Cryptocurrency for Beginners: What Is Cryptocurrency and How Does it Work?
Depending on who you ask, cryptocurrency can either be the money of the future or an extremely risky asset that you should avoid at all costs. But, which is it, and should you be investing in it?
Different strategies and thoughts regarding cryptocurrency spread rapidly because, even though it’s a unique and complicated technology, it’s extremely accessible. Anyone can understand cryptocurrency regardless of their background, which is why it spreads so quickly.
With cryptocurrency showing up in the news even more often lately, many people are wondering if they should invest in it, if it’s safe, and how it actually works.
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We’ll walk you through the basics so that you can decide if cryptocurrency is the right investment for you.
Looking to learn more about the basics of Crypto? Check out our Crypto terms every investor should know.
What Is Cryptocurrency?
It’s easy to get confused by the technical aspects of cryptocurrency; let’s start with the basics. Cryptocurrency is digital money. Because it’s digital, there aren’t any physical assets tied to it. It also is not tied to any real-world assets, which is why the value of cryptocurrencies fluctuates so erratically.
Let’s check out some examples of these price fluctuations: Bitcoin fell by over $500 in less than an hour in July 2019. In February 2021, Bitcoin rose to over $50,000, which set a new record. What caused these two massive fluctuations? While there was speculation, no one really has an answer.
Unlike other investment vehicles (stocks, bonds, mutual funds, etc.), cryptocurrency does not have value or use outside of possession.
Think about cryptocurrency vs. gold: they both have value and get invested in frequently. There’s one significant difference: gold has uses other than as a currency. It gets used in manufacturing things like jewelry and electronics. Cryptocurrency, on the other hand, only has value because people want it.
Currency, whether digital or not, has always faced two general problems: The need for an authority to regulate their production and value and fraudulent creation.
Bitcoin, the most well-known cryptocurrency, was created to solve these two problems with blockchain and encryption addresses. Because it’s automated and encrypted, it doesn’t need an authority to regulate it, and fraudulent transactions are nonexistent.
How Cryptocurrency Works
To understand the basics of how cryptocurrency works, let’s define some principles and technology it uses:
Cryptocurrencies use cryptography, which is a way to disguise and reveal information. This use of cryptography ensures users’ information gets protected and transactions get performed safely.
Blockchain, the tech that powers cryptocurrency, is basically a database that’s spread over various operators and essentially acts as a digital ledger to verify accounts, transactions, and balances.
One term that you’ll frequently hear when talking about blockchain is a “node,” which is an individual part of the entire data structure of a blockchain. Without nodes, the system wouldn’t work.
With blockchain and cryptography, cryptocurrencies can create coins, enforce transactions, and create and manage a secure system.
Most cryptocurrencies are decentralized, which means that the collective authoritative power gets distributed among everyone in the network. As a result, there’s not a single individual point of failure.
But, what does that mean in practice? Decentralized cryptocurrencies are basically unhackable—for someone to gain control of the network, they would have to hack into 51% or more of the computers running Bitcoin, which is widely considered impossible.
Cryptocurrency transactions are “peer-to-peer,” meaning that you can exchange crypto without needing a broker. These transactions have low processing fees (used to compensate the network running the currency), which makes it possible for users to ignore larger transaction fees of middlemen like PayPal, Venmo, and banks.
Forms of Cryptocurrency
When cryptocurrency beginners think of crypto, Bitcoin is probably what comes to mind. It’s considered the flagship cryptocurrency and has launched thousands of coins. There are over 2,500 types of cryptocurrencies, and many of them use custom blockchains designed for specific purposes.
You don’t need to know every single one to understand the basics—let’s look at some popular forms of cryptocurrency:
Bitcoin, also called “digital gold” is the gold standard for crypto. It debuted in 2009, and BTC has been on top of the market ever since. Bitcoin dominates other cryptocurrencies with its market capitalization of over $900 billion, and it has the lion’s share of the total market cap.
However, investing in a single BTC is an expensive endeavor: as of the time of writing, one Bitcoin is equal to approximately $38,000.
If Bitcoin is gold, then Litecoin is silver. It was created as a split (also called “fork”) of Bitcoin. LTC was released in 2011 as Bitcoin’s main competitor.
Litecoin was created to process transactions cheaper and faster than Bitcoin: as of the time of writing, one Litecoin is equal to approximately $170.
Ethereum, another powerhouse in the crypto market, works a little differently than BTC and LTC—it’s not a peer-to-peer system in the same way as the previously mentioned currencies.
It was launched in 2015 as a platform that powers smart contracts (contracts enforced programmatically) and distributed, decentralized applications (dApps).
dApps are decentralized applications that are autonomous, open-source, have a 100% uptime, and utilize all of the blockchain benefits we talked about earlier. An easy way to think about dApps is to imagine the apps on Google’s Play Store as their own entities rather than being centralized through Google.
Ethereum’s blockchain contains thousands of dApps.
