What Is Cryptocurrency?

Cryptocurrency Explained

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Cryptocurrency (crypto) is a digital currency system. It uses encryption and cryptography methods, similar to solving complex math problems, to confirm and secure transactions on a shared ledger such as a blockchain.

Cryptos can be traded for one another or for fiat currencies such as the U.S. dollar. Still, they are not backed by governments and are not legal tender.

Learn how crypto works, how it came about, and what to know before you buy it.

Definition and Examples Cryptocurrency

Crypto is a digital money system that lives on a blockchain. This is where every transaction is verified and secured by computers or nodes using crypto.

  • Alternate names: Digital currency, virtual currency

The concept of crypto was first mentioned in 1998 by Wei Dai. Dai talked about using cryptography to create and transact a new form of money, rather than rely on a central authority to do that.

Bitcoin, the oldest and most well-known crypto, is the first real version of that concept. Bitcoin was first introduced in 2009 through a white paper authored by Satoshi Nakamoto. While Nakamoto's identity remains a mystery, the concept of a decentralized virtual payment system that does not depend on banks and other financial institutions has caught on.

Ethereum, XRP, and Litecoin are among some of the most known cryptos.

As of July 24, 2021, there were more than 11,000 cryptos, with a global market value of over $1.3 trillion being traded on 390 exchanges, according to CoinMarketCap.

How Cryptocurrency Works

A simple crypto transaction is sending it from one person to the next. Cryptos are stored in virtual “wallets,” and the transfer occurs from one wallet to the next.

All crypto moves have a unique cryptographic signature, which creates a fixed record on the blockchain.

Each wallet has a public key and a private key attached to it. The public key is used to create an address for your wallet so you can receive cryptos. A private key is what makes you the owner to the wallet. This key must never be shared with other people. A private key and the wallet give you the cryptographic signature that helps verify crypto trades to and from your wallet.

For instance, if Sam decides to send one Ethereum (1ETH) to Nina, the act would require 1ETH to be taken from Sam’s wallet and added to Nina’s. The transaction would be a piece of code that would include data such as the recipient’s address, the sender’s signature, and the value of crypto to be moved, among other things. Once it's done, this move would be broadcast on the Ethereum network to be verified or mined

Computers on networks across the world receive many such requests, which they bundle together in what is called a block. These machines then verify the authenticity of all the transactions in the block by solving complex cryptographic problems. Once the block is validated or mined, it gets added to the blockchain. The miner, or the computer, that does this gets paid for its effort.

Notable Happenings

The concept of electronic money has been around since the 1990s. Many versions of cryptos came and went over the years without getting much notice until Bitcoin came along in 2009.

After some hiccups with the adoption of cryptos, they are now being taken by a growing number of financial service providers. In 2014, online retailer Overstock began taking Bitcoin payments early on. Visa and PayPal also provide options for making crypto transactions.

You need as little as $1 to buy crypto, and you can choose to spend them using crypto credit or debit cards.  You should beware of the tax consequences of spending your crypto.

Buying crypto has changed over the years. It has become fairly easy to trade using platforms such as Coinbase and even retail trading platforms such as Robinhood.

It is vital to understand that laws having to do with crypto are still being formed. The Commodities Futures Exchange Commission (CFTC) governs the trading of crypto futures and spot markets, and the Securities and Exchange Commission (SEC) governs crypto investments.

Pros and Cons of Investing in Cryptocurrency

Pros
  • Potential for high returns

  • Offers diversification

Cons
  • Volatility risk

  • May be hard to understand

  • No known benchmark for valuation

  • Open scams and fraud

Pros Explained

  • Potential for high returns: No return can be promised. Still, the value of Bitcoin has seen vast growth and volatility in recent years. In its 13-year history, Bitcoin has given average yearly returns of 180%, Bank of America reports.
  • Offers diversification: Crypto may enhance your portfolio simply by being different from your other investments. The returns on crypto appear to be unrelated to other asset classes, such as equities. Thus, using a modest amount of crypto as a diversifier could add to overall returns or stave off bigger losses.

Cons Explained

  • Volatility risk: If you invest in crypto, settle in for a wild ride. Its value has gone up and down in recent years. For instance, Bitcoin’s price went over $1,000 for the first time in 2017 and reached a record high of more than $19,000 by the end of the year, before diving to nearly $3,000 just a year later. In April 2021, the crypto set new highs when its price went past $64,000.
  • May be hard to understand: You should almost always invest in things you know about. If you invest in a company, for instance, it is vital to know what it does and how it makes money. Knowing the ins and outs of crypto may be hard since it’s a digital currency, unlike a tangent product or service. You may need (and want) to understand blockchain and other terms that go with crypto before buying it.
  • There’s no benchmark for valuation: Unlike other assets like stocks or real estate, there’s no uniform understanding of how to value crypto. That makes it hard to know whether you’re paying more than it's really worth.
  • Open to scams and fraud: Anonymity, complexity, and changing rules and laws make cryptos open to scams and fraud. Regulatory bodies such as the CFTC, SEC, and Financial Industry Regulatory Authority (FINRA) have all issued warnings to investors about Ponzi schemes and other scams pertaining to crypto.

Crypto has often been maligned for the one key thing that makes it unique compared to other currencies: its anonymity. Bitcoin and other cryptos have been used to purchase things on the “dark web” such as weapons, drugs, and other illegal items. These actions have led to concern over crypto as a tool to commit crimes. 

What It Means for Investors

Crypto may not be the right thing to invest in for most people due to its high-risk nature. While you may be able to make money quickly from it, values are also highly volatile. If you're not careful, you can lose money as quickly as you can earn it. 

That said, some experts think of crypto as an “alternative” investment, lumped in with precious metals, private equity, collectibles, and any other investments not easy to access on major exchanges.

If you have a lot of money and a diverse set of investments, adding a small investment of alternative buys such as crypto may help diversify your portfolio even more.

Key Takeaways

  • Cryptos are Virtual money systems where transactions are checked by computers on a blockchain.
  • Cryptos may be traded for one another or fiat currencies, but they are not considered legal tender just yet.
  • There is growing adoption of cryptos for transactions, with many financial services providers accepting them.
  • They may offer the promise of great returns, but many factors make them a risky investment.