A cryptocurrency is a decentralized virtual or digital currency based on blockchain technology and secured by cryptography. This security measure makes it almost impossible to double-spend or counterfeit.
One defining feature of cryptocurrencies is that they aren’t issued by any central authority, making them theoretically impervious to government interference.
Most people are familiar with the popular versions of cryptocurrency: Bitcoin and Ethereum. Still, according to investing.com, there are more than 5,000 distinct coins in circulation.
People can use crypto to buy everyday goods and services, but most invest in them like they would do so with precious metals or stocks. However, although crypto is an exciting and novel asset, purchasing it is considered risky. Interested individuals should research it to understand how the system works and its nuances.
How Do Cryptocurrencies Work?
Cryptocurrencies are a digital exchange medium that is decentralized and encrypted. Unlike common currencies like Euro or the US Dollar, there isn’t a central authority that manages or maintains its value. Instead, the system distributes these tasks among the users of cryptocurrencies through the internet.
The first crypto to ever emerge was Bitcoin in 2009. Satoshi Nakamoto published the paper on its specification and proof of concept in a mailing list of cryptography. In the article, Nakamoto described Bitcoin as an electronic payment system grounded on cryptographic proof, which replaced trust.
The cryptographic proof works by sharing a public ledger called “blockchain.” It provides a means of recording and verifying every transaction ever processed.
What Is a Blockchain?
A blockchain is an open, public, and distributed ledger that records every transaction. People can see it as a checkbook spread across innumerable devices across the world. It records transactions in “blocks” and links them together on a “chain” containing every previous cryptocurrency exchange.
A comparison would be writing down everything people spend money on every day in a book. Each page represents a block, and the entire book is the blockchain.
Everyone who uses cryptocurrencies has a copy of this book, thanks to the blockchain. It provides a unified record of transactions. The software logs transactions as they occur in real-time and updates all blockchain copies simultaneously with this data. It keeps records accurate and identical.
Experts consider that blockchain technology has considerable potential for other uses, such as crowdfunding and online voting. Other financial institutes like the JPMorgan Chase investment bank regard it as a potentially revolutionizing technology capable of changing how people transfer ownership, exchange valuable assets, and verify transactions.
Blockchain Validation Techniques
Blockchain has two primary validation techniques to check each transaction to prevent fraud: “proof of work” and “proof of stake.” These verify every transaction before they’re included in the blockchain that rewards verifiers with additional cryptocurrency. Every cryptocurrency uses either to validate their exchanges.
Proof of Work
This method verifies transactions on a blockchain via an algorithm that provides a complex mathematical problem that computers must compete to solve. Every participating device, which people most commonly denote as miners, solves the puzzle which aids in verifying a transaction group. Afterward, the miner includes them in the blockchain ledger.
The first computer that successfully solves the problem gets rewarded with a small amount of the corresponding cryptocurrency for its work. Unfortunately, this race to crack the puzzle often requires substantial computer processing power and electricity. Most miners only break even after receiving the crypto for validating transactions after taking into account the electricity bills incurred.
Proof of Stake
Cryptocurrencies often employ this transaction validation method when they wish to reduce the necessary power required. With it, the number of transactions an individual can check gets limited by the quantity of cryptocurrency the person is willing to stake or temporarily imprison within a public safe.
Individuals who stake their cryptocurrency are entitled to validate transactions, but their odds of being picked increase depending on the amount they decide to risk. In a way, it’s similar to offering collateral to a bank.
This procedure is more efficient than proof of work because it removes the necessity to solve complex equations. It allows for faster exchange confirmation times and requires significantly less energy.
When a stake owner, verifier, or validator gets picked to verify a group of transactions, they receive a reward in cryptocurrencies. This reward often equals the aggregate transaction fees from the exchange block. However, individuals selected to verify transactions have to surrender a part of their stake as a means to discourage fraud.
Both validation methods, proof of stake and proof of work, depend on consensus mechanisms to carry out their procedures. While each user validates the exchange, most ledger holders verify and approve each of these verified transactions.
For instance, hackers can’t alter the blockchain ledger unless more than half of the ledger holders somehow match the fraudulent version in the end. The necessary resources required to perform this greatly discourage scams.
Cryptocurrency’s Advantages and Disadvantages
Cryptocurrencies make it easier to transfer funds directly between parties without the aid of a credit card company or a bank. Instead, these transfers use public and private keys along with the previous validation methods.
In most cryptocurrency platforms, a user’s wallet has a public key that allows them to receive transactions and a private key to sign and retrieve the currency. Depending on the service individuals use, they can enjoy minimal processing fees or none at all.
Unfortunately, the mostly anonymous nature of crypto transactions makes them a notable host for illicit activities. Bad actors use this technology in money laundering and tax evasion schemes. Still, several cryptocurrencies highly value their privacy, referring to benefits such as protection for whistleblowers and activists under oppressive governments.
Bitcoin, in particular, isn’t the best choice for illegal businesses. There are recorded cases in which forensic analysis of its blockchain helped governing authorities to prosecute criminals. However, coins focusing on privacy do exist, such as Monero, Zcash, and DASH, which are considerably harder to trace.
How Do People Mine Cryptocurrencies?
Mining is the process in which new cryptocurrency units are released into circulation, often in exchange for verifying transactions. While the average person can theoretically mine cryptocurrencies, it’s significantly challenging in specific proof of work systems, such as Bitcoin and Litecoin.
