What Is Cryptocurrency and How Does It Work?
You’re not alone if you still feel out of the loop when someone mentions Bitcoin, Ethereum, or cryptocurrency. Crypto is a new, alternative form of payment that challenges all we know about traditional money, and wrapping your head around it may initially seem complex. Luckily, understanding cryptocurrency and its workings is not as complicated as you may think.
Let’s put the jargon aside once and for all. This article will answer the question, “What is cryptocurrency?” in a way that makes sense.
KEY TAKEAWAYS
- Cryptocurrency is a digital form of money that is secured with cryptography.
- Some of the most popular cryptocurrencies are Bitcoin, Ethereum, and Litecoin.
- All crypto transactions are processed and recorded on a blockchain
- Cryptocurrencies can be bought, sold, and traded on various exchange platforms
- The currency offers the potential for high returns, but it comes with risks, just like any other investment
What Is Cryptocurrency?
Cryptocurrency is a virtual currency that exists only in electronic form. You don’t need a bank to verify a transaction. Instead, crypto payments are made online, and the transaction is stored in a public ledger.
While traditional currencies like the dollar or the euro can be physically exchanged, cryptocurrencies are decentralized. This means they operate independently on networks like a blockchain instead of a central authority like a government or bank. Every crypto transaction is verified and added to the blockchain, making it more transparent and harder to tamper with.
The top cryptocurrencies are Bitcoin, Ethereum, Litecoin, Ripple, Tether, and Dogecoin. One of the seven CEOs saving the world, Elon Musk, is known for favoring Bitcoin and Dogecoin in his portfolio.
How Does Cryptocurrency Work?
To understand how cryptocurrency works, consider it a digital or virtual version of traditional paper money. While you can use crypto to purchase everyday items, most people buy, sell, and trade it like a stock or gold coin.
Let’s get familiar with a few fundamental terms commonly used when discussing cryptocurrency:
- Cryptography: This is the term used to describe the practice of encoding data — it allows digital currency transactions, like crypto transactions, to be secure. These advanced mathematical encryptions protect your money and identity.
- Blockchain: Most cryptocurrency transactions are verified and recorded on a blockchain public ledger. The name comes from its operating system, which groups each transaction into blocks and then links them together in a chain. No single entity controls this system, making it completely transparent and reliable.
- Crypto exchanges: You can purchase cryptocurrency through crypto exchanges, which are marketplaces for buying, selling, and trading cryptocurrencies. Exchange features vary by platform, but they typically require an account to access trading features, educational resources, and storage options.
- Wallet storage: Crypto wallets keep your digital currency safe. You can choose a hot wallet or a cold wallet. The former is better suited for regular trading because they can be accessed anywhere with an internet connection, while the latter is more commonly used to store crypto long-term. Exchanges usually offer wallet storage.
Pros and Cons of Cryptocurrency
Before adding alternative assets like crypto to their investment portfolios, many ask, “Is it safe to invest in crypto?” As with any investment, there are advantages and disadvantages to the currency:
| Pros | Cons |
| Potential for high returns using a more diversified portfolio | Price volatility makes the investment riskier |
| No third-party players lead to faster transactions than traditional transfers | Lacks regulation, which could lead to significant changes over time |
| Digital wallets can lead to more secure, transparent transactions with proper user practices | Not immune from security risk and criminal activity |
| Decentralized market gives owners more control of their money without government interference | It can be difficult to understand without the help of an investment advisor familiar with alternative assets |
Advantages of Cryptocurrency
First and foremost, cryptocurrency has the potential for high returns as its value increases. For instance, if you had purchased $100 of Bitcoin in 2010 for $0.08 per Bitcoin, your investment would have grown to $87 million by 2021, when Bitcoin reached its peak of $69,000.
Moreover, many investors are attracted to crypto because it is cryptographic, meaning it can not be changed or deleted on the blockchain.
Cryptocurrency is also very accessible—to complete a transaction, you need only an internet connection and a digital crypto wallet.
Disadvantages of Cryptocurrency
Like any other investment, cryptocurrency has disadvantages and risks. Understanding how to buy, sell, and trade crypto online may require a small learning curve.
More importantly, the crypto market is highly volatile and unpredictable. This could scare away lower-risk investors looking for better guarantees later on. Significant price swings are common. In May 2021, the value of Bitcoin dropped nearly 30% in a single day. The FDIC (Federal Deposit Insurance Corporation) does not insure crypto. If you lose it, you can’t recover it.
And while a lack of regulation is a plus for some, the lack of crypto regulation makes the market susceptible to fraud and scams. In 2021 alone, crypto scammers stole around $14 billion worth of crypto assets. According to the latest FBI report, crypto-related scams increased 45% from 2022 to 2023, totaling more than $5.6 billion.
Digital crypto wallets and exchanges are not totally hack-proof. In 2023, the Mixin Network was hacked, compromising $200 million of crypto assets on the platform. Doing your research before exploring cryptocurrency is important to ensure you invest responsibly.
How to Buy Cryptocurrency
Most transactions are made using a digital wallet on cryptocurrency exchanges. Whether you buy Bitcoin, Ethereum, or other altcoins, getting your hands on cryptocurrency is quite straightforward. You have several options:
- Online cryptocurrency exchanges, like Coinbase and Binance, offer easy ways for beginners to buy, trade, and store crypto on their platforms
- Online brokerages, like Robinhood or TradeStation, offer cryptocurrencies in addition to more traditional investment options like stocks, ETFs, and mutual funds
- Blockchain-based projects like mining reward miners with crypto coins. However, you’ll need the right technology and mining experience to make money this way. Please note that this is not technically a way to “buy” cryptocurrency but to earn it through computing power.
- Payment for services like freelance work. Some companies are willing to pay employees using crypto if you ask, but this is easier said than done, and there are inherent risks to accepting alternative forms of payment for services.
What Can You Buy with Crypto?
Cryptocurrency isn’t just for collecting or trading — you can also use it to buy things. As cryptocurrencies become more popular, we predict the list of purchasable goods will grow. For now, here are some of the most common examples:
- Many online retailers, like Newegg, Microsoft, and PayPal, accept cryptocurrency for products and services.
- Some real estate companies accept crypto for property purchases, allowing you to invest in homes or commercial properties using digital currency.
- From web hosting to streaming platforms, many online services are available for purchase with cryptocurrency.
This list is by no means exhaustive. You can also use cryptocurrency to buy food and beverages, gift cards, make charitable donations, purchase luxury goods, and take advantage of travel opportunities.
What is cryptocurrency? Cryptocurrency is more than just digital money; it’s part of a larger movement towards decentralized finance, where you can buy, lend, borrow, and invest transparently without dealing with an intermediary. If you’re considering diving in, research your options and start with small investments to ensure you never invest more than you’re willing to lose.
