Digital currency and how it works

Last updated: 23 May 2022   By Dr Lucy Brown, Editor

Cryptocurrencies are tradable assets that only exist digitally and generally exist outside of traditional currencies.

While the biggest name in cryptocurrency is Bitcoin, there are thousands of other cryptoassets available on the open market.

Users keep track of their assets in a crypto wallet and use exchanges to buy and trade these digital currencies.

Cryptocurrency is not regulated in the UK and users are therefore warned that investing in crypto is a high risk, speculative investment.

bitcoin digital currency
Credit: Parilov/

What is cryptocurrency?

Cryptocurrencies are tradable forms of money or digital assets that can be used to hold money outside of traditional currencies or to make purchases.

There are various names used to describe cryptocurrency such as cryptoassets or digital currency.

It's also possible for digital currencies to be created by a nation's monetary authority to create a government-backed digital currency called a Central Bank Digital Currency (CBDC). These are different to the type of cryptocurrencies we see advertised on the open market because they are backed and controlled by central bank.

As we explore later in this guide, regulation around cryptoassets in the UK is still being discussed and cryptocurrencies are warned to be speculative and unsafe investments.

What is blockchain?

Cryptocurrency is underpinned by blockchain technology.

The blockchain is a public ledger of transactions that cannot be retrospectively altered or tampered with. This is why proponents of cryptoassets say these currencies are more secure than other traditional payment methods.

How many cryptocurrencies are there?

Data from Statista suggests there were 10,397 active cryptocurrencies in February 2022.

However, they also say that 90% of the cryptocurrency market is made up of 20 types of cryptoasset, leaving over 10,300 battling for the remaining 10%.

These are the biggest cryptocurrencies and their value (market capitalisation) at the time of writing:

  1. Bitcoin (BTC) - £537 billion
  2. Ethereum (ETH) - £240 billion
  3. Tether (USDT) - £57 billion
  4. Binance Coin (BNB) - £46 billion
  5. U.S. Dollar Coin (USDC) - £32 billion

Tether and the U.S. Dollar Coin are both stablecoins - we explain more about those below.

However, Bitcoin is by far the biggest cryptocurrency in terms of value, with the rest of the top five leagues behind.

How does cryptocurrency work?

Cryptocurrency transactions are made using computers or electronic wallets that are connected to the internet and have no physical banknotes or coins.

Most cryptocurrencies utilise blockchain technology. This is essentially a digital ledger or database that keeps track of all crypto transactions but does not allow the information to be edited.

To use cryptocurrency, customers will need a crypto wallet that can securely store the currency. This wallet comes with a public key (code) that is known by everyone on the system and a private key that the customer will use to authenticate their transactions.

Benefits of cryptocurrency

Advocates of cryptocurrency will often list the following benefits of holding and using cryptoassets instead of traditional currencies:

  • They aren't tied to a specific currency or economy so their price reflects demand while inflation is kept under control by caps
  • It is independent of central banks and third-party intermediaries like banks
  • The technology allows for privacy because no personal information is divulged during the transaction
  • The underlying blockchain infrastructure is inherently secure because it is a decentralised ledger that cannot be erased

In some countries, the fact that transactions are rapid and the costs are low will be cited as a benefit of cryptocurrency over traditional currencies.

However, in the UK, this is largely irrelevant as mobile banking makes transferring cash straightforward and most banks don't charge fees for sending/receiving money from another UK bank.

The lack of ID checks are also promoted as a benefit in some countries, yet UK law requires most crypto exchanges to undertake anti-money laundering identity checks, reducing the benefits of this. While there are ways around this, they are generally time-consuming and may not provide the best value.

Downsides of cryptocurrency

On the flip side, the following points are frequently raised in criticism of cryptocurrency:

  • Many merchants will not accept cryptocurrency
  • There is no buyer protection
  • They are volatile investments with big highs and lows
  • Crypto wallets can be lost or private keys stolen
  • It requires internet access and a smartphone
  • The process of mining cryptocurrency uses huge volumes of computing power and energy

Some advocates of crypto point out that it is an investment that can go down as well as up, and that warnings about this are clear.

However, investments in the UK are regulated and firms must operate according to certain rules. Those rules simply aren't present yet when it comes to crypto, leaving investors more exposed and more liable to lose their whole investment.

Is cryptocurrency safe?

The unpredictability of cryptocurrencies mean they are an inherently risky investment.

The volatility of cryptocurrency was reiterated in early 2022 when major names like Bitcoin and Luna experienced severe crashes. At the time of writing, Luna has dipped from being valued at over $100 in April to trading at $0.00015.

