What is cryptocurrency? Definition, types, and how it works (2024)

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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 others.
  • Investing in cryptocurrency can be extremely risky, and the underlying technology is very new.

Cryptocurrency is a controversial investment often met with either enthusiasm or skepticism. Since its debut in 2009, Bitcoin, as the first cryptocurrency, has revolutionized the financial landscape, propelling some investors to financial success while leaving others with substantial losses.

Unlike traditional stocks and bonds, cryptocurrencies stand out for their volatility, complexity, and scam susceptibility.

While cryptocurrency investing is a hotly debated topic, it's worth understanding what's happening to make an informed decision before investing with the best cryptocurrency exchanges.

Understanding cryptocurrency

Definition of cryptocurrency

Cryptocurrency is a decentralized digital currency bought and sold using blockchain technology. Unlike fiat money, cryptocurrencies don't have a physical equivalent and can only be accessed using computers and other electronic devices.

All cryptocurrency transactions are accessible to the public, as blockchains act as public ledgers. However, using private keys provides a degree of anonymity (more on that below).

Digital currencies like crypto are often appealing to investors who are wary of government-issued funds and are seeking alternatives.

"There's a strive toward decentralization," says Nisa Amoils, a managing partner at A100xx Ventures. Digital currencies like cryptocurrencies continue to be worthwhile investments for many investors."

However, cryptocurrency is an immensely risky and volatile investment unsuitable for beginners or conservative investors. Only advanced investors who can afford to lose their cryptocurrency investments should consider buying digital coins and tokens.

"From an investment perspective, crypto is rapidly evolving," says Donna Parisi, global head of financial services and FinTech at Shearman & Sterling. "You shouldn't put in an amount of assets you're not willing to lose. It should be, relatively speaking, a small portion of your portfolio."

How cryptocurrency works

Cryptocurrencies are decentralized, meaning they aren't controlled by any single person, company, or government. This allows anyone with technical skills to create a new cryptocurrency by modifying an existing blockchain or developing a new one from scratch.

For example, ether is the native cryptocurrency of the Ethereum blockchain, and bitcoin is the native cryptocurrency of the Bitcoin blockchain.

Similar to the way supply and demand affect the price of gold, the value of cryptocurrencies is largely determined by supply and demand. The limited quantity of coins available for each cryptocurrency plays a significant role in determining its price, much like other investable assets.

What is crypto mining?

Cryptocurrency mining is the process of creating new coins. But unlike traditional mining for precious metals, cryptocurrency mining involves solving complex mathematical problems to add new blocks to the blockchain.

Generally, one of two mechanisms is used to create a system of trust and determine which transactions are valid and added to their blockchain:

  • Proof of work: People worldwide, known as miners, compete to be the first to solve complex cryptographic puzzles and add the next block to the blockchain. The winners are paid after the other network members confirm that the required amount of computing power was used to find the solution. "The way you ensure all the participants are validating the transactions is the hard work, effort, and money they're spending solving the problem," says Parisi. However, proof-of-work systems require a lot of energy to power.
  • Proof of stake. This is a newer and less energy-intensive mechanism. "Proof of stake is they validate transactions on the blockchain by people putting value on the line," explains Parisi. "They stake some of the currency they own to make sure they only validate true transactions."

Types of cryptocurrencies

Bitcoin

Bitcoin, the first cryptocurrency, was launched in 2009 as an alternative type of decentralized and digital money. Since then, people have also created cryptocurrencies that serve other functions or are designed for specific transactions.

All non-Bitcoin cryptocurrencies are often referred to as altcoins.

Ethereum

Ethereum is an open-source, decentralized computing platform network. The Ethereum network works like theBitcoin network in that it's built on blockchain technology,essentially a digital public ledger where financial agreements can be verified and stored entirely by software —without the intervention of a third party.

Non-Bitcoin and non-Ethereum cryptocurrencies are sometimes referred to as crypto tokens.

Stablecoins

Stablecoins are a specialized type of cryptocurrency that attempts to maintain a steady and fixed exchange rate with another asset, such as the US dollar. Although still a decentralized currency traded on the blockchain, stablecoins have a more centralized structure, making them slightly less risky.

Governance tokens

Governance tokens are another example of a specialized cryptocurrency. They give token holders voting power in a corresponding crypto project. These tokens are generally used for decentralized autonomous organizations and DeFi projects.

