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At least 8,000 other cryptocurrencies have evolved since Bitcoin became the first in 2009.
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Cryptocurrencies are digital assets that are created and run on a blockchain.
Bitcoin and ether are two popular cryptocurrencies, but there are many others.
Investing in cryptocurrency can be extremely risky, and the underlying technology is very new.
Understanding how cryptocurrencies work, who creates and controls them, and why you might want to buy cryptocurrencies is important for investors.
While there may be opportunities to build wealth, there’s a lot of risk involved with crypto investing, and you need to be mindful of scams.
What is cryptocurrency?
Cryptocurrencies are digital assets that you can buy, trade, and use to purchase goods. People and organizations create cryptocurrencies for different reasons, but they generally share a few common characteristics.
How do cryptocurrencies work?
While there are thousands of cryptocurrencies, many with unique traits, they all tend to work in similar ways. It’s hard to avoid some jargon when discussing cryptos, but the concepts can be relatively easy to understand.
They use blockchain technology
A cryptocurrency’s blockchain is a digital record of all the transactions involving that crypto. Copies of the blockchain are stored and maintained by computers around the world. They’re often compared to general ledgers, part of traditional double-entry bookkeeping systems where each transaction leads to a debit and credit in different sections of the books.
“It works like a general ledger — it’s that simple,” says David Donovan, executive vice president, financial services, at the digital consulting firm Publicis Sapient. Perhaps you start with two coins and send one to someone. “On the blockchain, it would say I’m sending you one coin, and I now have one coin, and you have one coin.”
Each grouping of transactions is turned into a block and chained to the existing ledger. Once a block is added it can’t be reversed or altered — which is why people describe blockchains as “immutable.”
Some cryptos have their own blockchain. For example, there are Bitcoin and Ethereum blockchains. But there are also cryptos that are built on top of an existing blockchain rather than starting from zero.
The blockchains are decentralized
Cryptocurrencies are distinguished from fiat currencies, such as the US dollar, because they’re not issued or backed by a government. In fact, no single person, company, or government controls a crypto’s blockchain. Instead, they’re run by a decentralized network of computers around the world.
The lack of a central authority can also make cryptocurrencies more secure. “It’s hack-proof because there’s no one central point of failure,” explains Donovan.
But who decides which transactions get added to each block?
Coming to consensus
Cryptocurrencies commonly use one of two mechanisms to create a system of trust and determine which transactions are valid and added to their blockchain:
Proof of work. This relies on people around the world, known as miners, competing to be first to solve complex cryptographic puzzles and add the next block to the blockchain. The winners are paid after the other members of the network confirm that the required amount of computing power was used to find the solution. “The way you make sure all the participants are validating the transactions is the hard work, effort, and money they’re spending solving the problem,” says Donna Parisi, global head of financial services and FinTech at Shearman & Sterling. However, proof-of-work systems require a lot of energy to power. Proof of stake. This is a newer and less energy-intensive mechanism. “Proof of stake is they validate transactions on the blockchain by people putting value on the line,” explains Parisi. “They stake some of the currency they own to make sure they only validate true transactions.”
Transactions are public but pseudonymous
Cryptocurrencies also have another defining feature. The blockchains are public ledgers, which means anyone can see and review the transactions that occurred. However, they can also provide a degree of anonymity.
“You have a private key, which is how you initiate transactions, and a public key, which is how someone identifies you in the market,” says Donovan.
A blockchain’s transactions are tied to a crypto wallet’s public key, but nobody necessarily knows who controls that wallet. This is why cryptos are often described as pseudonymous — the public key is a person’s pseudonym.
How many cryptocurrencies are there?
According to CoinMarketCap.com there were more than 8,000 different cryptocurrencies with a global market value of about $2.24 trillion as of Dec. 12, 2021.
Bitcoin, the first cryptocurrency, was launched in 2009 as an alternative type of decentralized and digital money. Since then, people have also created cryptocurrencies that serve other functions or are designed for specific types of transactions.
“Cryptocurrencies can have many different uses,” says Parisi. “Some are used in gaming environments to earn rewards in a game, while others facilitate payments. Some are designed for cross-border remittances … some are designed for micro payments.”
For example, stablecoins are a type of cryptocurrency that try to maintain a steady and fixed exchange rate with another asset, such as the US dollar. Governance tokens are another example of a specialized cryptocurrency. They give token holders voting power in a corresponding crypto project.
Are cryptocurrencies secure?
The blockchain technology behind cryptocurrencies can help ensure that the coins and systems remain secure. “What’s never been refuted is the value of blockchain,” says Donovan. “The way the ledger system is set up and every transaction is recorded. And the fact that it’s immutable.”
However, that doesn’t mean you don’t need to worry about security. The crypto world is rife with scams. Of course, that’s also true of traditional financial systems and currencies. Someone asking you to pay with a gift card or wire transfer is a red flag that you’re dealing with a scammer. But several factors could make crypto scams especially worrisome.
For example, cryptocurrency transactions can’t be reversed. There’s also less regulation of cryptocurrencies and platforms than of traditional financial services in the US. Plus, some people may feel pressure to act quickly and send or invest their money because they’re worried about missing out on an opportunity.
“One way to avoid a scam is to invest in more well-established cryptocurrencies, like Bitcoin or Ethereum,” says Parisi. “You still may be subject to scams or fraud in terms of how you hold it, send it, or receive it.” But you can have some certainty that the cryptocurrency itself isn’t a scam.
Are cryptocurrencies a good investment?
Cryptocurrencies may present a good investment opportunity, and there are many ways to invest in the crypto world.
You could buy a coin (or coins) and hold onto them, hoping they’ll increase in value. Or you could use your coins in a decentralized finance (DeFi) platform to earn interest through staking or lending. You also might take a more traditional route, such as an exchange-traded fund (ETF) that is tied to cryptocurrencies. There could even be opportunities to invest in projects or supporting industries rather than in the cryptocurrencies themselves.
“From an investment perspective, crypto is rapidly evolving,” says Parisi. “You shouldn’t put an amount of assets you’re not willing to lose. It should be, relatively speaking, a small portion of your portfolio.”
Before making any investment, consider the potential pros and cons:
Pros
Cons
It can be easy to invest.
Cryptos could diversify your portfolio.
There is a lot of opportunity.
Cryptocurrencies can be very volatile.Some crypto projects may fail.The investment may be a scam.
The bottom line
While cryptocurrency investing is a hotly debated topic, it’s worth understanding what’s going on so you can make an informed decision. If you decide to get started, you could fully jump in or just dip your toe.
“Learn about crypto by opening up wallets, accounts, trading currencies, and learning more about the use cases,” says Parisi. “But do it in a reasonable way. We’re still in the early days, and regulation of crypto is still evolving.”
Donovan suggests starting by opening an account with a regulated and publicly traded company like Coinbase. But, he says, “it’s really about being smart and using the system to take baby steps.”