The problem came when Luna's sister currency, the stablecoin TerraUSD, lost its peg to the dollar and Luna experienced hyperinflation. Luna lost its value because there were too many tokens on the market and crashed, with the knock-on effects echoing across the market.

While proponents argue that volatility is to be expected when it comes to emerging technologies, the severity of the crash has spooked many investors and there have been anecdotal reports of holders losing hundreds of thousands in the crash.

So, the 2022 crash demonstrates the volatility of cryptoassets and it has led to calls for more regulation to ensure financial stability.

A previous crash of Bitcoin in 2018 led to credit card providers banning cardholders from buying the cryptocurrency.

Given that cryptocurrency is attractive to many precisely because it is outside the confines of traditional currency regulations, it remains to be seen whether users will still invest in crypto and hold currencies if they become more regulated assets.

Theft and fraud

If a user loses their private key or is duped into handing it over to a scammer, there is no way of getting it back.

The security of a user having a key (and a back-up code) that is only accessible to them is touted as one of cryptocurrency's defining features, but there have been high-profile cases of users being defrauded and the money in their crypto wallets stolen.

These scams can work in the same way as other online scams, with others responding to phishing attempts and giving away personal information related to their crypto wallet.

Other crypto scams include:

  • Fake cryptocurrencies
  • Fake wallets and exchanges
  • Cloned exchanges
  • Blackmailers demanding payment in crypto
  • Celebrity impersonation scams
  • Malware scams
  • Mining scams

Some of these scams are not unique to the crypto space, yet the anonymity of cryptocurrency and the lack of regulation means that users have even less chance of getting their money back than if they were victims of other scams.

What are the different types of cryptocurrency?

If we think of cryptocurrency, it's likely we will think of payment tokens like Bitcoin and Ethereum. These are used for paying for goods and services, with many cryptocurrencies falling into this category.

However, there are other types of cryptoassets including:

  • Utility tokens - These provide access to specific products or services.
  • Security tokens - These can be equity tokens or asset-backed tokens and are governed by financial regulations.
  • Exchange tokens - These are tokens that can be exchanged on specific crypto exchange platforms.
  • Non-fungible tokens (NFTs) - These have limited issuance and have unique identities to make them difficult to copy or replicate.

It's also worth pausing to examine stablecoins in more detail.

A stablecoin is designed to be less volatile and more predictable than other types of cryptocurrency because they are backed by a stable asset such as another currency.

TerraUSD, the sister currency of Luna discussed above, is a stablecoin pegged to the USD. However, once it lost the peg, the currency became unstable. This has raised questions about how stable these so-called stablecoins can truly be.

Cryptocurrency regulation

There is currently no regulatory framework for cryptocurrency in the UK. This means customers have no protection if things go wrong.

The warnings on the Financial Conduct Authority's (FCA) website are stark. They say:

  • Cryptoassets are considered to be very high risk, speculative investments
  • Purchasers of cryptoassets are unlikely to have access to the Financial Ombudsman Service (FOS) or the Financial Services Compensation Scheme (FSCS) if something goes wrong
  • If a customer invests in cryptoassets, they should be prepared to lose all their money

While the FCA have some coverage of security tokens and e-money tokens that fall under the remit of the Electronic Money Regulations (EMRs), this doesn't apply to the cryptoassets that are widely advertised and traded.

Future of cryptocurrency in the UK

It was announced in April 2022 that the Treasury intends to bring stablecoins as means of payment under regulatory control.

The Government say regulating the sector now will help financial stability and will ensure the technology can be used safely and reliably in the future.

There are also plans to work with the Royal Mint on the first official NFT and enhance the UK tax system to encourage further development of the cryptoasset market.

How successful these endeavours will be and whether the 2022 crash will impact their development remains to be seen.

In addition, the UK central bank is exploring whether a Central Bank Digital Currency (CBDC) is appropriate for the UK, but this would not be a cryptocurrency in the usual sense. Instead, it would be a digital currency usable by all and pegged to the pound.

Summary: Approach with caution

Research from the FCA suggests 2.3 million adults in the UK held cryptoassets in 2021, an increase of more than 20% compared to the year before. They also found that 78% of adults have now heard of cryptocurrency.

It's clear that awareness of cryptocurrencies in the UK is growing, yet their usage is not underpinned by regulation and that makes them an inherently risky prospect for investors.

Anyone thinking of investing in cryptocurrency should ask:

  1. Does the cryptocurrency have a long history and could it be a scam?
  2. Is the exchange I'm planning to use reputable?
  3. Is the crypto wallet I'm planning to use secure?
  4. Can I afford to lose the money I'm investing in cryptocurrency?

If the answer to the last question is "no", we'd refer you back to the FCA's warnings on cryptocurrency: users should be prepared to lose all their money when they invest in cryptocurrency.


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