Today, interest in cryptocurrency seems like it’s only continuing to rise among seasoned investors and newcomers alike. However, even as more people are starting to view it as a viable option for investing, many still have questions about the basics of what cryptocurrency is and how it works.
While the origins of cryptocurrency are pretty technical, the concept behind it is also reasonably simple. To start satisfying your crypto curiosity, take a look at our introduction to what this type of currency is, how it works and how you can use it.
Defining Cryptocurrency: What It Is, and What It Isn’t
Cryptocurrency, also referred to as crypto, is a type of currency that exists solely in a virtual space. In the simplest sense, it’s digital money that only works through a computer network — and it’s a type of currency with some unique features that you don’t find in fiat currencies like the U.S. dollar.
Cryptocurrencies are usually based on blockchain technology, which is a digital ledger that creates secure and unalterable records of each transaction performed with a particular cryptocurrency. Additionally, crypto is decentralized. That means there isn’t a single authority that oversees, issues or regulates the currency the way that the Federal Reserve regulates the U.S. dollar. Instead, there’s a public record logging the activities, and the cryptocurrency users themselves assist with any distribution and tracking-related tasks.
Functionally, cryptocurrency is a peer-to-peer (P2P) payment system that doesn’t rely on traditional banks. The ledger associated with the crypto logs all associated activities, including trades and payments, and users make those payments directly to each other. The payments aren’t processed through a central bank or clearinghouse the way fiat currency transactions and checks are.
How Cryptocurrency Works
As mentioned above, cryptocurrency relies on blockchain technology for its recordkeeping system. The ledger maintains entries logging all of the transactions made with a particular cryptocurrency, with users playing the role of initiators and verifiers for these activities. Each type of cryptocurrency has its own native blockchain where all the transactions involving it are stored. This means Bitcoin transactions will only be recorded on the Bitcoin blockchain; they won’t appear on the Ethereum blockchain ledger.
In many ways, the distributed ledger isn’t unlike a transaction log for a collective bank account. It logs all activities relating to the funds – in this case, the coins – associated with the cryptocurrency in question. When a new action takes place – such as a trade or a payment – it creates a new line item, referred to as a block. That block is linked to the previous line item, creating a chain of transactions.
The process of ensuring each new block is recorded accurately occurs in one of two ways: proof of work and proof of stake. In both cases, a process involving a mathematical problem that computers solve is part of the equation.
With proof of work, anyone with a capable computer can work to verify the transaction, effectively creating a race to completion. With proof of stake, individuals must first temporarily lock up some of their crypto – their stake – to have a chance to solve the equation.
As the math problem is solved, new coins can generate. Typically, this process is referred to as mining. Many people participate in mining, mainly because it’s a way to generate and own crypto without making a direct financial investment to purchase it. There are some associated expenses – such as the cost of the computer itself and the power required to run it – but the potential earning power of mining often outpaces the cost.
Regardless of whether a coin is mined or purchased, it functions the same way and investors treat it the same way. All coins of a specific cryptocurrency have the same value in the broader marketplace, regardless of when they were mined. Once acquired, crypto becomes both an investment and payment vehicle.
Popular Cryptocurrency Coins
Today, there are thousands of cryptocurrencies within the broader marketplace. For many people who are new to crypto, this can make the process of deciding which coin to acquire a bit overwhelming. As a result, it can be beneficial to focus on those with longer histories and higher levels of popularity.
Bitcoin is the quintessential example. It was the first cryptocurrency and is generally the most well-known. It’s also available on the widest array of platforms, making it accessible, and it has the largest overall market cap.
Ethereum is the second-most popular cryptocurrency and has the second-highest market cap. Like Bitcoin, it’s highly accessible and widely traded. Plus, the associated token – called Ether – is used in numerous ways to support certain technological functions within Ethereum-based applications.
Dogecoin isn’t in the top 10 when it comes to market cap but has nonetheless generated a substantial amount of attention due to its association with a meme. While it was technically created as a joke, interest in the coin subsequently made it a functionally viable option.
Buying, Selling and Storing Cryptocurrency
While mining can help you acquire cryptocurrency, it’s a complex process that can involve a large upfront investment. Most people choose to purchase crypto from others. Typically, the simplest way to do so is through a cryptocurrency exchange of a traditional broker that offers cryptocurrency as an investible asset.
In either of those cases, you’ll start by opening and funding an account. Usually, identity verifications are a part of that process. Once that’s complete, you can fund your upcoming purchase using a connected bank account or payment card, depending on what the platform supports.
After funding the account, you can select the cryptocurrency you’d like to purchase and choose an order type. As long as you meet any conditions relating to the purchase, such as adhering to a minimum purchase amount, and there’s a willing seller, the transaction goes through. After that, you become the owner of some cryptocurrency.
The process of selling cryptocurrency also typically takes place on platforms. As long as the coins are associated with the brokerage or exchange, you can sell using the platform’s built-in trade processes.
Storing your acquired crypto is also reasonably straightforward. After a purchase, the cryptocurrency is then held either within your account through an associated wallet service or in a personal crypto wallet.
There are some indirect ways to have a stake in a cryptocurrency, too. For example, there’s an increasing number of traditional investment vehicles – such as mutual funds and ETFs – that now feature cryptocurrency as all or part of their makeup. You can invest money into these products without needing to create a digital wallet or manage multiple platform accounts like you would when investing in crypto directly.
How to Use Your Cryptocurrency
Right now, cryptocurrency is largely considered an investment vehicle. While the coins certainly have potential outside of that space, people largely haven’t been willing to adopt crypto as a payment mechanism on a wider basis just yet. Since that’s the case, it’s difficult to spend cryptocurrency directly.
But that doesn’t mean it’s impossible to make purchases with crypto. An increasing number of websites and other entities do view cryptocurrency as a reasonable, viable way to pay for goods and services. One prime example is Overstock.com, which supports paying for purchases using a broad selection of cryptos through its partnership with Coinbase. However, the retailer is more of an exception than a rule when it comes to acceptance.
Despite the fact that options are currently limited, there are other ways you can spend your cryptocurrency similarly to a fiat currency. For example, some crypto debit cards are crypto-backed. When a person makes a purchase, the card issuer deducts enough cryptocurrency to cover the cost from the account.
In time, more retailers and service providers may accept cryptocurrency directly. But in the meantime, it’s often easier to use alternatives like crypto debit cards. Otherwise, treating cryptocurrency as an investment is always an option.