Governance tokens can be used to vote on proposals such as modifying crypto rewards for liquidity providers, adjusting compensation rates on lending sites, and native staking on a dApp to increase liquidity when a digital coin is traded on the market.

Blockchain technology

How blockchain technology works

A cryptocurrency's blockchain is a digital record of all crypto transactions. Copies of the blockchain are stored and maintained by computers around the world. They're often compared to general ledgers, which are part of traditional double-entry bookkeeping systems where each transaction leads to debit and credit in different sections of the books.

"It works like a general ledger — it's that simple," says David Donovan, executive vice president at Publicis Sapient. Perhaps you start with two coins and send one to someone. "On the blockchain, it would say I'm sending you one coin, and I now have one coin, and you have one coin."

Each grouping of transactions is turned into a block and chained to the existing ledger. Once a block is added, it can't be reversed or altered — which is why people describe blockchains as "immutable."

How the blockchain supports cryptocurrency

The blockchain technology behind cryptocurrencies ensures that the coins and systems remain secure. "What's never been refuted 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."

Blockchains are public, which means anyone can see and review the transactions that occurred. There's a degree of anonymity, as people can protect their identities under public keys or pseudonyms.

"You have a private key, which is how you initiate transactions, and a public key, which is how someone identifies you in the market," says Donovan.

Still, having a public record of all crypto transactions makes buying and selling cryptocurrencies more transparent and protects investors against fraudulent activity.

Decentralization and security

Decentralized digital currencies, like cryptocurrencies, are not issued by governments or financial institutions. Instead, they operate through peer-to-peer financial networks that eliminate the middleman (a.k.a. banks), allowing lending, trading, and borrowing directly with merchants.

"Some people who had been excluded from the traditional financial system or have had their currencies devalued are seeking an opportunity to participate in the markets, and this is a retail-driven phenomenon first," says Amoils. "There's this crisis of trust, and people want wealth creation for themselves. And so that spurred this whole kind of trading speculative movement."

However, the crypto world is rife with scams. Of course, that's also true of traditional financial systems and currencies. The lack of regulatory oversight and general consumer protection leaves crypto investors vulnerable to exploitation. Cryptocurrencies' decentralized nature makes recovering funds or tracking down scammers difficult.

Uses of cryptocurrency

Digital payments

Beyond investing, cryptocurrencies can be used as a means of payment. A growing number of online businesses, such as Microsoft, PayPal, AT&T, and Dish TV, allow customers to pay for their products and services with Bitcoin or other cryptocurrencies.

Cryptocurrencies are subject to significant price volatility, meaning the cost of purchases can fluctuate rapidly. Your transactions may fail if your digital assets lose value while processing the purchase.

Investment

Cryptocurrencies are popular investment options that can help diversify your portfolio. Many reputable online brokerages now offer cryptocurrency trading, allowing you to invest in bitcoin, ether, crypto futures, and crypto ETFs.

The best Bitcoin IRAs provide retirement savings tax benefits but involve substantial risks. Cryptocurrencies' long-term growth prospects are uncertain, and investors should only consider a Bitcoin IRA if they're prepared to lose their entire investment.

Decentralized finance (DeFi)

Decentralized finance (DeFi) applications are secure, blockchain-based platforms that enable peer-to-peer financial transactions without intermediaries. DeFi allows individuals to send, receive, and spend digital currency without relying on traditional financial institutions.

By leveraging blockchain technology, DeFi applications offer increased user autonomy and potentially lower costs than traditional financial systems. However, while DeFi transactions are recorded on the blockchain, they may not provide the same level of anonymity as traditional cryptocurrency trading, meaning government officials can potentially trace them.

Like cryptocurrencies, DeFi is still in its infancy and carries significant risk due to its unregulated status and susceptibility to hacks and scams.

Benefits and risks of cryptocurrency

Benefits of cryptocurrency

Despite its bad rap, cryptocurrency offers significant growth opportunities and can outperform traditional investments. Cryptocurrencies can diversify your portfolio and hedge against inflation, as they are not directly tied to conventional market fluctuations.

Cryptocurrency transactions are also remarkably efficient, often taking only a matter of minutes to complete. This starkly contrasts with traditional financial institutions' lengthy processing times, which can take anywhere from 24 hours to several days for wire transfers.

Risks of cryptocurrency

While there may be opportunities to build wealth, there are a lot of risks involved with crypto investing, and you need to be mindful of scams.

