How Cryptocurrency Works
The most popular cryptocurrency is the Bitcoin. Cryptocurrencies modeled after this one are often called “altcoins” and are often less secure than the Bitcoin.
Bitcoin was created in 2009 (at present, nobody knows exactly who created it). Investopedia says it offers “lower transaction fees than traditional online payment mechanisms and, unlike government-issued currencies, it is operated by a decentralized agency.”
There aren’t any physical Bitcoins you can see or touch. Instead, there is a totally public ledger that everybody on Earth has access to. Bitcoins aren’t issued or backed by any government or bank, and individual Bitcoins aren’t valuable as a commodity.
All Bitcoin transactions are verified by a huge amount of computing power, though. The system consists of a collection of computers, referred to as “nodes” or “miners,” that all run the Bitcoin code and store the blockchain record of all transactions.
Since every computer running this blockchain has the same lists of blocks and transactions, and everyone can see the new blocks being filled, it’s almost impossible to cheat the system.
As of January, 2021, Bitcoin has around 12,000 different nodes (and that number is growing), so such an attack is highly unlikely.
Even if it did occur, the Bitcoin miners (the actual people involved in the Bitcoin network with their computers) would notice the change and simply “fork” to a new blockchain and make the whole attack a waste of time.
Bitcoin mining is the process by which the bitcoins are released into circulation. Investopedia explains that this mining “requires the solving of computationally difficult puzzles to discover a new block, which is added to the blockchain.”
When a new block is added, miners are rewarded with a few Bitcoins. This reward is halved after every 210,000 blocks, so the 50 Bitcoin reward in 2009 is now down to 6.25 Bitcoins.
You can use a variety of different hardware to mine Bitcoins. Some will get you better results, of course, and these are called “mining rigs.”
For example, certain computer chips (Application-Specific Integrated Circuits, or ASIC) and more advanced processing units (like Graphic Processing Units or GPU) will yield higher rewards than other systems.
One Bitcoin can be divided into eight decimal places. The smallest unit is called a Satoshi (0.00000001 of a Bitcoin) because the mysterious entity who created the Bitcoin used the pseudonym Satoshi Nakamoto. If participating miners agree, the Bitcoin may be divided even further in the future.
Bitcoin can be used as a means of payment for products or services. Physical stores can accept Bitcoin in lieu of fiat money—transactions would be handled with a special terminal or with QR codes and touch screen apps.
An online business can easily accept Bitcoins along with its other online payment options like credit cards or PayPal. There are also job-site websites that will hook up prospective employees with employers who pay in Bitcoin, like Cryptogrind, Coinality, or Bitwage.
Many Bitcoin supporters feel that digital currency will become the norm in the future. In 2014, the IRS proclaimed that all virtual currencies, including Bitcoins, would be taxed as property instead of currency.
This means that gains or losses from Bitcoins held as capital will be realized as capital gains or losses, while those held as inventory will incur ordinary gains or losses.
To purchase cryptocurrency like Bitcoins, you will need an online “wallet,” an app that can hold your investments. Usually, you create an account with an exchange, and then you can transfer fiat money into cryptocurrencies.
One popular trading exchange is Coinbase, which allows you to create a wallet and buy and sell cryptocurrencies.
While cryptocurrency opens the doors to countless investment and financial instruments, because of the lack of guaranteed value, as well as its digital nature, there are risks involved that you should know about before you get started.
Barry Sibert, CEO of Digital Currency Group (which builds and invests in Bitcoins and blockchain companies) says “It is pretty much the highest-risk, highest-return investment that you can possibly make.”
Here are some of the risks you can incur:
Regulatory Risks: Bitcoins are a digital rival to government currency and, thus, may be used for illegal activities, black market transactions, money laundering, or tax evasion.
Governments, therefore, might seek to regulate, restrict, or ban the use of such currency (some already have). Other governments are coming up with various rules concerning cryptocurrency.
Security Risks: Most people who own and use Bitcoins have obtained their currency through any of many popular online markets, called Bitcoin exchanges. These are entirely digital, so as with any other virtual system, are at risk from hackers, malware, and even operational glitches.
Hackers may target these exchanges and gain access to thousands of accounts and digital “wallets” where Bitcoins are stored.
Users can only prevent these risks by storing their currency on a computer not connected to the internet or by choosing to use a “paper wallet” where they print out the Bitcoin private keys and addresses without keeping them in a computer at all.
Insurance Risk: Currently, cryptocurrency exchanges and accounts are not insured by any federal or government program.
In 2019, one dealer and trading platform (SFOX) did announce they’d provide Bitcoin investors with FDIC insurance, but only for those transactions involving cash.
Fraud Risk: Bitcoin does use private-key encryption to verify owners and register transactions, but scammers might try to sell fake Bitcoins. There have also been documented cases of price manipulation, which is another common form of fraud.
Market Risk: As with any other investment, Bitcoin prices can fluctuate. In fact, Bitcoin value has seen wild swings since 2009.
There is also plenty of competition for Bitcoin, and a technical breakthrough in the form of a better virtual coin is always a threat.
If you’re looking to invest in cryptocurrency in an ICO (Initial Coin Offering), you should ask yourself the following questions:
- Who owns the company? Is it a recognizable name or an identifiable owner?
- Are there other major investors already in?
- Will you own a stake in the company or just currency or tokens? The former means you’re an actual owner in the company, while the latter just gives you cryptocurrency to buy or sell.
- Is the currency already developed or is the company trying to raise money to develop it? The further along the product is, the less risky it will be.