What is Cryptocurrency? How Does it Work?

Investing
Updated: 1st Sep 2021
Written by Kim Pinnelli
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Investing
January 20, 2021
Written by Kim Pinnelli

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Cryptocurrency, digital assets, or crypto assets are a form of decentralized and digital money powered by blockchain technology.

They make our lives easier by enabling trustless value transferring that allows us to be our own banks.

The cryptocurrency market features more than 4,000 unique coins and tokens. While their number is vast, only a few currencies make it to the top.

But what is this elusive cryptocurrency that everyone talks about, and how does it even work?

What is Cryptocurrency?

A cryptocurrency is a cryptographically encrypted virtual currency. They were introduced to the world for the first time in 2009 with the launch of Bitcoin. Additionally, Bitcoin is the first and original cryptocurrency in the modern sense.

To transact cryptocurrencies, holders use decentralized blockchain networks. These networks have no central authority, are not controlled by any major entity, and can theoretically work without manipulation or influence from any governing body.

If a cryptocurrency runs on its own blockchain network, we refer to it as a coin. In the case that the asset is developed by a project who runs it on another blockchain network, like altcoins on Ethereum, we call it a token.

Ethereum is notably the number one smart contract ecosystem, hosting thousands of cryptocurrencies and decentralized applications.

How Many Cryptocurrencies are there?

As of January 2021, data suggests that there are more than 4,000 cryptocurrencies in the market. However, their exact number cannot be tracked as developers, and solo users list new tokens almost every day.

Booms like the initial coin offering (ICO) and DeFi euphoria have led to the creation of many crypto assets.

Moreover, the use of decentralized exchanges made it possible for any user to publicly list an asset without having to meet requirements historically imposed by centralized exchanges.

Popular Cryptocurrencies

While the list of dominating cryptocurrencies changes almost every month, users can orient themselves in the market by using leaderboards based on market capitalization.

At the time of writing, Coingecko features the next top 10 digital assets:

  • Bitcoin (BTC)
  • Ethereum (ETH)
  • Tether (USDT)
  • Polkadot (DOT)
  • XRP (Ripple)
  • Cardano (ADA)
  • Litecoin (LTC)
  • Bitcoin Cash (BCH)
  • Chainlink (LINK)
  • Stellar (XLM)

How Do Cryptocurrencies Work?

The exact processes that drive cryptocurrencies are enough to make your head feel dizzy. But the main premise behind digital assets is rather simple.

Cryptocurrencies run on blockchain networks, where transaction data is stored. The features and number of tokens that a cryptocurrency has are set by the project’s developers.

Once set, these aspects are impossible to change without having the entire community ‘fork’ to a new network.

The first cryptocurrency was described in a 2008 paper by Satoshi Nakamoto. Named “Bitcoin: A Peer-to-Peer Electronic Cash System,” the document describes the use of a P2P online cash system supported by miners. It is the first place that mentions Bitcoin.

Bitcoin, just like all other cryptocurrencies, exists inside a blockchain network that acts like a decentralized and distributed database.

Learn More: How to Buy Bitcoin

What is a Blockchain?

Blockchain technology, created by anonymous developer Satoshi Nakamoto, can be described as an online, decentralized, public, and distributed ledger.

This ledger is immutable, meaning that it cannot be changed, and contains information on all transactions that have ever been created.

To support the network and keep it online, miners are financially incentivized to verify transactions.

These transactions are bundled in a block, cryptographically hashed, and connected to the next block forming a Merkle tree.

While most cryptocurrencies use existing blockchain networks like Ethereum, certain developers create their own networks to run their projects and coins.

Ready to Buy Cryptocurrency? Check out our round up of the best cryptocurrency exchanges.

Why are Cryptocurrencies Popular?

Cryptocurrencies owe their popularity to their inherent design. Being anonymous, decentralized, and requiring no intermediary authority to use, crypto assets offer the easiest way to make payments or manage your finances.

Aside from their abstract and quite revolutionary goals, cryptocurrencies offer speculative value as well. Millions of traders and investors worldwide use them to speculate the market and create more money.

Since they are extremely volatile, investors prefer participating in crypto markets rather than the stock market. Another factor behind their popularity is the lack of regulation which enables everyone to trade.

Are Cryptocurrencies a Good Investment?

A growth rate of 9,000,000% over the span of a decade makes Bitcoin the most successful asset in all of history. But while cryptocurrencies are a good investment in the long-term, their incredible volatility leaves many traders with a difficult answer.

