How does cryptocurrency work?
Home > How does cryptocurrency work?
Killian Bell
Apr 30, 2023 10 mins read

How does cryptocurrency work?

With Web3 poised to take off and the Metaverse growing ever popular every year, it is becoming increasingly difficult to ignore the immensely valuable cryptocurrency industry. Although it may not be as widespread as early adopters might have hoped it would be by now, it’s hard to deny that digital assets are shaping up to be a staple of the impending online evolution.

In this AAG Academy guide, we’ll explain what cryptocurrency is, how it works, and the different kinds of coins and tokens in use today. We’ll also look at how cryptocurrencies are made, why they are already so popular, and the pros and cons of virtual currencies.

What is cryptocurrency?

Cryptocurrencies are digital coins and tokens that are built on blockchain technology. There are a number of different kinds — which we’ll cover later on — but for the vast majority, their primary function is to serve as a method of payment for the digital age. Unlike traditional currencies, such as the U.S. dollar and the euro, cryptocurrencies are not available in physical form.

One of the biggest advantages of cryptocurrencies is that they provide a fast, inexpensive way to make payments, particularly between different countries. They are also more direct, unlike fiat currencies, which require the input of banks, payment processors, and other “middlemen.” They are also tradable, and a growing number of investors see cryptocurrency as a great opportunity.

In addition, cryptocurrency is accessible to almost anyone with an internet connection. It offers a level of anonymity that traditional payment methods cannot offer, and when it comes to decentralized currencies like Bitcoin and Ethereum, there is complete transparency. Anyone can see how these projects operate and where their tokens are going on the blockchain.

Although adoption of cryptocurrencies isn’t yet widespread, there is hope that that will change in the coming years with the rise of Web3 and the Metaverse, which are built around digital currencies, blockchain technology, and decentralization. It is already an incredibly valuable industry, with Bitcoin alone worth almost $550 billion today.

How does cryptocurrency work?

As we touched on above, cryptocurrency is powered by blockchain technology — a network of computers or nodes that share a distributed database. Every coin and token is essentially a unique piece of data contained in the database, which also keeps a record of every single transaction that has ever taken place.

When a new transaction is carried out, a request is sent to the network and processed by the nodes. They verify that the transaction is valid and ensure that the sender holds the cryptocurrency they are trying to send — preventing “double spending” — and then approve it. Transactions are bundled together into blocks and added to the rest of the chain.

Nodes that validate transactions are rewarded for their efforts, which helps ensure that the network is always active and online. In addition to direct payments, cryptocurrencies can also be used to purchase goods and services, and inside decentralized applications (DApps), which can have a wide range of purposes, from offering loans to providing blockchain-based games.

What are the different types of cryptocurrency?

As we mentioned above, while many cryptocurrencies were created as a form of payment — which are aptly referred to as payment tokens — there are a number of other types that exist today. The following is not an exhaustive list, but these are the most common kinds:

Utility tokens
These are similar to payment tokens, but they are used specifically for blockchain operational services, such as paying fees for transactions or hosting. Utility tokens can also be used inside certain DApps to unlock certain features or provide access to certain perks.

Security tokens
These represent tangible assets, from stocks to real estate, on the blockchain. They are one of the few cryptocurrency types that are backed by something physical. They can be traded just like any other cryptocurrency, but those who hold them share ownership of the underlying asset.

Exchange tokens
Similar to utility tokens, exchange tokens are mostly used to pay transaction fees, and they are issued by centralized exchanges (CEX), such as Binance.

Governance tokens
Governance tokens are used to provide distributed control of a blockchain project. Those who hold them get to vote on project decisions and have a say in its development. They may also provide other benefits, such as a discount on the project’s services.

Stablecoins
These are a unique type of cryptocurrency that, unlike all others, have a value that is pegged to a fiat currency, such as the U.S. dollar. They may also be pegged to other assets like gold. Unlike other cryptocurrencies, the value of stablecoins doesn’t fluctuate that significantly.

Why is cryptocurrency popular?

Cryptocurrency has long been growing in popularity for a number of reasons. It not only offers a fast and affordable way to send payments between different countries, which provides a huge advantage over slow and expensive banking systems, but it also allows users with a level of anonymity that traditional payment methods do not offer.

In addition, most cryptocurrencies are completely decentralized and transparent. They are not governed or regulated by governments like fiat currencies, and anyone can examine their code on the blockchain to find out exactly how they operate. This ensures that things like token supply and distribution are clear and predictable.

Cryptocurrencies are also open to anyone. So long as you have a device that can access the internet, you can buy and trade cryptocurrency without having to prove your identity or where you live. You don’t even need a bank account, though you will need funds to acquire the coins and tokens you wish to purchase initially.

On top of all of this, cryptocurrency is becoming an increasingly appealing and very lucrative investment opportunity for many traders. The cryptocurrency industry as a whole is currently worth over $1.19 trillion as a result of investors pouring their capital into blockchain projects with the belief that they’re only going to get bigger and even more valuable over time.

