Cryptocurrency: what it is and how it works

What crypto-assets really are

The word most people use every day, “cryptocurrency,” isn’t the most precise one. Banca d’Italia, on its financial education portal, defines crypto-assets as digital representations of value or of a right, and immediately clarifies the point that matters most: unlike official currencies such as the euro or the dollar, crypto-assets are not legal tender. No one has to accept them as payment, and no central bank guarantees their value. That’s why the institution prefers the term “crypto-assets.”

The “crypto” prefix isn’t decorative. CONSOB explains it by describing a kind of value that is “hidden,” usable only if you know a specific piece of computer code, and existing exclusively in digital form: it’s created and exchanged only electronically, never as a banknote or a coin. The first of these crypto-assets, Bitcoin, was created in 2008 as an alternative payment method to currencies issued by central banks, according to the European Parliament. Since then the phenomenon has multiplied: by 2020 there were already 5,600 different versions of it, worth an estimated 250 billion euros combined.

The blockchain: a ledger no one runs alone

The piece of technology that makes all this possible is the blockchain, literally the “chain of blocks.” Banca d’Italia defines it as a public, decentralized digital ledger that stores transactions securely and in a way that can’t be altered; it’s decentralized because it needs no central intermediary, and its data lives in blocks protected by cryptography. CONSOB adds a practical detail: it’s a constantly growing list of records, the “blocks,” linked together and secured through cryptography. The mechanism that holds the chain together is simple to describe: each block contains part of the information plus the identifying code of the previous block, somewhat like how a network of connected computers exchanges data, the same principle behind the internet.

Practical example: picture a ledger shared across thousands of copies scattered around the world, each updated in real time. If someone tries to change a single page that’s already written, the code linking it to the previous page no longer matches: the tampering shows up immediately, and every other copy of the ledger keeps displaying the original version.

This structure, according to Banca d’Italia, makes the blockchain more secure than traditional record-keeping systems: there’s no single database that would bring the whole system down if compromised, because the same information is duplicated across a huge number of nodes on the network.

Mining and proof-of-work: why validating blocks costs energy

Adding a new block to the chain isn’t automatic: Bitcoin’s system requires mining, which CONSOB describes as the computing power needed to solve complex algorithmic calculations — in practice, an algorithm that anyone with enough computing power can run. The Bank for International Settlements explains why that calculation has to be so costly: Bitcoin achieves data immutability, and therefore payment finality, through costly computations, “proof-of-work.” Making the calculation cheap would open the door to what’s known as “double-spending,” spending the same digital coin twice: among the reasons the system is built this way is precisely the goal of making that kind of fraud too expensive to be worth it.

Whoever contributes computing power to validate blocks gets newly created bitcoins in return, the so-called “block rewards,” which according to the Bank for International Settlements have made up the bulk of mining income so far. That very race to compute is, according to estimates cited by the European Parliament, one of the factors that pushes Bitcoin’s overall energy consumption to levels comparable to a small country — a general estimate, without an exact kilowatt-hour figure.

Proof-of-stake: a lower-energy alternative

Proof-of-work isn’t the only way to keep a network like this running. A Banca d’Italia study, published in its Questioni di Economia e Finanza series, notes that proof-of-work requires large amounts of electricity while several other distributed-ledger protocols consume far less, and it proposes moving from proof-of-work to proof-of-stake as one path to cutting the energy impact. The sources consulted for this Recap don’t go into the technical detail of how proof-of-stake picks who validates blocks: what stays confirmed is that it’s an alternative to mining capable of running on far less energy.

Wallets and keys: what “owning” a crypto-asset means

There’s no physical piggy bank to keep a crypto-asset in: Banca d’Italia defines the wallet as the electronic vault that holds it, and CONSOB calls it, more simply, a “digital wallet.” Inside that vault there aren’t actual coins, but a pair of cryptographic keys — public and private, as CONSOB calls them — that identify the owner and authorize transactions.

Practical example: the public key works a bit like an account number, something you can hand to anyone who needs to send you a payment. The private key, instead, is the secret code that authorizes an outgoing transfer: whoever knows it can spend the crypto-assets held in the wallet, which is why it has to stay confidential and never get shared.

The risks, according to financial regulators

The picture that emerges from official sources is far from reassuring on practical safety. Banca d’Italia warns that buying crypto-assets exposes people to varying degrees of risk, and that for the unbacked kind, like Bitcoin or Ether, the risk is very high: money can be lost to technical failures, theft, errors, or simply a collapse in value. CONSOB adds that the prices of major cryptocurrencies are subject to very wide swings, even within a single day, and it flags concrete scam risks.

There’s also a protection gap: CONSOB notes that, without clear legal rules to fall back on, anyone who suffers harm has no effective legal protection to rely on. The European Parliament notes that people holding crypto-assets aren’t covered by the European Union’s consumer-protection rules, and that transactions are largely anonymous — a feature that, the same source notes, is also one of the reasons cryptocurrencies get used in criminal activity. That’s part of why the European Union introduced tracing rules for crypto-asset transfers above €1,000, through a legislative process the European Parliament formally approved in April 2023 and the Council of the European Union approved in May 2023.

It’s worth keeping this separate from a currency that does carry legal tender status, like the euro: its purchasing power can erode over time because of inflation, but it remains a means of payment that must be accepted by law, with a value central banks work to keep stable. Crypto-assets carry none of those institutional guarantees.