What is cryptocurrency and how does it work?


Cryptocurrency is growing a life of its own, and people who once scoffed at it are gaining interest. 

Even as a novice, chances are you’ve heard of Bitcoin and other popular cryptocurrencies. While Bitcoin is still one of the most popular and well-known assets, you’ll want to know the ins and outs of cryptocurrency as a whole and the technology driving it to know if it’s the right investment for you. 

TL;DR

  • At its core, cryptocurrency is a system enabling secure payment via digital or virtual currency that is secured by encryption methods. Most are stored with blockchain technology.
  • Bitcoin was the very first blockchain-based cryptocurrency and remains the most popular. 
  • Altcoins, or cryptocurrencies similar to Bitcoin, include Ethereum, Litecoin, and Namecoin. 
  • Cryptocurrencies are easily transferable between two parties, but regulators have concerns about security and illicit activity.
  • Some experts foresee cryptocurrency as being a major disruptor of the financial industry, though its volatility exceeds that of the stock market.

Types of cryptocurrency to be familiar with

Of course, no discussion of cryptocurrency would be complete without spending some time on Bitcoin. This is the first digital currency to become popular, which was launched in 2009 by a still-unidentified source deemed Satoshi Nakamoto. It was first announced in a whitepaper published on bitcoin.org

There is no physical product involved in Bitcoin, only records of balances kept on the public ledger. This decentralized ledger system (called blockchain) is where Bitcoin is born, distributed, traded, and stored. In many countries, Bitcoin is not legal tender, but more and more entities are beginning to accept Bitcoin as payment. (El Salvador recently adopted Bitcoin as legal tender.) 

Bitcoin also spurred the creation of altcoins, which include other cryptocurrencies such as Ethereum (the largest altcoin by market capitalization), Litecoin, Namecoin, and EOS. Thousands of cryptocurrencies are in existence today. 

A few other cryptocurrencies with significant market caps are:

  • Tether
  • Binance Coin
  • Cardano
  • XRP
  • USD Coin
  • Dogecoin
  • Polkadot
  • Binance USD

As of July 22, 2021, the total market cap of all global crypto, including Bitcoin and altcoins, was $1.33 trillion. As far as what the best cryptocurrency is, that depends on your preferences and reason for investing. 

What is blockchain technology?

Blockchain is essential to most cryptocurrencies, as cryptocurrency is backed by a decentralized network using blockchain technology. Some people like its potentially greater security than other payment systems. 

Think of blockchain as a database that stores information digitally within a computer system. 

Although blockchain may be used in various applications (like identity verification), cryptocurrencies and their transaction records are a popular use. 

In blockchain, individual pieces of data are stored in blocks that are chained together. 

Once data is entered on a blockchain, it is permanent and unchangeable. 

Many blockchains are decentralized, meaning that there is no single clearinghouse of all computers on a certain blockchain. No individual person or group has control; instead, all users have collective control. 

How is cryptocurrency secured?

A cryptocurrency user wallet is secured by public keys and private keys. Proof-of-Work (PoW) and Proof-of-Stake (PoS) are a couple of ways developers can secure blockchains. 

PoW is key for adding new blocks to the Bitcoin blockchain and ensures that no one can double-spend coins.

Altcoin-favorite PoS verifies transactions based on how many coins someone has. It requires less energy than PoW and may pose less risk for attacks. PeerCoin was the first cryptocurrency to use PoS. 

What can cryptocurrency be used for? 

Cryptocurrency is a form of payment for goods and services that’s fully virtual. However, it isn’t universally accepted, so you need to be aware of how useful it might be to you. It is legal to use in the U.S., and many companies are adding crypto compatibility so you can use things like Bitcoin to pay. 

Here are a few companies that accept Bitcoin as currency:

  • Microsoft—for XBox store credit only
  • Overstock
  • Home Depot
  • Starbucks
  • PayPal
  • Newegg online retailer

You can buy some cryptocurrencies (including Bitcoin) with U.S. dollars, but others require payment with Bitcoin or another cryptocurrency. Buying cryptocurrency also first requires creating your crypto “wallet” that is purely digital and maintains a record of all of your cryptocurrency. 

As more online brokerages begin offering cryptocurrency trading, it’s easier than ever to dive in.

Potential impacts of cryptocurrency

Financial experts don’t all agree on the value of a crypto-driven society. While some praise the idea that cryptocurrency is beyond the oversight of most regulatory authorities, others voice concerns with security.

Warren Buffett, billionaire investor and chairman of Berkshire Hathaway, has scorned cryptocurrency. One of his complaints is that cryptocurrency has no value in and of itself; it’s only useful as a payment tool. He also criticized investors for depending on the next investor to pay more than they did, making crypto someone else’s problem. 

There’s also the issue of crypto mining, which has a huge carbon footprint. PoW systems are especially guzzling, and developers are working on ways to make crypto more eco-friendly.

Advantages and disadvantages of cryptocurrency

Advantages

One of the key reasons some investors love crypto is that it removes the need for middlemen or third parties like banks. It enables a direct transfer of funds between two parties. Transfers of funds can also be cheaper due to lower processing fees. 

Plus, cryptocurrency should offer greater ease of payment and reduced volatility as it’s more widely adopted, enabling mobile payments and accessibility to more people. 

Proponents of cryptocurrency say it can eventually eliminate exchange rate risk since all Bitcoins will have the same value at the same time, rather than being subject to different rates in different countries. 

Disadvantages

A big thing to watch out for in cryptocurrency is its volatility, as prices have a tendency to surge and drop. For currency, volatility is not a benefit, since the more the price varies, the more reluctant crypto holders will be to use it. 

Due to its anonymous nature, there’s also potential for illicit activity through the use of cryptocurrency (like with the ransom paid to the Colonial Pipeline hackers, which was eventually largely recovered). However, research from the Crypto Council for Innovation suggests illicit crypto trading is on a strong downtrend.

Source: Crypto Council for Innovation

Can cryptocurrency be converted to cash?

Since a relatively small percentage of retailers currently accept coins like Bitcoin, traders often want to convert their crypto into cash. 

There are various ways to sell cryptocurrency and convert it into cash. You might sell it on a cryptocurrency exchange, then withdraw it directly into the same bank account you originally used to deposit. Peer-to-peer transactions and Bitcoin debit cards are also options. Keep in mind you may have to pay taxes if you made any gains while holding cryptocurrency. 

Bottom line

Cryptocurrency trading can feel like peering at the world through a looking glass, but it’s gaining legitimacy. For investors, it’s important to choose your crypto broker wisely, and be aware that nothing in the blockchain-powered market is guaranteed.

Rachel Curry is Pennsylvania-based content writer and journalist talking all things finance. She likes to give meaning to numbers by humanizing them. You can connect with her on Twitter at @writingsofrach.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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