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By now, you’ve likely heard of cryptocurrency. But you need to actually understand what it is and how it works before you invest.
Bitcoin, Ethereum, Dogecoin and others have surged in popularity, and it seems like everyone wants to get in on the action. Now, everyday investors can: Buying crypto is now as easy as opening the Venmo app, and it can be traded like stocks and bonds via trading apps like Robinhood.
But the actual technology behind cryptocurrencies is a bit complicated. While it’s easy to get swept up in the excitement around how some investors are making a ton of money trading Bitcoin, it’s important to understand what cryptocurrency actually is before you invest.
Here’s everything you need to know about cryptocurrency.
How does cryptocurrency work?
Cryptocurrency is digital money designed to allow users to send online payments quickly anywhere around the world without having to go through a bank and without oversight by any government.
The anonymous creator of Bitcoin, the original and most popular cryptocurrency, said in what came to be called the Bitcoin white paper that he wanted to create a peer-to-peer electronic cash system, meaning that you could instantly send money to someone else (think PayPal, but without the company doing the transacting for you). The idea was that eliminating banks and brokers from the equation could reduce fees and allow senders and receivers to keep the exchange private.
In addition to avoiding banks, many fans of cryptocurrency see it as a new way to fight corrupt and oppressive governments, as it aims to remove governments from financial transactions completely by operating completely anonymously. It’s certainly shown its use. For example, Venezuelans have turned to crypto as they face hyperinflation and an economic crisis.
Ideally it requires nothing more than an Internet connection to start trading cryptocurrency, making it different from opening an account at a traditional bank (think about how much information you need to provide to get a credit card).
But many critics — including the Chinese government, which went so far as to ban cryptocurrency — say crypto assets can also be used for illegal activities like money laundering and gambling. The U.S. government, for example, has taken steps to ensure that those who are buying cryptocurrency actually pay the taxes they owe when they earn profits. Regulation could take away some of the convenience crypto promises.
On top of this, cryptocurrency prices are extremely volatile. For the majority of Bitcoin’s first five years of its existence, it was worth less than $1,000 per coin. But in 2017, it surged to $20,000. before falling back down to less than $5,000 in 2018 and skyrocketing to more than $60,000 per coin in 2021.
Plus, it’s hard to buy a lot of the things you actually want to buy with crypto. While the number of companies that accept Bitcoin as payment is growing, with major names like AT&T and Microsoft on the list, you’ll still find it much easier to whip out a credit card for most of your everyday purchases.
Still, crypto has taken the financial world by storm and its underlying technology, called blockchain, has been adapted for new innovations, like buying digital art.
Crypto advocates can’t get enough of these digital currencies. But investing in cryptocurrency is certainly not for everyone. It’s important to know the pros and cons of cryptocurrency before you decide if it’s a good investment for your portfolio.
Pros:
Cons:
Blockchain is the underlying technology used to create cryptocurrencies. While traditional money is created by governments and managed by banks, cryptocurrency aims to do without these authorities. Instead of relying on a particular bank’s accounting system to keep track of who owns what, cryptocurrencies store this information on what is called a “distributed ledger” stored simultaneously on thousands of computers all around the world, known as nodes.
This ledger, which records all of a particular cryptocurrency’s account balances and transactions, is known as the blockchain. While the ledger is public, making it difficult for anyone to cheat the system by surreptitiously creating new coins, the accounts are anonymous offering the secrecy crypto investors crave.
When new transactions occur, nodes monitoring the system rush to verify and record them, storing the information on a new ledger entry known as a “block.” Each block is given a unique identifier known as “hash.” New blocks are added at regular intervals (every 10 minutes in the case of Bitcoin) to the past chain of blocks, hence the system’s “blockchain.”
The transactions are secured with digital cryptography, which ideally makes data inaccessible to anyone but the intended recipient. Each person gets a public and private key: The public key is like an address that you can share with others to receive cryptocurrency while the private key is for your eyes only, and used to prove you are the one who should receive a transaction.
