How Does Cryptocurrency Work? | NextAdvisor with TIMEbit2main
The cryptocurrency market grew from less than $200 billion to nearly $3 trillion in 2021, attracting a flood of new crypto investors in the process.
But then it all came crashing down in the first half of 2022. While the crypto market is still worth about $900 billion, the risks have become abundantly clear over the last few months for investors who’ve been drawn to this emerging asset class.
That’s why it’s more important than ever for investors to do their due diligence and understand what they’re investing in. If you’re thinking about investing in crypto, you may be wondering: What exactly is cryptocurrency? And how does it work?
Here’s what investors should know about it, and how to be smart with your crypto investments.
What Is Cryptocurrency?
Cryptocurrency is a form of digital currency that in theory can be used to purchase goods and services, but which in practice is more commonly bought and sold as investments or used to power decentralized finance (DeFi) software projects on various blockchains.
Bitcoin was the first cryptocurrency, and in the years since its introduction, the number of coins available to purchase has grown to more than 19,000. Bitcoin was designed for digital payments, though investors have come to see it more as a store of value than a practical digital currency. It is often described as a form of “digital gold.” Bitcoin’s all-time high price was about $69,000 in November 2021, though a steep drop in 2022 has taken it down to around $20,000.
Ethereum is the second-biggest cryptocurrency, but unlike bitcoin it works more like a software platform. Developers buy into the ethereum network to build crypto-oriented apps and software programs. Ethereum also hit its all-time high price in November 2021, reaching $4,878. But like bitcoin, its value has dropped in 2022 and has recently been trading around $1,000.
What Is Blockchain, and How Is It Related to Crypto?
Cryptocurrencies are powered by blockchain networks. A blockchain is essentially a digital ledger made up of expanding blocks of data.
With a blockchain’s distributed ledger, records are be kept across multiple computers on a network. Each computer is called a node, and these nodes verify and store the data. As new transactions are completed, they are added to a “block” of data, and then that block is added to the chain. The entire ledger can be updated as new transactions occur.
Many crypto enthusiasts say blockchain technology has the potential to underpin the next evolution of the internet, sometimes called web3. It’s possible to use blockchain technology for gaming, finance, and other purposes. And, in order to complete transactions, you need to be able to pay the appropriate fee in the related cryptocurrency.
What Is the Value of Cryptocurrency and How Is It Determined?
The value of a cryptocurrency depends on several different factors. With so many cryptocurrencies, it can be difficult to figure out which are truly valuable.
Like many other assets, demand is one of the main drivers contributing to a cryptocurrency’s value. If more people use a coin or a blockchain associated with a coin, it’s more likely to see an increase in price.
Well-established cryptocurrencies like bitcoin and ethereum are used by more people, so they have a higher perceived value. Because more people use those networks, the prices of bitcoin and ethereum are higher than other cryptocurrencies. Some experts also point to the first-mover advantage enjoyed by bitcoin and ethereum with regard to setting the market in the first place.
Supply can also influence the price of cryptocurrency, or at least investors’ perception of its value. Many experts say bitcoin is more likely to maintain its value because there’s a cap to how many bitcoins can exist. Only 21 million can exist, so that scarcity is thought to contribute to its value, as opposed to a cryptocurrency that doesn’t have an upper limit.
When considering which cryptocurrencies to invest in, it’s good to look into coins that have a strong use case and greater likelihood of wider adoption. One of the reasons ethereum is considered valuable (second only to bitcoin) is because its smart contract capability makes it possible to build a number of applications, including for finance and gaming.
How Can You Use Cryptocurrency?
It’s possible to use bitcoin and other cryptocurrencies to buy things in the real world, but experts say it doesn’t make sense for most people. The volatility and fluctuation in value of crypto means the price you pay today might effectively be much higher or lower tomorrow.
Beyond crypto’s use as an investment, it can also be used to gain access to blockchain networks like ethereum and other networks that allow for developers to build software on.
“It’s possible to use cryptocurrency to pay for using networks as well,” says Adam Blumberg, CFP, co-founder and president of Interaxis, a firm that educates financial advisors about crypto assets. “If I want a smart contract transaction on ethereum, I need to use ether to pay for the use of the network.”
There are also various crypto debit and credit cards available, linked to exchange accounts, that allow you to integrate real-world purchases with your crypto portfolio. Even PayPal allows you to use cryptocurrency to pay online.
But the most common use for cryptocurrencies is as investments. And there are signs of growing mainstream availability of such crypto investments. For example, Fidelity recently announced plans to add bitcoin to its 401(k) plans. There are also self-directed IRA custodians that connect to an exchange like Coinbase to create a way for you to invest your cryptocurrency in tax-advantaged retirement plans.
How Is Cryptocurrency Mined?
Cryptocurrency mining is a process of using computing power to help validate transactions on a blockchain. Miners lend their computing power to the network to help complete transactions. In return, those who solve cryptographic puzzles and do other computational work can be rewarded with more cryptocurrency.
Crypto mining has become increasingly challenging — and competitive — over the years. In order to provide the computational power needed in an increasingly competitive environment, many miners build or buy specialized equipment. This can be costly, and it doesn’t guarantee that you’ll receive the reward for mining. There are also environmental concerns that come with crypto mining, thanks to the massive amounts of electricity required to power increasingly sophisticated and powerful mining computers.
How Is Cryptocurrency Stored?
There are various ways to store your cryptocurrency. Many crypto exchanges allow you to store your coins on the exchange. However, if your coins are on an exchange, they can be vulnerable to a hack. While some exchanges maintain insurance to help mitigate losses, it’s important to note that crypto investments don’t have the same federal protections and guarantees as your conventional stock portfolio.
The most secure way to store cryptocurrency is with a crypto wallet. There are two main types of wallets:
- Hot wallets are connected to the internet and can be accessed via your browser or your phone. They are easy to access and you can connect them to various online marketplaces. You can quickly send your cryptocurrency from an exchange to a hot wallet, storing them separately. Hot wallets are sometimes called software wallets.
- Cold wallets aren’t connected to the internet. These are hardware wallets that look similar to USB drive. Cold wallets are often more expensive than hot wallets, but they are considered more secure. Since they aren’t connected to the internet, they aren’t as vulnerable to hackers. But that also means if you lose your cold wallet, you may lose your crypto forever.
When choosing between a hot wallet or cold wallet, it’s important to understand the risks associated with each.
A hot wallet often has a way for you to retrieve lost keys. You can usually use them like another account with a password. As long as you have the right pass phrases, you can often get back in. However, you have to be willing to take on the security risks.
With a cold wallet, you’re less vulnerable to hacks, but you might not have the ease of recovery. If you forget the keys needed to access your wallet, you might not be able to get to your crypto assets. Additionally, if the hard wallet is destroyed with no backup, you could also lose your assets.
When storing your crypto, it’s important to figure out a system that works for you. For trading, it can make sense to keep coins on an exchange. However, you might also want a hot wallet for online transactions and moving your cryptocurrencies around. For long-term storage, a cold wallet could be your best bet, as experts recommend cold wallets for top security. You can use a combination of storage options to get the result you want.
Based on our own research and input from experts, we think these are the best crypto wallets for most long-term investors: