If you’re wondering whether cryptocurrency works or not, you’re probably not very familiar with the basics of how it works. It has changed the game for modern economic systems across the world. So, cryptocurrency, does it work?
The short and quick answer is yes; but how, where, when, and why, are all very considerable components to this answer. Is it really the ‘money of the future’, a ‘valuable asset’ in which you can invest, or an extremely risky asset that you should never approach?
The more cryptocurrency grows, and the more people hear about it, the more you’ll regret not knowing the basics. Maybe you have some, maybe you’re thinking about it, maybe you’re just curious about what it is?
The goal of this article is to help you have a fundamental understanding of cryptocurrency by breaking down its complexities. Once you understand the risks and advantages that come with cryptocurrency assets you can make an educated decision on whether it’s something you want to take on.
Once you reach the end of this article you’ll be able to understand:
- How cryptocurrency applies to our current economic system
- Why and how cryptocurrency exists
- How cryptocurrency works
- Common crypto-terminology
- Different types of cryptocurrencies
- Places to obtain, store, and use cryptocurrency
- Risks and benefits that will come with owning cryptocurrency
What is Cryptocurrency?
Cryptocurrency is a digital asset that can work as a medium of exchange. The data of ownership and transactions of the cryptocurrency are held, using cryptography, on a public blockchain ledger.
If you don’t know what these terms mean here’s a sum-up
- Medium of exchange: intermediary instrument or system used to exchange goods and services
- Cryptography: a method of disguising & revealing info using coded language to ensure the security of user information and that transactions are done safely
- Blockchain Ledger: a public list of digital codes chained together using cryptography;
I’ll explain how all this works. In order to do that, however, let me give you an example of currencies outside of the digital world, taking us all the way back to the era of ‘primitive money’.
The reason why we’re going so far back is simply that out of all the currencies throughout time, the system of rice stones (image on the left), used in the Yap Island most strongly reflects how cryptocurrency works today.
These large stones carved from limestone functioned as a currency in the primitive ages, they came in various sizes.
They were placed in prominent locations where everyone could see them. Due to them being very tough to transport they were used as a payment method without the need of moving them.
All that would happen is that the owner would announce to all townsfolk that the ownership of the stone had now moved from one person to the other. The entire town would then recognize the new ownership of the stone and the new owner could now use it to make a payment whenever he/she pleased.
There was no way of stealing or fraudulently making transactions with the stone because its ownership was known by everybody. This is how cryptocurrency works today.
Think of it this way:
Rice Stones = Cryptocurrency
Townsfolk awareness of the transaction and ownership = Public Blockchain Ledger
Person making transaction by announcing it = Transaction that occurred is sent to the blockchain
The words used to announce the ownership of the stone = Cryptography
Similar to the awareness of all the townsfolk knowing of the new owner and the transaction of the stone, in cryptocurrency, when a transaction occurs and balances are transferred from one account to another, the transaction is sent out to the public blockchain ledger.
Here, everyone is aware of the transaction that has taken place. Since everyone is aware of the transaction and ownership no one can falsely claim it or make a fraudulent transaction that never actually occurred.
This eliminates a very common problem with modern regular fiat currency today, like the US Dollar (USD).
Up until August 15th, 1971, the value of USD currency was backed by a gold standard. We used bills instead of actual pieces of gold for the convenience of simple transactions. After 1971, when the US got rid of the gold standard, the bills it provided were only backed by the government’s promise of its value.
So, what is fiat currency? It is money, often established by government regulation, that does not have any intrinsic value.
The value it has is only because a government maintains its value, or because peers agree on its value based on trust. Trust that when one peer accepts the currency, they can take it and use it as a medium of exchange for a different product or service.
