It’s hard to find a person who hasn’t at least heard of cryptocurrency these days. But actually understanding how cryptocurrency works is a different story. If you’re considering putting money in crypto, there are many assumptions to question and risks to consider. In this article, we’ll elaborate on the following cryptocurrency basics:
- Cryptocurrency is a digital currency that can be used to buy goods and services or traded for profit.
- Like other forms of currency, cryptocurrency has no inherent value, and prices fluctuate wildly.
- Today there are thousands of existing cryptocurrencies, with new ones always coming and going. Bitcoin was the first and remains the most reliable.
- Cryptocurrency is not a traditional “investment” any more than exchanging dollars for euros is. Unlike an investment, cryptocurrency has no interest or dividends, and it is possible to lose everything you put in if the price shrinks to zero.
- Cryptocurrency is an unregulated sector with lots of uncertainty. Do your research and proceed with caution before “investing” in crypto.
What is cryptocurrency?
Cryptocurrency is a digital currency. The root “crypto,” meaning code, offers a hint as to how it works: each “coin” or unit of currency is actually a line of code used to track transactions.
Though cryptocurrency is totally digital, it works a lot like the real currency. Just like you would exchange dollars for pesos before visiting Mexico, you also exchange money for cryptocurrency, which you can then use to purchase goods or services, or trade for profit.
Some experts also liken cryptocurrency to arcade tokens or poker chips, because – like foreign currency – their use is confined to particular contexts. You can’t use Bitcoin to buy a hamburger at McDonald’s, yet. You can only use it for goods and services for which the provider has agreed to accept Bitcoin.
So if cryptocurrency is just another form of currency, what’s the big deal? Why is there so much hype around “crypto”?
The current crypto outlook
The first cryptocurrency, Bitcoin, was released in 2009. Though it remains the most well-known and reliable, since then thousands of cryptocurrencies have come and gone – and the total number changes as quickly as currency prices do. This volatility further underscores the uncertainty inherent in the crypto market.
- Total cryptocurrencies: At least 8,936
- Global market cap: $1.75 Trillion
- Top 5 currencies: Bitcoin, Ethereum, Binance Coin, Tether, and Cardano
How much is cryptocurrency worth?
As with any form of currency, the value of a given cryptocurrency is arbitrary. Bitcoin has no inherent value; it is evaluated based on what someone is willing to pay for it. This is why investor Warren Buffett blasted cryptocurrency as about as valuable as a paper check back in 2014, claiming that – like a paper check – crypto is nothing more than a way of transmitting money. It has no value on its own, just like a paper check is only worth the amount of money written on it.
Whether you believe in the power of crypto or not, the analogy is worth noting. Buffett’s point was that cryptocurrency is unreliable as an investment or wealth-generator because your money disappears as soon as the value of the currency does.
How does cryptocurrency work?
To buy cryptocurrency, you can’t go to a traditional broker like you would for stocks or mutual funds. Instead, you have to buy it from cryptocurrency exchange – like brokerage firms designated specifically for cryptocurrency. These include:
Robinhood is one of few – if not the only – traditional brokerage firms that also offer cryptocurrency, with the bonus of requiring no commissions or fees.
You can also buy cryptocurrency directly from individuals, but this comes with more risks.
How cryptocurrency is stored, accessed, and used
As a refresher, cryptocurrency is still mostly used by individuals to purchase goods or services in an anonymous, decentralized marketplace. Here’s a breakdown of what that looks like:
Cryptocurrency is stored in cryptocurrency wallets, most often software programs. These are sometimes called digital wallets, but not all crypto wallets are digital – some live on hardware, like USB drives, or locally on personal desktop computers. The other common forms are:
- Online wallets: These are software programs that allow you to store and access your currency in the cloud. Though this presents its own cybersecurity risks, it’s also a reliable storage method since you can access your assets from any computer.
- Mobile wallets: These typically live on smart devices and are accessible through apps.
One of the most crucial elements of the crypto market is the blockchain. This is a decentralized (meaning stored on many computers), completely public ledger of every transaction that’s ever happened in a given cryptocurrency. Some experts compare it to a very long public receipt.
Accessing and using your currency
Currency holders use both a public key (or passcode) and a private key to access the blockchain as well as their individual assets. Their own transactions are recorded on the blockchain through what is known as a “cryptocurrency address.”
Regulation and legality
One important thing to recognize about cryptocurrency is that it’s completely unregulated by the government or financial institutions. Though this decentralization and lack of financial “middlemen” creates freedom and flexibility (particularly the omission of transaction fees and commissions), it also creates space for uncertainty and volatility, not to mention fraud and criminal activity.
What are the benefits of cryptocurrency?
To recap, champions of cryptocurrency point to the following advantages:
- Anonymity – Cryptocurrency holders are identified on the blockchain only through anonymous codes
- Decentralization – No financial middlemen, no transaction fees, no regulation
- Potential for profits – Speculators can make a profit by selling highly valued crypto at higher prices than what they paid
Many people believe that the anonymous, decentralized, cloud-based nature of the crypto market makes it the future of commerce (at least for online transactions).
What are the drawbacks of “investing” in cryptocurrency?
- Crypto has no inherent value. It’s only worth what someone is willing to pay for it, and prices are highly volatile. Currency takes a long time to gain stability, and even the most reliable cryptocurrency – Bitcoin – has fluctuated wildly in value since its inception in 2009.
- Crypto isn’t really an investment like stocks or mutual funds, so you can’t profit through dividends or interest. In fact, you can easily lose everything if the value of the currency drops.
- It’s very difficult to plan ahead with crypto. Unlike stocks, mutual funds, and other traditional investments, you can’t predict returns using established patterns.
Tips for getting started
- Choose a cryptocurrency wisely. If you’re considering an initial coin offering (ICO – the crypto equivalent of an initial public offering or IPO), do thorough investment research, Who manages the company? Are other investors getting involved? Is the currency still in development (making the investment even riskier)? Carefully review the prospectus, no matter how laborious.
- Only invest a small portion of your portfolio. The currency won’t make a profit on its own and can become a total loss if the value shrinks to zero. Most experts agree it’s not a good way to build wealth.
- Beware of fraud and hackers. Though crypto is legal in the U.S., it creates a lot of opportunities for fraud, theft, hacking, etc. because it’s an unregulated sector in which people operate with anonymity. Plus, many people store their currency in digital wallets, and cloud storage is always vulnerable to some risk.