Updated April 19, 2020
Cryptocurrency, a form of digital currency or electronic currency, is a medium of exchange that utilizes cryptography for security. There are currently over 1,000 cryptocurrencies. Some of the most popular cryptocurrencies include Bitcoin, Ether (often incorrectly referred to as its underlying platform "Ethereum"), Bitcoin Cash, Ripple, Dash, Bitcoin Gold, Litecoin, IOTA, Cardano, Monero, Ethereum Classic, and Zcash.
To better understand cryptocurrency, it is helpful to compare it to fiat currency such as the United States dollar, Euro, Japanese yen, and pound sterling. Fiat currency, or fiat money, is not backed by a physical commodity and instead derives value from supply and demand. Most every country in the world utilizes a fiat currency. We will begin with some similarities between cryptocurrency and fiat currency and then move on to some differences.
How is cryptocurrency like fiat currency?
Both cryptocurrencies and fiat currencies are mediums of exchange which do not derive value from a commodity such as gold. They can be used for purchases, used for loans, converted to another currency, and the like. For example, a cryptocurrency, like a fiat currency, can be used to purchase goods, services, and even portions of companies in the form of stocks and options. Cryptocurrency can also be used for personal loans, bonds, and mortgages similar to fiat currency. And in most cases, conversions can be performed between cryptocurrencies, between fiat currencies, and between cryptocurrencies and fiat currencies.
To illustrate these similarities, let’s first take a look at software for managing each type of currency. Most banks and other financial institutions provide web-based or mobile applications that allow users to view account balances containing fiat currency, transfer fiat currency from one account to another, and transfer fiat currency to another individual or company by way of wire, EFT, and/or ACH. Similarly, software wallets and hardware wallets utilize applications run on desktop or mobile devices that allow users to perform identical actions with respect to cryptocurrency. In this sense, cryptocurrency is very similar to fiat currency held within an account at a bank, credit union, or the like.
Let’s now take a look at a more specific example of sending each type of currency. Sending fiat currency via an online payment solution such as PayPal requires only the recipient’s email address. Similarly, using Bitcoin as an example, only the recipient’s Bitcoin address is needed to send Bitcoin to an individual or business. Both an email address and a Bitcoin address are non-secure pieces of information, and therefore, can be openly shared for the purpose of sending currency.
How is cryptocurrency different from fiat currency?
There are several differences between cryptocurrency and fiat currency. To help focus the discussion, we will cover the following high-level differences: decentralization vs. centralization; transaction verification; and transaction histories.
Decentralization vs. centralization
In general, cryptocurrencies are considered to be decentralized whereas fiat currencies are considered to be centralized. Any disagreement over these characterizations usually stems from a varying definition of the terms "decentralized" and "centralized." To simplify the discussion, the more common definitions will be used which focus on whether or not the funds are passed through a third party.
Fiat currencies are said to be centralized since electronic transmission of funds requires at least one third party. For example, wiring of funds from one person to another involves at least the sender’s bank and recipient’s bank. International wire transfers are even more convoluted as they often involve intermediary banks in addition to the sender’s bank and the recipient’s bank.
In contrast, cryptocurrencies are touted as being decentralized because funds can be sent directly from a sender to a recipient. Although there is some involvement of third parties related to transaction validation and confirmation (collectively referred to as "transaction verification") as discussed below, the funds are still transferred directly from the sender to the recipient. In this sense, cryptocurrencies are peer-to-peer (P2P).
Decentralized currencies are advantageous as they typically result in lower transaction fees (payable to the third party confirming the transaction) and the ability for users to set the fee for each transaction. The transaction times, regardless of the location of the sender and the recipient, are also much lower with cryptocurrencies because of decentralization.
Transaction verification for fiat currencies is typically performed by the bank(s) or financial institution(s) executing the transfer. For example, a sender’s bank will verify that the funds exist in the sender’s account before sending them to the recipient’s bank or financial institution.
On the other hand, most cryptocurrencies delegate transaction verification to users or nodes of the network itself. For example, verifying a Bitcoin transaction is a two-step process involving validation (link: https://bitcoin.org/en/bitcoin-core/features/validation) and confirmation.
After a transaction is initiated by a user, it is broadcast to the network. Each "full node" running a Bitcoin client validates the transaction before relaying it to other nodes on the network. Validation involves determining, for example, whether or not the user has the funds to send and if the recipient is valid.
A valid Bitcoin transaction can then be confirmed by a "miner." Miners are users or nodes of the Bitcoin network who confirm transactions in exchange for the transaction fee as well as a "reward." The reward is a predefined amount of Bitcoin added to the total supply of Bitcoin. Based on the hashcash proof of work (PoW) system, the Bitcoin mining algorithm allows miners to compete to confirm transactions by solving cryptographic puzzles. This requires immense processing resources and energy.
Although it may seem a bit odd to some, the PoW system or algorithm helps to increase security. Attacks are made more costly and less profitable since attackers must compete to confirm fraudulent transactions. And in combination with other security features of the Bitcoin algorithm, fraudulent transactions can be effectively undone or removed to thwart double-spending attacks, 51% attacks, and the like.
Mining is utilized by a number of cryptocurrencies other than Bitcoin. Examples include altcoins such as Ether (often incorrectly referred to as its underlying platform "Ethereum"), Bitcoin Cash, Dash, Litecoin, Monero, Ethereum Classic, Zcash, BitConnect, and Steem.
For cryptocurrencies that do not use mining, the transaction fee is typically the sole compensation for confirming transactions. Examples of non-mineable cryptocurrencies are Ripple, IOTA, NEM, NEO, Qtum, Omisego, Lisk, Stratis, Waves, and EOS.
There is unfortunately a large amount of misinformation related to transaction verification even from seemingly reputable sources. For example, articles and posts about mining often incorrectly use the term "validation" when the author actually means "confirmation." It is also common to completely omit a discussion of validation when covering the topic of verification, which isn’t technically incorrect but can be confusing.
Ledgers for fiat currency accounts are kept and maintained by the bank or financial institution providing the account. The ledgers include every debit and credit for the account as well as provide a balance for the account. The ledger includes or is tied to personal information about the account holder, and therefore, is kept confidential.
Each cryptocurrency utilizes a "blockchain," sometimes referred to as a ledger, that permanently stores records for all transactions ever executed across all users. The blockchain is a series of blocks, and in the case of Bitcoin, each block can hold up to a few thousand transactions.
Copies of the blockchain are distributed across users or nodes of the network and used to validate and confirm transactions. The blockchain is also used, by cryptocurrency wallets, to determine and update account balances for each user.
Blockchains do not store personal information such as names, addresses, phone numbers, social security numbers, or other personal information. Instead, information about each transaction is stored including identifiers of the sender and recipient of the funds. The identifiers are ciphertext and do not inherently identify any person or organization. That said, these identifiers can be tied to personal information in certain situations, thereby reducing anonymity to some extent.
The blockchain is updated with new transactions after they are confirmed. For Bitcoin, miners work to confirm all transactions in a block. Once a block is completed, it is broadcast throughout the network to allow users or nodes to update copies of the blockchain.
Complete copies of the blockchain are not stored on every node in the network. For example, only "full nodes" in the Bitcoin network store complete copies of the blockchain. Since the Bitcoin blockchain is relatively large and growing every day, only systems with larger processing and storage resources are suited to implement full nodes. Other nodes store only partial copies of the blockchain. This offers an improved user experience especially on devices with limited resources such as mobile phones.