Their difficulty lies in the network’s growth. As it expands, the more complex the problems become, requiring significantly more processing power to solve. At first, the average user could mine without much trouble, but nowadays, the overall cost is prohibitive. There are too many experienced miners with optimized technology and equipment arranged and designed solely to outperform.
Besides, the proof of work validation method requires substantial amounts of electricity to mine. In fact, Bitcoin farms consume over 121 terawatt-hours per year, and the number isn’t likely to fall anytime soon.
This amount of energy consumption surpasses Argentina, the Netherlands, and the United Arab Emirates. Most bitcoin miners end up using a large portion of their earnings to cover the costs of electricity.
For the average person, earning crypto by mining in a proof of work platform is entirely impractical. However, the proof of stake model doesn’t require highly specialized equipment. It picks validators at random, depending on how much they risk.
Still, this method requires all participating individuals to own a cryptocurrency, as people without them have nothing to stake. Currently, several prominent cryptocurrencies such as Ethereum and Dogecoin are planning to switch into a proof of stake method in an effort to solve environmental concerns.
What Are the Uses of Cryptocurrency?
People can use cryptocurrencies to make everyday purchases of goods and services. However, this payment method isn’t widely available yet. A couple of online stores accept Bitcoin, such as Microsoft and Overstock, but it’s far from being the standard. Still, this fact may change soon.
In October 2020, the worldwide online payment system, Paypal, launched a service that lets users buy, hold, and sell crypto from their accounts. Although it has several limitations, such as the fact that it’s only available for the US or that the cryptocurrency purchases get locked in the platform, it’s a massive step in the right direction.
Recently at a CoinDesk’s consensus 2021 event, the VP and GM of Paypal’s blockchain, crypto, and digital currencies announced that a withdrawal function to third-party wallets is in development. It’s a considerable improvement over the current situation, and it might encourage other online payment platforms to offer similar services.
Until cryptocurrencies become more widespread, users can exchange them for gift cards with eGifter, Coingate, or Bit Refill. For example, with Bit Refill, people can acquire Amazon, eBay, and Uber gift cards.
Regardless, the most popular use for cryptocurrencies is as an alternate investment option besides stocks, bonds, and precious metals. Some people refer to Bitcoin as digital gold for this very reason. Still, every cryptocurrency has volatile prices, making it a risky investment.
Using Cryptocurrency for Secure Purchases
Whether people can safely purchase goods and services with crypto depends entirely on the item in question. For stores that don’t accept digital currency directly, users can opt for a crypto debit card, such as Coinbase, in the US.
In case the retailer or individual does accept it, people need a Bitcoin wallet. This software interacts with the blockchain to enable users to buy and sell cryptocurrencies. There are two methods by which people can transfer money from their wallets. They can scan the QR code of the recipient’s wallet or manually type in their address.
Some wallets and services streamline this process by allowing users to send and receive with just a phone number. However, transactions aren’t immediate. Each has to pass through a validation method by either proof of work or proof of stake. This process may take anywhere between 10 minutes to two hours, depending on the cryptocurrency.
Still, this minor setback is a fair price to pay. After all, it’s what makes every transaction so secure. Ill-intentioned users trying to modify an exchange can’t get anywhere unless they have the proper keys, so the system promptly rejects their transactions.
Investing in Cryptocurrency
Individuals can purchase a cryptocurrency on a peer-to-peer platform or a crypto exchange such as Coinbase and Binance. Users should pay attention to transaction fees as some slip in incredibly high costs on minor cryptocurrency purchases.
For example, Binance’s trading and purchasing fees range from 0.02% to 0.10%, and it has 3% and 4.5% for debit cards. However, this is the case for the global platform. US users have to use the BInance.US platform, which has higher trading and purchasing fees (0.10% to 0.50%) and fewer trading pairs. Still, the commissions it demands are better than other famous exchange platforms, including Coinbase Pro.
Robinhood is a stock trading and investing app that allows users to acquire several prominent cryptocurrencies without any fees. Unfortunately, it only offers seven choices, including Ethereum, Bitcoin, Dogecoin, and Litecoin.
It’s essential to remember that buying a particular cryptocurrency is similar to purchasing individual stocks. When users put their financial weight into a single asset, they’re taking considerably more risk than spreading the worth over multiple ones.
Exchange-traded funds and mutual funds are a simpler way to diversify investments. Unfortunately, there aren’t that many that take cryptocurrencies. So far, two funds invest in them, the Grayscale Bitcoin Trust (GBTC) and the ARK Investment Management.
The former only accept accredited investors that have earned over $200,000 or those with a net worth of $1,000,000 at least. ARK’s ETFs are a good choice but ultimately a risky one. They have seen considerable success lately, but there isn’t a result representative of the future.
People who want to start by getting light exposure into the market can invest in the stocks of individual cryptocurrency companies, such as Coinbase. Others who desire less risk can invest in large companies that have implemented blockchain technology, such as ConsenSys and IBM.
The Bottom Line
Cryptocurrencies are a digital asset form based on a network spread across its user’s computers worldwide. This decentralization makes it mainly immune to the control of central authorities and governments.
Blockchains are an essential component of every cryptocurrency. They’re an open and public ledger that records every transaction. Experts believe that blockchain, along with other related technologies, may influence multiple industries.
Users most commonly utilize cryptocurrency as an alternative means of investment. Although there are cases in which it’s possible to use digital coins to pay for goods and services, the method isn’t widely adopted.
ChesWorkShop commits to presenting fair and reliable information on subjects including cryptocurrency, finance, trading, and stocks. However, we do not have the capacity to offer financial guidance, advocating instead for users to conduct their own diligent research.