What is Cryptocurrency and how does it Work?
The term cryptocurrency has been discussed in several print, media, and social media platforms over the past year. But what exactly is cryptocurrency? The core concept behind Bitcoin is that it is a digital currency that is unrelated to banks. What motivates crypto transactions, and how may beginners access them?
In this introductory lesson, investors asking ‘what is cryptocurrency?’ will find all the answers they need. We will look also examine if it is legal to buy or invest in cryptocurrencies.
What is Cryptocurrency?
The short answer to the question “what is cryptocurrency?” is that it is essentially a digital currency. It can be used to purchase and pay for goods and services. But what backs crypto up, and why is it dubbed the ‘new frontier of finance’?
To begin with, cryptocurrencies are supported by blockchain technology. A Cryptocurrency blockchain ledger is a cutting-edge digital distributed ledger technology that records all Bitcoin transactions and stores them in a block-like fashion. The system is based on cryptography, which guarantees that all transactions on an underlying network are secure and immutable while also allowing for transparency because they are publicly available. Cryptography is also important in guaranteeing that all transactions are encrypted and not a double-spend or counterfeit.
Cryptocurrencies are decentralised; there is no need for a third party or middleman. No financial institutions or central monetary authorities are required to be involved before a cryptocurrency transaction is confirmed or settled.
Bitcoin popularised virtual currencies when it was founded in 2009 by a pseudonymous developer – or group of developers? – named Satoshi Nakamoto. Bitcoin’s existence has resulted in the spread of other digital currencies during the past years. The growing industry currently has over 20,000 digital items.
Cryptocurrency is often formed through a process called mining, which involves sophisticated mathematical calculations to generate new currencies. Another option is to purchase a cryptocurrency from one of the many cryptocurrency exchanges. This comes with a little price, which customers should keep in mind.
Users will require digital wallets to store cryptocurrency or to make online payments. A digital wallet can be in the form of a tangible item or software. These wallets work just as a traditional bank account and can used for storage of cryptocurrency holdings but also crypto purchases or cryptocurrency payments.
How Do Cryptocurrencies Work?
Cryptocurrencies, like other financial instruments, are used to facilitate financial settlements and as an investment vehicle. However, cryptos accomplish these functions without the support of a central bank or government agency.
They cannot be physically handled; they are actually lines of computer code. Their worth, however, is decided by market forces of demand and supply.
The Blockchain is crucial to how cryptocurrencies are created and used. This technology is essentially a digital ledger that keeps track of who owns crypto assets, who transmits and who receives it. The distributed ledger technology (on a blockchain network) records are also tamper-resistant since no single entity can change them.
Transactions are typically carried out utilising public and private keys. Public keys, like conventional bank accounts, are produced at random. A private key, on the other hand, is a secret seed phrase that only the wallet holder has access to. The PIN on a user’s bank card is a common example. They are often alphabetic and cryptographic in nature.
Blockchain technology is based on consensus algorithms because there is no central authority verifying and confirming cryptocurrency transactions. The proof of work (PoW) and proof of stake (PoS) algorithms are currently the most used and therefore also the most well-known. These algorithms ensure that transactions are censorship-resistant and decentralised, but how they do achieve this differs greatly.
The proof of work system was introduced by Bitcoin, still the most prominent cryptocurrency, and it is based on the concept of competition. Miners (network nodes) compete to be the first to solve challenging mathematical puzzles using the proof of work method. Because more computer networks are trying to validate transactions, the cryptocurrency mining difficulty level rises, making it highly safe from outside assault. However, PoW requires more energy to verify transactions.
Miners are no longer used in the proof of stake system, and stakers have taken their place. Network validators stake or lock-up network tokens to safeguard the network and take turns to verify transactions. This is done within time constraints, minimising the blockchain network’s energy use. Stakers receive additional coins or tokens in exchange for committing their tokens.
Bitcoin and Ethereum, two of the major blockchain-based solutions, are now using the PoW mechanism. However, Ethereum is moving on and switching to the proof of stake system to reduce energy and transaction costs while enhancing transaction speed.
Cryptocurrency mining plays an important part in the creation of new crypto coins. Miners decipher complicated problems to receive block rewards. At press time, the Bitcoin block reward is 6.25 BTC, which is equivalent to thousands of dollars.
What are some of the advantages and disadvantages of this energy-intensive process?
The Pros of Mining
Here are some advantages of mining:
Utilisation of Idle Computing Resources
Prior to the emergence of cryptocurrencies, many people had tonnes of computing resources that were either unused or overburdened with computer programmes or apps. However, mining makes good use of the available resources. Miners can use their idle resources to help secure the network and validate transactions.
Mining remains the most appealing option for large-scale companies and wealthy users when it comes to a controversial validation process. This is because the block rewards frequently outweigh the tasks.
