What Is Cryptocurrency, and How Does It Work?

What Is Cryptocurrency?

A cryptocurrency is a digital or virtual currency that is protected by encryption, making counterfeiting and double-spending practically impossible. Many cryptocurrencies are built on blockchain technology, which is a distributed ledger enforced by a distributed network of computers.

Cryptocurrencies are distinguished by the fact that they are not issued by any central authority, making them potentially impervious to government intervention or manipulation.

KEY TAKEAWAYS

  • A cryptocurrency is a form of digital asset based on a network that is distributed across a large number of computers. This decentralized structure allows them to exist outside the control of governments and central authorities.
  • Experts believe that blockchain and related technology will disrupt many industries, including finance and law.
  • The advantages of cryptocurrencies include cheaper and faster money transfers and decentralized systems that do not collapse at a single point of failure.
  • The disadvantages of cryptocurrencies include their price volatility, high energy consumption for mining activities, and use in criminal activities.

Understanding Cryptocurrencies

Cryptocurrencies are digital or virtual currencies that rely on cryptography technologies to function. They make it possible to make safe online payments without the involvement of third-party payment processors.

Various encryption methods and cryptographic approaches, such as elliptical curve encryption, public-private key pairs, and hashing functions, are referred to as “crypto.”

 Cryptocurrencies can either be mined or bought on cryptocurrency exchanges. Not all e-commerce sites accept cryptocurrency payments. In fact, even famous cryptocurrencies like Bitcoin are rarely used for retail purchases.

Cryptocurrencies, on the other hand, have become popular as trading instruments because of their increasing value. They are also utilized for cross-border transfers to a limited extent. 

Blockchain

Blockchain technology is at the heart of Bitcoin’s and other cryptocurrencies’ attractiveness and usefulness. A blockchain is, as its name implies, a collection of interconnected blocks, or an online ledger. Each block comprises a collection of transactions that each network member has independently validated.

Every new block must be validated by each node before being confirmed, making forging transaction histories nearly impossible. The contents of an online ledger must be agreed upon by the whole network of a single node, or computer, that keeps a copy of the ledger.

According to experts, blockchain technology can benefit a variety of industries, including the supply chain and operations like online voting and crowdfunding.

Financial institutions such as JPMorgan Chase & Co. (JPM) are testing the use of blockchain technology to lower transaction costs by streamlining payment processing.

Types of Cryptocurrency

The most well-known and valued cryptocurrency is Bitcoin. It was conceived and introduced to the public in 2008 by an unidentified individual named Satoshi Nakamoto through a white paper. Thousands of cryptocurrencies are currently available on the market.

Every cryptocurrency claims to have a unique purpose and specification. Ethereum’s ether, for example, is marketed as “gas” for the underlying smart contract platform. Banks utilize Ripple’s XRP to ease transfers between different locations.

The most commonly traded and covered cryptocurrency is Bitcoin, which was first made available to the public in 2009. There were around 18.8 million bitcoins in circulation as of November 2021, with a total market cap of around $1.2 trillion. There will only be 21 million bitcoins ever created.

In the wake of Bitcoin’s success, many other cryptocurrencies, known as “altcoins,” have been launched. Some of these are clones or forks of Bitcoin, while others are new currencies that were built from scratch.

They include Solana, Litecoin, Ethereum, Cardano, and EOS. By November 2021, the aggregate value of all the cryptocurrencies in existence had reached over $2.1 trillion, and Bitcoin represented approximately 41% of that total value.

Are Cryptocurrencies Legal?

Fiat currencies derive their authority as mediums of transaction from the government or monetary authorities. For example, each dollar bill is backstopped by the Federal Reserve.

Cryptocurrencies, on the other hand, are not backed by any government or corporate entity. As a result, establishing their legal standing in many financial countries throughout the world has proven problematic. The fact that cryptocurrencies have mostly operated outside of the current financial infrastructure doesn’t help matters.

Cryptocurrencies’ legal status has ramifications for their use in regular transactions and trade. The Financial Action Task Force (FATF) suggested in June 2019 that cryptocurrency wire transfers be subject to the provisions of its Travel Rule, which mandates anti-money laundering compliance.

As of December 2021, El Salvador was the only country in the world to allow Bitcoin as legal tender for monetary transactions. In the rest of the world, cryptocurrency regulation varies by jurisdiction.

The Payment Services Act of Japan declares Bitcoin to be legal property. Customers’ personal information and wire transfer data must be collected by cryptocurrency exchanges functioning in the country.

Within its boundaries, China has outlawed cryptocurrency trades and mining. In December, it was claimed that India was working on a cryptocurrency architecture.

In the European Union, cryptocurrencies are legal. Cryptocurrency derivatives and other products will need to be classified as “financial instruments.”

The European Commission published the Markets in Crypto-Assets (MiCA) regulation in June 2021, which defines regulatory safeguards and requirements for organizations or suppliers who provide financial services utilizing cryptocurrency.

Crypto derivatives such as Bitcoin futures are offered in the United States, the world’s largest and most sophisticated financial market.

Advantages and Disadvantages of Cryptocurrency

Cryptocurrencies were introduced with the intent of revolutionizing financial infrastructure. As with every revolution, however, there are tradeoffs involved.

At the current stage of development for cryptocurrencies, there are many differences between the theoretical ideal of a decentralized system with cryptocurrencies and its practical implementation.

Some advantages and disadvantages of cryptocurrencies are as follows.

Advantages

  • Cryptocurrencies are a new, decentralized money paradigm. To enforce trust and police transactions between two participants, centralized intermediaries such as banks and monetary organizations are not required in this system. As a result, a system based on cryptocurrencies reduces the risk of a single point of failure, such as a huge bank, triggering a global crisis, similar to the one generated in 2008 by the failure of institutions in the United States.
  • Cryptocurrencies promise to make it easier to move funds between two parties without the need for a trusted third party such as a bank or credit card firm. The use of public and private keys, as well as various incentive mechanisms, secures such decentralized transfers.
  • Cryptocurrency transfers between two transacting parties are faster than traditional money transfers since they do not employ third-party intermediaries. Flash loans are a nice illustration of decentralized transfers in decentralized finance. These loans, which are not backed by security, can be completed in seconds and are employed in trading.
  • Investing in cryptocurrencies can be profitable. Over the last decade, the value of cryptocurrency markets has surged, reaching nearly $2 trillion at one time. On December 20, 2021, Bitcoin was worth over $862 billion on crypto marketplaces.
  • The remittance economy is testing one of cryptocurrency’s most prominent use cases. Currently, cryptocurrencies such as Bitcoin serve as intermediary currencies to streamline money transfers across borders.
  • Thus, a fiat currency is converted to Bitcoin (or another cryptocurrency), transferred across borders, and, subsequently, converted to the destination fiat currency. This method streamlines the money transfer process and makes it cheaper.

Disadvantages

  • Although they claim to be an anonymous form of transaction, cryptocurrencies are actually pseudonymous. They leave a digital trail that agencies such as the Federal Bureau of Investigation (FBI) can decipher. This opens up the possibility of governments or federal authorities tracking the financial transactions of ordinary citizens. 
  • Cryptocurrencies have become a popular tool with criminals for nefarious activities such as money laundering and illicit purchases. The case of Dread Pirate Roberts, who ran a marketplace to sell drugs on the dark web, is already well known. Cryptocurrencies have also become a favorite of hackers who use them for ransomware activities.
  • In theory, cryptocurrencies are meant to be decentralized, with their wealth distributed among many parties on a blockchain. In reality, ownership is highly concentrated. For example, an MIT study found that just 11,000 investors held roughly 45% of Bitcoin’s surging value. One of the conceits of cryptocurrencies is that anyone can mine them using a computer with an Internet connection.
  • However, mining popular cryptocurrencies requires considerable energy, sometimes as much energy as entire countries consume. The expensive energy costs coupled with the unpredictability of mining have concentrated mining among large firms whose revenues run into the billions of dollars. According to an MIT study, 10% of miners account for 90% of the country’s mining capacity.
  • While ThThoryptocurrency blockchains are highly secure, other crypto repositories, such as exchanges and wallets, can be hacked. Many cryptocurrency exchanges and wallets have been hacked over the years, sometimes resulting in millions of dollars worth of “c” coins being stolen. Cryptocurrencies traded in public markets suffer from price volatility.
  • Bitcoin has experienced rapid surges and crashes in its value, climbing to as high as $17,738 in December 2017 before dropping to $7,575 in the following months. Some economists, therefore, consider cryptocurrencies to be a short-lived fad or speculative bubble.

$862.1 billion

Total market cap of Bitcoin, as of Dec. 20, 2021.

Frequently Asked Questions

What Is Cryptocurrency in Plain Words?

Cryptocurrencies are digital assets and decentralized systems that allow for secure online payments.

How Do You Get Cryptocurrency?

Any investor can purchase cryptocurrency from popular crypto exchanges such as Coinbase, thru apps such as Cash App, or thru brokers.

Another popular way to invest in cryptocurrencies is thru financial derivatives, such as CME’s Bitcoin futures, or thru other instruments, such as Bitcoin trusts and Bitcoin ETFs.

What Is the Point of Cryptocurrency?

Cryptocurrencies are a new paradigm for money. Their promise is to streamline the existing financial architecture to make it faster and cheaper.

Their technology and architecture decentralize existing monetary systems and make it possible for transacting parties to exchange value and money independently of intermediary institutions such as banks.

Can You Generate Cryptocurrency?

Cryptocurrencies are generated by mining. For example, Bitcoin is generated using Bitcoin mining. The process involves downloading software that contains a partial or full history of transactions that have occurred on its network.

Tho anyone with a computer and an Internet connection can mine cryptocurrency, the energy- and resource-intensive nature of mining means that large firms dominate the industry.

Bitcoin is by far the most popular cryptocurrency, followed by other cryptocurrencies such as Ethereum, Binance Coin, Solana, and Cardano.

Are Cryptocurrencies Securities?

The SEC has said that Bitcoin and Ethereum, the top two cryptocurrencies by market cap, are not securities. It has not commented on the status of other cryptocurrencies.

Investing in cryptocurrencies and other initial coin offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs.

Because each individual’s situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.

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