What Is Cryptocurrency? 8 Common Questions Answered was written by Brian Thorp and originally appeared on Wealth of Geeks. It has been republished with permission.
Cryptocurrencies like Bitcoin, Ethereum, and dozens of lesser-known digital currencies frequently appear in the news, often following wild price spikes, and sometimes to cover the revolutionary blockchain technology they are built upon.
But these news reports usually do a poor job of explaining what cryptocurrency is if they attempt to do so at all. You can try searching the internet to learn more about cryptocurrencies. Still, it can be hard to find unbiased education among the banter of promoters and investors who stand to benefit if you choose to invest in the projects they’re backing.
This article strives to answer eight frequently asked questions about cryptocurrency in the most unbiased manner possible. We will follow that up with questions you should ask yourself or a financial professional before investing in digital assets.
1. What Is Cryptocurrency?
Cryptocurrency is any digital store of value that one can exchange for goods and services. Bitcoin is the oldest and most well-known example of a digital currency, invented by a person or persons using the pseudonym “Satoshi Nakamoto” in 2009. Since then, many cryptocurrencies have emerged as alternatives with unique features or use cases to distinguish themselves from the original Bitcoin.
2. What Is the Purpose of Cryptocurrency?
Cryptocurrency was initially conceived as a way of making international trade easier. Consumers in developing countries often lack consistent access to conventional fiat currency options such as U.S. Dollars or European Euros. So Bitcoin was proposed as a virtual currency and alternative form of payment versus traditional banking. In addition, the added benefits of near-instant transactions recorded on a public blockchain with less government intervention were seen as attractive among early Bitcoin proponents.
Since then, the price fluctuations of most cryptocurrencies have turned them into high-risk investment vehicles that can offer massive profits and devastating losses. The crypto community separates when discussing whether Bitcoin and similar currencies should be a viable monetary system or considered a highly speculative investment opportunity.
3. What Is Blockchain Technology?
All cryptocurrency transactions are recorded on a blockchain public ledger. These ledgers are known as decentralized networks. You can think of a blockchain similar to your account history on an online bank account. Transaction information gets stored in “blocks” that can be “chained” together to create a system with infinite memory, where the name originates. Every token has a unique blockchain with all its transactions, so Bitcoin transactions are stored on the Bitcoin blockchain while Ripple transactions are on the Ripple blockchain.
If you ever hear the phrase “hard fork,” that means that one blockchain was split into two at a certain point, diverging into two distinct tokens that share a transaction history up until that point. A hard fork occurred when Bitcoin split into Bitcoin and Bitcoin Cash in 2017.
4. What Do Transactions Look Like on the Blockchain?
Every transaction includes three critical pieces of information: Input, Output, and Amount. The Output is the name of the cryptocurrency account (called a wallet) that is receiving funds, while Amount is self-explanatory. However, the Input is not the account making a payment but instead the account(s) that gave the funds to the account making a payment. For example, if Jane gives Jennifer three Bitcoins that she then transfers to Jim, Jane’s wallet is the Input of the transaction between Jennifer and Jim.
5. How Do Cryptocurrency Wallets Work?
Each wallet consists of two random strings of characters. The first string acts like a username to signify your account on the blockchain, while the second is a private key or password. You cannot make any crypto transactions without inputting your private key, making it the most important way to keep your account secure. If you don’t currently have a cryptocurrency wallet, many crypto vendors will create one for you as part of the services they provide.
6. Are Cryptocurrencies Safe?
Blockchain technology is often described as “hack-proof” because any hacker would need to modify all blocks simultaneously to ensure that the chain was in agreement. Volunteer “miners” verify each transaction, and they can trace every token through every account it’s been held in to ensure they are coming out of the correct wallets. Miners receive compensation for their efforts through transaction fees in additional tokens from the corresponding decentralized network behind each cryptocurrency.
While no blockchain has been successfully hacked to date, there have been instances where hackers have been able to siphon virtual assets from wallets. Scam artists are also common in the space since they can take advantage of the public’s lack of knowledge for Ponzi schemes or promote fraudulent “investment advice” as a guise intended to drive prices higher of the cryptocurrencies they own.
7. How Does the Mining Process Work?
A complex process called a cryptographic hash function is at the root of mining. Put simply, a hash function is a mathematical trick that takes data of any size, performs an operation on it, and outputs something of a fixed size. That is how any system that requires an online password works.
For cryptocurrencies, miners must add a nonce (or arbitrary input data) to all of the inputs on the block to make the output begin with a set number of zeroes, “solving” the block and adding it to the blockchain. The process is time-consuming and energy-intensive. There is no way to predict the correct nonce, forcing miners to use powerful computers to trial-and-error the right solution.
8. What Determines the Price of Crypto Coins?
The price of cryptocurrency is not regulated by any centralized authority, meaning that market forces dictate prices daily. Most tokens have a fixed cap and a maximum number of tokens available, meaning that supply is a known quantity. Bitcoin is relatively scarce, with a cap of 21 million BTC in circulation, so the value of each token tends to be higher than a cryptocurrency with a much greater supply. For example, Ripple has a circulating supply of 100 billion XRP, so each token is likely to be worth less.