Bitcoin transactions are irreversible, since they’re based on an agreement between two parties called a “smart contract” that executes a transaction when certain conditions are met, and can’t be walked back.
When it comes to Bitcoin and many other popular cryptocurrencies, the computers tied to the network (known as nodes) verify vet and record transactions by solving complicated cryptological math problems. Verifying transactions helps crack down on double-spending, which is when a digital currency is spent twice.
To incentivise as many powerful computers to join the network as possible — and make transactions more secure — the system rewards them for their efforts with newly minted coins. This process of verifying and recording transactions in exchange for newly created coins is known as “mining.”
With prices of Bitcoin and other cryptocurrencies so high, mining for popular cryptos is mostly handled by specialized computers run by professional outfits. One downside: Proof-of-work takes a lot of computational power and a mind-boggling amount of electricity. The Bitcoin network’s electricity consumption is about the same as Washington state’s yearly usage, according to The New York Times. That has led to criticism that Bitcoin isn’t eco-friendly. As a result, some newer cryptocurrencies use a different method to verify and record transactions on the blockchain. This is known as proof-of-stake.
Proof-of-stake, like proof-of-work, is a way to add new transactions to a blockchain to create tokens. This system requires those who are hoping to create new digital tokens to deposit other coins — called stake — into the network.
In exchange for staking their coins, these computers get a chance to validate a new transaction, which can be added to the blockchain and earn rewards. But if these computers, known as validators, sign off on a fraudulent transaction, they lose part of their stake.
While Bitcoin runs on proof-of-work, some newer popular cryptos, like Cardano, run on proof-of-stake. Ethereum is transitioning from proof-of-work to proof-of-stake.
In the early days of Bitcoin, cryptocurrency transactions were negotiated in internet forums and required some technical knowledge about how the medium of exchange works. But then crypto exchanges came on the scene, making it easy to buy and sell cryptocurrency much the way investors trade stocks and bonds.
Coinbase is a popular option, and one of the biggest cryptocurrency exchanges in the U.S. The platform offers Coinbase geared towards beginners and Coinbase Pro, the premium service for more avid and experienced traders.
While exchanges offer convenience, they take away some of the original benefits of crypto, like the privacy and the security of peer-to-peer actions. They also may put you at risk of getting hacked. (There are “decentralized exchanges,” like Uniswap, but these aren’t as mainstream as an exchange like Coinbase).
As cryptocurrency has gained popularity, more and more companies are offering ways to buy and sell digital currencies. You can now buy coins via Venmo and Cash App. Some trading apps like Robinhood also offer crypto.
There are also Bitcoin ATMs popping up in grocery stores and retailers across the country, including in Walmart. To buy Bitcoin from one of these kiosks, users insert cash into the machine and receive a physical voucher for Bitcoin that can be redeemed online.
In many ways, trading cryptocurrencies is like trading stocks — especially if you’re doing so via a trading app.
On Coinbase, for example, the process is straightforward: You can simply hit the “sell” icon on the app, pick the crypto you want to sell and how much of it you want to sell. Then hit “sell now,” and you can get the best available current market price.
However, it’s important to note that exchanges usually charge trading fees, and also you’ll likely have to pay a spread when you buy and sell cryptocurrencies (like you do when buying and selling stocks).
One big difference between trading stocks and trading cryptocurrency is the volatility. Cryptocurrency’s prices often skyrocket or plummet within just a few days. For example, Bitcoin lost 50% of its value between April and July of 2021, before surging to an all-time high of above $68,000 in November.
Many financial advisors recommend that if you are going to invest in cryptocurrency to make it a small portion of your portfolio — no more than 5% — and treat it as a long-term investment.
