such as a blockchain, and that works as a medium of exchange. A currency, simply defined, can be understood as a system of money that stores value, serves as a unit of account, or facilitates transactions as the aforementioned medium of exchange. A store of value is present when an owner of the currency can hold on to an ownership stake and use the value to purchase commodities at a later date. The general volatility of cryptocurrency arguably makes this element difficult to meet. While a user can ultimately purchase goods with cryptocurrency at any point in time, the value of that ownership stake is ever changing in a fashion, unlike most fiat currencies. Prospective and actual owners alike frequently change their perception of the value of cryptocurrency, which affects the quantity of purchasing and selling of the currency, resulting in volatile pricing. The most widely used cryptocurrencies, however, have yet to lose their value entirely, which could qualify them as currencies after all as a result of their continuous purchasing power. A currency acts as a unit of account when one can express prices using the system. Prices are expressed in terms of cryptocurrencies daily, and this element is subsequently met. Ultimately, using these two elements and before analyzing the third, cryptocurrencies are likely classified as currencies by economic definitions, albeit unreliable and volatile currencies.

Currencies are further classified according to the value. Fiat currencies are valued in accordance to what the government and free-market determine that money is worth. Virtual currencies are a type of unregulated, digital money, that obtain value through demand. A digital currency is a form of virtual currency that is electronically created and stored. Cryptocurrencies, which operate as a subset of a digital currency, are defined by their use of cryptography and the fact that they are not issued by any central authority. Because cryptocurrencies do not have the backing of a government, critics have asserted that cryptocurrencies are not currencies. The SEC, however, recognizes that cryptocurrencies are intended to provide many of the same functions as long-established fiat currencies, such as the U.S. dollar or Japanese yen. Consequently, cryptocurrencies, although not issued by the government, may be considered digital currencies used to regulate the generation of units of currency and verify the transfer of funds. 

IV.   Degree of Usage and Limitations

Cryptocurrencies have been a topic of debate in recent months due to increased trading, volatile prices, and a developing regulatory landscape. Media coverage, additionally, is one of the reasons why cryptocurrencies have reached their popularity. Today, cryptocurrencies like Bitcoin can be used to pay for hotels, flights, jewelry, and even online purchases. Demand for cryptocurrencies, however, is relatively low, with less than 8% of Americans owning any digital coins.