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What is cryptocurrency? - An in-depth guide

While the ideas and principles behind cryptocurrencies have been around for decades, it was really the 2008-09 financial crisis that sparked the creation of cryptocurrencies. These digital assets aim to cut out intermediaries such as banks and governments, which had been seen as part of the problem by some after the crisis.

Today, there are thousands of cryptocurrencies with their total value being over $1.3 trillion in June 2021, according to Coinmarketcap, while the next great digital token, which will spur another illusory gold rush, might only be released tomorrow.

You can easily have access to cryptocurrencies, and in this article we will show you how. However, be extra careful when investing in cryptos. Before investing in cryptocurrency, you should be aware that it is a highly volatile and speculative market, which can create the illusion of quick gains but it is just as easy to lose your money.

What is cryptocurrency?
What is a cryptocurrency and how does it work?

Cryptocurrencies are systems that allow for secure payments online which are denominated in virtual cryptocurrency "tokens" or coins. These are digital assets created by cryptographic means, mostly using blockchain technology as their backbone. Similarly to traditional currencies, digital currencies can be used for buying products and services. 

 

Cryptography makes cryptocurrencies very difficult to counterfeit or double-spend. Blockchain, the technology at the core of most cryptocurrencies, is a decentralized technology that keeps a record of transactions across a network of computers creating a safe, online, distributed ledger. The different parties participating in maintaining the blockchain are called miners, who use their computers to validate transactions. 

The creation and the transfer of cryptocurrencies is also decentralized, meaning there is no single central authority or body, such as a central bank, that oversees the creation and distribution of tokens or the amount available on the market. It also rules out inflation from the cryptocurrency system. This is party embedded into the crypto ecosystem, and partly decided by the majority of users

 

What is the point of crypto?

 

The first widely-known cryptocurrency was Bitcoin, which still is the most popular in terms of how much value is stored in it. One of the main reasons it was created is to allow anyone to make financial transfers without the need for a central financial authority, relying instead on blockchain technology.

 

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.

- Excerpt from the original paper guiding the development of Bitcoin

 

Another issue which the original developers of Bitcoin identified was that transactions with traditional financial institutions are non-reversible:

 

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes.

- Excerpt from the original paper guiding the development of Bitcoin

 

Digital currencies seek to solve these problems through various means involving cryptography and other technology solutions like blockchain technology.

 

Those who praise cryptocurrencies highlight their transparency, their resistance to inflation, becasue there is no central bank in the crypto ecosystem, which can print money, decreasing their value. Cryptocurrencies’ supplies are limited and cannot be arbitrarily created. For instance there will only ever be 21 million Bitcoins ever produced. Another advantage of cryptocurrencies is their portability, it is easy to access them whether you hold it in an online or offline wallet. However, cryptocurrencies have also faced criticism for their use in illegal activities, exchange rate volatility, unregulated status that attracts speculators, and vulnerabilities in the digital infrastructure underpinning them.

 

Be aware when investing in cryptocurrencies! Cryptocurrencies are extra risky, their regulation is patchy, the market is extremely volatile, consumer protection is very weak, and security breaches, scams and frauds pester the market. Only invest money in cryptocurrencies that you are prepared to lose. The idealistic drive behind cryptocurrencies might seem romantic but reality will kick in once you lose your money. In this and a series of other articles, we will guide you through how cryptocurrencies work, and - after careful consideration - how to invest in them. 

What is cryptocurrency?
How does cryptocurrency make money?

You can earn cryptocurrency tokens by mining. Miners receive crypto tokens as a reward for completing blocks of verified transactions which are added to the blockchain. This incentivizes participants across the network to maintain a clean and verified ledger of transactions on the blockchain without a central authority’s bookkeeping. It is also a way to “mint” cryptocurrencies, ie. to enter new coins into the system. 

 

You can also trade cryptocurrencies, but be extra careful when you invest. It is not a simple goldmine. Decide whether you want to buy Bitcoin (or other currencies) on cryptocurrency exchanges or via traditional brokers. Think carefully about how you want to store your crypto coins. Hot and cold wallets both have advantages and drawbacks, so you should choose based on your personal preferences when it comes to security.

 

Figure out how much you want to invest. Be prepared to lose it all due to hacks, scams, or simply because the market is so volatile. Devise an investment plan; think about your goals with crypto investments in the long-term. 

 

What is the benefit of buying cryptocurrencies?

 

The inherent benefit of digital currencies is that you can store them independent of state actors. It promises a quick transfer of cryptocurrencies at low costs. The crypto market is usually available for trading 24 hours a day, 7 days a week because there is no centralized authority watching over the market. 

In theory, cryptocurrencies also offer users more autonomy over their own money than fiat currencies do, as participants do not have to deal with a bank or a government.

Crypto transactions are also much less easily linked to the personal identity of the people who make the transactions. Similarly to cash purchases, crypto transactions are relatively anonymous, which explains their popularity for use in illegal activities such as drugs or arms trafficking.

 

Is cryptocurrency legal?

