Cryptocurrencies have revolutionized the way we buy goods and services, use apps and games, and even trade for profit. In this article we’ll take a llok at what cryptocurrency is, how it works, and the key factors to consider when buying or trading in cryptocurrency.
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Read: How to Buy Cryptocurrency: What Investors Should Know
What is cryptocurrency?
Cryptocurrency, also known as crypto, refers to digital currencies used for alternative payments or investments. The name “cryptocurrency” derives from the cryptographic techniques that enable secure transactions without the need for a central authority, such as a government or financial institution.
Bitcoin was the first cryptocurrency and was designed as a decentralized form of payment, free from government control. Ethereum, on the other hand, empowers developers to create automated applications within its Decentralized Finance ecosystem. Tether is a stablecoin, with its value pegged to the U.S. dollar.
Why invest in cryptocurrencies?
Investing in cryptocurrencies is driven by the belief that if the demand for a particular cryptocurrency rises, its value will increase as well. Let’s consider a simplified example with Bitcoin:
If consumers and businesses prefer using Bitcoin over the U.S. dollar, and this trend gains widespread adoption, the demand for Bitcoin would surge. Consequently, its price in dollars would rise. If you purchased Bitcoin before this surge you could sell it for a profit.
The same principle applies to Ethereum. As the cryptocurrency powering the Ethereum blockchain, its value increases with the growth of decentralized applications built on the platform.
Some cryptocurrency enthusiasts view cryptocurrencies not just as investments but as superior alternatives to traditional monetary systems due to their secure and decentralised nature.
How does cryptocurrency work?
Cryptocurrency is a digital form of currency that operates on the principles of blockchain technology. It allows for secure and decentralized transactions without the need for intermediaries like banks.
At the core of cryptocurrency is the blockchain, a decentralized and transparent digital ledger. This ledger records all transactions across a network of computers called nodes. Each transaction is bundled into a block and added to the chain of previous transactions, creating a permanent and tamper-resistant record.
Cryptocurrencies are not controlled by a central authority. Instead, they are maintained and updated by a network of participants who validate transactions and ensure the accuracy of the ledger. This decentralization eliminates the need for intermediaries and promotes transparency.
To ensure security, cryptocurrencies use cryptography. Transactions are secured through cryptographic techniques, and public-key cryptography allows only the intended recipient to access the funds. This cryptographic security provides confidence in the integrity of transactions.
Cryptocurrencies enable direct transactions between users without intermediaries. Users can send and receive funds directly, verified by participants on the network. This peer-to-peer nature allows for fast and efficient transactions across borders.
How is a cryptocurrency created?
One common method of creating cryptocurrencies is through a process called mining, notably employed by Bitcoin. Mining involves solving complex puzzles to verify transactions on the network, with participants receiving newly created cryptocurrency as a reward. This process is known as Proof of Work (PoW). Other cryptocurrencies employ different methods of creation and distribution, often with a lower environmental impact.
Staking is a process where a user locks or holds their cryptocurrency in a wallet to participate in maintaining the operations of a proof-of-stake (PoS) based blockchain system. It’s essentially the PoS version of mining in the proof-of-work (PoW) blockchain systems.
In staking, the right to validate transactions is baked into how many coins are “staked” in the system. The more coins you have staked, the higher the chances that you’ll be chosen to validate transactions and earn rewards.
For most people, buying cryptocurrency through exchanges or from other users is the easiest way to acquire it.
What are the different kinds of cryptocurrency?
While Bitcoin is the first and most valuable cryptocurrency, the market boasts over 22,000 publicly traded cryptocurrencies, each serving unique purposes. Some cryptocurrencies hold market valuations in the billions, while others remain obscure and virtually worthless.
Beginners are advised to start with well-established and widely traded cryptocurrencies. Here are some popular ones:
Selecting the right cryptocurrency does not guarantee success in a volatile market. The interconnected nature of the crypto industry means that issues can impact the value of various assets. For instance, liquidity problems faced by the FTX cryptocurrency exchange led to market-wide repercussions and price drops in November 2022.
Are cryptocurrencies considered financial securities?
Whether cryptocurrencies qualify as securities is currently a gray area. In finance, a “security” represents a tradable value. Stocks and bonds are examples of securities. Regulators are increasingly inclined to regulate cryptocurrencies similarly to securities, but this stance faces resistance from scholars, legal firms, and prominent figures in the crypto industry.
The Securities and Exchange Commission (SEC) recently targeted crypto staking, arguing that staking rewards should be registered as securities. In February 2023, the SEC forced Kraken, a crypto exchange, to close its staking program for allegedly failing to register it as a security. The treatment of cryptocurrencies as securities will significantly impact crypto regulation and the asset class’s future.
Are NFTs cryptocurrencies?
Non-fungible tokens (NFTs) represent digital assets that confer ownership of unique digital files. Although NFTs share similarities with cryptocurrencies and are traded on similar marketplaces, they differ in one crucial aspect: fungibility.
Cryptocurrencies are fungible, meaning each unit is equivalent to another. For example, one Bitcoin is equal in value to another Bitcoin. NFTs, on the other hand, are non-fungible, signifying that each token represents a distinct and irreplaceable item.
Cryptocurrency legal and tax issues
Cryptocurrencies are legal in the U.S., although their legal status varies across countries. However, the legality of cryptocurrencies is only one aspect to consider. Taxation and the acceptance of cryptocurrency as legal tender are also significant factors.
Legal tender: Unlike traditional currencies, cryptocurrencies are not required to be accepted as legal tender in most places. In the U.S., the acceptance of cryptocurrency as a payment method depends on the seller’s discretion. Countries like El Salvador have adopted Bitcoin as legal tender, while China is developing its own digital currency.
Crypto taxes: Cryptocurrencies are taxed as property in the U.S. instead of currency. This means that capital gains taxes apply when selling cryptocurrencies, based on the difference between the purchase and sale prices. If received as payment or rewards, the value of the crypto at the time of receipt is subject to taxation.
Is cryptocurrency a good investment?
Investing in cryptocurrency carries high risks. As a general rule, high-risk investments should make up a small portion of your portfolio, typically no more than 10%. Before investing in cryptocurrency you should prioritize building retirement savings, reducing debt, and considering less volatile investments like stocks and bonds.
Managing risk within your crypto portfolio can involve diversifying your holdings across different cryptocurrencies. Since crypto assets experience varying rates and periods of growth and decline, investing in multiple products can help mitigate losses.
Thorough research is essential before investing in cryptocurrencies. Unlike stocks, cryptocurrencies are loosely regulated in the U.S., making it more challenging to evaluate their viability. Consultation with a financial advisor knowledgeable about cryptocurrencies is recommended.
New cryptocurrency projects or ‘coins’ are being launched at a staggering rate. It’s a good idea to assess the adoption rate of a new cryptocurrency before investing. Reputable projects often provide metrics indicating the number of transactions conducted on their platforms, reflecting their growing usage. Additionally, reviewing a cryptocurrency’s white paper, outlining its functionality and token distribution, can provide further understanding.
If considering investments in less established crypto products, several additional questions should be addressed:
Examining a prospectus in detail, preferably with comprehensive information, improves the likelihood of a legitimate investment. However, legitimacy does not guarantee success.
The cryptocurrency space, like any other investment sector, can attract scammers who try to exploit investors. Here are some tips to help you stay safe:
- Do Your Research: Before investing in any cryptocurrency, thoroughly research the coin, the team behind it, its purpose, and its technology. Be wary of coins that promise high returns with no risk.
- Secure Your Investments: Use hardware wallets or other secure forms of wallets to store your cryptocurrencies. Avoid sharing sensitive information about your investments online.
- Beware of Phishing Attempts: Be cautious of emails or messages that attempt to lure you into providing your personal information or cryptocurrency wallet details.
- Avoid “Too Good to Be True” Opportunities: High yield investment programs and other “get rich quick” schemes that promise high returns in a short period of time are often scams.
- Use Reputable Exchanges: Stick to well-known, reputable cryptocurrency exchanges for buying and selling cryptocurrencies.
- Be Cautious of ICOs: Initial Coin Offerings (ICOs) can be legitimate, but they’ve also been used as a vehicle for scams. Research thoroughly before investing.
- Understand What You’re Investing In: Cryptocurrencies and blockchain technology can be complex. Make sure you understand at least the basics before you invest.
Frequently Asked Questions
How does a blockchain work?
Blockchain is a networking protocol that enables a ‘distributed’ network of computers to collaborate in maintaining a shared and tamper-proof record of transactions. The key challenge in a blockchain network lies in achieving consensus among participants on the accurate copy of the historical ledger. Without a reliable validation mechanism, trust in the security of cryptocurrency holdings would be difficult to establish. Consensus mechanisms like “proof of work” and “proof of stake” are commonly employed to address this challenge.
What is proof of work?
Proof of work incentivizes users to contribute to the maintenance of an accurate historical record on a blockchain network. Bitcoin, the pioneering cryptocurrency, utilizes proof of work. Users are responsible for collecting and submitting blocks of recent transactions to be included in the ledger, and successful participants are rewarded in a process known as mining. Mining involves solving complex puzzles that consume substantial energy and computing power. This competitive process ensures that only one user can win the right to create a new block. The goal of proof of work is to make it more profitable for users to abide by the rules rather than attempt to manipulate the system.
What is proof of stake?
Proof of stake is an alternative consensus mechanism used to establish agreement on the accuracy of transaction records in a blockchain. Unlike mining, proof of stake relies on a process called staking, where individuals stake a portion of their cryptocurrency holdings to validate new transactions. Cryptocurrencies such as Cardano, Solana, and Ethereum utilize proof of stake protocols.
Proof of stake systems share similarities with proof of work mechanisms, as both rely on users to collect and submit new transactions. However, they differ in how they incentivize honest behavior among participants. In proof of stake, individuals proposing new blocks must stake a certain amount of cryptocurrency. Typically, higher stakes increase the chances of landing a new block and earning rewards. Participants submitting inaccurate data risk losing a portion of their staked funds. Proof of stake uses considerable les energy than proof of work.
How is cryptocurrency mined?
Mining cryptocurrency is primarily associated with proof-of-work cryptocurrencies like Bitcoin. However mining requires substantial investment in mining ‘rigs’ (computers) and may not yield significant returns without significant resources. Initially, Bitcoin could be mined using regular computers, but as the network grew, the process became more challenging.
Nowadays, miners employ specialized computers dedicated to running complex calculations required for mining. Some miners even operate warehouses filled with mining equipment. For those unable to compete with large-scale miners, joining a mining pool is an option where users collaborate and share rewards. While this reduces the individual reward, it increases the likelihood of obtaining some return on the investment.
How cryptocurrency converted into cash?
Converting your cryptocurrency holdings into cash offers several options. While decentralized exchanges and peer-to-peer transactions suit some investors, many prefer using centralized services to sell their holdings.
If you already own crypto, using a centralized exchange simplifies the process:
- Connect your wallet that contains the cryptocurrencies you want to sell, ensuring that the chosen exchange supports both the wallet and the specific asset.
- Transfer your cryptocurrency to the exchange.
- Sell your cryptocurrency.
- Transfer the proceeds back to your bank account.
Keep in mind that each exchange has different transaction processes and fees, so it’s important to research the specific exchange you choose. Additionally, selling digital assets may increase your tax liabilities, so it’s important to be aware of the tax implications.
