What is Cryptocurrency and How Does it Work?

What is Cryptocurrency and How Does it Work? banner

Cryptocurrency is a hot topic these days, with tech gurus and novices alike getting in the game in hopes of scoring major profits. The concept behind this revolutionary technology and monetary system is compelling, but does it really deserve all the hype?

If you’re not sure whether to make the next move as a crypto miner or investor, you’re certainly not alone. Several noteworthy risks accompany today’s crypto endeavors and explorations into this growing class of financial assets, so it’s unwise to enter this often-complex world without at least a basic understanding of how it works and where pitfalls might exist.

In this guide, we’ll explain the basics behind today’s top cryptocurrencies and blockchain technologies. We’ll also delve into advantages and potential downsides so you can determine for yourself whether cryptocurrency is a worthwhile pursuit — and whether you might benefit from additional training before you take the next step as a crypto enthusiast.

What Is Cryptocurrency?

At its most basic level, cryptocurrency involves a digital system of payment. This approach to currency mimics real money but is not backed or governed by a central authority.

Depending on who you ask, this decentralized system either represents a powerful opportunity or a huge source of risk. No matter how it’s perceived, it’s clear that this alternate form of currency has revolutionized how we exchange money and pay for goods and services online.

Who Invented Cryptocurrency?

Cryptocurrency was conceptualized by a person (or group) under the pseudonym Satoshi Nakamoto, who introduced Bitcoin (the first decentralized cryptocurrency) in 2008 through a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” Satoshi Nakamoto remains anonymous, and to this day, their true identity is unknown. Nakamoto’s invention solved a major problem in digital transactions — the need for a trusted third party — by creating a system that could validate transactions and establish trust through a distributed ledger (blockchain) that was open, decentralized, and secure.

The launch of Bitcoin’s blockchain in 2009 sparked interest in cryptography and decentralized finance, leading to the creation of “altcoins” like Litecoin and Ethereum, the latter of which introduced programmable “smart contracts” for decentralized applications. As Bitcoin gained popularity, particularly during a 2017 boom, cryptocurrencies received widespread media attention that attracted investors and regulatory scrutiny. Though challenges with volatility and regulation remain, today, cryptocurrency has grown into a global asset class, drawing institutional interest and shaping new applications in finance.

How Does Cryptocurrency Work?

Understanding how the blockchain functions is only the first step to conceptualizing the power of cryptocurrency. The system also relies on a variety of participants who mine, sell, or exchange tokens.

Mining is a crucial part of the cryptocurrency setup. This process involves recording blockchain transactions. Top cryptocurrency systems such as Bitcoin make this endeavor more time-consuming than it could be in hopes of limiting the potential for fraudulent or trivial transactions.

When miners receive transaction data, they run it through cryptographic algorithms. This, in turn, generates strings of numbers and letters known as hashes. These are able to verify the validity of key data without actually revealing it. Hash technology makes it easy to check block validity, although proof of work is also required.

While many miners are passionate about crypto and eager to see it succeed, this is by no means the only source of motivation for their hard work. They are also compensated for their effort. After all, while the above explanation breaks down the crypto concept to the simplest level possible, it’s actually a complex process that requires a lot of electricity and advanced technology. As such, crypto miners often operate within pools that allow them to share resources.

Is Bitcoin a Cryptocurrency?

Bitcoin is a cryptocurrency because it is a form of digital currency that uses cryptographic techniques to secure transactions, control the creation of new units, and verify the transfer of assets on a decentralized network. Bitcoin operates on a peer-to-peer network without a central authority (like a bank), relying instead on a public ledger called the blockchain, which records all transactions transparently and immutably. Its cryptographic structure ensures security, privacy, and integrity, making it resistant to counterfeiting and double-spending (essential characteristics of a cryptocurrency).

What Is the Blockchain?

The concept of cryptocurrency rests on the power of the blockchain—a digital ledger that uses a system of public verification to record transactions via a peer-to-peer network.

Both verifiable and permanent, transactions that take place over the blockchain are highly secure. Hence, the popularity of this system not only for cryptocurrency but, increasingly, for other functions such as automated smart contracts or even governance for product quality.

The blockchain may be vast, but it can be broken down into separate blocks of information that are arranged chronologically. Once the storage capacity of each block has been filled, it is linked to the previous block. Together, these blocks create a strand known as a chain. They also form a timeline of sorts, because blocks are set in stone as soon as they’re filled. These blocks are given timestamps that cannot be altered.

