By: Steven Hay | Last updated: 4/24/20

Cryptocurrencies are the latest evolution of digital money. But what exactly is a cryptocurrency and what are its characteristics? This post explains it all, simply.

Cryptocurrencies are digital coins that arent controlled by a central authority but through a network of equally privileged participants that follow an agreed set of rules. The three ingredients that make a cryptocurrency are: A peer-to-peer (p2p) network, cryptography, and a consensus mechanism.

Thats the definition of a cryptocurrency in a nutshell. For a more detailed definition keep on reading, heres what Ill cover:

The term cryptocurrency is a contraction of cryptographic currency. While a cryptocurrency is a form of digital currency, there are many digital currencies today that arent cryptocurrencies.

For example PayPal, Zynga chip and even our traditional fiat currencies (USD, EUR, etc.) are mostly digital.

In March 2018, Merriam-Webster announced that they would include this term in their dictionary. Their definition is as follows:

cryptocurrency noun cryptocurrency krip-t-kr-n(t)-s , -k-rn(t)-s : any form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units, and that relies on cryptography to prevent counterfeiting and fraudulent transactions. First Known Use: 1990

Lets try to break this confusing sentence down to the 3 main ingredients that constitute a cryptocurrency.

Unlike traditional digital currencies, cryptocurrencies dont rely on any central authority to validate or facilitate transactions.

Instead, theres a network of equally privileged participants that validate and update transactions in a shared ledger called a blockchain.

Cryptography is the art of secure communication in a hostile environment. Cryptography is used in cryptocurrencies so peers can communicate securely without the need of a central authority to validate their messages.

Now that we have a group of equally privileged participants that can communicate securely, we need to establish rules for our cryptocurrency. These rules are known as a protocol and they also include a consensus mechanism.

The consensus mechanism is a rule regarding who gets to update our shared ledger of transactions. In Bitcoins case, the mechanism used is called Proof of Work. Different cryptocurrencies use different consensus mechanisms.

If we visit Websters definition again after understanding these core ingredients, you can see that it makes much more sense.

While all cryptocurrencies claim to be decentralized, the truth is far from it. In reality, you have completely decentralized currencies like Bitcoin and centralized cryptocurrencies like stablecoins and Ripple.

Centralized cryptocurrencies are usually issued by a for-profit company that established the cryptocurrencys protocol and also determines who can participate in the network.

A good example would be the upcoming Facebook Libra a coin to be issued by Facebook, that while all participants in the network are equal, the network itself isnt open to everyone.

Centralized cryptocurrencies can be looked upon as an upgraded version of traditional fiat currencies, as they are still prone to all of the risks of centralized management (fraud, negligence, control).

Decentralized cryptocurrencies are usually issued by a non-profit organization. With decentralized cryptocurrencies, the playing grounds are leveled for all to participate.

The classic example for this would be Bitcoin. Anyone in the world can participate in the Bitcoin network, receive funds or become a Bitcoin miner, without the need to request permission.

Truly decentralized cryptocurrencies are completely transparent, open to all and censorship resistant.

Its important to note that while some cryptocurrencies are indeed built as decentralized, they are in fact centralized since not enough people are participating in their network. This makes the decentralized platform effectively controlled by a small number of participants.

The main takeaway here is that true decentralization is a matter of both design and adoption.

One important distinction that needs to be made is the difference between cryptocurrencies and tokens.

Cryptocurrencies are coins that have all of the three ingredients Ive mentioned above, hence creating their own blockchain of transactions.

Token, on the other hand, are a representation of an asset that resides on an already existing blockchain. For example, Tether is an ERC-20 token that uses the Ethereum blockchain to operate.

So tokens can be considered as a sub coin of a certain cryptocurrency that has its own blockchain and has the ability to run code that creates tokens (also known as the ability for smart contracts).

Tokens can start as part of an already existing blockchain and then convert to their own cryptocurrency. For example, EOS started as an ERC-20 token and later on became an independent cryptocurrency.

Tokens can be divided into two main categories utility tokens and security tokens.

Utility tokens are tokens that promise the future use of a product or service. They arent meant to be an investment, they have a utility.

Security tokens, on the other hand, are tokens that represent tradable financial assets, a share or a bond from a company, for example. They are meant to be a form of investment.

Cryptocurrencies use blockchains in order to operate in a decentralized manner. Cryptocurrency is the coin and blockchain is the ledger of transactions that documents the coins transactions.

Another way to describe this is that blockchain is the technology behind cryptocurrencies.

Having said that, a blockchain is, in fact, the cryptocurrency itself as cryptocurrencies are just a record on a ledger (theres no actual physical coin). But for the sake of distinction, people use cryptocurrency to describe the end and blockchain to describe the means to that end.

Cryptocurrencies are the next evolution in digital currencies. Money has come a long way from commodities to coins, paper and finally digital information controlled by a central authority. Today, in its next phase of evolution, money is becoming decentralized through the use of cryptocurrencies.

Its important to distinguish between centralized cryptocurrencies, decentralized cryptocurrencies, and tokens. Hopefully, this guide made the difference clearer.

What are your thoughts about cryptocurrencies? Are they indeed the future of money? Let me know in the comment section below.

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