What differentiates virtual currencies from cryptocurrencies is that the latter term implies the use of cryptography. This is evident in the wording used in a series of policy documents from the institutions referred to in the previous section.
For example, the IMF (2016) contrasts virtual currencies and cryptocurrencies as follows: “VC [virtual currency] wallets are used by VC holders to hold and transact in VCs. Cryptocurrencies are stored in digital wallet software associated with cryptographic keys”. A report published by the Bank for International Settlement (BIS)12 clearly mentions that “these [virtual currency] schemes are frequently referred to as ‘cryptocurrencies’, reflecting the use of cryptography in their issuance, and in the validation of transactions”.
Last, the World Bank states that “Cryptocurrencies are a subset of digital currencies that rely on cryptographic techniques to achieve consensus”.13
FATF (2014) defines cryptocurrencies as follows: “Decentralised Virtual Currencies (a.k.a. crypto-currencies) are distributed, open-source, math-based peerto-peer virtual currencies that have no central administrating authority, and no central monitoring or oversight”, while the European Union Agency for Cybersecurity (ENISA) provides the following definition: “Cryptocurrency refers to a math-based, decentralised convertible virtual currency that is protected by cryptography. – i.e., it incorporates principles of cryptography to implement a distributed, decentralised, secure information economy”.
Summing up the above definitions, cryptocurrencies are a subset of virtual
currencies that use cryptography to operate in a distributed, decentralized, and secure environment.
The term “tokens” is not included in Figure 3.1, but it is commonly used interchangeably with the term “cryptocurrencies”. This term is also used as a core term in the following chapters, so it is important to define it and explore any differences from “cryptocurrencies”.
The European Securities and Markets Authority (ESMA) defines tokens as “any digital representation of an interest, which may be of value, a right to receive a benefit or perform specified functions or may not have a specified purpose or use”.14 According to the ECB, tokens are “mere digital representations of existing assets, which allow recording these assets by means of a different technology”.
Both definitions above imply that tokens carry a broader range of functions from “cryptocurrencies”, since the latter emphasize on the “currency” concept that they include. Specifically, tokens do share the three main functions of digital currencies and cryptocurrencies mentioned above (medium of exchange; a unit of account; a store of value), but their role is broader and not restricted to being just a “currency”.
Tokens differ from cryptocurrencies in that they perform more functions than the ones mentioned above. For example, they can provide privileged access to the product or service for which they are issued or even the right to participate in the development of the product/service. This complexity of their functions is also why they are not considered digital currencies and are usually described as digital chips.
How cryptocurrency transactions work
Cryptocurrencies operate in peer-to-peer networks, with open source protocols.
A network with the above technical characteristics is not subject to a central authority and there is no intermediary. The whole network and its transactions are controlled by the users themselves, who are responsible for both confirming the transactions and securing the network.
Cryptocurrencies do not exist in material but only in digital form. The only
way to store them is in digital wallets. A digital wallet is a software that sends, receives, and stores digital codes that represent and reflect the value of cryptocurrencies. There are online platforms that offer online digital wallets, but users can also use offline devices that allow them to store their cryptocurrencies offline (hardware wallets).
Digital wallets comprise of two keys (Figure 3.2): (a) a public key, which is being used to receive funds; it identifies the individual user’s account on
the network and it is visible and known to everyone, and (b) a private key, which is only used to sign transactions and prove that the individual user owns the related public key; it is only known by the user and should not be shared.
This pair of public key/private key is generated via a specific encryption algorithm. The two keys are in the form of a string (they contain Latin characters, numbers, and symbols) and have a mathematical relationship between them.
Usually, the more characters they contain the greater their security. The symbols and numbers occur randomly after the application of a hash function
These two keys are stored in the user’s digital wallet. Each cryptocurrency has its own digital wallet and therefore its own keys. For example, someone who owns three different types of cryptocurrencies will have three different digital wallets with their respective digital keys; note, however, that there already are mixed wallets that allow the storage of more than one cryptocurrencies in one wallet, with different “pockets”, namely different public keys.
The owner of a cryptocurrency is the person who owns the private key. This
private key is only known to its owner and is the most important element for the operation of the digital wallet. The private key cannot be reissued. If the owner loses the private key, they lose access to their digital wallet and all the cryptocurrencies it contains. The public key on the other hand is the public address of someone’s wallet, visible to all users, and where all transactions are being made.
But although the public key of the user is publicly visible, it is impossible (technically and computationally) to use it to find the respective private key
To better understand the key pair function, this could be compared to the function of e-mails. The public key is like the email address that is known to someone who wants to send a message and the private key is like the password of the email account needed to log in and read the message. To give an example of how this pair of key works, suppose that Bob wants to send any type of information (i.e., a message or 1 bitcoin) to Mary (Figure 3.3). Bob uses the public key of Mary (her bitcoin address) to encrypt the digital information of the transaction. Mary then receives the encrypted message and she must use her private key to decrypt it.
Read more information about Blockchain