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Home»Investment»Cryptocurrency: What it is and how it works
Investment

Cryptocurrency: What it is and how it works

July 28, 2024No Comments6 Mins Read
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Cryptocurrency, a form of digital currency designed as a medium of exchange, has gained popularity in recent years. Bitcoin, in particular, has emerged as the most widely followed alternative currency. Unlike traditional forms of currency, cryptocurrency exists only in digital form — the graphic representation of currency is simply an artist’s interpretation.

One of the main appeals of cryptocurrency is its decentralized nature, free from control by central banks. This independence offers a level of privacy and security not typically found in traditional financial systems. Additionally, the blockchain ledger system, which manages cryptocurrency, makes it extremely difficult to counterfeit.

Investors have been drawn to cryptocurrencies due to the significant value appreciation seen in some coins since their inception. However, they have also experienced sharp declines, particularly in response to actions taken by central banks. Despite these fluctuations, cryptocurrencies like Bitcoin and Ethereum have rebounded from their lows in recent years.

Here’s a closer look at what cryptocurrency is, how it functions, and the risks associated with it.

How Cryptocurrency Works

Cryptocurrencies are created, tracked, and managed through a distributed ledger system, such as blockchain. This decentralized network of computers processes currency movements to ensure the integrity of financial data and ownership. Essentially, it functions like an endless receipt of all transactions, continuously verified by network participants.

This decentralized structure is a defining feature of many cryptocurrencies, eliminating the need for a central authority. This aspect is especially appealing to supporters of cryptocurrencies like Bitcoin, as it limits government and central bank interference in the financial system.

Many cryptocurrencies have a limited supply of units. For example, Bitcoin has a cap of 21 million bitcoins that can ever be issued.

Mining is a key process by which new cryptocurrency is generated. Powerful computers, known as miners, perform calculations and process transactions on the ledger to earn units of the currency. However, mining requires substantial processing power and energy consumption.

Cryptocurrency owners typically store their currency in digital wallets, which enable them to send and receive funds. Transactions are recorded on the public ledger using a unique key, which offers a level of anonymity for users.

One of the primary attractions of cryptocurrency is its potential for anonymous transactions.

The number of cryptocurrencies in existence is virtually limitless, with thousands of new currencies emerging in recent years. Some of the most popular cryptocurrencies include Bitcoin, Dogecoin, Ethereum, Tether, and XRP.

List of the 10 Largest Cryptocurrencies

The size of a cryptocurrency is determined by the number of coins in circulation and their price. Market capitalization, the total value of all coins, is calculated by multiplying these two factors. The top cryptocurrencies and their approximate market caps, according to CoinMarketCap as of mid-July 2024, include:

  1. Bitcoin – $1.3 trillion
  2. Ethereum – $419 billion
  3. Tether – $113 billion
  4. BNB – $85 billion
  5. Solana – $75 billion
  6. USD Coin – $34 billion
  7. XRP – $33 billion
  8. Toncoin – $19 billion
  9. Dogecoin – $18 billion
  10. Cardano – $16 billion

Given the volatility of cryptocurrencies, these values can fluctuate significantly over a short period.

Uses of Cryptocurrency

Cryptocurrency serves various purposes depending on its design. While commonly associated with a payment system, it can also function as a token enabling specific actions, similar to tokens in an arcade. For example, Bitcoin facilitates money transfers but is not widely accepted as currency and can be slow compared to other payment networks.

Ethereum allows users to create “smart contracts,” self-executing agreements. Internet Computer enables the creation of apps and websites, while Dogecoin was created as a parody of Bitcoin’s popularity.

Despite potential real-world applications, speculation remains a significant use of cryptocurrencies. Speculators drive price fluctuations, aiming to profit from market movements.

Although cryptocurrencies offer functionality, many buyers focus on trading for profit rather than utilizing them for intended purposes.

Converting Crypto to Cash

Converting cryptocurrencies into traditional currency like dollars or euros is relatively straightforward. Owners can trade directly through exchanges or payment apps like PayPal or CashApp. Bitcoin ATMs also provide access to cash.

Those trading Bitcoin futures can sell positions during market hours, but fees and tax implications may apply. Immediate liquidation may result in lower returns due to market fluctuations.

Given the high volatility of cryptocurrencies, trading fees, and tax considerations, converting crypto to cash requires careful planning.

Major Risks of Cryptocurrency

Despite the potential benefits of digital currencies, significant risks exist in their current form. These risks, if left unaddressed, could limit the utility of Bitcoin and other cryptocurrencies as a medium of exchange.

Critics, including prominent investors like Warren Buffett, have raised concerns about cryptocurrencies, highlighting their limitations as currencies. Buffett famously referred to Bitcoin as “rat poison squared,” questioning its value as a productive asset.

Some of the key risks associated with cryptocurrency include:

Costly and Polluting Mining

Cryptocurrency mining requires substantial energy consumption, leading to environmental concerns. The energy-intensive process of creating coins contributes to pollution and waste, with Bitcoin’s energy usage ranking among the highest globally.

Environmental backlash against the energy-intensive nature of cryptocurrency mining is a growing concern.

Fixed Supply of Some Cryptocurrencies

While a fixed supply of coins is touted as a positive aspect of Bitcoin, it poses risks such as deflationary pressures. Limiting the total currency supply can lead to economic instability during downturns, as consumers and businesses hoard money, slowing economic activity.

By constraining the money supply, cryptocurrencies may exacerbate economic downturns, a risk not present in fiat currencies.

Volatility Impeding Usability

The high volatility of cryptocurrencies, driven by limited supply and speculative trading, undermines their utility as a stable medium of exchange. Price fluctuations render cryptocurrencies impractical for everyday transactions, as their value can vary significantly in a short period.

Stability is essential for a currency to function effectively, a quality lacking in volatile cryptocurrencies.

Increasing Regulatory Scrutiny

Governments worldwide are implementing regulations to control and monitor cryptocurrencies, posing challenges to their adoption. While regulation aims to curb illicit activities, excessive restrictions could render cryptocurrencies ineffective within certain jurisdictions.

Growing regulatory oversight, especially in major markets like the U.S., may shape the future of cryptocurrencies and impact their viability.

Other Concerns

Additional drawbacks of cryptocurrencies include security vulnerabilities in digital wallets, criminal misuse, slow transaction processing compared to traditional networks, and tax implications. The IRS categorizing Bitcoin as an asset triggers tax obligations for each transaction, complicating its use as a currency.

Conclusion

While cryptocurrency offers potential benefits, it also presents significant risks that hinder its viability as a currency. Investors should approach cryptocurrencies cautiously, considering their volatility and associated risks. Those interested in exploring cryptocurrencies should start with small investments and be prepared for potential losses.

— Note: Bankrate’s Brian Baker contributed to an update of this story.

Cryptocurrency works
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