This a repost of an old explainer from the original Bitfalls website back in 2017. Some references may be slightly outdated, but the explanation is still very much on point.
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You've heard of Ethereum, Bitcoin, maybe even Tezos, Zcash, Onecoin or Dash? In this introductory post, we'll briefly introduce you to the concept of cryptocurrencies in a way that should be understandable to everyone, even those not computer savvy. First, let's take a look at money's history.
Feel free to skip this part if you're not interested in why cryptocurrencies came about.
Long ago, people used goods to trade for other goods. An ox could, for example, be worth three chunks of cheese.
This exchange worked well, because both sides of the transaction benefitted from it directly. The cheese recipient got food with which his family was fed, and the new owner of the ox got some good farming muscle and a decent barbecue for when that muscle grows weak.
Eventually a situation arose in which one party really wanted what the other had, but had no goods the other party desired. Luckily, precious metals were already widespread and could be used to signify debts.
"I'll give you this chunk of rare gold, worn only be the noblest of kings, if you give me twelve wagons of cheese."
In time, banks appeared. They offered safe-keeping services for the gold. Rather than carry around a heavy bit of metal, a gold owner now had a piece of paper that said "Yes, this person really has 15g of gold in our vaults. Sincerely, the Bank."
That paper was then given to other people as payment who, in turn, could exchange it back for gold in that very same bank whenever they wanted. Hence, paper currency was born.
This approach gave birth to the "gold standard" via which a given nation's currency was bound to a particular precious metal – most commonly gold. The government took everyone's gold under threat of persecution, and gave everyone who presented their gold paper IOU-s for the same value – official paper currency. Back then, this currency was backed directly with the country's gold reserves, so the inflation levels were kept at a minimum because gold supplies rose steadily, but slower and slower. People lived within their means because they literally couldn't spend more money than they had.
But as the population exploded and the economy stagnated during the Great Depression in the 1930s, Franklin Roosevelt decided to cut the dollar-gold tie, effectively abolishing the gold standard in order to print new money without gold backing, infuse it into society, and kickstart the economy. Most economists today agree that this was necessary to escape the Depression, but this caused other problems in the long run.
First, printing new money kickstarted the inflation as well – as new currency was printed into the society, its value diminished. This new currency was not backed by anything else than the citizens' faith into their government. Furthermore, it was perfectly fine to still exchange the dollar for a matching value of government gold up until 1971, which meant that these un-backed "empty" dollars were being used by cash-heavy people to drain the country's gold reserves.
With the dawn of the computer age, this creating of unbacked money became even simpler – all it took was clicking a button in the software UI of a government bank and new money flowed into an account. Paper, which at this point was being used less and less, didn't even need to be printed in significant amounts. This digital "click-created" money is the money we all use when paying via credit card, PayPal, etc.
Currency like this is called fiat currency from the latin "Let it become". This money has no backing, no intrinsic value beyond the one the government told us it had. In other words, we value the money we have in our wallets because the institution we live under commanded us to value it. Today's money is completely and fully centralized and government controlled.
Cryptocurrency appeared as an answer to this problem.
Cryptocurrencies are unique digital tokens (digital coins) which cannot be copied or produced at will, and which serve a specific purpose when sent from one address to another.
"Hold on", you may be thinking. "That sounds an awful lot like the above example of digital fiat, or even coins in mobile or Facebook games which I can win or buy for real money in order to get an advantage in the game!"
The key difference is this part: cannot be copied or produced at will. The coins in a game are a digital currency, and differ from cryptocurrency in the following ways:
So… it's all just software?
Pretty much.
Just like there's an app on your phone or computer for browsing the web, looking at email, or playing some games, so too is a cryptocurrency no more than software. The difference is in the word crypto which, when translated into non-tech, means that these coins cannot be duplicated or falsified.
Cryptocurrency is not falsifiable
Whereas other applications, digital documents, even a bank account's status can be copied and moved to another location without deleting the original, with cryptocurrencies this is impossible because of a thing called the blockchain. The blockchain deserves its own post – we recommend you dive into it immediately after this one to learn how exactly this security is guaranteed into perpetuity.
It's important to note that cryptocurrency is not currency per-se.
The definition of the word "protocol" is "a set of rules defining the exchange of information between endpoints". To make the following paragraph easier to understand, let's draw an unconventional and dumbed down parallel: we all use the water supply network. The process of sending water from one place to another entails pushing it in at one end and getting it out at the other. This system of exchange is a "protocol" for sending water where the unit of transfer is a cubic foot of water, while the medium of transfer is a pipe.
Bitcoin and Ethereum are protocols. They are ways of transferring data from one electronic location to another. Each protocol has its own data type we send (cubic feet in the case of water). In the world of cryptocurrency, that's called a token. The Bitcoin protocol has a token called Bitcoin, or 1 BTC. The Ethereum protocol has a token called Ether, or 1 Eth.
Cryptocurrency is therefore the token of a given protocol, software, a set of data we send from one location to another in a way which forces us to let every other participant in that protocol know about our transaction. When we send a token from one electronic address (i.e. wallet) to another, we publicly acknowledge our transaction and everyone witnesses and confirms it.
A cryptocurrency transaction is no more than a publicly announced and verifiable statement that we're sending an arbitrary amount of tokens of a given protocol to a user of said protocol.
The tokens we send have no value on their own. Their value was bestowed upon them by us, the users. In the case of the aforementioned "water protocol", water on its own has no value. But once we realized we can drink it, cook with it, wash with it, even generate power with it, we attached value to it.
Cryptocurrency has a value because we decided that it does, and not a central authority
Just like the world can collectively decide that gold is no longer worth anything overnight (by ceasing all buying of the precious metal everywhere), so too can the users of a protocol make a cryptocurrency jump or drop in value. That's exactly what happens when we witness the Bitcoin price jumps. Here's a graph of Bitcoin price in USD from 2010 to 2017:
While the price is indeed dictated mainly by supply and demand (if more people are familiar with cryptocurrency, more people want some and thus the value increases), some scandals, problems, developments, etc. also affect the price. The most important part of it all is that we are the drivers of it all – not bankers, not politicians. We decide how much it's worth, and the government cannot simply print more of it when they feel like it.