The main reason institutional investors buy Bitcoin is to hedge against the market, treating it as a store-of-value asset.

On the other hand, the rest of the market is treated in a purely speculative fashion since other assets do not possess Bitcoin’s dynamics and design.

Furthermore, the high level of technical expertise required to wield cryptocurrencies is a significant obstacle that prevents ‘the average joe’ from investing.

If you do not acknowledge the risk behind trading digital assets, it is hard for anyone to suggest that you join the market.

How do I Buy Cryptocurrency?

Cryptocurrencies can be bought both on centralized (CEX) and decentralized exchanges (DEX). Centralized exchanges represent the main fiat gateway through which users can exchange fiat currencies for digital currency.

Since all trading activity, decisions, and other processes are handled by a company, centralized exchanges offer a far safer option.

Alternatively, users can purchase cryptocurrencies with other cryptocurrencies on decentralized exchanges. Due to regulatory reasons, the number of DEXs that offer fiat gateways is quite limited, if not non-existent.

Learn More: How to Invest in Cryptocurrency

How Do You Store Cryptocurrency?

One can store cryptocurrencies via two main storage methods: hot wallets and cold wallets.

Hot wallets represent a form of crypto wallets that users can instantly access. Users can access this wallet format using decentralized applications either on PC or smartphones. They are always connected to the internet. We often refer to hot storage wallets as software wallets.

Cold wallets and alternative hardware wallets are crypto wallets that store cryptocurrencies in an offline and physical format. Ledger and Trezor are the two main hardware wallet producers who create computerized devices.

By not having constant access to the internet and the difficulties of storing crypto offline, hardware wallets are the safer storage method.

Advantages of Cryptocurrency

Cryptocurrencies offer several advantages that make it easier to transfer, store, and exchange value.

One such advantage is that users can sign transactions without having to deal with a third-party company or institution. Cryptocurrency holders avoid the use of banks and government administrations.

Transacting cryptocurrencies takes considerably less time. Additionally, the fees are significantly lower compared to using wire transfers and paying fees imposed by banks.

Disadvantages of Cryptocurrency

Cryptocurrencies have several disadvantages as well. They are merely pseudo-anonymous.

While your real identity is hidden, all your transactions can be publicly tracked. In the case that someone discovers the identity of a wallet holder, the person reveals all of his financial activity to the world.

Since they are fully decentralized, it is possible to permanently lose assets to your money without anyone being able to help you.

If you lose a password or seed phrase connected with your wallet, you will never be able to manage the wallet again.

Are Cryptocurrencies Legal?

The legality of cryptocurrencies varies from jurisdiction to jurisdiction. Each country treats them differently. While some have a crypto-friendly approach, authoritative countries often tend to act aggressively towards them.

Even those countries that do not recognize cryptocurrencies as legal tender can support their development. A list of more progressive regulatory jurisdictions includes Spain, Belarus, Japan, Luxemburg, and Malta.

While cryptocurrencies are legal, they are not on par with fiat currencies. Many financial networks and compliance agencies enforce a strict set of regulatory measures that control the use of cryptocurrencies.

What was the First Cryptocurrency Ever Created?

Bitcoin is the world’s first cryptocurrency, launched in 2009 by Satoshi Nakamoto. A couple of years later, the first altcoins, cryptocurrencies other than Bitcoin, were created. In 2011 Charlie Lee created Litecoin, a Bitcoin fork.

A year later projects such as Peercoin, Dogecoin, Primecoin, and Ripple have entered the crypto market. However, only a few of the original first few cryptocurrencies have stood the test of time.

Bottom Line: What Is Cryptocurrency?

A cryptocurrency is a digital currency that can be used to transfer value. They are cryptographically secured on a blockchain network in which every transaction is permanently and immutably stored.

Bitcoin is the first cryptocurrency, and all other assets are referred to as altcoins. While cryptocurrencies mostly use one dominating blockchain network, Ethereum, others utilize their own independent networks.

Cryptocurrencies allow users to make payments and exchange value without the use of an intermediary. They are decentralized and anonymous, making them the perfect financial solution.

Crypto assets are incredibly volatile. Due to that reason, traders and investors often use them to speculate on the digital crypto market.

At the time of writing, the global crypto market cap is valued at $1.04 trillion.

More Crypto Resources:

Kim Pinnelli
Kim Pinnelli
Kim is a personal finance expert with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been freelance writing for 13 years for a number of large publications. Kim thoroughly enjoys helping people take charge of their personal finances.