For example, Bitcoin miners were initially rewarded with 50 BTC for validating transaction blocks. However, in the last decade, the reward has been reduced to 6.25 BTC. While it may appear smaller, the value of each BTC has increased. In November 2021, Bitcoin was trading just below $70,000, implying that 6.25 BTC was worth well over $437,500 at the time.
Protects Against Double Spending
A double spend is when a currency is spent twice. One of the problems that led to the failure of DigiCash, the first attempt at virtual currency, was the double spend problem. To address this issue, Nakamoto made certain that the first cryptocurrency, Bitcoin, is based on mining. Network transactions are placed in the memory pool (mempool), which serves as a temporary storage location for new transactions. Miners collect them and work to solve the puzzle. If the same amount is sent to two different addresses, the first one is confirmed as valid once the puzzle is solved, while the second is discarded.
Mining, in essence, aids in the discovery of any discrepancies in transactions sent into the network.
Improves Network Security
Given that mining makes double spending impossible on a network, it increases the blockchain’s security level. This is because miners must compete to validate transactions, each with a digital copy of the blockchain. The only way to gain access to the network would be to launch a 51% malicious attack. A 51% attack occurs when a single entity controls more than 50% of the hash power on the network. Hash power is the computing resources required to keep network operations running.
Because network nodes are distributed across different regions, a 51% attack on a network like Bitcoin is nearly impossible.
The Cons of Mining
Is crypto mining all rosy? Check out some disadvantages of mining:
Mining Requires a Lot of Money
The first thing to understand is that mining requires a significant investment. This is because miners need to have access to multiple mining rigs to solve the puzzle quickly and receive the block reward. These specialised hardware miners are not inexpensive. Bitmain’s Antminer series of application-specific integrated circuits is one of the most popular (ASICs). Each costs $5,000 on average, with prices varying greatly depending on efficiency levels and energy demands.
A proper mining establishment also requires software and a proper ventilation system. The energy costs of running these machines are also a major factor, as the annual energy output from crypto mining exceeds that of a number of countries.
Unsustainable for the Environment
A single Bitcoin transaction can consume up to 1401.46 kW/h, which equates to 781.68kg CO2. This large energy expenditure is equivalent to what an average US household would use in 48 days. Because it generates so much heat, this requires a significant amount of energy. Given this, crypto mining is not a long-term sustainable practise given global climate problems.
Is Cryptocurrency Legal?
Bitcoin and all other crypto assets have introduced an entirely public-centered financial ecosystem. The emerging industry grew to over $2.5 trillion in November 2021, since its inception in 2009.
However, its legitimacy is largely determined by a central authority or government’s stance on cryptos. Some countries, such as China and Russia, have significantly reduced their use cases within their borders. China, for example, has outright prohibited cryptocurrency investing, trading, or use for purchasing or measuring services rendered in the country.
Meanwhile, countries such as the United States have been more welcoming. Bitcoin and Ethereum are classified as “commodities” by the US Commodities and Financial Trading Commission (CFTC), but they are classified as “property” by the Internal Revenue Service (IRS). The latter definition implies that users must pay crypto taxes when selling or receiving cryptocurrency in exchange for services rendered.
All other cryptocurrencies have not yet been classified at all, with the SEC and CFTC battling over who should have the authority of oversight.
Is Cryptocurrency Safe?
When it comes to digital asset security, cryptocurrency is safe. This is because it employs blockchain technology despite operating on a decentralized system. Blockchain employs some of the most secure and complex cryptographic mechanisms available to prevent external entities from seizing control of the network. The fact that it is also transparent means that miners or anyone else can easily see the transactions.
Each miner has a digital copy of the network and only confirms transactions that adhere to the rules. However, this does not imply that cryptocurrencies are inherently secure in the traditional sense. They lack the same safeguards as traditional fiat currencies. This means that if a crypto asset is lost in transit or due to fraud, users may be unable to recover it.
Furthermore, due to the lack of a real-world asset backing them at this point in time, cryptocurrencies are known to have wild price swings. A cryptocurrency can rise nearly 20% in a single trading day before plummeting sharply the next. As a result, they are high-risk investment options.
To withstand volatile trends, investment experts recommend diversifying investments. This is why investors are flocking to Bitcoin ETFs, also known as exchange-traded funds. Traditional brokerage services provide these, allowing investors to gain access to Bitcoin without directly owning it.
The Best Exchanges to Invest in Cryptocurrency
One of the most popular ways for investors to purchase cryptocurrency is through cryptocurrency exchanges. These trading platforms provide direct access to digital currencies by enabling users to buy, sell, and exchange thousands of cryptocurrencies while benefiting from high liquidity and low fees.
