How Does Cryptocurrency Work?
Cryptocurrency is a form of digital money that relies on blockchain technology. While Bitcoin and Ethereum are the most well-known examples, there are over 9,000 different cryptocurrencies available today.
How Does Cryptocurrency Work?
Cryptocurrencies are digital, encrypted, and decentralized. Unlike traditional currencies such as the U.S. Dollar or Euro, cryptocurrencies do not have a central authority managing their value. Instead, users across the internet collectively manage and maintain these currencies.
You can use cryptocurrencies to buy goods and services, though many people invest in them similarly to stocks or precious metals. Investing in cryptocurrencies requires thorough research to understand each system fully, as the market can be risky.
Bitcoin, the first cryptocurrency, was introduced in 2008 by Satoshi Nakamoto in a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” Nakamoto described it as an “electronic payment system based on cryptographic proof instead of trust.”
What Is a Blockchain?
A blockchain is an open, distributed ledger that records transactions in code. Imagine a checkbook shared across numerous computers worldwide. Transactions are grouped into “blocks” and then linked together in a “chain” of previous transactions.
“Imagine a book where you write down everything you spend money on each day,” says Buchi Okoro, CEO and co-founder of African cryptocurrency exchange Quidax. “Each page is like a block, and the entire book, a collection of pages, is a blockchain.”
Each user maintains their own copy of this ledger, updating it with every new transaction to ensure consistency and accuracy across the network.
Proof of Work vs. Proof of Stake
To prevent fraud and verify transactions, cryptocurrencies use consensus mechanisms. Two of the most common are proof of work and proof of stake.
Proof of Work
In proof of work, computers solve complex mathematical puzzles to validate transactions. “Proof of work is a method where an algorithm creates a problem that computers compete to solve,” says Simon Oxenham, social media manager at Xcoins.com.
Miners solve these puzzles to verify a block of transactions and add it to the blockchain. The first miner to solve the puzzle receives a reward, such as Bitcoin. For example, Bitcoin rewards miners with 6.25 BTC, worth roughly $200,000, for each validated block.
Mining requires significant computational power and electricity. As the Bitcoin network grows, the complexity and cost of mining increase, making it less accessible for average users.
Proof of Stake
Proof of stake offers a different approach. Instead of solving puzzles, validators are chosen based on the amount of cryptocurrency they are willing to “stake” or lock up temporarily.
“It’s almost like bank collateral,” says Okoro. Validators are more likely to be selected based on the amount of crypto they stake. PoS is more energy-efficient compared to PoW, enabling faster transaction verification.
For example, Bitcoin’s average transaction speed is at least 10 minutes, while Solana, using proof of stake, processes around 3,000 transactions per second.
The Role of Consensus in Crypto
Both proof of stake and proof of work use consensus mechanisms to verify transactions. Each verified transaction must be approved by the majority of ledger holders to maintain accuracy.
How Can You Mine Cryptocurrency?
Mining releases new cryptocurrency units into circulation, typically in exchange for validating transactions. While theoretically possible for average users, mining has become increasingly difficult, especially in proof-of-work systems like Bitcoin.
“As the Bitcoin network expands, it becomes more complex, requiring more processing power,” says Spencer Montgomery, founder of Uinta Crypto Consulting. “Average consumers used to mine Bitcoin, but now it’s too expensive and competitive due to optimized equipment.”
How Can You Use Cryptocurrency?
Cryptocurrencies can be used to buy goods and services or as alternative investments. Bitcoin, for example, is often referred to as “digital gold” due to its secure, decentralized nature
How to Use Cryptocurrency for Secure Purchases
To make purchases with crypto, you’ll need a cryptocurrency wallet. A “hot wallet” is a software program that interacts with the blockchain, allowing users to send and receive cryptocurrency.
Transactions require validation and are not instantaneous.
Best Crypto Exchanges
You can buy cryptocurrencies through exchanges like Coinbase, which supports popular options such as Bitcoin, Ethereum, and Dogecoin. Ensure that your chosen exchange supports the crypto pairings you need.
For instance, you can use USD Coin, a stablecoin, to purchase Ethereum on Coinbase.
“It was once difficult, but now it’s relatively easy, even for beginners,” says David Zeiler, a cryptocurrency expert at Money Morning. “Exchanges like Coinbase are user-friendly and allow you to link your bank account.”
How to Invest in Cryptocurrency
Investing in cryptocurrencies is akin to buying individual stocks, with associated risks. To gain exposure to the crypto market, consider investing in companies involved in blockchain technology, such as IBM, Bank of America, and Microsoft.
Should You Invest in Cryptocurrency?
Opinions on cryptocurrency investments vary. Experts caution that cryptocurrencies are highly speculative and subject to significant price volatility. Some financial advisors recommend avoiding them altogether.
Peter Palion, a certified financial planner, prefers traditional currencies backed by governments. “The U.S. dollar provides stability,” Palion says. “Bitcoin’s volatility makes it unsuitable for anything but speculation.”
Conversely, wealth advisor Ian Harvey advises clients interested in crypto to allocate a small portion of their portfolio. “Determine what percentage you’re willing to lose if the investment fails,” Harvey suggests. “This could range from 1% to 10%, depending on your financial situation and risk tolerance.”