I was asked this question yesterday, and tried to come up with something brief but which captures the essentials. Spoiler: I did not succeed 100% in the former.
This is not financial advice.
Money has not been “real” or carrying inherent value for years now. The United States famously unpegged the Dollar from gold in 1971. Things such as bananas (edible), steel (used in construction and products), mobile phones (communication) have inherent value, i.e. value in themselves. Once money disconnected from the gold standard, it became “fiat money”, i.e. money that has value because governments say it has value, and people trust the governments to repay debts issued in their currency. Governments do not always deserve this trust, and in these cases, their currencies have inflated, losing their value. Famous examples (check out the links, they are crazy!): Germany after their World War 1 defeat, Zimbabwe recently, etc. You would need a wheelbarrow filled with big denomination currency notes to buy a loaf of bread in the worst days of Zimbabwe’s and Germany’s respective hyperinflations. Bitcoin was created in 2008, during the Great Recession (it has that name now) of that period in the US and Europe. People were distrustful of banks and governments and wished to create money that was independent of these institutions.
There are other cases for people who distrust government currencies. Governments can manipulate them in other ways, such as imposing currency controls that prevent you from taking your money abroad, suddenly declaring that your currency notes are no longer valid and pulling them from circulation, tracking your transactions to see what exactly you are doing with your money (and identifying whether you watch porn, have political views that oppose theirs, contribute money to people they deem disagreeable, etc.).
Ledgers and blockchain
Fiat currency transactions happen using cash or through the modification of ledgers kept by banks and organisations. To transfer $x from ABank to BBank, ABank makes the following changes on their ledger: subtract $x from their account and add $x to BBank’s account with them. BBank does the same on their ledger. New lines are added to the ledgers reflecting these transactions. As long as both ledgers reconcile, the system works. An important feature to ensure trust in the ledger is that lines should only be added, they should not be struck off. To reverse a transaction, both ledgers need an additional transaction that has the opposite of the previous transaction, i.e. transfer from A to B is reversed by an equal value transfer from B to A.
Bitcoin uses the blockchain, a ledger that is shared by not two, but millions of computers. I have a Bitcoin node on my personal computer that has every Bitcoin transaction in history. Every ten minutes, a new “block” is added to the blockchain. Think of a block as a new page in the ledger. Anytime a new block is created, it gets propagated to all the computers running Bitcoin nodes so that everyone has an identical copy of the ledger / blockchain.
Who gets to write the next block? People or groups called “miners” collect Bitcoin transactions into blocks and then repeatedly play a game of chance until one of them wins the game, sort of like many people throwing three dice each and seeing who rolls three sixes first. A person who rolls 4 times per second is more likely to win than a person who rolls once a second. Miners spend a huge amount of computational power trying to win the game. The miner who wins writes the new block, rewarding themselves with a fixed amount of Bitcoin. Immediately the game begins again to collect new transactions and write the following block.
Fiat currency has value because people trust their governments and banks. Bitcoin has value because people trust the integrity of the Bitcoin protocol to ensure that the transactions are correct. They also believe that other people will want Bitcoin and therefore the price of Bitcoin will go up. This is not “inherent value” as that of a banana or steel or gold. But it is the same kind of value that the Dollar or Rupee has – value based on trust and the perception that other people see value in it.
I talk about Bitcoin because this is where it all started. There are other cryptocurrencies and other blockchains and there may be considerable differences and nuances in how they are built. Largely the concepts as explained above explain blockchain. Ether, based on the Ethereum blockchain is another cryptocurrency. When a friend who had left the country needed to transfer me some money, we agreed an exchange rate in Ether; I gave him my address; received the amount in seconds; the transaction fee was negligible; nobody asked for my name, where I lived, or a bunch of other irrelevant questions. To do the same by bank transfer would have been prohibitively expensive, have taken a few days and have required a lot of personal data to be provided to the service provider. Some things have changed since the time I wrote the linked article – I do not expect to split a bar tab in Bitcoin in the next three years.
There are other strengths and weaknesses, which I won’t describe here. Read this article I wrote about key weaknesses in the cryptocurrency industry. The key intent behind cryptocurrency use as of now is to have options beyond the government and banks. Simplification of cross-border transactions is a major real-life advantage that I came across.
German hyperinflation in pictures: https://mashable.com/2016/07/27/german-hyperinflation/
Zimbabwe hyperinflation: https://www.quora.com/What-can-be-explained-about-the-hyperinflation-in-Zimbabwe-What-were-the-causes-of-it-and-its-impact-on-the-economy-of-the-country
Demonetisation in India: https://knowledge.wharton.upenn.edu/article/demonetization-india-will-pay-price/
Bitcoin.org – How does Bitcoin work: https://bitcoin.org/en/how-it-works
Investopedia – How does the blockchain work: https://www.investopedia.com/tech/how-does-blockchain-work/
Lifewire – What are Bitcoins? How do Bitcoins work?: https://www.lifewire.com/what-are-bitcoins-2483146
Blockchain – erosion of trust: Blockchain: Erosion of the promise of trust