What is Cryptocurrency?
Cryptocurrency, often shortened to “crypto,” represents a digital or virtual currency, such as Bitcoin or Ethereum. These currencies are designed to function as an alternative payment method or as an investment. Crypto’s core feature is its use of cryptographic techniques, which enable secure transactions without the need for traditional financial institutions like banks or central governments. These cryptographic methods ensure the integrity of financial transactions.
Examples of Cryptocurrencies:
- Bitcoin: Bitcoin was created to serve as a decentralized payment system, free from control by central banks. Instead of relying on financial institutions to verify transactions, Bitcoin employs a secure, decentralized process.
- Ethereum: Building upon Bitcoin’s underlying technology, Ethereum facilitates not only peer-to-peer payments but also transactions on its network. This network allows for the creation of entire financial ecosystems, such as insurance platforms or real estate titling systems, without traditional intermediaries.
Following Bitcoin’s success, numerous “altcoins” (any cryptocurrency other than Bitcoin) emerged, aiming to capitalize on the various uses for blockchain technology.
Why Invest in Cryptocurrency?
People invest in cryptocurrency for basically the same reason they invest in any asset: to profit from an increase in value. The potential for profit in crypto comes from the interplay of supply and demand.
For example, if demand for Bitcoin rises—perhaps because more people use it for payments—its price in dollars would likely go up. If you purchased Bitcoin before the surge in demand, you could sell it for a profit.
The cryptocurrency “Ether” (often known as ETH) is the lifeblood of the Ethereum blockchain. Developers use Ether to create and operate applications on Ethereum. The more that is built on the Ethereum blockchain, the higher the demand for Ether.
It’s important to note that some enthusiasts view cryptocurrencies not as investments but as the future of money. They believe Bitcoin offers a superior monetary system and prefer that it be used as an everyday payment method, often emphasizing that “one Bitcoin is one Bitcoin,” expressing its value as a new monetary system.
How Does Cryptocurrency Work?
Cryptocurrencies function on a technology called blockchain. Blockchain maintains a permanent, tamper-resistant record of transactions and tracks ownership of digital assets. This system addresses an earlier problem that digital currencies faced: preventing users from duplicating and spending their holdings multiple times.
Individual units of cryptocurrency can be referred to as coins or tokens, depending on their specific use. Some are designed for use as currency for goods and services, others as stores of value, and some grant access to specific software programs or financial products.
How Are Cryptocurrencies Created?
Cryptocurrencies are created with a process called mining, used by Bitcoin. Bitcoin mining is an energy-intensive process where computers solve complex problems to verify transactions on the network. In return, the owners of these computers receive newly created cryptocurrency.
Other cryptocurrencies use different token creation methods and often have lower environmental impacts.
For newcomers, the easiest method to acquire cryptocurrency is typically by purchasing it on an exchange platform or from another user.
Why Are There So Many Kinds of Cryptocurrency?
It’s helpful to distinguish between Bitcoin and the broader market of cryptocurrencies. Bitcoin is the initial cryptocurrency and maintains the greatest value, but thousands of other cryptocurrencies exist. While some of these other currencies have market valuations in the hundreds of billions of dollars, others may be obscure and essentially worthless.
When getting involved in cryptocurrency, it can be helpful to start with a well-established coin that’s commonly traded. However, the cryptocurrency market is volatile; therefore, careful selection does not guarantee success.
Are Cryptocurrencies Financial Securities?
The designation of cryptocurrency as a security is a complicated issue currently under debate. In finance, a “security” is anything representing value that can be traded, such as stocks and bonds. Financial regulators have indicated they intend to bring cryptocurrency under similar regulations as existing securities. The Supreme Court ruling in June 2024 (Loper Bright Enterprises v. Raimondo) may change this, potentially requiring Congress to clearly define crypto regulation through legislation rather than allowing the SEC to enforce rules based on its interpretation. This could dramatically affect how the market functions.
Pros and Cons of Cryptocurrency
Cryptocurrency attracts passionate opinions. Here’s a look at why some see it as a groundbreaking technology, while others are more cautious.
Pros:
- The value of many well-established cryptocurrencies has increased considerably over time.
- Cryptocurrency can remove central banks from managing the money supply.
- Cryptocurrency can be empowering for communities traditionally underserved by the financial system.
- The underlying blockchain technology is decentralized and may be more secure than traditional payment systems.
- Some cryptocurrencies offer staking, giving owners the ability to earn passive income without buying more crypto.