How are cryptocurrencies made?

They are several primary ways cryptocurrencies are made or “minted.” One of those is with the proof-of-work (PoW) consensus mechanism, which uses “miners” to verify cryptocurrency transactions by solving complex cryptographic puzzles using specialized hardware. As part of this process, new coins are produced and awarded to the miner for their efforts.

Other cryptocurrencies use the proof-of-stake (PoS) consensus mechanism, which relies on token staking as opposed to computing power for significantly greater efficiency. PoS uses validators, which are typically chosen based on the number of tokens that have staked, to verify transactions instead of miners. They are also awarded coins or tokens for their contribution.

Alternatively, some cryptocurrencies are simply “premined,” which means their maximum supply is created as the project is launched on the blockchain. These tokens are usually released or distributed over time rather than all at once, which helps provide a level of scarcity and ensures that the value of the token is not diluted by an excess supply.

What are the most popular cryptocurrencies?

Bitcoin is by far the most popular cryptocurrency in the world with a market value of almost $550 billion as of March 31, 2023. That’s more than double the value of Ethereum, which is the second-most valuable cryptocurrency. Here are the top ten in terms of their market cap:

  1. Bitcoin (BTC) — $549.26 billion
  2. Ethereum (ETH) — $219.19 billion
  3. Tether (USDC) — $79.67 billion
  4. BNB (BNB) — $49.90 billion
  5. USD Coin (USDC) — $32.51 billion
  6. XRP (XRP) — $27.98 billion
  7. Cardano (ADA) — $14 billion
  8. Dogecoin (DOGE) — $10.64 billion
  9. Polygon (MATIC) — $10.14 billion
  10. Solana (SOL) — $8.05 billion

An interesting thing to note is that Dogecoin is the only “meme coin” in the top ten cryptocurrency rankings. It is considered a meme coin because, as you might have guessed, it is based on a popular meme, and it has no real-world use case. It exists solely as a collectable, tradable asset and its value is based purely on speculation.

Pros and cons of cryptocurrency

We’ve covered cryptocurrency’s biggest advantages above in the section on why it has become so popular, but it is important to be aware of the cons and downsides to virtual currencies, too. One of the biggest of which is that cryptocurrency is incredibly volatile — even more so than traditional investment options like stocks, bonds, commodities, and real estate.

Some investors like this because it allows for potentially large gains in a short space of time, but it also makes cryptocurrency a risky investment. You can just as easily lose money as quickly as you can make it, especially if you’re the kind of trader who enjoys short-term tactics. However, that risk can be minimized with a more cautious and longer-term approach.

Another issue with cryptocurrencies is their scalability. Large networks like Bitcoin and Ethereum can be overwhelmed by the sheer number of users, which can lead to hefty fees and lengthy transaction times. “Sidechains” have been developed to help alleviate some of these issues, but they are only going to get worse as cryptocurrency becomes more widespread.

It should also be noted that while cryptocurrencies were designed to be secure, they have not been able to escape a rise in attacks and scams that were created to fool unsuspecting investors into handing over their valuable assets. This means that users should be just as careful with their cryptocurrency as they would be with traditional cash.

References

Frequently Asked Questions

It’s difficult to say what the “best” cryptocurrency is because that’s subjective — it all depends on what you want to use cryptocurrency for, your investment strategy, and more. However, the most popular cryptocurrencies, which include Bitcoin, Ethereum, and Tether, are listed above.

Cryptocurrency can be purchased from a centralized or decentralized exchange, otherwise known as a CEX and DEX, respectively. For more information, see our in-depth guide on how to start trading cryptocurrency.

Cryptocurrency can be an incredibly lucrative investment option, but just like any other, a profit is never guaranteed. It’s important to carry out your research and create a solid trading plan before you put capital into anything.

Cryptocurrency coins and tokens don’t actually leave the blockchain that they exist on, but you can access your “wallet” by using a wallet application. Centralized exchanges provide these for you, but if you want to use a decentralized exchange, you’ll need to set up a decentralized wallet in advance. We recommend the MetaOne wallet from AAG.

MetaOne is the most advanced and most secure digital wallet available today. It is built from the ground up with usability and security in mind, and despite being a decentralized wallet that allows you to use DApps, it does away with complicated and insecure seed phrases used by other DEX wallet options. It also boasts innovative features, like the ability to flag potentially fraudulent apps and services that are likely to try stealing your digital assets and personal data.

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About the author

Killian Bell
Senior content writer
United Kingdom
Senior copywriter for AAG Marketing team with the focus of educating our community on all things web3, blockchain and Metaverse.

Disclaimer

This article is intended to provide generalized information designed to educate a broad segment of the public; it does not give personalized investment, legal, or other business and professional advice. Before taking any action, you should always consult with your own financial, legal, tax, investment, or other professional for advice on matters that affect you and/or your business.

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