What Is Cryptocurrency?
Cryptocurrency is becoming more widely used, with several major companies accepting Bitcoin as payment, including Starbucks, Overstock, Whole Foods, and AT&T. Unlike cash or a debit card that you can store in your wallet, cryptocurrency is a digital currency that uses a process of encryption and decoding called cryptography to secure transactions.
How Does Cryptocurrency Work?
Cryptocurrency is based on a peer-to-peer system to verify transactions. Transactions are recorded in blocks that exist as an entry in an online database serving as a public ledger. The blocks are linked together, each including a reference to the block immediately before it, forming a chain, or blockchain.
Blockchains prevent duplicate or fraudulent transactions by using a consensus algorithm. Bitcoin, for instance, uses a process called “mining.” Miners use computers that race to solve mathematical problems with an algorithm that verifies codes in the blockchain. The first miner to verify the block is paid in cryptocurrency coins or tokens. Once blocks are verified, they become locked, securing the transactions against any attempt to modify the chain.
Brokers also sell cryptocurrency on an exchange. Most exchanges will store your cryptocurrency for you, but most crypto advocates suggest using a crypto wallet. Crypto wallets are different than a digital wallet on your phone, although those transactions are also processed through encryption. Digital wallets allow you to store a digital representation of a physical payment method, like a credit or debit card. Crypto wallets do not technically store cryptocurrency. Instead, they store private codes called keys that give the holder the authority to transfer cryptocurrency ownership on the blockchain.
Cryptocurrencies operate on a decentralized system that is not government-regulated, which makes them more volatile but also allows them to be exchanged anywhere in the world. Fiat currency, such as the U.S. dollar, is government-issued legal tender not backed by a physical commodity like gold or silver; instead, its value is based on supply and demand.
Types of Cryptocurrencies
Thousands of cryptocurrencies exist, and because they are new, many fail as quickly as others are launching. Here is a list of some of the best-known and widely used.
- Bitcoin: Founded in 2009, Bitcoin was the first and is still the most widely known form of cryptocurrency. It has an extensive network of miners and is chosen by more users than other forms of cryptocurrency. Because of its popularity, other types are often referred to as “altcoins,” or alternatives to Bitcoin.
- Ethereum: Developed in 2015, Ethereum has its own currency called Ether (ETH). It is the second most popular due to its use of smart contracts, which automatically execute when conditions are met. Smart contracts are the technology that led to non-fungible tokens (NFTs) and decentralized finance (DeFi) booms over the last couple of years.
- Tether: As its name implies, Tether attempts to anchor to a specific value of $1 per coin. Because of its tie to the U.S. dollar, it’s also known as a stablecoin. Tether is often used when traders move from one cryptocurrency to another.
- USD Coin: Another type of stablecoin, USD Coin also attempts to stay pegged to the dollar, so its value doesn’t fluctuate. Centre Consortium, backed by Circle and Coinbase, launched the coin in 2018. Because Circle is based in the U.S., it is subject to regulation, which makes USD Coin a regulated stablecoin.
- Binance Coin: Binance is the third-largest cryptocurrency, and those who use the token can receive benefits from the Binance Exchange, one of the most widely used exchanges in the world. Binance also created Binance USD, another type of regulated stablecoin.
- XRP: Created in 2012 by a company called Ripple, XRP offers a way to pay in many different real-world currencies, making it useful in international transactions. Ripple has been involved in a multi-year lawsuit with the SEC over whether XRP is unregulated security.
How Is Cryptocurrency Used?
Cryptocurrencies can be bought, sold, and used to pay for goods and services online, and more companies are accepting Bitcoin on their e-commerce sites. You can buy cryptocurrency using fiat money, like U.S. dollars, through a broker or an online exchange. Each exchange will have different currencies, wallet storage, interest-bearing account options, and transaction fees.
Users can also invest in crypto, like buying Bitcoin trusts with a brokerage account. Although cryptocurrencies are not traded on the stock market, users can invest in stocks or Exchange-Traded Funds (ETFs) of companies that use blockchain technology.
Because a governing entity does not oversee the transactions, users participate at their own risk. While cryptocurrencies are legal in many countries, some have restrictions, and others consider them illegal, with jail sentences for those who participate in a transaction.1
Investing in Crypto
If you are thinking about investing in cryptocurrency, know the risks involved. Because crypto is largely unregulated, scams and worthless coins are common, with the most common being the “pump and dump” scheme. In this scam, a group of people will buy a cryptocurrency for a low price. They will then flood the internet and social media with positive and often false information about the currency to drive up the price. When the price increases, they will sell their tokens at an inflated price, leaving the later investors holding the bag as the price plummets.
Crypto is relatively new, its value is highly volatile, and there’s no guarantee it will be worth anything in the future.
Also, while you may have heard about early Bitcoin investors who made millions, investing in crypto is highly risky and speculative. It’s relatively new, its value is highly volatile, and there’s no guarantee it will be worth anything in the future.
Consider that a single Bitcoin was valued at about $6,300 in early November 2018. Just three years later, Bitcoin values had skyrocketed to over $65,000 — more than ten times its value for anyone who had the exceptional fortune of timing an investment just right. However, eight months later, in July 2022, Bitcoin values bounced between $19,000 and $21,000. Anyone who bought in November 2021 at the height of the market would have experienced an erosion of more than two-thirds of their investment.2 Big swings attract speculators and thrill the fortunate, but many who follow this siren song end up all wet!
Read more about the cyberattacks and risks associated with cryptocurrency from The Motley Fool. It’s important to point out that many financial advisors would regard this as gambling more than investing. However, if you’re determined to jump in, only do so if you truly understand the risks — namely that your investment could plummet to zero — and risk only as much money as you can comfortably afford to lose.1 "Countries Where Bitcoin Is Legal and Illegal" from Investopedia.com
2 "Bitcoin's Price History" from Investopedia.com
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