If you’re like most people, you’ve probably heard of cryptocurrency at least once in the last decade. But if you’re like most people, you probably have only the faintest idea of what it all means. Does it actually live up to the hype, or is it just a fad that will look dated in another decade?
What is Cryptocurrency?
Cryptocurrency is a system for online payments that uses digital “coins” or “tokens.” It gets its name from the cryptographic methods used to secure transactions. Cryptocurrency differs from your online banking app in that there is no central authority, whether a bank or a government entity, managing transactions and backing up its value. Instead, it relies on a peer-to-peer network of “miners” who verify transactions in exchange for compensation in the form of new cryptocurrency coins.
The oldest and most well-known cryptocurrency is Bitcoin, which was established in 2009. Today there are thousands of different cryptocurrencies, but Bitcoin still represents about 60% of the total worldwide value, far outpacing any of its competitors.
Cryptocurrency has several advantages that make it appealing to its users. It can be used by people who, for whatever reason, don’t have access to a traditional bank account. Transactions don’t contain personal information, such as your name or credit card number, so the risk of identity theft is significantly reduced. Since it’s decentralized, it isn’t subject to market fluctuations or bank closures in the way a traditional bank account using government-issued currency would be. The blockchain technology used to verify transactions is more secure than traditional payment methods.
Of course, cryptocurrency also has its disadvantages. Although it doesn’t rise and fall in response to the same factors as traditional bank accounts, its value does have a history of fluctuating wildly. Cryptocurrencies also aren’t accepted by many different retailers— and are outright banned in a few countries— so you would have to convert your coins back to cash in order to spend them and lose all of the attendant advantages of crypto-transactions.
Some critics of cryptocurrency argue that its anonymous nature allows illegal transactions to flourish. It’s also terrible for the environment. A single Bitcoin transaction uses more electricity than the average household uses in a month. Cryptocurrency mining drives up power prices and, in many cases, produces large carbon emissions.
Most cryptocurrencies, including Bitcoin, are secured via a method called blockchain. Various people around the world process transactions in order to verify that there are no duplicates, whether due to error or fraud (i.e. someone trying to copy their cryptocurrency key and use the same key to pay for more than one thing). Every time a chunk of transactions are processed, they are packaged into a “block” which is then appended to the “chain” — a record of all previous blocks, and by extension all previous transactions.
Each computer, or “node,” that processes these transactions has a copy of the blockchain. Each node can compare its copy of the data to the other nodes’ copies to ensure no mistakes have snuck in. This redundancy and decentralization make it incredibly secure. If a hacker wanted to alter financial records for their own profit, they would have to somehow gain access to at least 51% of the nodes in any given network. The amount of computing power this would require is so vast that it would be virtually impossible to pull off.
How and Where to Buy Cryptocurrency
These days, most cryptocurrency users obtain it by purchasing it in one of several ways.
- Cryptocurrency exchanges. The largest of these in the U.S. is Coinbase, but there are many others.
- Investment brokerages. The first of these to offer cryptocurrency was Robinhood.
- Bitcoin ATMs.
- Peer-to-peer purchases.
You can purchase most cryptocurrencies with U.S. dollars.
Once you’ve purchased the cryptocurrency, you need to store it. There are two main types of storage. “Hot wallets” are cloud storage sites accessed via your browser or an app. “Cold wallets” are encrypted portable devices, similar to a thumb drive, onto which you can download your cryptocurrency. Most people will have both a hot and a cold wallet. Hot wallets are much easier to use for purchases, buying and selling cryptocurrency, etc. However, they are also much easier to hack. If you’ve made a significant investment in cryptocurrency it’s probably best to keep most of it in a cold wallet and only as much as you need on a day-to-day basis in your hot wallet.
If you’ve heard of cryptocurrency, you’ve probably heard of cryptocurrency mining. Despite the name, cryptocurrency mining doesn’t involve pickaxes or pack mules. “Miners” are simply the people—or groups of people—who make up the nodes who create the blockchain. Miners will verify the legitimacy of each transaction by comparing it to all other transactions. So if you try to spend the same cryptocurrency twice, the miners will notice and reject your duplicate purchase.
With Bitcoin, each block in the blockchain comprises 1 MB of verified transactions. After the miners complete a block, they have to be the first to answer a complex mathematical problem in order to be rewarded with the prize for completing the block. This prize started out as 50 bitcoins per block but has been repeatedly halved until it reached 6.25 bitcoins in May of 2020. However, the value of each bitcoin in U.S. dollars has also increased dramatically since 2009, so the current reward for mining bitcoins isn’t as paltry as it might seem.
So why isn’t everyone mining Bitcoin? As the number of miners has increased over the years, the complexity of the mathematical problems you need to solve after completing a block have also become more and more complex. Back in 2009, you might have been able to mine bitcoins using your average home PC. Nowadays, it requires a powerful custom-built machine that can cost you thousands of dollars up front, with no guarantee that your mining efforts will prove profitable.
Is Cryptocurrency a Good Investment?
Cryptocurrency has the potential for huge growth. Bitcoin, for example, started out with each coin worth a fraction of a penny. In early 2021, a single bitcoin was (briefly) worth $60,000. If you had a crystal ball a decade ago you could be raking in huge profits now.
The trouble is, nobody has a crystal ball. Bitcoin could continue gaining value for many years to come, or it could be a fad that fizzles next year. Other cryptocurrencies are similarly volatile.
Cryptocurrencies also aren’t immune to hacking. As discussed above, blockchains are almost impossible to hack. However, hot wallets, where people store the keys they need to make cryptocurrency purchases, can be hacked. If you lose money this way, there’s no guarantee you’ll be able to get it back. The SIPC insures investors for up to $500,000, but this protection doesn’t apply to cryptocurrencies. Few financial regulations do.
If you do decide to invest in cryptocurrencies, treat it like any other extremely high-risk investment and only devote a tiny slice of your portfolio to it.
Are you still intrigued by the concept of cryptocurrency? Are you considering making space for it in your investment portfolio? Make sure you understand the strategies and risks first. Our webinar on June 22 is a good place to start learning. Sign up here and come at 11 a.m, Eastern Time, to hear data analyst Matt Havin share his insights.