Understanding Proof of Work vs. Proof of Stake

Proof of work (PoW) and proof of stake (PoS) are two different consensus mechanisms used by cryptocurrencies to validate transactions and secure the blockchain. Both mechanisms serve to secure the blockchain, but PoW prioritizes security through computational difficulty, while PoS seeks energy efficiency and scalability. Key differences include: 

Proof of Work (PoW)

In PoW, network participants (miners) compete to solve complex cryptographic puzzles, a process that requires significant computational power. The first miner to solve the puzzle gets the right to add a new block of transactions to the blockchain and is rewarded with cryptocurrency (like Bitcoin). PoW is secure and decentralized, but it’s energy-intensive and often slow, as it requires considerable computational resources that make it costly and environmentally impactful.

Proof of Stake (PoS)

PoS selects validators based on the number of coins they hold and are willing to “stake” as collateral, rather than relying on computational power. The more a person stakes, the higher the chance they will be chosen to validate transactions and add blocks, earning transaction fees or new coins as rewards. PoS is more energy-efficient and scalable than PoW because it doesn’t rely on intensive computation. However, it may face centralization risks, as wealthier participants with more coins have higher chances of being chosen as validators.

What are the Most Popular Cryptocurrencies?

When most people think of cryptocurrency, they picture Bitcoin. Invented in 2008, Bitcoin revolutionized the concept of digital currency and has been a dominant force in the crypto world ever since.

Those who mine within this system receive bitcoins as rewards—and these can be used to purchase products or services. Bitcoins can also be exchanged for other currencies.

Bitcoin may be the most prominent form of crypto, but it’s certainly not the only option. Other popular cryptocurrencies include:

Ethereum

Not only is Ethereum the second largest crypto, based on market capitalization, it also constitutes the largest blockchain. This derives from Ethereum’s mission to decentralize not only money, but also the digital world in general. Under this proposed system, conventional servers would be replaced by nodes, capable of forming ‘one computer for the entire world.’

Tether

Tether (USDT) is a stablecoin cryptocurrency designed to maintain a 1-to-1 fixed rate with the U.S. dollar, making it less volatile than other cryptocurrencies. It is widely used for trading, as it allows investors to move quickly between cryptocurrencies without converting back to traditional currencies.

BNB

BNB (Binance Coin) is the native cryptocurrency of the Binance ecosystem, initially launched to facilitate trading fee discounts on the Binance exchange (one of the most popular globally). Over time, its use has expanded to include payment for transaction fees on Binance’s own blockchain, Binance Smart Chain, and various other services and applications.

Dogecoin

Originally formed as a joke, this cryptocurrency is, as its official website claims, ‘favored by Shiba Inus worldwide.’ There’s more to Dogecoin than pure humor, however. It’s also noteworthy for its short block intervals and its emphasis on fundraising. In 2014, for example, the Dogecoin community famously supported the Jamaican bobsled team for the Winter Olympics.

Legal and Regulatory Aspects of Cryptocurrency

Cryptocurrency regulation varies widely across countries but generally aims to protect consumers, prevent fraud, ensure market integrity, and prevent illicit activities like money laundering. Regulation of cryptocurrency remains a complex landscape as governments seek a balance between fostering innovation and ensuring consumer protection, market stability, and compliance with financial laws.

In the United States, two main regulatory bodies — the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) — play key roles in overseeing aspects of the cryptocurrency market:

  • The SEC considers some cryptocurrencies as securities, meaning they represent an investment contract or have characteristics akin to stocks. If a cryptocurrency meets the criteria of the “Howey Test” (a legal test to determine if an asset is a security), it falls under the SEC’s jurisdiction, which requires strict compliance with securities laws. Initial coin offerings (ICOs) and some newer cryptocurrency projects often face SEC scrutiny, as they can resemble unregistered securities offerings.
  • The CFTC treats cryptocurrencies like Bitcoin and Ethereum as commodities rather than securities. This classification allows the CFTC to regulate derivatives and futures markets related to these cryptocurrencies, focusing on preventing fraud and market manipulation in trading environments. Unlike the SEC, which focuses on asset classification, the CFTC’s approach primarily involves market integrity and oversight of cryptocurrency-based futures and other financial products.

In terms of other regulatory aspects, U.S. laws like the Bank Secrecy Act require cryptocurrency exchanges to implement anti-money laundering (AML) and “know your customer” (KYC) practices, verifying users’ identities to prevent illicit activities. In addition, the IRS treats cryptocurrency as property, so gains or losses from transactions, sales, or trading are subject to capital gains tax.

