Definition and Example of Cryptocurrency
Cryptocurrency is a digital money system that lives on a blockchain. The blockchain is where every transaction is verified and secured by computers or nodes that use cryptocurrency. The concept of cryptocurrency was first mentioned 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 it.
- Alternate names: Digital currency
Bitcoin is the best-known cryptocurrency and the first industrial-strength version of the blockchain implementation. It was first introduced in 2009 through a white paper authored by Satoshi Nakamoto. The concept of a digital, decentralized, and secured payment system that does not depend on banks and other financial institutions has caught on.
As of August 2022, there are more than 20,000 cryptocurrencies, with a global market value of over $1 trillion being traded on 502 exchanges, according to CoinMarketCap. Ethereum, XRP, and Litecoin are among some of the best-known cryptocurrencies.
How Cryptocurrency Works
A simple cryptocurrency transaction involves sending it from one person to the next. Cryptocurrencies are stored in virtual “wallets,” and the transfer occurs from one wallet to the next.
All cryptocurrency transactions have a unique cryptographic signature, which creates a fixed record on the blockchain.
Each wallet has a public and private key attached to it. The public key is used to create an address for your wallet so you can receive cryptocurrencies. A private key, combined with the wallet, gives you the cryptographic signature that helps verify cryptocurrency transactions.
For instance, if Sam decides to send one Ethereum (1ETH) to Nina, 1ETH is 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.
Cryptocurrencies are not backed by governments and are not legal tender.
Computers on networks around the world receive these 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.
The concept of electronic money has been around since the 1990s. Many versions of cryptocurrencies came and went over the years without much notice until Bitcoin came along in 2009.
After some hiccups with the adoption of cryptocurrencies, they are now being accepted by a growing number of financial service providers. In 2014, online retailer Overstock began taking Bitcoin payments. Visa and PayPal also provide options for making cryptocurrency transactions.
You need as little as $1 to buy cryptocurrency, and you can spend it using cryptocurrency credit or debit cards. However, you should be aware of how taxes work when you spend your cryptocurrency. If your bitcoin has increased in value since you acquired it, the increase in value is considered to be taxable income or capital gains, depending on the circumstances.
The way you can buy cryptocurrency has changed over the years. It has become fairly easy to trade using platforms such as Coinbase or retail trading platforms like Robinhood.
It is vital to understand that cryptocurrency laws are still being formed. The Commodities Futures Trading Commission (CFTC) governs the trading of cryptocurrency futures and spot markets in the United States, and the Securities and Exchange Commission (SEC) governs cryptocurrency-linked investments.
Pros and Cons of Investing in Cryptocurrency
Potential for high returns
May be hard to understand
No benchmark for valuation
Open to scams and fraud
- Potential for high returns: There is no guarantee, but returns can be high. However, the value of Bitcoin has seen vast growth and volatility in recent years. In its 13-year history, Bitcoin has given very high average yearly returns.
- Offers diversification: Cryptocurrency 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.
- Volatility risk: If you invest in cryptocurrency, settle in for a wild ride. Its value has gone up and down since it was released. For instance, Bitcoin’s price topped $1,000 for the first time in 2017, reached a record high of more than $19,000 by the end of the year, then dove to nearly $3,000 a year later. In October 2021, the cryptocurrency set new highs when its price went up to nearly $66,000.
- May be hard to understand: Generally, you should only invest in things you know about. For instance, if you buy a stock, it is vital to know what the company does and how it makes money. Cryptocurrency may be hard to grasp, because it’s digital and not tangible. Before buying any, you may need (and want) to understand blockchain and the other concepts behind cryptocurrency.
- No benchmark for valuation: There’s currently no uniform method to compare the cryptocurrency's value to other investment types. This makes it hard to know whether you’re paying more than it's intrinsically worth.
- Open to scams and fraud: Anonymity, complexity, and changing rules and laws make cryptocurrencies more vulnerable to scams and fraud. Regulatory bodies such as the CFTC, the SEC, and the Financial Industry Regulatory Authority (FINRA) have all issued warnings to investors about Ponzi schemes and other scams using cryptocurrency.
Cryptocurrency has often been maligned for the one key thing that makes it unique compared to other currencies: its anonymity. Bitcoin and other cryptocurrencies have been used for illicit activities, Because of this, it's commonly believed that cryptocurrencies are the tools of criminals.
What It Means for Investors
Cryptocurrency may not be right for many investors, due to its high-risk nature. While you may be able to make money quickly from it, prices are also highly volatile. You can lose money just as quickly as you can make it.
Some may think of cryptocurrency as an “alternative” investment, lumped in with precious metals, private equity, collectibles, and any other investment that is not traded on stock exchanges.
- Cryptocurrencies are lines of digitally signed code where transactions are verified by computers on a blockchain.
- Cryptocurrencies may be traded for fiat currencies, but are not yet considered legal tender in the U.S.
- There is growing adoption of crypto 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.