Peer-to-Peer (Virtual Currency): Definition and How It Works

What Is Peer-to-Peer (Virtual Currency)?

Peer-to-peer refers to the exchange or sharing of information, data, or assets between parties without the involvement of a central authority. Peer-to-peer (P2P) involves decentralized interactions among individuals and groups. This approach has been used in computers and networking (peer-to-peer file sharing), as well as with trading virtual currencies, which are a digital representation of value.

Understanding Peer-to-Peer (Virtual Currency)

In a digital peer-to-peer network, each user is (in theory) an equivalent owner of and contributor to the network. This kind of network can be used for almost any type of information or file-sharing. One of the earliest mass uses of P2P networks was the now-defunct music-sharing service Napster.

With currencies, P2P refers to the exchange of cryptocurrencies, which were created to enable anonymous P2P transactions that don't require processing by a financial institution. This required encryption and blockchains to enable two parties to safely conduct a transaction without the need for a trusted third party.

Blockchain can confer what P2P advocates consider a notable security advantage; with transactions recorded on every peer's network, it is extremely difficult—even "computationally impractical"—to overwrite or falsify cryptocurrency transactions on a sizeable network.

Peer-to-Peer vs. Centralized Exchanges

Truly peer-to-peer cryptocurrency transactions generally do not require the involved parties to provide identification, thus protecting everyone's privacy. True cryptocurrency peer-to-peer transactions occur when the sender enters the recipient's wallet address and the amount sent into their wallet and signs the transaction, sending the asset. But this can be complex, so cryptocurrency exchanges were created to help users connect.

However, centralized cryptocurrency exchanges are not peer-to-peer, no matter what they advertise. These exchanges are subject to the regulations of the countries where participants live. This means that governments sometimes require the exchanges to collect information about users' identities and transactions, eroding the privacy for which Bitcoin was aiming.

Some users find that decentralized exchanges (DEX) make them feel more anonymous and outside anyone's control—but even these exchanges are not true peer-to-peer. They generally have a platform that provides services and uses smart contracts to ensure transactions between parties are completed. So, all crypto exchanges act as intermediaries or trusted third parties in transactions, which further diminishes one of the primary tenets behind cryptocurrency—removing all intermediaries.

If you want true and pure peer-to-peer interaction, you must use your wallet to send the recipient cryptocurrency directly. However, this entails being comfortable with the entity you're sending funds to and transacting outside of any type of safety controls. The transaction should turn out fine if you know your recipient is trustworthy. But if you don't, there is a chance that you could lose your money and not have any legal means of recourse.

The Bottom Line

Peer-to-peer in cryptocurrency means one person sends tokens to another without the services of an intermediary. Exchanges are intermediaries, even though they might advertise peer-to-peer services. If you want true anonymity, you'll need to find an exchange that doesn't collect your information or provide services other than a connection to other users. Otherwise, you must know your recipient's wallet address to send cryptocurrency. This is risky because there is no guarantee you'll receive what you're paying for, and you're not covered by a financial institution if something happens.

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