What is cryptocurrency and how does it work?

One of the biggest reasons preventing businesses from accepting cryptocurrency payments is because many people don’t understand it. A recent survey revealed that 31.18% of millennials, a relatively digitally savvy generation, found cryptocurrency too complicated.

To help demystify digital currency, we take an in-depth look at what cryptocurrency is, how it works and things to consider if your business is thinking about accepting it as a form of payment.

What is cryptocurrency?

Cryptocurrency is a decentralised digital currency that uses encryption techniques to control the creation of new units and confirm transactions. These techniques allow cryptocurrency to be created and traded securely, without the need for a central bank or government.

Prominent cryptocurrency researcher Jan Lansky proposed that digital currency must meet six requirements to qualify as cryptocurrency:

• It must be decentralised or independent from the government and central banks.

• A ledger must be kept that provides an overview of available cryptocurrency units as well as who owns each unit.

• The system must have a process for determining if new cryptocurrency units can be created as well as their origin and methods of distribution.

• Cryptocurrency ownership must be verifiable through cryptography.

• Transactions must be available that allow cryptocurrency ownership to be transferred from one individual to another. Current ownership must be proven before any transaction can occur.

• When simultaneously presented with two different instructions for changing the ownership of the same digital currency, the system must be able to only perform one transaction.

A brief history of cryptocurrency

While cryptocurrency has recently received widespread media attention, it has existed, at least in concept, since the 1980s. During the 1980s and 1990s, several digital currency systems, such as B-Money, DigiCash and BitGold, were put forward but never proceeded past the initial stages of development.

In 2008, pseudonymous developer Satoshi Nakamoto (whose real identity remains unknown) released a whitepaper titled Bitcoin: A Peer-to-Peer Electronic Cash System. It explains the framework and feasibility of Bitcoin, the world’s first completely decentralised cryptocurrency.  

In 2011, following Bitcoin’s increase in popularity and the public’s acceptance of the concept of decentralised digital currencies, other cryptocurrencies emerged.

Since 2011, the number of available cryptocurrency types has exponentially grown and today, more than 1,000 cryptocurrencies are in circulation. However, only a few of them have been successful. On today’s crypto-market, Bitcoin (2009), Ripple (2012) and Ethereum (2015) rank as dominant cryptocurrencies.

How does cryptocurrency work?

Cryptocurrency is relatively similar to other types of payment methods that are processed electronically, such as PayPal or debit cards. The cryptocurrency system uses a blockchain to create digital currency, at a specific controlled rate, and to track transactions.

Digital currency can then be transferred from one account, or digital wallet, to another account to purchase goods or services from companies such as yours.

Unlike fiat currency (pound sterling, US dollars, etc), cryptocurrency is decentralised, which means it’s not regulated and monitored by one central authority such as a bank or government. Instead, the system and users collectively regulate and control the ledger.

While anyone can view and access the ledger, the identities of individuals are encrypted by pseudo anonymous or unique sets of keys. These unique sets of keys connect the individual to an account and to the cryptocurrency in the account.

Cryptocurrency key terms

Perhaps one of the biggest challenges when it comes to understanding cryptocurrency is the unique terminology. Terms such as blockchain, proof-of-work scheme, cryptocurrency mining and digital wallets can seem confusing to newbies. We’ve broken it down for you below:

Blockchain

A decentralised public ledger of records (known as blocks) which are protected and linked via cryptography or encryption. Blockchains are extremely secure as once information is entered into them it cannot be changed.

This level of security lends itself well to a range of applications such as smart contracts and cryptocurrency. Within the latter, blockchains are managed by peer-to-peer networks and used to securely record financial transactions.

Timestamping

Cryptocurrency systems use timestamps to confirm the validity of transactions. Most cryptocurrencies, such as Bitcoin, use a proof-of-work scheme that employs SHA-256 and scrypt (or password-based keys) to create timestamps.

