Digital money: How do cryptocurrencies work?

Digital money: How do cryptocurrencies work?

In 2009, the first digital coins were created – called Bitcoins. Since then, other new cryptocurrencies followed, which received more and more attention thanks to adventurous price developments. Today, nearly 2,000 different currencies are in circulation. We explain how the system behind works.

Summer 2007: A speculative bloated real estate market triggers a global banking and financial crisis. At least now, people have completely lost confidence in the financial sector. They want a currency system that works independently of state and banks.

Only a year later, an unknown person or group of people under the pseudonym Satoshi Nakamato lays the foundation for this: the document about the idea of ​​a digital currency suddenly pops up on the internet – it explains a payment system that works from person to person, without a bank is interposed (peer-to-peer). The name of the first digital currency: Bitcoin.

But how exactly does the internet currency work? In contrast to the euro, which changes its owner in  form of printed bills, in principle everyone can create a digital file (so-called mining) and trade it on the internet. The virtual money is kept in an electronic wallet. To manage all of the digital money assets, you need an online account that everyone can set up with a pseudonym. Once registered, the network user receives two keys: A public key that allows the system to verify transactions. That means: If the Bitcoins really belong the one who sends them from A to B. A private key signs and saves the operation – preventing changes of the transactions. The payment system is based on a special web-based and decentralized database called blockchain, which is managed by the participants themselves.

Dig or buy: How to get cryptocurrency

But how do you get digital coins? Theoretically there is the possibility, e.g. to generate Bitcoins by yourself. This requires a computer that solves highly complex mathematical equations. The problem: The computer would now have to provide an extremely high and energy-intensive computing power, so that it would be no longer economical for currencies such as Bitcoin to create the coins this way.

A more effective way to mine coins are the so-called mining pools which are offered by specialized service providers. Here, several participants can unite by summarizing computing power. These are made available to the service provider, who then generates the common cryptocurrency. The profit will be shared later among the pool participants.

In addition to “digging” you can buy digital currencies on special stock exchanges. For this you need ‘real’ money such as euros or US dollars, often called fiat money among crypto experts. As well you have to sign up here – but with your real name. This serves to combat money laundering. Though anonymity is no longer guaranteed, but it’s the only way to transfer real money from a bank account to an exchange. Once you have made a purchase, the digital money can be transferred to the wallet. Best known exchanges are Kraken, Anycoindirekt, Poloniex or Bitcoin.de.

If you want to take an easier way or remain anonymous, you can alternatively change your fiat money at special exchange machines. So far, these machines are only available in some major cities for the currencies Bitcoin and Ethereum.

Alternative currencies

 Even if Bitcoin is currently the best-known internet currency, strong price gains attracted more and more investors for new payment systems. Today there are 1,629 cryptocurrencies (stand of: 06/15/2018, source: coinmarketcap.com). The most well-known alternatives beside Bitcoin are Ethereum, Ripple and Litecoin – a small overview:

1. Ethereum:

  •      After Bitcoin the second most used cryptocurrency worldwide
  •      Actual name of the currency: ether
  •      Price: about 505 US dollar
  •      Ethereum was originally developed as a platform that executes smart contracts
 2. Ripple:
  •      Originally planned as a network (similar to Ethereum)
  •      The principle consists of the verification of promissory notes
  •      No mining possible, output via a digital bank
  •      Restriction 100 billion
  •      Price: about 0.5 US dollar
 3. Litecoin:
  •      Price: about 98 US dollar
  •      Similar network as Bitcoin
  •      Difference: Faster transaction rate (2.5 minutes intervals, Bitcoin every 10 minutes) 
  •      More security, higher power consumption
The money supply of each cryptocurrency is usually predetermined – for example, the upper limit of Bitcoins is 21 million units. While it’s theoretically possible to reprint real banknotes without limits, that’s impossible with digital money. The advantage: the currency is safe from inflation. The value of a cryptocurrency arises – as in real financial life – from supply and demand. With higher demand, the value of the currency increases and vice versa. Neither a government nor other currencies can influence the price.

How legal are cryptocurrencies?

The majority of states accept the use of cryptocurrencies. Exceptions are Bangladesh, Ecuador, Bolivia and Kyrgyzstan. Germany sees digital currency as “private money” that can be used for trading.
Estonia even intends to issue its own state cryptocurrency. The so-called Estcoins could be managed directly by the republic. Unlike Bitcoin, this currency would be tied to a central bank. In order for the rest of the world to gain access to the currency, an Initial Coin Offering (ICO) will be introduced to make the exchange for funds possible. Digital currencies are actually bypassing the influence of state and banks, Estcoin could be the first counter-move to an independent payment method. 

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