Smart contracts are basically lines of code that execute tasks automatically when a certain condition is met. For example, you can use them to automatically send payments to someone when they fulfill their end of a contract, like providing a good or service.
Types of Cryptocurrency
This is where many people get tripped up when trying to understand the basics of cryptocurrency—there are two types of crypto: coins and tokens.
Coins are cryptocurrencies that have their own blockchain, e.g., Bitcoin, Litecoin, and Ethereum. When people talk about buying cryptocurrency, they are referring to coins.
Tokens are cryptocurrencies that get built on other blockchains, e.g., a dApp running on Ethereum’s blockchain. They represent assets or utilities for specific projects. These tokens get sold (or given away) during an Initial Coin Offering (ICO), which is the first public sale for a crypto project.
There are two types of tokens: utility and security.
Utility tokens are intended only to buy products or services from the platform or company that issued them.
Security tokens are basically digital versions of financial security. They act like a share of the value of a company, like how owning a stock essentially means that you own a chunk of the company. Security tokens pay dividends, interest, share profits, or invest in other assets or tokens to generate profits for their holders. An asset is a security token if:
- It requires a monetary investment
- The funding goes to a single company
- Investors purchase them with the expectation of gaining income
Security tokens also must be compliant with these regulations:
- Regulation D: The person offering the security can raise money only from accredited investors and must provide them with information that does not contain any false or misleading statements.
- Regulation A+: This regulation is an exemption to the above: creators can solicit non-accredited investors with SEC-approved securities for a maximum of $50 million. This route takes more time and is the most expensive option for issuance.
- Regulation S: This one outlines security offerings from non-US countries, which are not subject to some registration requirements. The creators of the security token must follow the regulations of the country in which they want to solicit investment.
How Cryptocurrency Transactions Work
To understand how cryptocurrency transactions take place, let’s look at an example:
Let’s say Adam wants to send some Bitcoin to his friend Barry. Here’s what it would look like:
- Barry gives Adam his Bitcoin address, also called a hashed public key. This address is linked to an exchange or cryptocurrency wallet that Barry has previously set up. These addresses are long, unique strings of random numbers and letters.
- Adam would then enter that address into his exchange or wallet along with the amount of BTC he wants to send. It doesn’t have to be a whole number—You could send 100 0.000005 Bitcoin.
- Barry would receive the amount minus a small fee. These fees are typically under $1.00, regardless of the amount sent.
It sounds simple, but how is it possible? Let’s take a peek behind the scenes.
As soon as Adam submits the transaction to the blockchain, every node in the BTC network receives the request and ensures that:
- Adam is who he claims to be. The nodes verify his identity through his private, unique key that identifies his source of funds.
- Adam actually sent the Bitcoins to Barry. The nodes perform a check to ensure that Adam has the funds available before going through with the transaction.
51% or more of the nodes need to agree that those two criteria are met before the transaction will go through.
Buying and Selling Cryptocurrency
Purchasing and trading cryptocurrencies is much more user-friendly than it used to be, and there are various ways to invest in crypto. Some popular options are:
Coinbase has a reputation for being a leading cryptocurrency exchange since it simplified the process of buying crypto. Simplicity comes with a price, though, and Coinbase has some of the most expensive transaction fees of all exchanges.
Coinbase Pro, an offering by Coinbase, caters to more advanced users. It features advanced, detailed trading charts and graphs and more trading options. In addition, the transaction fees are lower than Coinbase and range from $0.10 to $0.30.
Binance is one of the largest exchanges by users and volume. It offers hundreds of different currencies, robust trading tools, and advanced trading features. Binance has a trading fee of 0.1%.
Cryptocurrency wallets make it easy to store, send, and receive crypto. There are various types of cryptocurrency wallets, but there are two general categories: Hot and cold.
Hot cryptocurrency wallets are connected to the internet. Many exchanges provide users with a hot wallet. Out of the two options, hot wallets carry slightly more risk. If someone was able to connect to your hot wallet, they could easily gain access to all of your cryptocurrency.
Cold wallets are the opposite: they are not connected to the internet. Most exchanges hold large amounts of crypto in cold wallets to minimize damage in the case of a data breach. Another type of cold wallet is a hardware wallet—a physical device that safely holds your private key.
Cryptocurrency Best Practices
The wide accessibility of cryptocurrencies comes with many advantages, but there are also some downsides. Not having a central authority means that there’s no customer service and no guaranteed asset protection, leaving your cryptocurrency at risk from hackers or getting lost through personal negligence (e.g., losing your private key or sending funds to the wrong address).
However, you can avoid these issues by following the cryptocurrency best practices, which revolve around keeping your private key safe and secure.
Remember that your private key allows for complete access to all of your funds. So, for example, if you wrote it down on a notecard and someone else found it, they would have access to all of your cryptocurrency and have the freedom to transfer it to anyone, anywhere.
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As long as you keep that key safe, your crypto will be safe from almost any threat.