Cryptocurrency mining

Transactions are verified and added to the blockchain through the process of cryptocurrency mining. When a transaction is made, miners must solve complex mathematical codes to obtain the required hash function. These hash functions are essential for confirming the transactions and adding them to the previous block within the blockchain.

As the successful miner is rewarded with cryptocurrency, mining is very competitive and some people even make a living doing it. However, miners must invest in highly advanced computers as your average computer is too slow to successfully compete.

The popularity of cryptocurrency, especially Bitcoin, has made mining very competitive and thus nearly impossible to make an income.

Should your business start accepting cryptocurrency?

Cryptocurrency has recently received widespread popularity for its soaring prices, which have made some people very wealthy. As cryptocurrency has become more mainstream, businesses are increasingly considering if they should jump on the crypto bandwagon.

While it may seem like a good idea to accept cryptocurrency, is it a sensible business decision? Well, it depends on who you ask…

Why your business shouldn’t accept cryptocurrency

While prices have certainly soared, businesses must also be prepared for the bubble to burst. The crypto market is extremely volatile and fake news stories can drastically alter cryptocurrency prices. In 2017, when Ethereum’s founder was incorrectly reported dead, $4bn (£3bn) was instantly wiped off Ethereum’s market. Similarly, fake tweets from well-known figures promoting a certain cryptocurrency can send prices sky-high.

The extreme volatility and sensitivity of the crypto market caused many business owners to waver over the decision. Well-known brands such as Microsoft and Steam have stopped accepting cryptocurrency due to market volatility, while others such as WatchBox and Overstock.com have continued to hang on.

Companies that decide to press ahead are recommended to translate cryptocurrency into fiat currency as quickly as possible. This can be achieved with merchant service companies such as BitPay or Coinbase. Otherwise, you’re essentially gambling with your revenue.

You should also consider how cryptocurrency may affect your reputation. Due to the anonymity it provides and lack of regulation, cryptocurrency is sometimes used for black market purposes.

One study conducted by Oxford Law found that 25% of Bitcoin users and 44% of transactions are associated with illegal activities. It also reported that Bitcoin is used for approximately $72bn (£54bn) of illegal activity each year, which is similar to the estimated profits of the American and European illegal drug trade.

As a result, many countries are now implementing stricter cryptocurrency regulations. While some countries promote the use of cryptocurrency, most have regulations on how it can be used.

China has some of the strictest regulations, having banned ICOs (initial coin offerings), frozen bank accounts associated with cryptocurrency exchanges, banished cryptocurrency miners, and prevented citizens from accessing anything related to cryptocurrency online.

The threat of new regulations certainly creates many unknowns and business owners who decide to accept cryptocurrency should be prepared to change their policies to adapt to changes in the law.

Why your business should accept cryptocurrency

On the other hand, by not accepting cryptocurrency, you might miss out on the opportunity to attract cryptocurrency users.

Plus, as cryptocurrency funds don’t need to be transferred into a local currency, you won’t need to pay high fees to trade with customers located overseas. According to Business News Daily, cryptocurrency allowed one company to sell $300,000 (£226,425) of merchandise to customers in more than 40 countries.

The global economy is undoubtedly becoming more contactless as very few people carry any hard currency and almost everywhere accepts card payments. By 2026, it’s predicted that in the UK cash will be used in only 21% of transactions. It could be argued that accepting cryptocurrency is just the next natural step towards becoming a more digital business.

It certainly offers some advantages for businesses over traditional economies. For example, due to its use of blockchain technology, cryptocurrency is more secure than traditional transactions and offers greater protection against fraud and identity theft.

It also isn’t regulated by the government. As such, cryptocurrency can offer businesses lower transactions fees, offer an easy way to pay international staff or accept global payments, and ultimately increased sales.

Ready to get started?

Accepting cryptocurrency is not a decision that should be taken lightly. While it could pay off for your business, you may also be taking a relatively large risk. It’s worth taking the time to see whether cryptocurrency is worth using now.

If it’s not the right time, keep an eye on developments as cryptocurrency could be a key part of your business strategy in the future.