Cryptocurrency wallets hold the private information you need to make transactions. “Hot wallet” is the name for a digital wallet that allows you to transfer money via a crypto exchange. Meanwhile a “cold” wallet is hardware that is not connected to the internet (and therefore, very secure).
To pick a crypto wallet that is right for you, check out Money’s guide to the best crypto wallets. The guide includes the best wallets for those who want to trade just Bitcoin, for those who want to trade on their phones, for those who want to trade on their desktops and more.
While you may have only heard of Bitcoin, Dogecoin and a few of the other most popular cryptocurrencies, there are more than 14,000 cryptos in existence, according to CoinMarketCap. And there are more being created every day.
Plus, the pool of cryptos to choose from just keeps growing thanks to new types of cryptocurrencies, like altcoins (digital coins that aren’t Bitcoin) and stablecoins (digitals coins with values tied to an outside asset like gold or the dollar).
Experts say to stick with the more well-known, established cryptos, especially if you’re a beginner, rather than pick a random altcoin someone just created yesterday.
Bitcoin was the first cryptocurrency and was created by Satoshi Nakamoto — an alias for the unknown creator — in 2009. Since then, the cryptocurrency’s price has skyrocketed as high as $68,000 per coin.
The cryptocurrency’s more-than-$1 trillion market value makes up nearly half of the overall crypto market.
Ethereum is a software platform built on blockchain technology. Ether was launched in 2015 as the digital currency of the Ethereum network.
Ethereum is now the second largest cryptocurrency by market capitalization after Bitcoin. But crypto’s advocates say that Ethereum can be used for much more than Bitcoin, like non-fungible tokens (NFT) space. NFTs run on the Ethereum blockchain.
Dogecoin started as a joke in 2013 when two software engineers created the “altcoin” — the name for any cryptocurrency that isn’t Bitcoin — after seeing other altcoin creators claiming their coins would one day be worth millions.
“The original intent was a parody of all the ‘serious’ clone coins that were trying so hard to differentiate themselves, but all seemed the same,” one of the Dogecoin creators told Business Insider. “Dogecoin was just another clone coin, but instead of taking itself seriously, it was just Dogecoin.”
But the crypto amassed a huge following over the years and, while its market value was around $624 million at the beginning of 2021, it surged as high as $95 billion in May and now sits around $34 billion.
Binance Coin is a token issued by Binance exchange, one of the world’s largest cryptocurrency exchanges by trading volume.
Users on the exchange can pay for transactions and cover trading fees at a lower rate with Binance Coin than they would with other tokens. It’s what is referred to as a “utility token.”
Created by one of Ethereum’s co-creators the Cardano network and the associated crypto — called ADA — launched in 2017.
Cardano uses proof-of-stake technology instead of proof-of-work technology. The crypto has similarities to both Bitcoin and Ethereum but attempts to address issues of flexibility, security and scalability. This is why Cardano is often referred to as being part of “third generation blockchains.”
Litecoin is an altcoin that was developed by a former Google engineer based on Bitcoin’s open-source code but with several changes, like speeding the time it takes to mine new coins. (Blocks are generated every 2.5 minutes on Litecoin’s network versus 10 minutes on Bitcoin’s network, according to Gemini).
Due to the similarities, it’s been called the “silver” to Bitcoin’s “gold,” and at its height was the third largest cryptocurrency in the market.
Cryptocurrency mining involves the process of solving complicated mathematical problems in the hopes of successfully recording and verifying transactions and adding them to the blockchain.
Mining can look different for different cryptocurrencies. But for Bitcoin, successful miners receive a “block reward,” or a fixed number of new bitcoins (BTC). One block equals 6.25 BTC, but the rewards are halved after every 210,000 blocks, or about every 4 years, as part of Bitcoin’s design to ensure that a maximum of only 21 million bitcoins are created.
Being able to mint a coin worth thousands of dollars is tempting, but crypto mining isn’t as easy as it may sound. Despite having access to tools like a new direct-to-consumer mining service, individual miners are up against large firms that are able to mine with thousands of specialized machines at once. That leaves at-home miners with high hardware and electricity costs and less of an opportunity to actually mine any Bitcoin.