 

In the main economies of the developed world, Bitcoin and similar major cryptocurrencies are, by and large, legal. But the exact legal status of cryptocurrencies varies substantially from country to country and is still often undefined. Regulation is still in progress in many countries as governments try to make sure cryptocurrencies are not used for illegal transactions, the financing of terrorism or money laundering. In several countries, cryptocurrencies are treated as property rather than currency, which affects how much tax you pay on them. Bitcoin and other cryptocurrencies are not recognised as legal tender, a method of payment of debt. 

 

How to use cryptocurrencies?

 

In order to enjoy any of the benefits of digital currencies, you need to get hold of them.

  1. Get them
  2. Store them
  3. Transfer them

What is cryptocurrency?
How to get cryptocurrencies?

You can obtain digital currencies or get exposure on them in several ways:

 

Owning cryptocurrencies directly

 

Buying

A surefire way of owning cryptocurrencies is actually buying them, which you can do on services called cryptocurrency exchanges. These companies allow you to create an account on their website, transfer fiat money (i.e. USD or any other "normal" currency) to this account and exchange this money to one or more of the digital currencies they have available. (You can also transfer crypto coins to be exchanged for a different type of cryptocurrency.) From the user perspective, this process looks a lot like any traditional exchange.

Mining 

If you are willing to contribute technical knowledge, preparation and actual computing power (i.e. fast computers), you can help maintain the blockchain of your choice (i.e. Bitcoin or Ethereum) by crypto mining. In return, you will be rewarded with cryptocurrencies.

Initial coin offerings

Also requiring some technical savvy is when you invest in coins before they are actually available at the launch of a new cryptocurrency. The crypto coins are transferred to your wallet when the blockchain is started. This process resembles an initial public offering of stocks.

Before you invest through initial coin offerings, check who owns the company offering the crypto coin, and see also if there are other major investors investing in it to make sure you are not falling prey to a scam. You may also want to check whether you will own a stake in the company or just get tokens; and whether the currency is already developed or the company is still looking to raise money to develop it. 

 

Other ways of getting exposure to digital currencies

 

If you want to invest in cryptocurrencies or speculate on their price changes, here are some other popular methods.

CFD

Several online brokers offer cryptocurrencies as CFDs (Contracts for Difference). This allows you to invest in crypto currencies and bet on their price movements using a regulated and familiar environment (i.e. your favorite online broker which is a regulated financial institution) without having to deal with the technicalities. However, you don't directly own the digital currency in this case and therefore you can't use it for any transactions.

ETF/ETN

Several Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs) are available which give you various levels of cryptocurrency exposure. Cryptocurrency ETFs/ETNs track a single cryptocurrency or a basket of different crypto tokens and currencies. This allows you to choose an ETF/ETN that fits your investment strategy and style. This form of investment likewise does not require you to manage the digital assets themselves. So it is a good way for mainstream investors or those seeking a bit more security before they enter the digital currency market, as it creates an added layer of security compared to holding a digital wallet or investing through an exchange. 

Additional options

You can also invest in cryptocurrencies via futures and options, and other investment vehicles (e.g. Grayscale’s Bitcoin Trust on the OTC market).

What is cryptocurrency?
How to store cryptocurrencies?

Just like other currencies, crypto assets also need a wallet, although you don't actually keep your crypto tokens in your physical wallet. Digital wallets are a link to your cryptocurrency on the blockchain, the public ledger where the verified transactions are kept. We can guide you through how it works. Here is a quick summary of the basics you need to know: 

 

In digital wallets 

 

The default and most secure way of storing your coins is in digital wallets. Each cryptocurrency blockchain has its own wallet, which is a set of cryptographic information that identifies a destination to which only you have access to claim your crypto coins. Digital wallets can be either hot wallets, connected to the internet; or cold wallets, which are offline (hardware-based or paper-based).

Setting up a wallet requires some research and technical savvy on your end, so you might instead decide to keep your coins on an exchange.

 

On a cryptocurrency exchange

 

If you acquired your Bitcoin or other virtual currency on a crypto exchange, you can actually store it there as well.

The benefit of this is that you have a lot of control over your currencies there, meaning you have the power to send any amount to another party or make some other payment.

The downside is that you don't have direct access to the wallet behind it, meaning the exchange will act as a mediator. "Physically" the exchange has your coins, similarly to a bank or other financial institution. If, for any reason, the exchange becomes unavailable or goes bankrupt, users will have a hard time accessing their coins.

Check out our guide on how you can invest in Bitcoin through an exchange, a Bitcoin CFD, a Bitcoin ETF or Bitcoin Futures!

What is cryptocurrency?
The Bottom Line

Cryptocurrencies are digital assets created by cryptographic means mainly using blockchain technology as their backbone, eliminating the need for a central authority. The crypto market is extremely volatile and often attracts speculators. Therefore, before investing in cryptocurrencies, make sure you do your research and understand that even though they are popular, they are also volatile and you can easily lose your investment.

Author of this article

Eszter Zalan

Author of this article

Eszter is a Brussels-based content editor and writer with over fifteen years of experience in journalism. She thrives in researching complicated issues and explain their essence in a plain and clear language to guide you through the world of finance.

Eszter Zalan

Content Editor

Eszter is a Brussels-based content editor and writer with over fifteen years of experience in journalism. She thrives in researching complicated issues and explain their essence in a plain and clear language to guide you through the world of finance.

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