Although many crypto exchanges provide these services, some of the most popular include Binance, Coinbase, Kraken, Huobi Global, FTX, Gemini, and eToro. These platforms provide a robust library of digital assets, which users can easily trade from the comfort of their homes.
Choosing the best Bitcoin exchange is heavily influenced by a number of factors. These include, but are not limited to, low fees, a reasonable minimum deposit, access to a large coin library, ease of use, deep liquidity, and a rich trading experience.
The best crypto exchanges provide a large number of these features for a smooth trading session. For instance, Coinbase offers well over 9,500 cryptocurrencies to Binance’s 600+.
Should You Invest in Cryptocurrency?
Crypto trading has reached a new high. However, should investors invest in them?
Investing in cryptocurrencies can be a good way for investors to diversify their portfolios. As the world grappled with the Covid-19 pandemic in 2020 and 2021, digital currencies and the overall cryptocurrency market outperformed many other traditional markets.
Bitcoin has been largely responsible for the industry’s success. The premier cryptocurrency has a hard-cap limit of 21 million coins. Bitcoin has grown by leaps and bounds as supply has been limited and demand has been high. More businesses are investing in cryptocurrency as a way to combat rising inflation.
The Ethereum network extends the financial revolution by providing an entirely decentralised economy. Decentralised marketplaces and utility hubs are sprouting up on Ethereum. At the height of the crypto boom, the decentralised finance (DeFi) ecosystem founded on Ethereum reached $200 billion in total value locked (TVL) in less than two years after its launch.
Nonetheless, cryptocurrencies are regarded as high-risk investments. Before making any investment, investors should conduct thorough research and focus only on assets with long-term financial impact.
How to Invest in Cryptocurrency
Investing in cryptocurrencies is quite simple. To get started, new investors should take the following steps:
1. Create an Account
First, register on a crypto trading platform to buy cryptocurrency. Visit the platform and click on the ‘Register’ button to open up the sign-up page. Fill in relevant details like full name, email address, mobile number, and a unique, strong password.
2. Verify ID
Most Bitcoin exchanges are centralised and follow stipulated international financial laws. This requires new users to complete the know-your-customer (KYC) process to unlock the full potential of the platform. Click on the profile icon and locate the Verify button. Upload a copy of a recent driver’s license or official passport that boldly displays the name and other details used to register. A secondary set of documents will also be required, including a recent utility bill with the user’s residential address.
Every exchange has a stipulated minimum deposit. Also, the best exchanges support multiple payment methods, including bank wire transfers, credit/debit cards, e-wallet solutions like PayPal, Skrill, Neteller, and crypto deposits. Select the ‘Deposit’ icon and insert the stipulated minimum in the desired fiat currency.
4. Buy Crypto
Once a deposit is confirmed, the final step is to buy cryptocurrency. A quick search of the asset’s ticker symbol should reveal the cryptocurrency. Tap on the ‘Trade’ button and click on ‘Buy’ to complete the process.
How Does Cryptocurrency Gain Value?
Cryptocurrencies largely derive their value from the underlying network and adoption. A classical example is the Bitcoin network. From its value proposition in 2009, Bitcoin was created to offer a decentralized system for online payment without the intervention of centralised entities. The digital asset also comes with a hard-cap limit of 21 million coins that would ever be mined.
Bitcoin is perceived to be a better store of wealth than fiat currency and even principal commodity – gold. This is due to its definite number which has seen its value propel from under $10 in 2009 to well over $60,000 in its prime bullish run.
Given this, companies and businesses have added Bitcoin and other crypto assets to their platforms to attract more user base. With this, the more useful a crypto asset is in real-world scenarios, the more value it generates following market forces.
Most frequent questions and answers
Yes, Bitcoin is actually the first crypto asset; it was launched in 2009. The digital asset uses the blockchain to power its operations and does not have a central controlling body. Miners contributes to its functioning.
There is no central controlling body as cryptocurrency is decentralised. Instead, computer networks distributed across the globe vie to validate transactions. These decentralised entities ensure that all transactions follow the laid-down rules stated in the crypto’s whitepaper.
The main reason for the issuance of cryptocurrency is to enable a more financially-inclusive and trustless environment. With cryptocurrency, governments and a few individuals cannot control who and what trades while cutting down on their monopoly.
The average time to mine Bitcoin is 10 minutes. This is because Bitcoin mining relies on PoW, which requires miners to compete to solve puzzles. The process is quite slow and consumes a lot of energy as well.
Skrumble.com provides all its content for informational purposes only, and this should not be taken as financial advice to buy, trade or sell cryptocurrency or use any specific exchange. Please do not use this website as investment advice, financial advice or legal advice, and each individual’s needs may vary from that of the author. This post includes affiliate links with our partners who may compensate us.