What is Cryptocurrency and How Does it Work?

With more than 10,000 cryptocurrencies in circulation today, it can be overwhelming for newbies to understand what is going on without some basic background information.

A cryptocurrency or “crypto” for short is a form of digital currency you can use to purchase goods and services.

They are in some ways similar to the fiat money (e.g., US dollars) you use in conducting everyday transactions in that they can be used to store value.

That said, the differences between cryptocurrency and fiat currency are what makes them wildly popular.

What is the meaning of cryptocurrency? What are they used for? How can you buy or trade crypto?

We answer these questions and more in this article.

What is Cryptocurrency?

To understand what cryptocurrency stands for, we can simply consider the two words that make up the term: crypto and currency.

Crypto refers to the use of cryptography, or computer codes and algorithms that enable secure payments between peers.

Effectively, what cryptocurrencies have been able to achieve is the creation of digital financial assets that work like traditional money, without many of the disadvantages of paper (fiat) currency.

The first decentralized cryptocurrency (and the most popular one) is Bitcoin.

Since Bitcoin was first launched in 2009 by Satoshi Nakamoto, we have thousands of others become mainstream.

How Do Cryptocurrencies Work?

Cryptocurrencies emerged on the back of mistrust of governments and Central Banks.

The technology was borne out of a search for anonymous, secure, decentralised, and low-cost ways to send money electronically.

Using Bitcoin as an example, you can send this cryptocurrency directly to a recipient using a P2P network that does not involve any bank or centralised government.

The transaction is completed almost immediately, and it is recorded on a public ledger that is visible to everyone.

This public ledger is also known as blockchain technology and is how transactions are verified by Bitcoin miners.

On the Bitcoin blockchain, miners use what is called a “Proof of Work” validation technique to ensure that transactions are secure and irreversible.

For some cryptocurrencies, the validation technique uses a different cryptographic technique, known as Proof of Stake.

In exchange for the work miners do to validate and keep the system secure using complex encryption codes, they are rewarded with cryptocurrency, which is how new tokens or coins are created.

Also, it is worth noting that while blockchain or ledger transactions are public, the identities of the people conducting the transactions are extremely hard to decipher.

This brings us to the differences between fiat currency and cryptocurrency.

Cryptocurrency vs. Fiat Currency

Fiat currency is the money issued by governments all over the world e.g. U.S Dollar, Canadian Dollar, Euro, Japanese Yen, Chinese Yuan, British Pounds, etc.

Fiat money has no intrinsic value on its own and is dependent on government regulation for its “legal tender” status.

Simply put, the value of a fiat currency is tied to the value placed on it by the public which is largely dependent on the confidence they have in the issuer of the currency.

When a country’s economy is performing well and the government is stable, the powers of demand and supply, and sound money policies makes its currency valuable. If the country is in financial distress and/or has political problems, its currency does not fare as well.

Many of the advantages of cryptocurrencies have to do with the shortcomings of fiat currency and include:

Decentralized: Cryptocurrency do not rely on a bank to facilitate transactions between interested parties. This means you have the flexibility to complete transactions without government intervention or disturbance.

Privacy: While your public Key is visible on the blockchain, it does not include your private information (i.e., name, address, or other identifying data). This makes it possible to remain anonymous and to avoid censorship.

Security: The blockchain is secured using cryptography. People can send crypto to your public address, but they can’t access your wallet using this information. It is important that you keep your “private keys” securely as this is what prevents unauthorized access to your tokens.

Fast Transactions: You can complete a transaction almost instantly from anywhere in the world. This contrasts with the banking system where global money transfers can take days to complete.

Low Transaction Fees: Banks are not known to be compatible with low or no fees. Cryptocurrencies get rid of the middleman making speedy low transaction fees possible.

Deflationary: For tokens and coins with a predefined total supply, there is an increase in value over time as the coins in circulation is capped. This is counter to fiat money which a government can print at will.

While cryptocurrencies can be said to have many advantages, they also have downsides including:

  1. Complex and difficult to understand.
  2. Still susceptible to losses due to hacking or the loss of your private keys.
  3. Very volatile causing values to rise and drop significantly within short time frames.
  4. Impending government regulations may impact the crypto landscape negatively.
  5. Cryptocurrencies are favoured by criminals who want to hide their tracks. This gives the entire system a bad name and may attract strict regulations from governments.

Top Cryptocurrencies by Market Capitalization

As per CoinMarketCap, there are over 10,170 cryptocurrencies with a combined market capitalization of $1.63 trillion as of today.

Broadly speaking, you can divide cryptocurrencies into “Bitcoin” and “altcoins”.

Altcoins or alternative tokens other than Bitcoin are the many coins that have been created after Bitcoin. Many of these cryptos have been built using a protocol or framework similar to Bitcoin.

The top-10 cryptocurrencies by market capitalization as of June 1, 2021, are:

CryptocurrencyMarket Capitalization
Bitcoin BTC$689 billion
Ethereum ETH$305 billion
Tether USDT$61 billion
Cardano ADA$54 billion
Binance Coin BNB$53 billion
XRP$48 billion
Dogecoin DOGE$42 billion
USD Coin USDC$22 billion
Polkadot DOT$20 billion
Uniswap UNI$15 billion

Cryptocurrency Trading: How To Buy Crypto in 2021

You can buy crypto on a cryptocurrency exchange.

Like buying stocks on a stock exchange, a crypto exchange is an online platform that allows you to buy and sell cryptocurrencies.

You can buy crypto using fiat or other cryptocurrencies.

For example, you can fund your account with US dollars and use it to purchase Bitcoin. Alternatively, if you already have Bitcoins, you can exchange your bitcoins for altcoins like Ethereum or Rippler (XRP).

Transactions on an exchange incur fees and you may also get dinged with foreign currency conversion fees if you fund using a currency that the platform does not directly support.

The top platforms for trading cryptocurrency in 2021 include:

One way to keep your crypto coins secure is to move them from the exchange into your personal hardware wallet.

You can also use online wallets or software wallets; however, these are generally less secure due to increased exposure to hackers.

Are Cryptocurrencies Legal?

While cryptocurrencies are not “legal tender”, they are legal to own in most countries.

Countries where coins like Bitcoin have been banned include China, Bolivia, Egypt, Morocco, Nepal, Ecuador, Bangladesh, and Algeria.

Should You Invest in Cryptocurrency?

Cryptocurrency is a highly speculative asset, and you can lose a lot of money.

In 2021, we have seen Bitcoin reach a high of $64,863 USD and then crash back to as low as $30,681 USD within a matter of weeks.

That said, if you understand the risks, you could consider adding crypto to your investment portfolio based on your risk tolerance.

There are a few other ways to get exposure to cryptocurrencies. For example, you could buy a Bitcoin mutual fund such as the Grayscale Bitcoin Trust (GBTC).

You can also invest in Bitcoin or Ethereum via Canadian crypto ETFs like Purpose Bitcoin ETF (BTCC) and CI Galaxy Ethereum ETF (ETHX).

Like individual cryptocurrencies, these investment products (i.e., mutual funds and ETFs) can also experience significant price volatility.

You should always do your own research and due diligence before making any investment decisions.

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