“At-home mining is not economical,” Hanna Halaburda, an associate professor at NYU Stern School of Business previously told Money.
The crypto ecosystem isn’t regulated like traditional currency and its speculative nature means it comes with huge price swings. Bitcoin hit a high of $20,000 in 2017 before crashing to below $5,000 the next year. In 2021, it soared to more than $68,000 per coin at its peak, but a 10% drop in a day is not uncommon. It’s certainly a riskier investment than stocks and bonds, and should only be a small amount of your portfolio — less than 5% — if any, financial advisors say.
Because crypto is new, governments are just figuring out how to regulate it. For example, the U.S. Securities and Exchange Commission (SEC) sued Ripple Labs for allegedly raising $1.3 billion via XRP, Ripple’s cryptocurrency, which the government says is an unregistered security.
But the overall lack of oversight makes crypto’s future very uncertain. A government crackdown could hurt crypto’s value, and there’s always the possibility of it being outright banned.
The platform in which you trade your cryptocurrency also matters, especially since the technology is so new. Customers lost hundreds of millions of dollars when Mt. Gox — once the largest Bitcoin trading exchange in the world — crashed in 2014. Quadriga, another exchange, turned out to be a Ponzi scheme. Before you hand over your money to a crypto exchange, be sure that it’s legitimate and has safeguards in place, like reporting to the SEC.
To ensure extra security, you can store your crypto in an offline wallet (but make sure you don’t lose your password).
New cryptocurrencies are created through a process called mining. In many cases, like with Bitcoin mining, creating new coins entails running through algorithms to solve complicated mathematical problems. Miners who are successful receive a “block reward.” But mining is tough to do: While there are products that let you mine from home, all miners are competing against one another, including with larger firms who have an upper hand (and a lot more money to fund the mining process).
There are many ways to buy cryptocurrency nowadays. You can buy bitcoins and other cryptos with Venmo or Cash App, as well as via stock trading platforms like Robinhood. You can also go right to a cryptocurrency exchange, like Coinbase.
Mining for cryptocurrency may be hard but creating a brand new cryptocurrency is even more complicated. It involves coding a new blockchain, altering the code of an existing blockchain or using an existing platform — like Ethereum — to create a new digital token. After that, you’ll have to determine how nodes (the electronic devices like computers that connect to the blockchain) will function, design the crypto’s interface and more.
While you’ve likely heard of cryptos like Bitcoin, Ethereum and Dogecoin, there are thousands of cryptos in circulation and more popping up all the time. Experts tend to recommend sticking to the well-known digital coins and tokens that have proven themselves over the years, especially if you’re new to the space. If you want to research lesser known cryptos, you can start on sites like CoinMarketCap and CoinDesk, which provide performance details and research on altcoins.
Cryptocurrencies’ prices are very volatile, so while there’s a lot of room to make money, there’s also a lot of room to lose money. Financial advisors recommend that if you want to invest in riskier asset classes like cryptocurrencies to allocate more than 5% of your overall portfolio, and to treat it as a long-term investment instead of trying to time the market.
Yes, cryptocurrency can be converted to cash and USD. If you buy cryptocurrency via a trading app, crypto exchange or platform like Venmo, you can sell the crypto on the platform and transfer the money you make to your bank account. But don’t forget to pay Uncle Sam; if you make a profit on Bitcoin, you will have to pay taxes on it. You can also use a cryptocurrency debit card to make purchases or withdraw cash from an ATM, or use a Bitcoin ATM, which are offered in many major cities.
Coinbase for Beginners: A Complete Guide to Buying and Selling Cryptocurrency on a Popular Exchange
What Is Bitcoin and How Does It Work?
It Just Got Easier to Mine Bitcoin at Home
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