Pros and Cons of Investing in Cryptocurrency

Now that you know what cryptocurrency is and how it works, it’s time to determine whether mining or investing might be in your future. This begins with a closer look at some of the advantages and disadvantages of crypto outlined below:

Pros

  • High degree of control. If you struggle to place your financial destiny in the hands of anyone else, you may be a solid candidate for the crypto market. As a crypto investor, you will have full control over every decision.
  • Avoiding third parties. Not only does crypto grant you complete control over your investments, it allows you to avoid the potentially costly prospect of third-party providers who often assess high transaction fees when handling traditional investments.
  • Resistance to inflation. With cryptocurrency, inflation looks little like it does in other areas of investing. Many forms of crypto are designed, by nature, to hold limited availability. Meanwhile, as crypto enthusiasts point out, printing more money can quickly lead to significant rises in price levels. Hence, crypto’s common use as a hedge against inflation.
  • Affordable digital transactions. Often, online transactions are accompanied by significant fees. These arise as third-party vendors such as PayPal authenticate transactions. This can lead to fees of up to 3 percent, as compared to less than 1 percent for most crypto transactions. What’s more, crypto allows for more affordable international transactions, as it doesn’t treat these differently from domestic exchanges.

Cons

  • High volatility. The cliche about high risk begetting high rewards clearly describes the crypto market. While some cryptocurrencies are more volatile than others, prices tend to fluctuate significantly across the board—especially as compared to those in real estate or even the stock market. If you intend to get involved in crypto, you best be prepared to handle sudden and significant losses.
  • Tax concerns. While the IRS previously turned a blind eye to most cryptocurrency issues, the agency has recently cracked down on all things crypto. Get in over your head and you could be in a world of trouble come tax season.
  • Scams are common. While legitimate cryptocurrency is extremely secure due to the use of decentralized blockchain technology, it’s easy for those new to investing to get sucked into crypto scams. These can take many forms, with some proving sophisticated enough to part experienced investors with their hard-earned money.
  • Limited liquidity. As cryptocurrency becomes more common and more widely accepted, it’s far easier to use for everyday exchanges and transactions than it was in the early days. That being said, its liquidity remains limited as compared to investments tied into the stock market. Combine this with its inherently volatile nature, and it’s easy to see why some people are unable to take on the risk of crypto even when the potential rewards are significant.

Emerging Uses of Cryptocurrency

Cryptocurrency serves a vast range of applications beyond digital currency, with notable use cases that leverage its decentralized and secure nature.

  • Decentralized finance (DeFi) DeFi platforms aim to recreate traditional financial services like lending, borrowing, and trading on blockchain networks, eliminating intermediaries like banks. Built primarily on Ethereum and similar platforms, DeFi allows users to engage in financial activities through decentralized applications and smart contracts. This setup enables lower fees, accessibility for those without traditional banking, and a high level of transparency in financial transactions.
  • Cross-border payments and remittances – Cryptocurrency enables faster, cheaper, and more secure transactions across borders compared to traditional financial systems. By reducing the need for intermediaries and minimizing exchange rate fees, cryptocurrencies can offer cost-effective solutions for sending remittances and making international transfers, which is especially beneficial for those in regions with limited banking infrastructure.
  • Asset tokenization – Cryptocurrencies can represent real-world assets, a process known as tokenization, where physical or digital assets (like real estate, art, or stocks) are represented on the blockchain as digital tokens. Tokenization allows for fractional ownership and easier transfer of assets that open up investment opportunities for a broader audience.
  • Digital identity and verification – Blockchain technology can securely store and manage digital identities, enabling decentralized and tamper-proof identity verification systems. Using cryptocurrency-based platforms, individuals can verify their identity across different services without sharing sensitive information, thereby enhancing privacy and security.
  • Non-fungible tokens (NFTs) and digital ownershipNFTs are unique digital assets that represent ownership of specific items — often art, music, or collectibles. Using blockchain, NFTs establish verifiable ownership and authenticity, opening new markets for creators and collectors in the digital space.
  • Supply chain management – Cryptocurrencies and blockchain technology can enhance transparency and efficiency in supply chains. By recording each stage of a product’s journey on a blockchain, companies can reduce fraud, ensure quality, and provide consumers with a transparent view of the origins of their goods.
  • Gaming and virtual economies – Cryptocurrencies are increasingly integrated into gaming ecosystems, where players can earn, trade, and use tokens across platforms. Blockchain-based games allow for in-game asset ownership that let players trade items or currencies outside of the game, creating virtual economies with real-world value.

Explore Modern Financial Investment Strategies and More With JWU

As you can see, there is no easy answer as to whether you should get involved with cryptocurrency. This market is chock full of opportunities, but these are best taken advantage of following careful study and analysis. Do your homework and you could be in for an exciting journey through one of history’s most groundbreaking financial developments.

Interested in cryptocurrency and investing? Consider getting an edge on the competition by earning your Bachelor of Science – Finance or your Master of Science – Finance from JWU. For more information, complete the Request Info form, call 855-JWU-1881, or email [email protected].

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