What is Cryptocurrency and How Does it Work?

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, 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.

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.

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.

What are the Most Popular Cryptocurrencies?

When most people think of cryptocurrency, they picture Bitcoin. Invented in 2008 by an anonymous individual (commonly referred to as Satoshi Nakamoto), 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.’

Litecoin

Another major Bitcoin competitor, Litecoin is capable of producing a greater number of coins than many other forms of cryptocurrency. It relies on the relatively new algorithm known as Scrypt, which is not quite as complicated as the SHA-256 algorithm associated with Bitcoin.

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.

Polkadot

One of the most promising cryptosystems, Polkadot makes it possible to transfer arbitrary data across the web. Its overarching goal? To deliver ‘unprecedented economic scalability’ by way of common validators for securing multiple blockchains.

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 the pros and cons 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.

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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