Cryptocurrency transactions can't be reversed. There's also less regulation of cryptocurrency platforms than traditional financial services in the US. Plus, some people may feel pressure to act quickly and send or invest their money because they're worried about missing out on an opportunity.

"One way to avoid a scam is to invest in more well-established cryptocurrencies," says Parisi. "You still may be subject to scams or fraud in terms of how you hold it, send it, or receive it." But you can have some certainty that the cryptocurrency itself isn't a scam.

How to buy and store cryptocurrency

Cryptocurrency exchanges

You can start investing in cryptocurrencies through existing crypto exchanges and investing platforms. Some of the top cryptocurrency exchanges include:

  • Coinbase
  • Crypto.com
  • Abra
  • Kraken

If you want to get more advanced and start trading, note that you canuse strategies such asshorting crypto, which is popular with day traders who don't buy and hold for the long term.

"It's really about being smart and using the system to take baby steps," says Donovan.

Crypto wallets

A crypto wallet is a software program or physical device that allows you to store your crypto and send and receive crypto transactions. It consists of two key pairs: private keys and public keys. A public key is derived from the private key and serves as the address to send crypto to the wallet.

You should consider the best bitcoin wallets for storing private keys and securing investments.

Security measures

Although cryptocurrencies are more vulnerable to scams and hacks, there are security measures you can set up to further protect your investments. For example, cold wallet storage and hardware wallets allow crypto investors to store their private keys offline, protecting them against hacks.

Other notable security measures to take include enabling two-factor authentication, securing your private keys, and thoroughly researching the cryptocurrencies you're interested in to limit your risk of scams or bad investments.

"Learn about crypto by opening up wallets, accounts, trading currencies, and learning more about the use cases," says Parisi. "But do it in a reasonable way. We're still in the early days, and regulation of crypto is still evolving."

FAQs about cryptocurrency

What is cryptocurrency?

Cryptocurrency is a digital form of currency that uses cryptography for security and operates on decentralized technology called blockchain. Cryptocurrency has no tangible, physical form and can only be accessed through electronic devices.

How does cryptocurrency work?

Cryptocurrency works by allowing investors to make cryptocurrency transactions using blockchain technology via a computer or mobile device. Crypto transactions are recorded on the blockchain, a public ledger maintained by a network of computers.

What are the main types of cryptocurrencies?

The main types of cryptocurrencies include Bitcoin, Ethereum, altcoins, and stablecoins. Some other popular cryptocurrencies are Solana, Litecoin, and Dogecoin.

What is blockchain technology?

Blockchain technology is a decentralized ledger that records all transactions across a network of computers, ensuring transparency and security. Certain cryptocurrency have their own blockchains, such as the Bitcoin blockchain and the Ethereum blockchain. However, tech-savvy investors can create their own cryptocurrencies by modifying existing blockchains.

What are the uses of cryptocurrency?

Cryptocurrency uses include digital payments, investments, and participating in decentralized finance (DeFi) applications. However, crypto's significant price swings may impact your ability to make digital payments or profit from investing.

Tessa Campbell

Investing and Retirement Reporter

Tessa Campbell is an investing and retirement reporter on Business Insider’s personal finance desk. Over two years of personal finance reporting, Tessa has built expertise on a range of financial topics, from the best credit cards to the best retirement savings accounts.ExperienceTessa currently reports on all things investing — deep-diving into complex financial topics, shedding light on lesser-known investment avenues, and uncovering ways readers can work the system to their advantage.As a personal finance expert in her 20s, Tessa is acutely aware of the impacts time and uncertainty have on your investment decisions. While she curates Business Insider’s guide on the best investment apps, she believes that your financial portfolio does not have to be perfect, it just has to exist. A small investment is better than nothing, and the mistakes you make along the way are a necessary part of the learning process.Expertise:Tessa’s expertise includes:

  • Credit cards
  • Investing apps
  • Retirement savings
  • Cryptocurrency
  • The stock market
  • Retail investing

Education:Tessa graduated from Susquehanna University with a creative writing degree and a psychology minor.When she’s not digging into a financial topic, you’ll find Tessa waist-deep in her second cup of coffee. She currently drinks Kitty Town coffee, which blends her love of coffee with her love for her two cats: Keekee and Dumpling. It was a targeted advertisement, and it worked.

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What is cryptocurrency? Definition, types, and how it works (2024)

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