Cryptocurrency has been called everything from the money of the future to an extremely risky asset that shouldn’t be touched with a ten-foot pole. So which is it? And the bigger question is this: should you be investing in it?
Thoughts and strategies about cryptocurrency spread fast. This is because cryptocurrency is a complicated and unique technology that is also accessible. What I mean is that it can be understood by anyone, regardless of background, and that’s how it spreads like wildfire.
And let’s not forget about all the FOMO (fear of missing out) that cryptocurrency brings. Maybe you have had it recently.
From Bitcoin hitting new price milestones to Facebook launching their own international cryptocurrency, discussions about cryptocurrency’s impact on society and drastic price spikes and crashes, it seems as though something monumental in the cryptocurrency industry happens every week.
This may leave you wondering if you should be investing in it, if it’s even safe, or how it even works.
That’s what this article will do: help you understand the cryptocurrency basics by breaking down its complex nature so that you can become more knowledgeable on the topic.
Only after you understand these basics can you make a decision on whether or not it is right for your investment needs.
By the end of this article, you’ll have an understanding of cryptocurrency basics such as:
- What cryptocurrency fundamentally is
- The different types of cryptocurrency
- The current regulation and rules around it
- How investors buy and sell it
- Best practices investors follow
What Is Cryptocurrency?
It’s easy to get tripped over the technicalities of cryptocurrency, so let’s start with the cryptocurrency basics.
Cryptocurrency is digital money. Because it’s purely digital, there are no physical coins or bills tied to it.
Cryptocurrencies are not tied to valuable assets — they are not tied to anything of value in the real world, and this makes the value fluctuate erratically, which you’ve likely seen.
For example, in July of 2019, Bitcoin fell about $530, or 5%, in a 40-minute span after being mostly flat for the day. Why? There was speculation, but no real answer.
GoldSilver’s founder, Mike Maloney, likes to compare crypto to gold — except the big distinction there is that gold actually has a purpose outside of using it for currency.
Gold is a vital component in electronics, and jewelry — and thus has value outside of its limited supply.
Cryptocurrency, on the other hand, only costs money because someone else has it, and wants money to give it to you.
Currencies have always faced two problems in general:
- They require a central authority to regulate their value, production, and authenticity.
- They fall victim to fraudulent creation.
Bitcoin — one of the many forms of cryptocurrency — was invented to combat these exact problems.
The blockchain system (which we’ll explain in a minute) and high-level encryption address both problems.
Because Bitcoin is automated and highly encrypted, the system doesn’t require a central authority to regulate it (in fact, it can’t be regulated) and transactions cannot be fraudulent.
That’s all bitcoin is — the answer to the question “what would it take to create a virtual currency without a central authority?”
Cryptocurrency Basics: How Cryptocurrency Works
In order to understand cryptocurrency, you should also understand the following technologies and principles:
Cryptocurrency utilizes cryptography — the method of disguising and revealing information — to ensure the security of user information and transactions are done safely.
A blockchain is a form of Distributed Ledger Technology (DLT), which is essentially a database spread over multiple operators (nodes, computing devices, etc.)
This is the technology that powers an entire cryptocurrency. It’s essentially a digital ledger that verifies accounts, balances, and transactions.
There are many uses for blockchain outside of financial purposes such as supply chain management, tracking art ownership, and even digital collectibles.
A term related to blockchain that will also be used throughout this article is a node. A node is the individual part of the larger data structure that is a blockchain. Without nodes, the entire system would fall apart.
Cryptography and blockchain help cryptocurrencies create new coins, enforce legitimate transactions, and create a secure system.
Decentralization, as seen with Bitcoin, means that all authoritative power is distributed among all the peers on a network, and there isn’t one individual point of failure.
For example, in order to “hack” Bitcoin, someone would need to hack into at least 51% of the large network of computers responsible for running Bitcoin, which is considered an impossible task.
Cryptocurrency can be sent directly between two people without the need for a broker. These transfers are done with very low processing fees that go to compensate the network, making it possible for users to bypass hefty transaction fees by more traditional payment transfer services.
That means no need for a PayPal, Zelle, or a bank.
The Different Forms of Cryptocurrencies
When most people think of a cryptocurrency, chances are that they’re thinking of Bitcoin (BTC). Bitcoin is considered the cryptocurrency flagship — the coin that launched thousands of coins.
As seen on popular cryptocurrency price tracker CoinMarketCap.com, there are over 2,500 cryptocurrencies, many of which use their own custom blockchain designed to their specifications.
Don’t worry; you don’t need to learn every single cryptocurrency to understand the cryptocurrency basics. Let’s go over a few of the most popular types to give you an idea.
Referred to as “digital gold” or the gold standard for cryptocurrency, Bitcoin, which debuted in 2009, has reigned king over every other cryptocurrency.
It once had a market capitalization of nearly $240 billion, and currently dominates the rest of the cryptocurrencies with over a 70% lion’s share of the total cryptocurrency market cap.
Investing in just one Bitcoin is an expensive endeavor compared to other investment vehicles. Just for comparison, one bitcoin is equivalent to $8,596.21.
