What Is Cryptocurrency And How Does It Work ?

What is Cryptocurrency?

Cryptocurrency is a digital payment system that doesn’t rely on banks to verify transactions. It’s a peer-to-peer system that can enable anyone anywhere to send and receive payments. Instead of being physical money carried around and exchanged in the real world, cryptocurrency payments exist purely as digital entries to an online database describing specific transactions. When you transfer cryptocurrency funds, the transactions are recorded in a public ledger. Cryptocurrency is stored in digital wallets.

Cryptocurrency received its name because it uses encryption to verify transactions. This means advanced coding is involved in storing and transmitting cryptocurrency data between wallets and to public ledgers. The aim of encryption is to provide security and safety.

The first cryptocurrency was Bitcoin, which was founded in 2009 and remains the best known today. Much of the interest in cryptocurrencies is to trade for profit, with speculators at times driving prices skyward.

How To Buy Cryptocurrency

1. Choose An Exchange

Bitcoin can’t be purchased through your bank or investing firm yet — though some organizations are working toward that possibility in the future. For now, you’ll have to go through a cryptocurrency trading platform to exchange your U.S. dollars for Bitcoin or other digital currencies. 

There are hundreds of cryptocurrency exchanges you can use to buy crypto online, but a few of the more popular ones are CoinbaseGemini, Binance, Kucoin and Kraken. These exchanges are online platforms where you can buy and sell cryptocurrencies. 

You can narrow down your search for the right platform based on a few factors:

Security

Cryptocurrency investments are not backed by a central institution like FDIC-insured bank accounts. If your account is compromised, or the platform where you keep your coins is hacked, you could be at risk of losing your investment. 

If you plan to keep your crypto on your account with an exchange (rather than move it into your own wallet), make sure you choose an exchange that uses offline, cold storage, and has strong protections against theft. Some exchanges also have independent insurance policies to help protect investors from potential hacking. 

Fees

Exchange fees can vary greatly, and may be applied as a flat fee upfront or as a percentage of your trades. Fees can be based on price volatility, and many are charged per transaction. 

While fees should definitely be a consideration, experts say you also get what you pay for, especially when sticking to the bigger, more established exchanges like Coinbase. If an exchange has more protections, better security, or other important features to you, it may be worth slightly higher fees.

Some exchanges charge fees based on a spread, or margin on top of the market price. Others base fees on a flat rate or percentage of your total purchase, which can vary based on your location, payment method, and other factors. 

Exchanges with more active trading features often use a fee model determined by market price fluctuations, known as maker-taker fees. If you buy at the current market price, you’ll be charged a (usually higher) “taker” fee. Or, you can set a price at which you want to buy, and wait for the market to reach that point. That’s known as a limit order, and incurs a “maker” fee.

Make sure you know what fees you’ll be charged — which you can find on the exchange’s website — before signing up. The fee structure should be clearly stated when you make your purchase, but it can help to factor in that cost beforehand so you don’t spend more than you expected. 

2. Fund Your Account

Depending on the exchange you choose, you may need to provide information like your Social Security number, ID, and your source of income when you create your account. 

With most exchanges, you’ll be able to connect your bank account or a debit card to transfer U.S. dollars into your exchange account. There may be different fees depending on which method you use to fund your account — typically, bank transfers will cost less than card options. 

Remember, funding your account isn’t the same as actually purchasing crypto. Just like with traditional investing, you never want to leave uninvested money sitting in your account. Once you fund your account, you’ll still need to exchange your dollars for Bitcoin. 

3. Place An Order

Once you’ve connected a payment method, you’ll be able to actually place your order for Bitcoin. This process can differ depending on the exchange you use. 

Generally, if you’re using a platform like Coinbase or PayPal, you can simply enter the amount in dollars you want to trade for Bitcoin, and buy at the current rate (after accounting for any fees). 

