Thursday, 20th September 2018
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John Smiles

Qualified Financial Advisor

Cryptocurrencies - how do they work?

Most crypto-currencies are designed to work as a medium of exchange; using cryptography to conduct transactions, control the creation of additional units, and verify the transfer of assets.

In the case of Bitcoin, and most other cryptocurrencies, no central authority or server verifies transactions. Instead, the legitimacy of a payment is determined by Bitcoin 'miners' - a decentralized network of computers, which race to confirm transactions by solving a mathematical puzzle, thereby earning a reward in new Bitcoins.

This puzzle becomes steadily harder to solve, thereby limiting the supply of new coins.

The Bitcoin network collects all of the transactions made during a set period into a list, called a block, and writes them into a general ledger.

Each time a block is 'completed', it gives way to the next block in the 'Blockchain'. A block is thus a permanent store of records which, once written, cannot be altered or removed.

While the majority of cryptocurrencies are little more than Bitcoin clones, the most popular alternatives have their own unique features.

As the original cryptocurrency, Bitcoin offers users the most liquidity and significant network effects. It also has brand name recognition around the world, with an eight-year track record. However, it has a number of drawbacks in its design.

Developers have attempted to boost the attractions of rival currencies by attempting to address these flaws.

Litecoin, for instance, claims to offer a more effective way of conducting transactions since payments take just over two minutes to go through, compared with an average of around five hours for Bitcoin.

Ripple markets itself as a cross-border payments solution for large financial institutions, with its main aim to lower the cost of high-volume but low-value transactions.

Cardano claims to be the only coin with a "scientific philosophy and research-driven approach".

In reality, that means its open-source Blockchain undergoes a rigorous peer-review process by scientists and programmers in academia, with the aim being to reduce the risk of scandals and hacks that have plagued Bitcoin.

As for Ethereum, although the structure of its Blockchain is similar to that of Bitcoin, by switching to a different model of verification the goal is to use far less energy to carry out transactions.

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