Digital currencies have become a global phenomenon and have gained immense popularity all around the world.
Virtual currencies are ardently supported by some, feared by others, while the rest just don’t understand how they work or what makes them so special. Even bankers, economists and developers find it difficult to explain cryptocurrencies in common, layman terms.
Here, we will try to explain what cryptocurrencies are and what makes them so special.
What are Cryptocurrencies
Broken down to its simplest definition, cryptocurrencies are nothing but a record of entries in an electronic ledger that cannot be changed without meeting specific conditions.
Think of your bank account. When you deposit money into an account, the banker doesn’t actually put the money in a locker for you to take out when you need it in the future. They simply make an entry in their records of your deposit.
This entry-based system allows you to use your debit card anywhere for making a purchase. You can use the EFT system to buy from the local retailer, make a purchase online or take physical cash out of an ATM. Every time you make a purchase, the vendor sends a query to your bank on whether you have the required amount in your account. Once the bank confirms the amount, your order is approved.
Cryptocurrencies are similar with some key differences. When you use cryptocurrencies to make a transaction, the query is sent to a P2P network of ledger holders instead of a single bank. These ledger holders (called miners) use powerful computers to solve a complex algorithm that authenticates your transaction.
Once a transaction is confirmed it becomes part of the blockchain, a digital ledger that maintains a record of every transaction ever made in the digital currency.
The Role of Miners
Miners play an important role in maintaining the ecosystem. They hold copies of the blockchain ledger and confirm new entries into the system. After an entry is confirmed, all the miners update their own ledgers to ensure consistency.
To keep the system operational, miners get rewarded with a transaction fees for authenticating the entry. Miners are also responsible for generating and adding new coins into the system.
Decentralized Nature of Cryptocurrencies
No central banks or governments are involved in regulating the supply of cryptocurrencies and they are completely decentralized.
This can be a good thing or bad depending on how you look at it.
Fiat currencies are under the control of governments. As new money is printed it increases the money supply and puts pressure inflationary pressure on the currency causing a devaluation of its purchasing power.
This makes regular fiat currencies a bad investment option for the long-term.
What makes digital currencies, like Bitcoin, a good thing is that they have a limited supply. New coins are issued at regular intervals and the total supply of Bitcoin will be maxed at 21 million BTC.
This means that once the last of these coins have been issued, no further coins will be created. If the demand continues to rise after that point, the price can only go up. Long-term investors see that as a good proposition and buy the coin as an investment to hold rather than a medium of exchange.
That is the primary reason why we have seen a huge spike in the price of Bitcoin since the beginning of 2017.
The bad thing about being decentralized is that no regulatory authority can step in to stabilize the currency. If the U.S. dollar suddenly lost its value today, the Federal Reserve would step in to control the money supply and keep prices stable.
When digital currencies lose demand in the market due to panic or bad news, the prices take a greater hit. This makes digital currencies very volatile, which is not good for their wider adoption.
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