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January 28, 2019

A Cryptocurrency Primer

Every day, my newsfeed is full of stories about cryptocurrency, blockchain, and distributed ledger technology. I even see stories on how we can create our own digital currency, a notion that conjures up for me visions of my face on a coin, just like suffragette Susan B. Anthony. Could my own digital currency, known hereafter as the NEDNote, become a reality? My husband is a software engineer, so the technical piece is covered, but maybe offering a primer on the history of cryptocurrency and its confusing and rapidly changing nomenclature is the best place to start before I launch the NEDNote into the cryptographic biosphere.

The concept of virtual currency as a substitute for fiat currency dates back to the 1980s, with David Chaum being credited with introducing digital cash. (Fiat currency, often referred to in cryptocurrency discussions, is legal tender backed by a government or central bank.) Although early attempts at virtual currencies were made in the late ’90s, the anonymous white paper published in 2009 under the pseudonym Satoshi Nakamoto is credited for creating the first decentralized cryptocurrency, Bitcoin, and the blockchain database. And with that paper, a new lexicon began to emerge, some of which I define here.

  • Cryptocurrency, short for cryptographic currency, is a subset of digital currency.
  • Cryptography in the cryptocurrency world refers to the algorithms that encrypt data for transmission. In the analog world, think how the Navajo language was used to transmit secure messages during World War II.
  • Distributed ledger technology (DLT) refers to the infrastructure that allows a repeated digital copy of data to be available at multiple locations. With DLT, transactions take place over a peer-to-peer network, and do not require the use of a central administrator to govern or validate the transaction, but rather employ consensus algorithms to replicate the data across locations.
  • Blockchain is a type of DLT that organizes records in blocks, which are then linked with cryptographic hashes to create the chain. Each block consists of these hashes, data, and a unique timestamp. Because no trusted source or authority exists for the blockchain, it is necessary that data somehow be validated before anything can be added.
  • Validation protocols include “proof-of-work” and “proof-of-stake,” the two primary methods of validating transactions on a blockchain.
    • Proof-of-work involves mining and timestamping, which are key validation computations. Mining both validates transactions and obtains new cryptocurrency. The mathematical calculations performed in the mining process build the hash function that links the block to the chain. Miners are rewarded with new cryptocurrency for their contributions to the validation process. Timestamping tracks historical changes made to the data contained in the block.
    • Proof-of-stake employs a consensus method to determine ownership of the cryptocurrency. This method requires less computing power to complete than does proof-of-work validation but does not reward miners with new currency.
  • A crypto wallet provider is a cryptocurrency storage service that is online (hot wallet) or offline (cold storage). Hot wallets are connected to the internet and are frequently hosted by an online exchange platform. Cold storage, which is not connected to the internet, is viewed as more secure.

For many years, my husband allowed the SETI Institute to harness the excess processing power of our home computers in the search for extraterrestrial intelligence, when we could have been mining for cryptocurrency and making the NEDNote a reality. In my next post, I’ll talk about how cryptocurrencies are exchanged and some of the associated risks.

Photo of Nancy-Donahue  By Nancy Donahue, project manager in the Retail Payments Risk Forum  at the Atlanta Fed