- Money + Trust = Value = Fiat or Legal Tenure
Common Problems with Fiat Currency:
- They require a central authority to regulate their value, authenticity, and authority
- They can fall victim to fraudulent creation both digitally (double-spend problem) and physically (counterfeit money)
- Transactions are not transparent to the general public and are kept privately by the central authority
- The central authority can become corrupt
- Mismanagement by a central authority
- The interest of the central authority is not equal to that of the people using the currency
- Easy accessibility to making more currency (ie: printing more money) decreases its scarcity and devalues the currency
Due to the central authority controlling fiat currency, they are considered to be ‘centralized’. They require a middleman (such as a bank) to process each transaction through their own private ledger.
A perfect example of the middleman using its central authority for fraudulent operations was when Well’s Fargo employees used fraud to meet impossible sales goals from 2002 to 2016.
They opened millions of accounts in customers’ names without their knowledge, signed unwitting account holders up for credit cards and bill payment programs, created fake personal identification numbers, forged signatures, and even secretly transferred customers’ money.
You can read more about this here.
The limitless supply of money which causes inflation to rise (prices going up and value of the dollar going down) can be easily demonstrated during the COVID-19 pandemic when the US printed over $2 trillion worth of fiat currency, thus devaluing the dollar in the long run. These are all issues that cannot occur with cryptocurrency.
How is Cryptocurrency Different from Fiat
Cryptocurrency is unique for its limited supply, its transparency, and its decentralized state. It cannot be fraudulently created and transactions cannot be fraudulently made. It does not require the involvement of a third party because transactions are peer-to-peer (P2P).
How is all this possible?
- Decentralization & Transparency: First of all, cryptocurrency is P2P, which eliminates the need for a middleman by providing a decentralized trust ledger system with little exposure to fraud. All transactions are held on a public blockchain ledger that anyone has access to. There is no single computer that holds the ledger, every computer that participates in the system is also keeping a copy of the ledger and updating it.When someone makes a transaction, a cryptographic message is sent to the ledger saying which accounts have completed the transaction.All authoritative power is distributed among all the peers on a network and there isn’t an individual point of failure. For example, to hack a cryptocurrency, one would need to hack into at least 51% of the larger network of computers that hold and update the ledger. A task considered to be impossible.
- Privacy Despite Transparency: Even though everyone has the information on transactions, identities are still kept a secret because the only thing that is placed on the ledger in terms of ownership is something called the public key, which holds no personal information about its owner.
- Public keys are what is publically known for the identification of accounts but do not reveal the personal information of the owner.
- Private keys are the ones who hold that information and access to your currency. Private keys are a string of letters and numbers to access your cryptocurrency, these should be kept private because anyone who has access to this key has access to your cryptocurrency.
- Limited Supply: The supply of cryptocurrency is limited and each cryptocurrency has to be ‘produced’ by a process called ‘mining’. Mining is the process of hashing a blockchain together in the crypto-network to introduce new coins into the existing supply. Every cryptocurrency has a finite limited supply. For example, Bitcoin’s supply is limited to only 21 million. After that, no more Bitcoins will be produced.
- No Fraud: Cryptocurrency and transactions cannot be fraudulently made because all the computers in the system of a cryptocurrency have access to its ledger and continuously update it in sync. The process by which a cryptocurrency is mined is also very complex and halts any possibility of fraudulently producing a cryptocurrency.
On a side-note, another very interesting fact about cryptocurrency is that they have no physical form and have no physical use, they are not tied to anything of value that you can physically have (like gold). This is why their value is so volatile and fluctuates so dramatically, much more dramatically than stocks or bonds.
However, despite all these pros, you must take note that because of their level of trust compared to fiat currencies, they are a very risky asset to have. For example, they are not FDIC insured as a bank would be. If you lose your crypto, you lose it.
Several people are skeptical about cryptocurrencies, and trust is the most important factor of any form of currency. Its low level of trust makes it a very risky form of currency
With all this being said, it’s important to not confuse any cryptocurrency to be an investment vehicle. It’s okay to own a form of cryptocurrency but remember that its future is still unprecedented. No one knows for sure what will be of cryptocurrencies in the future which is why you cannot consider it an investment.
An investment operation is one which upon thorough analysis promises the safety of principal and an adequate return. Operations that do not follow these criteria are considered to be speculative.
The scarcity of each of these cryptocurrencies can confuse many people to view them as an investment vehicle, but they aren’t. They are simply a volatile asset that can be used as a medium of exchange but its future and value are not promised.
Different Forms and Types of Cryptocurrency
Cryptocurrencies come in many different forms. The most well-known is Bitcoin, after that, we have Etherium, Litecoin, and many more. These are all coins but we also have different types of cryptocurrencies.
2 types of cryptocurrencies:
- Coins: a cryptocurrency that has its own blockchain, for example, Bitcoin and Etherium
- Tokens: a cryptocurrency that is built on another blockchain, for example, dApp that runs on Ethereum’s blockchain
Tokens are a very particular kind of asset. They can:
- only buy products or services from the platform that issues them, or
- act as a security (like a financial security, such as a stock) and pay dividends, share profits, pay interest, or invest in other tokens or assets to generate profits for the token holders.
To act as a security, however, security tokens have to follow certain regulations:
- Regulation D: The individual who is offering the security can only raise money from accredited investors and the information provided to them is “Free from false or misleading statements” (Section 506C).
- Regulation A+: An exemption that allows the creator to solicit non-accredited investors with SEC-approved security for up to $50 million in investment. This option takes a lot more time and is generally the most expensive route for issuance.
- Regulation S: This regulation outlines security offerings from countries outside of the US, which are therefore not subject to the registration requirements of section 5 of the 1993 Act. The creators of the security offering still must follow the security regulations of the country that they plan to solicit investment. (Source)
As cryptocurrency becomes more widely known, government entities have become more acknowledging of it. The US government has focused its efforts on people laundering money or purchasing illegal substances and services through cryptocurrency, identifying fraudulent Initial Coin Offerings (ICOs), and collecting taxes.
One of the most important pieces of regulatory guidance comes from Notice 2014-21 of the IRS. In summary, it states that cryptocurrency is seen as property for federal tax purposes and falls under general tax principles. Gains and losses are acknowledged by the IRS and are taxed accordingly.
It’s important to acknowledge current regulations on cryptocurrencies and pay attention to the new regulations being imposed on them as more time passes. Certain governments and government officials who are not okay with the use of cryptocurrency as a medium of exchange are trying to completely ban its use.
It’s important to stay updated on your government’s regulations of cryptocurrencies as time moves on.
Where to Obtain, Store, and Use Cryptocurrency
If your objective is to buy and trade cryptocurrency, and you want the simplicity of an easy-to-understand platform for beginners, a great tool to go to would be Coinbase. Coinbase is an app where you can buy and sell several cryptocurrencies (including Bitcoin). It provides you with video lessons that teach about certain cryptocurrencies and gives you advice about them. On the downside, Coinbase is also known for having the highest fees of all cryptocurrency trading platforms
There is another version of Coinbase called Coinbase Pro, formerly known as GDAX. This platform is designed for more intermediate traders because of the details included in their charts and graphs, more trading options, and fees only range from $0.10 to $0.30.
Another platform that has hundreds of different cryptocurrencies for advanced trading features, highly detailed trading charts & graphs, and only charges a 0.1% trading fee is Binance. This is a very reliable platform in which you can execute practical trading strategies and make money by trading cryptocurrencies.
A similar platform to Binance with similar characteristics and a different look is Kraken. It provides you with your private and public keys and offers detailed charts & graphs for advanced traders.
These platforms are very valuable and one who knows how to trade cryptocurrency correctly can make very huge profits by using any of these platforms. However, if you simply want to buy and hold cryptocurrency because you’re confident in its future’s value. You don’t want to hold your precious digital ‘metals’ in a trading platform like the ones listed above.
The reason why is because your cryptocurrency runs the risk of being stolen or lost if your preferred trading platform ever becomes compromised. Your platform has full access to your cryptocurrency and unless it doesn’t have your private key stored in its data, your cryptocurrency runs grave danger by standing still within a trading platform.
