What Is Cryptocurrency?
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- Cryptocurrency is a decentralized, digital currency that relies on blockchain technology.
- Cryptocurrency can be used to make and send payments like the U.S. dollar, but it is unregulated by the Federal Reserve.
- Crypto can be a volatile asset with various pros and cons. On the plus side, transactions are anonymous and secure, while on the negative side, investments are high-risk.
Cryptocurrency, or “crypto” for short, is increasingly popular but often misunderstood. How does crypto work? How is it made? Is crypto something you should consider for your own financial situation?
What is cryptocurrency?
Cryptocurrency is a form of encrypted digital currency that functions like traditional money. You can use it to send and receive payments, but unlike the U.S. dollar and other government-issued currencies, it’s decentralized. This means crypto is not issued or regulated by a single agency such as the Federal Reserve. Instead, it’s controlled by a network of all its users.
There are different types of crypto available. Bitcoin was the first cryptocurrency, initially valued in 2010. Many types of crypto have since developed including Ethereum®, Tether®, Litecoin and Solana™, to name a few.
How is cryptocurrency created?
Crypto isn’t minted, meaning you can’t hold a physical representation (such as a bill or coin) in your hand. Instead, crypto is usually created through a complex process called mining.
Here’s how it works: For cryptocurrency transactions to be seen as legitimate, they must first be validated through a network of computers. These powerful computers run algorithms to compete to be the first to solve, or decrypt, the transaction, which is also called a block.
When the decryption is successful, the block is recorded in a digital ledger known as a blockchain. This process keeps crypto transactions secure in lieu of third-party oversight. New crypto is circulated when the winning miners are paid for their decryption services.
Crypto is commonly mined by large commercial operations with an extensive network of energy-intensive servers. Therefore, crypto mining is out of reach of most individuals who don’t have the resources or computing power to compete.
How does cryptocurrency work?
How does an average person access cryptocurrency if they can’t mine it themselves?
Although crypto can be used to make purchases, it functions similarly to a speculative asset, such as a stock. So, if you want to purchase crypto, you’ll have to seek a trading platform or a crypto exchange. There, you can buy any type of crypto you choose, either with traditional currency or with other forms of crypto.
You can also hire a crypto broker to make exchanges on your behalf, which closely resembles investing in the stock market. Also like the stock market, the crypto market can be extremely volatile, so investing in cryptocurrency comes with a certain amount of risk.
The IRS treats crypto as a capital asset. This means that profits on crypto transactions are taxed the same as stocks and other investments.
The pros and cons of cryptocurrency
Here are a few examples of some of the pros and cons you may want to think about as part of your research!
Pros of cryptocurrency
- High reward potential. Like any investment, cryptocurrency has the potential for a large payoff depending on the timing and size of your investment. However, the crypto market is unstable and prone to crashes, requiring informed, shrewd investors.
- Secure transactions. Cryptocurrency is encrypted, meaning it may be safer in some respects from criminal activity than your typical credit or debit card.
- Anonymous transactions. Encryption also means that sensitive purchases made with crypto remain confidential.
Cons of cryptocurrency
- High-risk investment. Crypto is a volatile asset. Its value can fluctuate wildly, and the market is young and unpredictable, so the risk to investors is high.
- Unregulated. Crypto isn’t regulated by a central authority or subject to certain financial laws that exist to protect consumers. Without these safeguards, crypto investors may risk losing a lot of money through no fault of their own — and with little or no recourse.
- Limited use. Crypto isn’t widely accepted as a form of payment. If you own it, you’ll likely have to convert it to U.S. dollars (or another government-issued currency) before making a purchase.
- Energy-intensive. Crypto mining requires a lot of electricity. So much, in fact, that American crypto farms produced 40 billion pounds of carbon dioxide in just one recent year.
What you should know before buying cryptocurrency
The promise of striking it rich with a crypto investment is tempting, but it isn’t a viable choice for everyone. Cryptocurrency is still relatively new and the market is volatile, making investments risky for most consumers. Plus, the U.S. and state governments are still struggling to regulate cryptocurrency, further increasing the risk of investment.
However, when viewed as a speculative asset, some investors may benefit from including cryptocurrency as part of a broader portfolio. Just remember that crypto comes with a large amount of risk and no guarantee that the investment will pay off. Be sure to thoroughly research your options when considering whether cryptocurrency is right for you.