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Cryptocurrency: What is it and how does it work?

  • / Updated:
  • Abbi Aruck 

Cryptocurrencies are a growing market, but it can be tough to navigate.


Here, you will find all the basics to understanding crypto, how it works, and if it is safe.

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What is cryptocurrency?

Cryptocurrency is digital money that is based on blockchain technology. Bitcoin and Ethereum are popular versions– but there are more than 19,000 different cryptocurrencies in circulation. A cryptocurrency is a digital, encrypted, and decentralized medium of exchange. Other currencies, like the US Dollar or the Euro have the value managed and maintained by a central authority. This is not the case with crypto. Rather, this is all done among cryptocurrency users on the internet.

How does it work?

Cryptocurrencies can be used to purchase regular goods and service but most people invest. You can invest in cryptocurrencies just like any other assets, like stocks, for example. These assets can be very exciting, but they are risky so you should do research first.

What is a blockchain?

A blockchain is an open, distributed ledger that records transactions in code. Transactions are recorded in “blocks” that are then linked together on a “chain” of previous cryptocurrency transactions.

If you wrote down every single thing you spend money on each day– each page would be comparable to a block and the entire book would resemble the blockchain. With a blockchain, everyone who uses cryptocurrency has their own copy to create a unified transaction record. Each transaction is checked using a validation technique– either proof of work or proof of stake. This extra step is to prevent fraud.

Transaction verification

Proof of work and proof of stake are the two most common methods to verify transactions before adding them to the blockchain. After verification, and the transaction is added to the blockchain, and you will receive your cryptocurrency.

Proof of work is a method of verifying transactions on a blockchain that provides a mathematical problem that computers race to solve. Each participating computer is referred to as a miner. These miners compete to solve a mathematical puzzle that helps to verify a group of transactions. The first computer to do so successfully is rewarded with cryptocurrency for the effort. For example, Bitcoin rewards a miner 6.25 BTC (which is roughly $200,000) for validating a new block.

The race to solve blockchain puzzles can require lots of computer power and electricity. Even though the amount of crypto sounds great, often times miners barely break even after factoring costs of power and computing resources.

Proof of stake requires less power to verify transactions. This method limits the amount of transactions each person can verify based on how much cryptocurrency they’re willing to “stake.” However much you stake will be temporarily locked up in a communal safe for the chance to participate in the process. In a way, this is like collateral with a bank.

Cryptocurrencies are not backed by any public or private entities. This has made it difficult to define their legal status in different financial jurisdictions throughout the world. As of December 2021, El Salvador was the only country in the world to allow Bitcoin as legal tender for monetary transactions.

However, regulation depends on financial jurisdiction. For example, Japan’s Payment Services Act defines Bitcoin as legal property. Meanwhile, China has banned cryptocurrency exchanges and mining within its borders. Cryptocurrencies are legal in the European Union. In the US, even though cryptocurrencies are considered a form of money, the Internal Revenue Service (IRS) treats them as a financial asset or property.

Is it a safe investment?

Cryptocurrencies have gotten the reputation of being unstable investments. This is because high investor losses as a result of scams, hacks, and bugs. The cryptography is secure, but using and storing crypto assets is complex. There are a variety of risks, in addition to the market risks. Crypto investors should be aware of some risks:

  • User risk: There is no way to reverse or cancel a cryptocurrency transaction after it has been sent. It is estimated that about a fifth of all bitcoins are now inaccessible due to lost passwords or incorrect sending addresses.
  • Counterparty risk: Lots of investors and merchants rely on exchanges or other custodians to store their cryptocurrency. Theft or loss by the third party could mean loosing an entire investment.
  • Market manipulation: Market manipulation remains a considerable problem in the cryptocurrency space. Some exchanges have been accused of manipulating prices or trading against their customers.

Despite these risks and others, cryptocurrencies have seen a major leap in prices, with the total market capitalization rising to over $1 trillion.

Advantages vs disadvantages

Cryptocurrencies promise to make it easier to transfer funds directly between two parties. This eliminates the need for a trusted third party like a bank or a credit card company. Transfers between two parties are faster than compared standard money transfers. Cryptocurrency investments can also generate profits. The market has dramatically increased in value over the last decade. In May 2022, Bitcoin was valued at more than $550 billion in crypto markets.

These transactions aren’t entirely anonymous. Rather, crypto transactions are pseudonymous. They leave a digital trail that agencies, like the FBI, can decipher. This opens a door for governments or federal authorities tracking the financial transactions of ordinary citizens.

Unfortunately, this type of currency has become popular among criminals for money laundering and illicit purchases. In theory, cryptocurrencies are meant to be decentralized. The wealth should be distributed between many parties on a blockchain. However, an MIT study found just 11,000 investors hold roughly 45% of Bitcoin’s surging value. Cryptocurrencies traded in public markets are susceptible to price volatility.

How do you buy crypto?

Investors can purchase cryptocurrency from popular crypto exchanges such as Coinbase, apps such as Cash App, or through brokers.

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