Cryptocurrencies are hot right now. Whether you tune into your local news, read The Economist, or scroll through tech sites like Ars Technica, odds are good that you’ve come across a story about Bitcoin, Litecoin, Dogecoin, Ripple, or a host of other cryptocurrencies. So what is a cryptocurrency exactly?
The term “cryptocurrency” is a portmanteau, combining the words crypto and currency. Let’s start with currency. A currency, or money, is a commonly accepted medium of exchange. As a medium of exchange, it’s an item that you accept and exchange, even though you don’t want to consume it, because you believe – and this is important – that you’ll be able to trade that item for some good or service that you would like to consume at some point in the future. That is, a currency acts as a medium through which you can exchange what you have for what you want.
A lot of items might function as a medium of exchange. For example, when I purchased my house, there was an old washer and dryer in the basement. I already had a washer and dryer, so I had no intention of consuming the services provided by the old washer and dryer that came with the place. Still, I accepted these items. Why? Because I was confident I could exchange them at some point in the future for some goods or services that I actually wanted to consume. In this case, I first traded the washer and dryer for dollars and then traded the dollars for a delicious dinner at my favorite restaurant. The washer and dryer, and then the dollars, functioned as a medium of exchange. They were items I had no intention of consuming but that I accepted because they would allow me to acquire goods and services I would like to consume.
A currency is a medium of exchange, but it’s not just a medium of exchange. It must also be commonly accepted, which raises an interesting question: How common is common? What fraction of the population must accept an item before we agree it’s a currency? 50%? 75%? 100%? The whole country? The world? We can probably agree that the old washer and dryer I mentioned are not commonly accepted. And we can probably agree that dollars are commonly accepted — certainly in the United States. It isn’t so clear where we should draw the line, and reasonable people might disagree. For our purposes, it is enough to understand that, when economists refer to money or currency, they are talking about a commonly accepted medium of exchange.
Next, let’s consider the crypto part of cryptocurrency. Crypto is short for cryptography, the practice of securing communication in the presence of third parties. In the case of cryptocurrencies, the term “crypto” denotes that the currencies are digital and rely on encryption for secure transactions. Since they’re digital, they might also be programmed to have a host of other features, like a slow and predictable rate of growth, for example.
So, putting the pieces together, what is a cryptocurrency? It’s an item intended for use as a commonly accepted medium of exchange that exists in the digital world and relies on encryption to make transactions secure.