Referred to as the “silver to Bitcoin’s gold,” Litecoin was created as a fork (or split) from Bitcoin and released in 2011 as competition.
Litecoin was made to process transactions faster and cheaper than Bitcoin.
Ethereum is another cryptocurrency powerhouse, but it isn’t actually meant to be a peer-to-peer payment system in the same way Bitcoin is.
Ethereum was launched in 2015 as a decentralized software platform that powers smart contracts (programmatically enforced contracts) and distributed applications (“decentralized” apps or dApps, which we’ll discuss next).
These decentralized applications are open source, autonomous, have 100% uptime, and leverage all the benefits of a blockchain (no central server, extremely difficult to be hacked, etc.)
Imagine the apps in the iTunes store are instead their own entites instead of being centralized through Apple — that’s what a dApp is.
There are nearly 3,000 dapps using Ethereum’s blockchain and the blockchain of a few Ethereum competitors such as EOS, NEO, and Qtum.
These are strings of code that automatically execute a certain task when specific conditions are met. For example, Alex could set up a smart contract to “pay Steven $40 if he sends 10 unique logo designs by December 8th, 2021”.
Once Steven completes this task, the smart contract automatically pays him the $40. If he doesn’t, then Alex is returned his $40.
Different Types of Cryptocurrency
Let’s go over a small difference that many people get tripped over when trying to understand cryptocurrency basics. There are two different types of cryptocurrency: coins and tokens.
A coin is a cryptocurrency that has its own blockchain, such as Bitcoin, Ethereum, Litecoin, Ripple.
A token is a cryptocurrency that is built on another blockchain, such as a dApp that runs on Ethereum’s blockchain.
Tokens represent an asset or utility for a specific project and are sold (or given) to during the first public sale for a project, an Initial Coin Offering (ICO), which mirrors an Initial Public Offering in the stock market.
The United States Government has been focused on tracking down fraudulent ICOs, but that’ something we’ll get to later on.
There is another very important distinction with tokens. There are two general types of tokens: utility and security.
A utility token is intended to only be used to buy products or services from the company or platform that issues them.
A security token is essentially a digital version of financial security that acts as a share of the value of an enterprise, similar to how owning AAPL essentially means you own a chunk of Apple.
In other words, security tokens pay dividends, share profits, pay interest or invest in other tokens or assets to generate profits for the token holders.
A digital asset is considered a security token if it meets three criteria:
- It requires a monetary investment.
- The collected funding goes to a single enterprise.
- Investors give their money with the expectation of gaining income derived on the work of the third party.
Security tokens must also be fully compliant and follow these regulations:
- Regulation D: The individual who is offering the security can only raise money from accredited investors and the information provided to them is “Free from false or misleading statements” (Section 506C).
- Regulation A+: An exemption that allows the creator to solicit non-accredited investors with an SEC-approved security for up to $50 million in investment. This option takes a lot more time and is generally the most expensive route for issuance.
- Regulation S: This regulation outlines security offerings from countries outside of the US, which are therefore not subject to the registration requirements of section 5 of the 1993 Act. The creators of the security offering still must follow the security regulations of the country that they plan to solicit investment.
Example of a Cryptocurrency Transaction
To further understand cryptocurrency basics, here’s how a hypothetical cryptocurrency transaction takes place.
Let’s assume Alex wants to send Steven $5 worth of BTC.
- Steven sends his Bitcoin address (what’s known as a “hashed public key”) to Alex. This Bitcoin address is linked to whatever exchange or cryptocurrency wallet Steven set up. It looks something like this: 3D94LKmtQuVG8JFB3F7cB7gwj614yG4CPg.
- Alex enters the address in his cryptocurrency exchange or wallet along with the Bitcoin (BTC) amount — about 0.0005 BTC, which is equivalent to just over $5, and presses send.
- Steven receives the BTC minus a small fee. According to bitcoinfees.info, these fees can range anywhere between $0.05 to be delivered within the next hour or $0.58 within ten minutes. It doesn’t matter if Alex sent $5 or $5,000,000 — the fees would still be the same.
How is all of this possible? Let’s jump behind the scenes:
From the moment Alex submits his transaction to the blockchain, every node in the Bitcoin network receives the transaction request. Every node makes sure that:
- Alex is actually who he is claiming to be. The nodes verify Alex’s identity through his private key — a private key identifies your source of funds. Anyone who has access to this private key has access to your money. This is why it’s paramount to make sure to keep your private key secure.
- He actually has the $5 to send to Steven. Since the nodes have a copy of the entire ledger of transactions, they can easily check to see if Alex has the money.
If at least 51% of the nodes come to a consensus on the two above elements, the transaction goes through and the nodes update the ledger with the new transaction.
How Investors Buy or Trade Cryptocurrency
Purchasing cryptocurrency has become a user-friendly process in the past year, with popular financial companies such as Robinhood and Square Cash jumping on board.
Here are a few alternative ways that investors currently buy or trade cryptocurrency to help boost your cryptocurrency IQ.
