If you’ve been following the news, you might have asked the “What is cryptocurrency” question a few times. Who hasn’t? Especially with Bitcoin posting unusual returns.
So, what exactly is crypto, and how does it work? Cryptocurrencies have become increasingly valuable over the past two years, and naturally, more people have become curious about these assets.
This guide explores the ins and outs of cryptocurrencies and how the assets function.
What is Cryptocurrency?
First off, let’s consider the most important question – what is cryptocurrency?
A cryptocurrency is a digital asset that can be traded and used to pay for goods and services online. There are thousands of cryptocurrencies available today. Two of the most popular ones are Bitcoin and Ethereum.
Unlike traditional currencies, like the pound sterling or US dollar, a cryptocurrency uses cryptography techniques to manage its monetary systems. Cryptocurrencies exist outside of the control of governments or any central authority.
A cryptocurrency is secured by a system called “blockchain technology.” The blockchain is simply a distributed database for storing information in chunks or “blocks.”
By design, blockchain ensures valuable data can be shared, stored and confirmed without intermediaries.
Cryptocurrencies look to offer several benefits over traditional money. These include:
- Speed: With cryptocurrencies, sending money – or value – across regions or continents happens in a few minutes. This trumps traditional cash, which takes hours to days in some cases.
- Security: Cryptocurrencies run on blockchains, which are distributed and decentralised. Since they are not centralised, there’s no single point of failure. This makes the blockchain harder to corrupt or hack.
- Censorship-resistant: Anyone can use cryptocurrencies. They offer users financial freedom. No government or central authority can censor or reverse a transaction once it’s completed.
How Does Cryptocurrency Work?
With the fundamentals above, you might wonder how does cryptocurrency work? What makes this system tick? To understand how cryptocurrencies work, we need to explain three concepts.
They are the blockchain, cryptocurrency mining, and cryptocurrency wallets.
A blockchain is similar to a database but better. Databases store a large volume of data electronically on a computer or on servers made up of powerful computers. These servers are often centralised in a location and built for easy storage and retrieval of data.
The blockchain differs from a database in setup. Unlike a database, the blockchain is a decentralised public ledger. The computers powering the network are not all under one roof or operated by one single individual.
In addition, a blockchain collects multiple data together in groups, otherwise known as ‘blocks.’ These blocks have specific storage capacities. Once filled, the blocks are chained and added to the previously filled block to form a chain of data known as a “block-of-chain” or the “blockchain.”
In the case of Bitcoin, the blockchain stores every Bitcoin transaction initiated on the network.
Before transactions are stored on the blockchain, they need to be verified. The blockchain network also has to be maintained. And more importantly, new cryptocurrencies are to be created from time to time. These tasks are carried out by a group of people called “miners.”
Cryptocurrency mining is the process of validating crypto transactions and then adding them to the network in exchange for crypto rewards. To validate Bitcoin transactions, for instance, miners have to solve complex mathematical questions using powerful computers. This is called the Proof-of-Work (PoW) consensus. Solving these equations involves powerful computers and energy, making the PoW an expensive endeavour.
Bitcoin miners who successfully solve the problems are allowed to add blocks of verified transactions into the blockchain. These miners are paid a reward of 6.25 Bitcoins for their trouble.
Other cryptocurrencies, like Solana and Cardano, use a Proof-of-Stake (PoS) consensus, where miners secure and maintain the network by “staking” their coins. PoS consensus attributes mining power based on the proportion of coins staked or held by the miner.
Unlike the Pound or US Dollar, cryptocurrencies don’t have a physical form. You can’t hold Bitcoin or Solana in your hands. They are digital assets that are transferred over the Internet. A digital or cryptocurrency wallet is a storage facility for your crypto holdings.
Technically, cryptocurrency wallets don’t store your crypto funds. They store your private keys. A private key is a password that proves ownership of your crypto holdings and is used to initiate transactions. Since your crypto lives on the blockchain, the private keys are required to provide access to the digital assets.
How Many Cryptocurrencies Are There?
The number of crypto assets has exploded since Bitcoin broke onto the scene in 2009, following the financial crisis of 2008. These days, digital coins are created almost daily.
Per data from industry data provider CoinMarketCap, there are almost 20,000 cryptocurrencies available and trading in over 47,000 markets, with these numbers rising all the time. The total market cap for the crypto market stands at over $2 Trillion. These are some of the most valuable coins:
- Bitcoin (BTC)
- Ethereum (ETH)
- Cardano (ADA)
- Tether (USDT)
- Binance Coin (BNB)
Is Cryptocurrency a Good Investment?
There is no doubt that cryptocurrencies are a good investment. But, they are also risky. It’s considered normal for a cryptocurrency to rise by 35% in a day. The price can also fall by a similar value within the same period. By nature, cryptocurrencies have been successful when compared to other assets.
For instance, when stacked up with other asset classes like the stock market, bonds or gold, Bitcoin investors took home a 5,507% return on their investment, per data from YCharts. The total profit earned from Bitcoin from 2011-2020 was about six million percent.
The cryptocurrency market also grew to a market cap of $2.31 trillion, making it larger than the market capitalization of any company, including Apple Inc.’s $2.08 trillion, at the time. The crypto market grew by 851%, from $243 billion in 2020 to a high of $2.31 trillion in May 2021.
Despite these gains, it’s common knowledge that the crypto market crashes from time to time. These price slumps rarely last long due to the volatility of the market. However, when choosing a cryptocurrency to invest in, it’s advisable that you only select assets with strong use cases and fundamentals, like Bitcoin or Ethereum. These assets are bound to post long-term gains irrespective of the general volatility in the market.
How Does Cryptocurrency Gain Value?
Cryptocurrency gains value primarily through the laws of demand and supply. When a coin’s demand starts to soar, its value increases – and vice versa.
This is the primary reason why you might notice slight price variations on exchanges. For instance, the price of Bitcoin on a platform like Binance might be $50,500, while one BTC goes for $50,700 on Coinbase.
Although these variations represent the exchange demand and supply metrics differences, they can be aggregated to find Bitcoin’s true value.
Another factor that affects a cryptocurrency’s value is scarcity. Cryptocurrencies tend to be more valuable once they’re scarce.
For instance, Bitcoin has a hard cap of 21 million, meaning that only 21 million BTC units will ever be produced. Once this happens, Bitcoin becomes increasingly rare and more valuable.
The digital asset’s utility is another factor that affects the value of a cryptocurrency. As the use case for a coin rises, the value would follow suit. Some exchanges offer discounts on trading fees and cash back on their crypto cards to customers who own their native digital assets.
Should I Invest in Cryptocurrency?
Should you invest in crypto? Is cryptocurrency a good investment? The answers to these questions would be dependent on your current situation and your financial goals. Cryptocurrencies are widely seen as the future of money, but the space is still largely unregulated. In some countries, crypto is outlawed. Is cryptocurrency legal in your jurisdiction? These are some of the details you should worry about. The crypto market is also more volatile than traditional stock markets. Before investing in crypto, we recommend learning how the market works, the fundamentals of the digital asset and how to trade cryptocurrency. You can start by reading our guides on Bitcoin and Ethereum.
Cryptocurrencies are taking the world by storm. They’ve gotten the attention of some of the biggest names on Wall Street, and their profiles continue to rise. Whether as an investment or a utility, more people are owning cryptocurrencies by the day. Investing in cryptocurrencies long term can also be profitable. As you take this next step, remember never to invest more than you’re willing to lose.