CRYPTOCURRENCIES EXPLAINED: WHAT THEY ARE AND HOW THEY WORK

Understanding Cryptocurrencies

Cryptocurrencies are a form of digital or virtual currency that rely on cryptographic technologies to secure transactions and control the creation of new units. Unlike traditional currencies issued by central banks, cryptocurrencies are decentralised and typically operate on peer-to-peer networks using blockchain technology—an immutable distributed ledger that records and verifies transactions.

The first and most well-known cryptocurrency is Bitcoin, created in 2009 by an anonymous individual or group using the pseudonym Satoshi Nakamoto. Since then, thousands of cryptocurrencies have emerged, each with varying use cases, governance models, and underlying technologies.

Cryptocurrencies are primarily used as:

• Mediums of exchange: To buy goods and services without intermediaries like banks.
• Stores of value: Similar to gold, offering a hedge against inflation and currency manipulation.
• Units of account: Enabling users to price goods and services denominated in crypto assets.

Cryptocurrencies differ significantly from fiat currencies in several ways. They are not universally regulated, they rely on user consensus for validation, and often have fixed supply limits coded into their protocols, making them deflationary by design.

Beyond currency functionality, many cryptocurrencies offer additional features. For example, Ethereum enables programmable contracts via smart contracts, which allow for automated and trustless transactions across a wide range of applications, including decentralised finance (DeFi), gaming, and digital identity.

In summary, cryptocurrencies are reshaping the global financial ecosystem by offering alternative means of conducting transactions, storing value, and creating decentralised applications—all without reliance on central authorities or institutions.

How Cryptocurrencies Work

To understand how cryptocurrencies function, it's important to grasp the underlying technologies and mechanisms that enable their operation. Central to most cryptocurrencies is blockchain technology, a decentralised ledger maintained by a distributed network of computers known as nodes.

In this system, every transaction is recorded in a digital "block". These blocks are cryptographically linked to form a chronological "chain", ensuring that once data is stored, it cannot be altered without modifying all subsequent blocks—a practically infeasible task given the network's consensus rules.

Key Components of Cryptocurrencies

• Blockchain: Serves as the shared ledger that records all cryptocurrency transactions in a secure and tamper-proof manner.
• Cryptography: Secure mathematical techniques are used to protect transaction data and user identities, enabling secure peer-to-peer transfers.
• Decentralised Consensus: Network participants must agree on the validity of transactions through protocols like Proof of Work (PoW) or Proof of Stake (PoS).
• Wallets: Software or hardware tools that enable users to store and manage their cryptographic keys, allowing them to send and receive digital currencies.

Transaction Flow

When a cryptocurrency transaction occurs, it is broadcast to the network, where nodes validate it based on consensus algorithms. In Bitcoin’s case, miners compete to solve complex mathematical puzzles to validate blocks of transactions—a process known as mining. The first to solve the puzzle gets to add the block to the chain and receives a reward, which also serves as the method by which new coins are introduced into circulation.

Other consensus mechanisms, such as Proof of Stake (used by Ethereum 2.0 and Cardano), rely on validators who “stake” their coins to propose and verify new blocks based on the amount staked and other algorithmic criteria, consuming significantly less energy than PoW.

Smart Contracts and Tokenisation

Ethereum introduced the concept of smart contracts—self-executing agreements with terms directly written into code. These enable complex financial operations like lending, trading, and insurance without the need for a central intermediary.

Additionally, cryptocurrencies can support tokenisation, where real-world assets—such as property, art, and stocks—are represented on a blockchain as digital tokens, paving the way for fractional ownership and increased liquidity.

This robust framework provides a comprehensive, self-sustaining mechanism for verifying and recording digital transactions in a decentralised way—fundamentally redefining notions of trust, value, and interoperability in the digital era.

Problems Cryptocurrencies Aim to Solve

One of the most compelling aspects of cryptocurrencies is their potential to remedy long-standing issues within traditional financial systems. From inefficiencies in cross-border payments to lack of financial inclusion, cryptocurrencies offer innovations designed to enhance transparency, security, and autonomy.

1. Centralisation of Financial Power

Traditional financial systems are heavily centralised, relying on banks and intermediaries that control access to capital. This centralisation can lead to high transaction fees, limited accessibility, and susceptibility to censorship or corruption. Cryptocurrencies decentralise control, enabling peer-to-peer transactions that don't require a central authority, reducing the risk of single points of failure and enhancing individual financial sovereignty.

2. High Transaction Costs and Slow Settlement

International wire transfers and remittances often involve multiple intermediaries, resulting in high fees and multi-day settlement times. Cryptocurrencies facilitate instant, low-cost transactions across borders, particularly through layer-2 solutions and blockchain networks with high throughput capabilities. This efficiency can have serious implications for global remittances, which are a lifeline for many in developing countries.

3. Financial Exclusion

Over 1.4 billion people globally remain unbanked due to geographical, regulatory, or infrastructural barriers. Cryptocurrencies only require a smartphone and internet connection, offering marginalised populations access to capital, savings, and even credit via decentralised finance platforms. By removing traditional gatekeepers, cryptocurrencies make financial services more inclusive and globally accessible.

4. Lack of Transparency and Auditability

Conventional financial systems often lack transparency, making it difficult to trace fund flows or verify transactions. Cryptocurrency blockchains are inherently transparent, with public ledgers that allow real-time auditing and immutable record-keeping. This feature supports anti-fraud mechanisms and supports corporate governance through traceable payment trails.

5. Currency Instability and Inflation

Residents of countries with unstable fiat currencies often lose purchasing power due to inflation or currency debasement. Cryptocurrencies like Bitcoin have limited supplies (21 million coins), making them attractive stores of value in regions where local currencies are volatile.

6. Arbitrary Censorship

Governments and institutions can freeze accounts or block payments with little explanation. In contrast, cryptocurrency networks provide censorship-resistant payment systems. Bitcoin, for instance, cannot be arbitrarily halted or reversed once a transaction is confirmed—offering a level of financial freedom many find liberating.

In conclusion, cryptocurrencies aim to create a more inclusive, efficient, and decentralised financial ecosystem. While challenges such as regulatory uncertainty and technological scalability remain, the problems they strive to solve are deeply rooted in legacy systems—making their continued evolution both significant and noteworthy.