What Is Cryptocurrency And How Does It Work?

Blockchain, Crypto 101, Digital Finance, Investing

If you haven’t read a lot about cryptocurrency, you may be wondering exactly what it is. 

Essentially, cryptocurrency is a digital form of currency based on cryptography, the study of secure communications techniques and data chains on a technology known as the blockchain. As experts describe, this blockchain functions as an immutable ledger that records the entire history of a cryptocurrency. 

People refer to cryptocurrency as decentralized financial assets. Through a consensus-based verification model, the facts surrounding the cryptocurrency are completely transparent instead of being tracked by an institution. What does that mean? Well, imagine you go to a wedding and there’s no marriage contract signed. How do people know the marriage happened? Easy – you just ask anyone who attended. Cryptocurrency works similarly. The asset holders can verify together what’s been happening on the blockchain through the distributed ledger. 

The Cryptocurrency Market 

There are over 7,000 currencies worth over 3 trillion dollars. The leading cryptocurrencies by market cap (as of November 2021) are: 

  1. Bitcoin (BTC) (1,274.83 Billion Dollars) 
  2. Ether (ETH) (549.72 Billion Dollars) 
  3. Binance Coin (BNB) (107.72 Billion Dollars 

Fiat Currency vs. Cryptocurrency 

How does cryptocurrency compare to national currencies, which we call “fiat”? 

One of the most significant differences is that cryptocurrency markets don’t respond to a central bank. For example, in the United States, the Federal Reserve, our central bank, sets monetary policy. They can print more dollars and dilute the value of the currency. They can’t do that with Bitcoin because it’s a global independent market. 

The value of fiat money is tied to government-issued currency, whereas the value of a digital asset is derived from its blockchain. This fact, along with cryptocurrency attributes, offers many advantages to investors and consumers alike. 

Cryptocurrency Attributes 

Another way to look at the differences between fiat money and digital currencies is to focus on how crypto is set up. As compared to fiat, cryptocurrencies are decentralized, anonymous, more secure, and universal. 

Cryptocurrency is… 

  • Decentralized. The process is peer-to-peer and doesn’t need institutional verification. That removes various bottlenecks and creates a more transparent process.
  • Anonymous — but not always private. In other words, the decentralized consensus-based system doesn’t require identifying the person holding the asset. However, governments created know your customer or KYC rules that also apply to digital currency operators that require them to ​​collect and verify identifying information.
  • Secure. In terms of cybersecurity, digital currencies have more robust security protocols. Having a decentralized nature means there’s security built into the system.
  • Universal. These digital assets are globally accessible through the internet. You don’t have to rely on a bank or third party to transfer various amounts of cryptocurrency. 

These attributes provide many advantages that make cryptocurrency more attractive to investors. While digital currencies can be divided into smaller units much like fiat money, their scarcity makes them valuable. Quantities are limited, so as supply goes down, demand goes up. That’s why you see investors scrambling to get a piece of the pie. 

How Does Cryptocurrency Work? 

Although seemingly daunting, it’s not that difficult to understand how cryptocurrency works. First, you must know where cryptocurrency comes from. 

Cryptocurrency comes from a practice called mining. This is where independent parties build data on the blockchain using their computer processing power. Cryptocurrency doesn’t come from a central bank or any financial institution – crypto experts instead create it — and due to blockchain technology, there’s no counterfeiting. Every transaction is transparent and publicly visible. 

Now, let’s talk a bit about what some of these verification processes look like. 

You can have a proof of work system where the miners show how they built their data blocks, or you can have something called a proof of stake system where the verification is in the person’s actual ownership of the digital currency.  

Storing Cryptocurrencies 

Where do you keep your digital currencies? You keep them in a digital wallet (a file system, not a physical wallet) that needs to be stored in a piece of hardware, whether a computer, a flash drive or another device. Many independent traders keep their digital assets on a flash drive. Beware, though… if you lose the flash drive, you lose your digital currency forever.  

Asset holders can also store digital currencies in a hot or cold wallet. The difference is that a hot wallet is connected to the internet for easy trading or transferring value around. The cold wallet is disconnected from the internet and provides a more secure way to hold your digital currency assets. 

Using Cryptocurrency 

You can use cryptocurrency in several ways: 

  • As an investment vehicle – interest in using cryptocurrency as alternatives to the traditional stock market has grown. As a result, the global crypto market cap has grown five times over the last year as digital currency becomes a diversification instrument. 
  • Hedge vs. inflation – cryptocurrency has been considered the new gold because of its potential to protect against inflation. Some investors have seen their holdings outweigh gold. 
  • A way to transfer value – digital currency offers options as a method to pay for goods and services, as well as payment as income. And more and more retail companies are starting to accept digital currency as payment. 

    Crypto Transactions 

    These transactions happen via wallets and crypto exchanges. A crypto transaction can happen in several ways: you can buy, sell, trade, and transfer crypto.  

    Here’s exactly how each of these transactions works. 

    • Buy or sell – crypto can be bought or sold using a digital wallet and an online app designed to store your currency. Once you have your account through a digital currency service provider, you’re free to buy and sell.  
    • Send or transfer to another wallet – each wallet has one or more unique wallet addresses that can be used to exchange cryptocurrency.  
    • Use to pay for goods and services – paying for products and services using crypto can be done using your online wallet or some debit cards issued by major credit card companies can be connected right to your cryptocurrency wallet. 

    Cryptocurrency Fees  

    Even though you won’t have your typical bank fees for doing digital currency transactions, you will still end up paying to trade crypto. 

    Common fees include:  

    • Network fees. Transaction or mining fees, where facilitators cover the costs of creating and handling the digital currency 
    • Exchange or wallet fees. These fees cover the cost of running the exchange 

    Challenges of Crypto 

    Suppose you’re interested in buying or selling cryptocurrency or some other kind of digital currency trading. In that case, you need to know about some of the challenges associated with this asset class. 

    This is a relatively new investment class, so financial regulators are still grappling with how to regulate this asset effectively. They’re working on it – for instance, the European Commission has its own carefully generated rules on crypto and American regulators like the SEC are going to the drawing board every day to figure out what to allow in terms of new digital currency money services. 

    Another challenge with cryptocurrency is the potential for fraud and money laundering. That’s why agencies have created know your customer (KYC) and anti-money laundering (AML) rules which can significantly decrease the likelihood of crypto being used for crime. 

    Cryptocurrency is also notoriously volatile. Just take Bitcoin (BTC), which spiralled to US$60,000 per coin and then sank back down to US$30,000 per coin all in the last year. That’s the volatility you don’t often see with established equities or commodities, for example. While some see this as a challenge, other traders make money on this volatility by analyzing certain market indicators to predict price fluctuations and then buy or sell at the right time. 

    Another challenge for some kinds of cryptocurrencies is the energy used to mine them. After pouring money into Bitcoin (BTC), Elon Musk (of Tesla, SpaceX, etc.) did a quick turnaround months ago, noting the energy-intensive process of crypto mining. But, some cryptocurrencies are less energy-intensive and/or use renewable energy sources. 

    How can you protect and manage your digital currency investments in a regulated and compliant way? Make sure you look for these three things in a digital asset service provider: 

    1. Ensure the service provider is regulated and licensed. 
    2. Verify the company is registered as a money services business. 
    3. Make sure they follow know-your-customer and anti-money laundering rules. 

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