This is why cryptocurrency wallets were invented. If you simply want to buy and hold your cryptocurrency for the long-term, you want to keep them in something called a wallet. Since cryptocurrency isn’t a physical asset that you can touch, this isn’t any ordinary wallet. With a cryptocurrency wallet, you can send, receive, store, and manage your cryptocurrency. Depending on your uses for your cryptocurrency, you may want to use more than one wallet or keep some of them on a trading platform.
What defines a wallet is where its private key is stored.
There are many kinds of cryptocurrency wallets, such as
- Hierarchical Deterministic (HD) Wallets: These generate a phrase known as a seed or common phrase that you can memorize instead of having to memorize your private key. If your wallet gets stolen or lost, you can enter this seed into a different wallet to reconstruct your private key.
- Full Nodes Wallets: Hold a full copy of the blockchain to validate every transaction that occurs
- Simple Payment Verification (SPV) Wallets: Don’t hold a full copy of the blockchain but are faster and consume less disc space in a monitor
From the wallets named above, there are two types of wallets that come in versions:
- Hot Wallets: any form (mobile or desktop) of wallet that is connected in some way to the internet, these tend to be the most popular but also the least secure since they allow access to their contents via internet connections
- Web Wallets: Least secure, relies on 3rd party, convenient to move money out and in, multi-factor identification advised, keep only small amounts of crypto in it
- Desktop Wallets: Stores your private key on your computer. If your computer is 100% free of possible malware, it is safe, usually, this is not the case
- Mobile Wallet: Stores your private key on your mobile phone, low security, low privacy, Multi-factor Authentication advised, very convenient
- Cold Wallets: any type of wallet that is independent of an internet connection, cannot be hacked remotely,
- Hardware wallet: Physical devices that safely store your private key, cannot be hacked remotely even if your device is compromised by malware, can be used on an untrusted computer, most provide a seed back up if the device is lost or stolen. To perform any type of activity with this wallet, you need to connect it to a computer and some sort of web page that allows control over the wallet. These wallets offer a mix of security and ease of use. Unfortunately, you need to keep it on you at all times to send the coins
- Paper wallet: Simply a paper with your key written on it, can be easily destroyed so keep multiple copies and keep them safe, you’ll have to import your private key onto a digital wallet to send or receive cryptocurrency
- Brain Wallet: Way to create a private key out of a predetermined phrase or set of words, you decide on the path phrase, they have a higher probability at being hacked because people are more predictable
- Multi-sig wallet: a wallet that allows access of crypto only with the approval of enough private keys out of a set of predefined keys. This means that to have access to the cryptocurrency, you need a specific amount of private keys to do so, ie: a couple wants to have access to the money but can only have access if both keys are present
As you can very well tell, there is quite a bit to cryptocurrency. It’s a unique digital asset that several people speculate to have a bright future in our world.
This information in this article covered very important basics to get you started with cryptocurrency and to get your foot in the door if you wish to take the risk. As we continue to evolve as a society, so is our currency.
As people see the flaws that come with a centralized standard of currency that is only based on a government’s promise, we try to find alternative and better monetary systems, cryptocurrency has become a system that more and more people are beginning to accept.
Though slowly, its popularity continues to expand across the world as even companies like Facebook have developed their very own cryptocurrencies.
For those who are finding interest in finance, economics, business, and other money-related sectors it’s important to begin understanding the fundamental basics of this possible new currency.
Nothing on cryptocurrency’s future is assured but our current monetary system in America is based on trust. An increasing number of people are slowly gaining trust in cryptocurrency, as this continues to happen, it’s important to not ignore the possibilities that cryptocurrency may bring. It’s important to have a fundamental understanding of it even if its future is not assured.
If there’s anything you might not have fully understood in this article or you still have questions about something, please leave them down below, I’ll be more than happy to answer them with detail.