If you use an exchange designed for more active trading — such as Coinbase Pro — you may have the option to place both market and limit orders. A market order means you purchase the cryptocurrency at that moment, for the current market price. A limit order means you’ll set a price you want to pay for the cryptocurrency. Once the currency reaches that point it will automatically be purchased.

With Bitcoin, you’ll likely be purchasing a fractional share of a coin — a single coin has traded for between about $30,000 and $60,000 in recent months. Whatever amount you put in will be reflected in the exchange as a percentage of a total Bitcoin. (Example: If you invested $1,000 at Bitcoin’s early July value of about $34,000, it would show that you own 0.029 of Bitcoin).

4. Hardware Crypto Wallet

Many exchanges allow you to leave your investment within your account, which is easiest for most beginners. But if you want to further secure your digital assets, you can transfer them into a cryptocurrency wallet. 

Crypto wallets are divided mainly into two types: hot wallets and cold wallets. Hot wallets use keys (a type of cryptography, like a password). They are created or stored on a connected device and are considered less secure compared to cold wallets.

A cold wallet is a cryptocurrency storage solution that is not connected to the Internet. They are also called Hardware wallets and use a physical medium — typically in the shape of a USB stick. It is considered the most secure type of wallet because it would require hackers to have access to your device and the associated PIN/Password.

Crypto Investment Guidelines

Cryptocurrency is a relatively risky investment, no matter which way you slice it. Generally speaking, high-risk investments should make up a small part of your overall portfolio — one common guideline is no more than 10%. You may want to look first to shore up your retirement savings, pay off debt or invest in less-volatile funds made up of stocks and bonds.

There are other ways to manage risk within your crypto portfolio, such as by diversifying the range of cryptocurrencies that you buy. Crypto assets may rise and fall at different degrees, and over different time periods, so by investing in several different products you can insulate yourself — to some degree — from losses in one of your holdings.

Perhaps the most important thing when investing in anything is to do your homework. This is particularly important when it comes to cryptocurrencies, which are often linked to a specific technological product that is being developed or rolled out. When you buy a stock, it is linked to a company that is subject to well-defined financial reporting requirements, which can give you a sense of its prospects.

Cryptocurrencies, on the other hand, are more loosely regulated in the U.S., so discerning which projects are viable can be even more challenging. If you have a financial advisor who is familiar with cryptocurrency, it may be worth asking for input.

For beginning investors, it can also be worthwhile to examine how widely a cryptocurrency is being used. Most reputable crypto projects have publicly available metrics showing data such as how many transactions are being carried out on their platforms. If use of a cryptocurrency is growing, that may be a sign that it is establishing itself in the market. Cryptocurrencies also generally make “white papers” available to explain how they’ll work and how they intend to distribute tokens.

If you’re looking to invest in less established crypto products, here are some additional questions to consider:

•  Who’s heading the project? An identifiable and well-known leader is a positive sign.

•  Are there other major investors who are investing in it? It’s a good sign if other well-known investors want a piece of the currency.

•  Will you own a portion in the company or just currency or tokens? This distinction is important. Being a part owner means you get to participate in its earnings (you’re an owner), while buying tokens simply means you’re entitled to use them, like chips in a casino.

•  Is the currency already developed, or is the company looking to raise money to develop it? The further along the product, the less risky it is.

It can take a lot of work to comb through a prospectus; the more detail it has, the better your chances it’s legitimate. But even legitimacy doesn’t mean the currency will succeed. That’s an entirely separate question, and that requires a lot of market savvy. Be sure to consider how to protect yourself from fraudsters who see cryptocurrencies as an opportunity to bilk investors.

How Does Trading Cryptocurrencies Differ from Stocks?

While you can invest in cryptocurrencies, they differ a great deal from traditional investments, like stocks. When you buy stock, you are buying a share of ownership of a company, which means you’re entitled to do things like vote on the direction of the company. If that company goes bankrupt, you also may receive some compensation once its creditors have been paid from its liquidated assets.