Cons:
- Many cryptocurrency ventures are unproven, and blockchain technology is not yet widely accepted.
- Crypto price swings tend to be dramatic.
- The environmental impact of Bitcoin and similar protocols can be significant.
- Government regulation of cryptocurrencies is still evolving, which introduces market uncertainty.
- High transaction fees on certain networks can reduce returns.
Cryptocurrency Legal and Tax Issues
Cryptocurrencies are legal in the U.S., but legality varies internationally. Legal considerations include taxation and what you can buy with cryptocurrency.
- Legal tender: Cryptocurrency is not legal tender in most jurisdictions. You can’t legally force a retailer to accept cryptocurrency at this time.
- Crypto taxes: The IRS treats crypto as property, not currency, for tax purposes. You pay tax on the capital gains when you sell. You also owe tax on the value of crypto received as payment or earned as a reward, such as from mining.
Your Decision: Is Cryptocurrency a Good Investment?
Cryptocurrency remains a risky investment. A common guideline suggests keeping high-risk investments to a small portion of your overall portfolio, no more than 10%.
Consider more stable investments like stocks, bonds, and retirement accounts ahead of cryptocurrency. Manage risk by diversifying your crypto holdings, as different crypto assets may appreciate or depreciate at different rates.
Research is crucial, especially for cryptocurrency, which is often related to a specific project’s development. Cryptocurrency projects can be more difficult to evaluate than a known company that is subject to defined financial reporting.
New investors might assess how widely used a cryptocurrency is. The number of transactions occurring on the platform can offer valuable insight into the level of adoption.
Additional Considerations
When investing in less established crypto products, start with these questions:
- Who’s heading the project? An identifiable and well-known leader can be a positive sign.
- Are there other major investors investing in it? Significant outside investment is a good indicator.
- Will you own a portion in the company or just the currency or tokens? Being a part owner means you can receive earnings, whereas buying simply means that you’re entitled to use the tokens.
- Is the currency already developed, or is the company looking to raise money to develop it? The more developed the product, the less risky it is.
Carefully review any prospectus. Even when everything appears legitimate, success is never guaranteed. Always consider how to protect yourself from investment scams.
Frequently Asked Questions (FAQ)
How does a blockchain work?
Most cryptocurrencies are based on blockchain technology, a networking protocol through which computers work together to keep a shared, tamper-proof record of transactions. The goal on the blockchain is to reach consensus on the ledger’s correct copy. This is done through these 2 methods:
- Proof of Work: Used by Bitcoin, incentivizes users to maintain an accurate record of transactions by rewarding successful miners.
- Proof of Stake: An alternative to mining where users stake (lock up some of their crypto) to validate transactions.
What does proof of work (PoW) mean?
Bitcoin’s method, “proof of Work” (PoW), incentivizes maintaining an accurate transaction record. Users submit blocks of recent transactions for inclusion in the ledger and are rewarded for doing so. This verification process is called mining.
Bitcoin requires users to solve a difficult puzzle, which consumes a lot of energy and computing power. The completion of this puzzle is the “work” in proof of work.
PoW makes it more rewarding to follow the rules than to attempt to break them.
What is proof of stake (PoS)?
Proof of stake (PoS) is another consensus mechanism that uses “staking” rather than mining to achieve consensus.
Participants stake their existing cryptocurrency holdings to secure the new transactions. Those with more staked cryptocurrency have a higher chance of being selected to propose the next block and earning a reward. Users who submit inaccurate data can lose their staked funds.
Some cryptocurrencies that use PoS are Cardano, Solana, and Ethereum.
How do you mine cryptocurrency?
Mining cryptocurrencies is most common with PoW cryptocurrencies such as Bitcoin. Mining requires considerable investment and technical expertise.
While early Bitcoin users could mine with standard computers, mining is now done with special computers that focus on solving complex calculations. Many miners use large warehouses full of mining equipment.
Those unable to compete can join mining pools, where users share rewards. This lowers the individual reward but increases the likelihood of return.
How do you pull your money out of crypto?
Just like buying cryptocurrencies, you have several options for converting crypto back into regular currency. Using a centralized exchange is the most user-friendly option.
Here are the general steps:
- Connect the crypto wallet that holds the coins you want to sell.
- Move your cryptocurrency to the exchange that supports the asset and wallet.
- Sell your cryptocurrency.
- Transfer the proceeds to your bank account.
Every exchange will handle transactions differently, and you may create tax liability, so be sure to check your local guidelines.