Besides that, altcoins have features that can drive their prices up or down. For example, Ethereum has a programmable blockchain that allows developers to add new functionality, while Monero is known as the “secret” cryptocurrency because it is difficult to trace.
The news can also sway the market one way or another. For instance, new regulations or taxes on crypto investors usually result in price decreases, while acceptance as legal tender by a company or country leads to gains. However, markets can be fickle, and some price swings don’t have a clear root cause.
Questions To Ask Yourself Before Investing in Cryptocurrencies
Now that you know the answers to many of the most common questions about cryptocurrencies, are you thinking about investing? Before you do, it’s essential first to ask yourself a few critical questions.
Should I Hire a Financial Advisor Who Specializes in Cryptocurrencies?
Before deciding to invest on your own, it’s worth considering if you should hire a financial professional who is a cryptocurrency expert.
While cryptocurrencies remain a newer asset class with many unknowns about their future, many financial advisors believe blockchain technology will usher in a new era of innovation across dozens of industries.
To demonstrate their commitment to understanding cryptocurrencies and helping their clients make more informed investment decisions, financial advisors pursue professional credentials like the Certified Digital Asset Advisor (CDAA) designation or Certificate in Blockchain and Digital Assets (CBDA).
If you choose to hire a financial expert, consider finding an advisor who holds either of these designations to ensure they are knowledgeable about investing in cryptocurrencies.
Do I Understand the Tax Implications of Cryptocurrency Investing?
After years of hands-off treatment, the IRS has finally caught on to the cryptocurrency craze, and now the tax agency wants its cut. When you buy and sell cryptocurrency, the IRS will notice, and even the famed secrecy of the blockchain will not shield you from the taxes you owe.
You might want to brush up on recent tax law changes before you jump into the cryptocurrency market or turn to your advisor and ensure they understand tax planning strategies for digital assets. While taxes alone should not impede your investment, knowing how the laws may impact you and the long-range implications is essential.
Can I Stand the Volatility?
The stock market’s volatility is nothing compared to what cryptocurrency investors have experienced. Even a glance at the trading chart for Bitcoin, Ethereum, and the like is enough to scare even the most intrepid investor, and you should ask yourself if you can handle that kind of volatility.
On occasion, Bitcoin can rise or fall as much as 20% or more in a single day. If this degree of volatility is unsettling for you, you could find yourself panicking and making investment decisions based on fear instead of logic.
Do I Have the Cash To Spare?
The most important question to ask yourself about cryptocurrency investing is whether or not you can afford it. If you put money into Bitcoin or other cryptocurrencies, you could see a huge immediate return…or an equally substantial short-term loss.
No matter how much you believe in blockchain technology and the future of digital currency, betting the rent money on something so volatile and unproven is a bad idea. If you plan to invest in the cryptocurrency market, you should do so only with money you can afford to lose.
Can I Keep the Money Tied Up?
Another critical question to ask yourself is if you are willing to keep the money tied up. Even those who believe strongly in the long-term promise of the blockchain and cryptocurrency admit that the short-term returns are unpredictable and challenging to experience.
It is essential to view any cryptocurrency as primarily a long-term investment. While there are opportunities for short-term trading, having a long time horizon can be a huge plus when investing in such a volatile and still emerging asset class.
How Will I Store My Cryptocurrency?
The very thing that makes cryptocurrency so promising is also one of its most significant weaknesses. The distributed nature of the blockchain ledger means that transactions, including fraudulent ones, are not reversible, making safe storage a huge issue, especially for new investors.
Investors who are used to keeping their stocks, bonds, and mutual funds safe in online brokerage accounts are often surprised at the complexity of cryptocurrency storage. They are just as often unprepared for the risks. If you want to buy and hold Bitcoin or other cryptocurrencies, you will need to decide how to store your cryptocurrency tokens, and every option comes with its own set of risks.
Many new cryptocurrency investors choose to keep their holdings in online crypto exchanges, relying on strong passwords and two-factor authentication (2FA) to keep their money safe. Unfortunately, some online exchanges have already been hacked, leading to millions of dollars in losses from fraudulent transactions and bad actors.
PayPal and CoinBase are popular cryptocurrency exchanges for beginners because they allow you to pay with a bank account. Still, more advanced crypto exchanges like Gemini and Kraken may be necessary, depending on your needs and goals. If you have any experience with Forex trading pairs on the stock market, you’ll be familiar with the format of some of the more advanced exchanges.
Hardware wallets eliminate the risk of hacking, but they also introduce another genuine danger. These devices are subject to failure, so robust backup procedures are essential. Investors also risk losing or forgetting their private keys, unique lengthy passwords required to access or cash in the funds stored on those hardware wallets.
The Bottom Line
Cryptocurrency is complicated, and investing in cryptocurrencies and other digital assets introduces considerable risk. But if you have the cash to spare and want to allocate a small percentage of your investment portfolio in cryptocurrencies, the payoff could be significant down the road.
Before getting started, be sure you understand what you’re investing in and are comfortable with your answers to the questions in this article. By doing so, you should be well on your way to deciding if investing in cryptocurrencies is right for you.