Buying cryptocurrency doesn’t grant you ownership over anything except the token itself; it’s more like exchanging one form of currency for another. If the crypto loses its value, you won’t receive anything after the fact.

There are several other key differences to keep in mind:

  • Trading hours: Stocks are only traded during stock exchange hours, typically 9:30 am to 4:30 pm ET, Monday through Friday. Cryptocurrency markets never close, so you can trade 24 hours a day, seven days a week.
  • Regulation: Stocks are regulated financial products, meaning a governing body verifies their credentials and their finances are matters of public record. By contrast, cryptocurrencies are not regulated investment vehicles, so you may not be aware of the inner dynamics of your crypto or the developers working on it.
  • Volatility: Both stocks and cryptocurrency involve risk; the money you invest can lose value. However, stocks are directly linked to companies and generally rise and fall based on those companies’ performance. Cryptocurrency prices are more speculative—no one is quite sure of their value yet. That makes them much more volatile and affected by something as small as a celebrity’s tweet.

How Does Cryptocurrency Work?

Bitcoin is the first and most well-known, but there are thousands of types of cryptocurrencies. Many, like Litecoin and Bitcoin Cash, share Bitcoin’s core characteristics but explore new ways to process transactions. Others offer a wider range of features. Ethereum, for example, can be used to run applications and create contracts. All four, however, are based on an idea called the blockchain, which is key to understanding how cryptocurrency works.

At its most basic, a blockchain is a list of transactions that anyone can view and verify. The Bitcoin blockchain, for example, is a record of every time someone sends or receives bitcoin. This list of transactions is fundamental for most cryptocurrencies because it enables secure payments to be made between people who don’t know each other without having to go through a third-party verifier like a bank.

Blockchain technology is also exciting because it has many uses beyond cryptocurrency. Blockchains are being used to explore medical research, improve the sharing of healthcare records, streamline supply chains, increase privacy on the internet, and so much more.

The principles behind both bitcoin and the Bitcoin blockchain first appeared online in a white-paper published in late 2007 by a person or group going by the name Satoshi Nakamoto.

The blockchain ledger is split across all the computers on the network, which are constantly verifying that the blockchain is accurate.This means there is no central vault, entity, or database that can be hacked, stolen, or manipulated.

What Can You Do With Cryptocurrency?

There’s a wide range of things you can do with cryptocurrency, and the list grows with time. Here are a few ways to get started, from participating in everyday activities to exploring new technological frontiers:

  • Shop: Over 8,000 global merchants accept cryptocurrency.
  • Donate to causes: There are benefits to donating and accepting crypto, and many nonprofit organizations accept bitcoin donations.
  • Gift it: Cryptocurrency makes a great gift for friends and family who are interested in learning about new technology.
  • Tip someone: Authors, musicians, and other online content creators sometimes leave Bitcoin addresses or QR codes at the end of their articles. If you like their work, you can give a little crypto as a way of saying thanks.
  • Explore unique new combinations of money and technology: Orchid is a VPN, which helps protect you when you’re online, and a digital currency at the same time. Basically it’s broken down into two parts, the Orchid VPN app and the OXT cryptocurrency, and it all runs on the Ethereum network.
  • Travel the world: Because cryptocurrency isn’t tied to a specific country, traveling with crypto can cut down on money exchange fees. There’s already a small but thriving community of self-titled “crypto nomads” who primarily, or in some cases exclusively, spend crypto when they travel.
  • Buy property in a virtual gaming world: Decentraland, which also runs on the Ethereum blockchain, is the first virtual world entirely owned by its users. Users can buy and sell land, avatar clothing, and all kinds of other stuff while partying in virtual nightclubs or mingling in virtual art galleries.
  • Explore decentralized finance, or DeFi: A wide variety of new players are aiming to recreate the entire global financial system, from mutual-fund-like investments to loan-lending mechanisms and way beyond, without any central authorities.

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