What Is Cryptocurrency?

Cryptocurrency Explained

Woman wearing a red coat checking her phone while sitting in front of laptop
•••

nazar_ab/ Getty Images

Cryptocurrency is a digital, or virtual, electronic currency system. It uses encryption and cryptography techniques, similar to solving extremely complicated math problems, to authenticate and secure transactions on a distributed ledger such as a blockchain.

Cryptocurrencies can be exchanged for one another or for fiat currencies such as the U.S. dollar, but they are usually not backed by governments and are not yet considered legal tender.

Learn how cryptocurrencies work, how they came about, and what to know before investing in them.

Definition and Examples Cryptocurrency

Cryptocurrency is a digital currency system that lives on a blockchain, where every transaction is verified and secured by computers or nodes using cryptography.

  • Alternate names: digital currency, virtual currency

The idea of cryptocurrency was first introduced in 1998 by Wei Dai, who 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 cryptocurrency, is the first practical iteration of that concept. Bitcoin was first introduced in 2009, through a white paper authored by Satoshi Nakamoto. While the identity of Nakamoto remains a mystery, the concept of a decentralized peer-to-peer electronic payment system that does not depend on banks and other financial institutions has caught on.

Ethereum, XRP, Litecoin are among other popular cryptocurrencies.

As of April 29, 2021, there are more than 9,000 cryptocurrencies with a global market capitalization of over $2 trillion being traded on 371 exchanges, according to CoinMarketCap.

How Cryptocurrency Works

A simple cryptocurrency transaction is sending that cryptocurrency from one person to another. Cryptocurrencies are stored in electronic “wallets” and the transfer occurs from one wallet to another.

All transactions have a unique cryptographic signature, allowing for the creation of an indisputable record on the blockchain.

Each wallet has a public key and a private key associated with it. The public key is used to create an address for your wallet so you can receive cryptocurrencies. A private key is what gives you the right of ownership to the wallet and it must never be shared with anyone. A private key and the wallet give you the cryptographic signature that helps verify cryptocurrency transactions to and from your wallet.

For example, if Sam decides to send Ethereum (1ETH) to Nina, the transaction would require 1ETH to be debited from Sam’s wallet and credited 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, the value of cryptocurrency to be transferred among other things. Once it is submitted, this transaction would be broadcast on the Ethereum network to be verified or mined

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

Notable Happenings

The concept of electronic money has been around since the 1990s. Various versions of cryptocurrencies came and went over the years without garnering much attention until Bitcoin came along in 2009.

After initial hiccups with the adoption of cryptocurrencies, they are finally being accepted by a growing number of financial services providers. In 2014, online retailer Overstock was an early adopter accepting Bitcoin payments. Visa, PayPal, and Mastercard also provide options for conducting cryptocurrency transactions.

You need as little as a dollar to buy cryptocurrencies and you can choose to spend them using cryptocurrency credit or debit cards.  Though beware of tax consequences of spending your cryptocurrency.

Investing in cryptocurrency has evolved over the years and it has now become relatively easy to trade in them using platforms such as Coinbase and even retail trading platforms such as Robinhood.

It is important to understand that laws pertaining to cryptocurrencies are still evolving. The Commodities Futures Exchange Commission (CFTC) regulates the trading of cryptocurrency futures and spot markets, and the Securities and Exchange Commission (SEC) regulates cryptocurrency investments.

Pros and Cons of Investing in Cryptocurrency

Pros
  • Potential for high returns

  • Offers diversification

Cons
  • Enormous volatility

  • May be hard to understand

  • No known benchmark for valuation

  • Potential for scams and fraud

Pros Explained

  • Potential for high returns: No investment return can be guaranteed. But the value of bitcoin, in particular, has seen remarkable growth—and volatility—in recent years. In its 13 year history, bitcoin has delivered average annual returns of 180%, according to research from Bank of America.
  • Offers diversification: Cryptocurrency can potentially enhance a portfolio simply by being different from what you may already be invested in. The returns on cryptocurrency appear to be relatively uncorrelated to other asset classes, such as equities. Thus, using a modest amount as a diversifier could add to overall returns, or stave off bigger losses.

Cons Explained

  • Enormous volatility: If you invest in cryptocurrency, settle in for a wild ride. Its value has gone up and down dramatically in recent years. For example, bitcoin’s price surpassed $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 plummeting to nearly $3,000 just a year later. In April 2021, the cryptocurrency set new highs when its price went past $64,000.
  • It may be hard to understand: In general, it’s a good idea to invest in things you are familiar with. If you are investing in a company, for example, it is important to understand what it does and how it makes money. Understanding the ins and outs of cryptocurrency, however, may be a challenge since it’s a digital and virtual currency, unlike a physical product or service. Investors may need (and want) to understand blockchain and other terms associated with crypto before investing.
  • There’s no benchmark for valuation: Unlike traditional assets like stocks or real estate, there’s no uniform understanding of how to value cryptocurrency properly. That makes it very difficult to know whether you’re paying more than the investment is really worth.
  • Potential for scams and fraud: Anonymity, complexity and evolving regulations make cryptocurrencies vulnerable 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 cryptocurrencies.

Cryptocurrency has often been criticized for the one key thing that makes it unique to traditional currencies—its anonymity. Bitcoin and other cryptocurrencies have been used to purchase things on the “dark web,” including weapons, drugs, and other illegal items. These actions have led to concern over cryptocurrency as a possible tool for organized crime. 

What It Means for Individual Investors

Cryptocurrency may not be a sensible investment for the average person due to its high risk nature. While it may be possible to make money quickly from it, values are also highly volatile, so you can lose money as quickly as you can earn it. 

That said, some experts consider cryptocurrency to be an “alternative” investment lumped in with precious metals, private equity, collectibles, and any other investments not easily available on major exchanges.

If you have a sizable amount of money and a diverse set of investments already, adding a small investment of alternative purchases such as cryptocurrency may help diversify your portfolio even more.

Key Takeaways

  • Cryptocurrencies are digital or virtual money systems where transactions are verified by computers on a blockchain.
  • Cryptocurrencies may be exchanged for one another or fiat currencies but they are not considered legal tender just yet.
  • There is growing adoption of cryptocurrencies for transactions with many financial services providers accepting them.
  • Cryptocurrencies may offer the promise of spectacular returns but there are many factors that make them a risky investment.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.