Coinbase built its reputation as a leader in the cryptocurrency exchange space by drastically simplifying how users buy cryptocurrency.
Coinbase has some of the highest exchange fees out of all of the cryptocurrency exchanges, with a 1.49% transaction fee if using a bank account or a whopping 3.99% if using a credit card.
Formerly known as GDAX, Coinbase Pro is an offering by Coinbase catering to more intermediate users. Coinbase Pro has more advanced and detailed trading charts and graphs, as well as more trading options.
The transaction fees are worth noting: they range from $0.10 to $0.30 depending on the order size.
Binance is one of the largest cryptocurrency exchanges by volume and by users.
Binance has hundred of different cryptocurrencies, advanced trading features, and robust trading charts and graphs. Binance charges a 0.1% trading fee.
Cryptocurrency Regulation And Rules
Your personal perspective on regulation will dictate your views on cryptocurrency as a whole.
Financial regulation is the product of disastrous market failures, and fraudulent trading. The regulation is the product of great depressions around the world.
Financial markets today, such as public stocks, are heavily regulated to avoid massive losses.
Cryptocurrency, on the other hand, is not regulated.
What the United States government has been focused on in regards to cryptocurrency has been those laundering money or purchasing illegal substances and services through cryptocurrency, as well as identifying fraudulent ICOs, and collecting taxes.
Perhaps the most important and relevant piece of regulatory guidance for average cryptocurrency users is Notice 2014-21 issued by the IRS.
Notice 2014-21 says that cryptocurrency is treated as property for federal tax purposes and falls under general tax principles.
Thus, a gain or loss is recognized whenever a specific cryptocurrency is sold or used to purchase goods, services, or other cryptocurrencies (i.e., trading Bitcoin for Ethereum).
As someone diving into the cryptocurrency basics, it's important to understand the regulatory climate around cryptocurrency is in a state of flux, with a few of the largest and most important landmark decisions still ahead of us.
Cryptocurrency Best Practices
While cryptocurrency allows anyone to become their own bank, this also comes with some unpleasant realities.
No central bank means no customer service, no guaranteed asset protection or FDIC insurance for cryptocurrency amounts, and no representative to call when things go awry.
This leaves your cryptocurrency at serious risk of:
- Getting hacked by malicious third parties.
- Being lost through personal negligence, such as sending your bitcoin to the wrong address or losing your private key.
However, both of these very real threats can be avoided by following cryptocurrency best practices.
Cryptocurrency basics and security hygiene revolve around keeping your private key secure.
Remember, your private key is complete access to your cryptocurrency. If you wrote down your 64 character private key on a notecard and someone gained access to it, they’re basically able to send your cryptocurrency wherever they please.
Here’s a quick cryptocurrency security checklist that investors utilize.
Use A Cryptocurrency Wallet
A cryptocurrency wallet is a platform that makes it possible to store, receive, and send cryptocurrency.
There are many different types of wallets, the two general categories are hot and cold.
“Hot” wallets are connected in some way to the Internet. For example, many cryptocurrency exchanges also provide users with a wallet feature.
If a hacker is able to finagle their way into someone’s exchange account, they’d be able to transfer the cryptocurrency. Additionally, if the exchange itself is hacked, the hackers could loot the cryptocurrency as well.
Another popular type of hot wallet is a software wallet, which is hosted as a program on your computer.
“Cold” wallets aren’t connected to the Internet and are therefore technically safer than hot wallets. For example, many cryptocurrency exchanges that hold massive amounts of cryptocurrency tend to keep a majority of the cryptocurrency in offline cold wallets to minimize the damage if a hack were to occur.
Cold wallets include hardware wallets, which are basically little plastic devices specifically designed for keeping someone’s private key safe.
Another type of popular cold wallet is a paper wallet, which is literally your private key printed (or written down) on a sheet of paper.
Enabling Two-Factor Authentication (and Google Authenticator)
Remember, most cryptocurrency such Bitcoin cannot be “hacked” in the sense that someone can manipulate its programming as they please.
However, the places that store private keys are very within reach of being hacked.
The first line of defense is someone’s personal account. If funds are being held on a cryptocurrency exchange, it’s important to use secure and unique passwords that aren’t used for any other account (Gmail, Facebook, etc.)
The next step is enabling two-factor authentication (2FA). If 2FA is enabled, even if someone uses someone else’s password, they’ll still need to be approved via a text sent to the person’s (or Google Voice number).
If available, Google Authenticator is an extra layer of security.
Google Authenticator is an app on phones that implements a 2FA verification and generates new codes every 30 seconds that must be entered correctly to gain access to an account.
Education Is The Key
Understanding cryptocurrency basics will help you to be aware of the ongoing cryptocurrency conversation that’s taking place seemingly everywhere.
If you are heavily against cryptocurrency, as an investor it’s important to have a fundamental understanding of it not only to keep up with the news, but also for explaining it to others, such as friends and family, who may be considering investing heavily in it.
Cash Lambert is WealthFit's Managing Editor. He is the author of Waves of Healing: How Surfing Changes the Lives of Children with Autism.