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Understanding Digital Payments and Cryptocurrencies

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Risks Associated with Digital Payments

Digital payments pose a unique set of risks, particularly when it comes to double spending. In traditional monetary systems, a person can use the same units of electronic money to pay different people.

  • The risk of double spending: This is a problem in traditional monetary systems where a person can use the same units of electronic money to pay different people.
  • Verification through public ledger: Bitcoin reduces this risk by allowing for verification of “confirmed” transactions through its secure public ledger of transactions.

Peer-to-Peer Systems and Cryptocurrencies

Peer-to-peer (P2P) systems are computer networks characterized by a large number of endpoints that interconnect with each other, unlike traditional centralized systems like the World Wide Web.

  • The P2P model: The P2P model gained popularity with the release of Napster in 1999 and is now used for trading video content through services like BitTorrent.
  • Decentralized and distributed: This model is decentralized and distributed, meaning that there is no central authority controlling the network.

Terminology

The terms virtual currency, digital currency, and cryptocurrency have been used interchangeably by some, but others recognize differences between them.

  • European Central Bank (ECB) definition: A European Central Bank (ECB) paper from 2012 defined virtual currency as an unregulated digital currency.
  • Bank of England (BOE) definition: The Bank of England (BOE) uses the term “digital currency” to describe decentralized distributed ledger systems like Bitcoin.

Transactions and Mining

Traditional monetary systems require a central authority to maintain a ledger of transactions. Distributed ledger-based digital currency systems use standard cryptographic techniques to maintain a public record of all transactions, ensuring integrity through mathematics rather than relying on a central authority.

  • Transaction process: In the Bitcoin protocol, when two parties engage in a payment transaction, a record is created indicating that value has been transferred out of one party’s “wallet” and into another’s.
  • Mining: This process involves solving complex mathematical problems to validate transactions and add them to the public ledger.