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Cryptocurrency Uncovered

Nobody can fail to be aware of Bitcoin – it’s been in the news rather a lot in recent months as the cryptocurrency’s value soared in November and December.  However, if you’re wondering what a cryptocurrency is, then you’ve come to the right place.  Today, we’re going to explain cryptocurrencies and how they work.

Basically, a cryptocurrency is a digital asset that’s designed to work as a medium of exchange that uses cryptography to secure transactions, , to control the creation of additional unites and to verify the transfer of assets.  Cryptocurrencies use decentralised control, as opposed to centralised electronic money and central banking systems.  The decentralised control of each cryptocurrency works through a blockchain (a public transaction database), functioning as a distributed ledger.  The validity of each cryptocurrency is provided by a blockchain – a continuously growing list of records known as blocks (each of which contains a hash pointer linking it to a previous block), which are linked and secured using cryptography.

By design, blockchains are resistant to the modification of the data they contain and is usually managed by a peer-to-peer network, with all members strictly adhering to a protocol for validating new blocks.  Once the data in a block has been recorded, it cannot be altered without the alteration of all subsequent blocks in the chain – an activity which necessitates collusion of the majority of the network.  Transactions take place directly between users – in other words peer-to-peer and they are verified by network nodes.  Special nodes known as miners record transactions to a publicly distributed ledger, the blockchain.   

In cryptocurrency networks, mining is a validation of transactions and successful miners obtain new cryptocurrency as a reward – this decreases transaction fees and creates an incentive to contribute to the processing power of a network.  However, mining for cryptocurrencies is a complex business, requiring the investment of large sums on employing high-performance ASICs (application specific integrated circuits) and the high energy bills to carry out the mining.  Environmental concerns have led to the development of a new generation of “minerless” cryptocurrencies, such as IOTA and RailBlocks which, unlike conventional blockchains, use a “pay-it-forward” system in which each account performs minimally heavy computations on two previous transactions to verify.

When it comes to the legalities, the legal status of cryptocurrencies varies from country to country and in many countries may still be undefined or in the process of change.  Some countries have banned or restricted cryptocurrencies, while others have allowed them to be used and traded. In 2014, the USA Internal Revenue Service (IRS) ruled that bitcoin should be treated as property (as opposed to currency) for tax purposes, rendering it subject to capital gains tax.  Here in the UK, cryptocurrencies are not regulated but they are legal and are treated as a foreign currency for most purposes, including VAT and profits and losses on cryptocurrencies are subject to capital gains tax. 

Since the launch of Bitcoin in 2009, the popularity of online currencies has increased the demand, leading to concerns that such an unregulated, person to person global economy may become a threat to society with the risk that the cryptocurrencies can be used by anonymous web criminals.

Next week, we’ll take a look at some of the more popular and successful cryptocurrencies available now.