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- Cryptocurrencies are digital assets that are created and run on a blockchain.
- Bitcoin and ether are two popular cryptocurrencies, but there are many more.
- Investing in cryptocurrency can be extremely risky and the underlying technology is very new.
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Cryptocurrencies are digital assets that you can buy, trade, and use to purchase goods. People and organizations create cryptocurrencies for different reasons, but they generally share a few common characteristics.
Understanding how cryptocurrencies work, who creates and controls them, and why you might want to buy cryptocurrencies is important for investors. While there may be opportunities to build wealth, investing in crypto comes with a lot of risk and you need to be careful of scams.
How do cryptocurrencies work?
Although there are thousands of cryptocurrencies, many of which have unique characteristics, they all tend to work in a similar way. It’s hard to avoid jargon when talking about cryptos, but the concepts can be relatively easy to understand.
They use blockchain technology
A cryptocurrency’s blockchain is a digital record of all transactions involving that cryptocurrency. Copies of the blockchain are stored and maintained by computers around the world. They are often compared to general ledgers, which are part of traditional double-entry bookkeeping systems where each transaction results in a debit and a credit in different sections of the books.
“It works like a general ledger – it’s that simple,” says David Donovan, executive vice president, financial services, at the digital consultancy Publicis Sapient. Maybe you start with two coins and send someone one. “On the blockchain, it looks like I send you a coin, and I now have a coin, and you have a coin.”
Each group of transactions is transformed into a block and chained to the existing ledger. Once a block is added, it cannot be reversed or changed – that’s why people describe blockchains as “immutable”.
Some cryptos have their own blockchain. For example, there are Bitcoin and Ethereum blockchains. But there are also cryptos that are built on an existing blockchain rather than starting from scratch.
Blockchains are decentralized
Cryptocurrencies differ from fiat currencies, such as the US dollar, because they are neither issued nor guaranteed by a government. In fact, no person, company or government controls the blockchain of a crypto. Instead, they are managed by a decentralized network of computers around the world.
The lack of a central authority can also make cryptocurrencies more secure. “It’s hack-proof because there’s no central point of failure,” says Donovan. But who decides which transactions are added to each block?
Transactions are public but pseudonymous
Cryptocurrencies also have another defining characteristic. Blockchains are public ledgers, which means anyone can see and review the transactions that have taken place. However, they can also provide some degree of anonymity.
“You have a private key, which allows you to initiate transactions, and a public key, which allows someone to identify you in the marketplace,” Donovan explains.
Blockchain transactions are linked to a the public key of the crypto wallet, but no one necessarily knows who controls this wallet. This is why cryptos are often described as pseudonyms – the public key is a person’s pseudonym.
How many cryptocurrencies are there?
According CoinMarketCap.com there were over 8,000 different cryptocurrencies with a global market value of approximately $2.24 trillion as of December 12, 2021.
Bitcoin, the first cryptocurrency, was launched in 2009 as an alternative type of decentralized and digital currency. Since then, people have also created cryptocurrencies that perform other functions or are designed for specific types of transactions.
“Cryptocurrencies can have many different uses,” says Parisi. “Some are used in gaming environments to earn in-game rewards, while others facilitate payments. Some are designed for cross-border remittances…some are designed for micro-payments.”
For example, stablecoins are a type of cryptocurrency that attempts to maintain a stable, fixed exchange rate with another asset, such as the US dollar. Governance tokens are another example of a specialized cryptocurrency. They give token holders voting power in a corresponding crypto project.
Are cryptocurrencies secure?
The blockchain technology behind cryptocurrencies can help ensure that coins and systems remain secure. “What has never been disproved is the value of blockchain,” says Donovan. “The way the ledger system is set up and every transaction is recorded. And the fact that it’s immutable.”
However, that doesn’t mean you don’t have to worry about security. The crypto world is full of scams. Of course, this also applies to traditional financial systems and currencies. Someone asking you to pay with a gift card or wire transfer is a red flag that you’re dealing with a scammer. But several factors could make crypto scams particularly worrisome.
For example, cryptocurrency transactions cannot be undone. There is also less regulation of cryptocurrencies and platforms than traditional financial services in the United States. Additionally, some people may feel compelled to act quickly and send or invest their money because they are afraid of missing out on an opportunity.
“One way to avoid a scam is to invest in more established cryptocurrencies, like Bitcoin or Ethereum,” Parisi explains. “You can still be subject to scams or fraud in how you hold, send or receive it.” But you can be sure that the cryptocurrency itself is not a scam.
Are cryptocurrencies a good investment?
Cryptocurrencies can present a good investment opportunity, and there are many ways to invest in the crypto world.
You can buy a coin (or coins) and hold them hoping they will go up in value. Or you can use your coins in a decentralized finance (DeFi) platform to earn interest through staking or lending. You can also take a more traditional route, such as an exchange-traded fund (ETF) linked to cryptocurrencies. There might even be opportunities to invest in supporting projects or industries rather than the cryptocurrencies themselves.
“From an investment perspective, crypto is moving fast,” says Parisi. “You shouldn’t place an amount of assets that you’re not prepared to lose. It should be, relatively speaking, a small portion of your portfolio.”
Before making an investment, consider the potential pros and cons:
The financial statement
Although investing in cryptocurrencies is a hotly debated topic, it helps to understand what’s going on so you can make an informed decision. If you decide to go for it, you can go for it completely or just dip your toe.
“Learn more about crypto by opening wallets, accounts, trading currencies, and learning more about use cases,” says Parisi. “But do it sensibly. We’re still in the early days and crypto regulation continues to evolve.”
Donovan suggests starting by opening an account with a regulated and publicly traded company like Coinbase. But, he says, “it’s really about being smart and using the system to take baby steps.”