Even though headlines have been full of news of cryptocurrencies like Bitcoin since 2020, only about 16% of American investors report that they have invested in cryptocurrency in some format. While cryptocurrency may not be as hot of a topic in 2023, it's never been easier or more accessible to invest in digital assets.
Retail cryptocurrency brokers have made it possible to buy Bitcoin and altcoins using direct bank transfer and even a credit card. But is there still potential in crypto technology? Read on to learn more about blockchain technology and how it works, cryptocurrency projects investors are buzzing about and more.
What are cryptocurrencies?
A cryptocurrency is a digital or decentralized currency used for enhanced security features. Unlike traditional paper and metal currencies (usually called "fiat currencies"), cryptocurrencies do not hold a physical form; they exist only in the digital realm, and their value is based entirely on what investors are willing to pay for each token or coin. Cryptocurrencies are increasing in value due to their decentralized structure and considerations for privacy.
This article aims to answer the question "How do cryptocurrencies work?” and make understanding the blockchain technology that powers these currencies easier to comprehend. It's important to understand the benefits of cryptocurrencies.
History and evolution of cryptocurrencies
While most people became familiar with the cryptocurrency world following the Bitcoin boom of 2020, the concept of crypto dates back more than 50 years. The idea of digital currency dates back to the 1970s, when researchers like David Chaum developed cryptographic protocols for secure communication. Considered to be one of the grandfathers of crypto, Chaum’s 1982 dissertation, "Computer Systems Established, Maintained, and Trusted by Mutually Suspicious Groups," is the first recorded proposal for a rudimentary blockchain protocol — the tech by which most cryptocurrencies function.
The world’s true cryptocurrency introduction came in 2008 when an anonymous individual or group operating under the pseudonym Satoshi Nakamoto published the whitepaper titled "Bitcoin: A Peer-to-Peer Electronic Cash System." The paper introduces the concept of electronic transactions, where individuals can send payments directly to one another without the need for intermediaries such as banks. It describes how transactions work in the Bitcoin system using a combination of a "proof-of-work" nexus that requires blockchain participants to solve puzzles to add new blocks to the blockchain.
On January 3, 2009, Nakamoto mined the first Bitcoin block, known as the "genesis block," and the Bitcoin network came into existence. From here, Bitcoin grabbed the attention of tech enthusiasts who were excited about the structure of blockchain technology. Bitcoin exchanges like Mt. Gox were established, allowing users to trade BTC for traditional currencies, and the first recorded Bitcoin transaction occurred in May 2010.
Bitcoin's success grew exponentially and inspired the creation of numerous alternative cryptocurrencies (altcoins), including Litecoin in 2011 and Ripple in 2012. The expansion of blockchain technology also expanded beyond cryptocurrencies with Ethereum's introduction in 2015. Thousands of additional altcoins entered the market in subsequent years, leading to a boom in individual coin and token value.
As prices rose, so did public attention and demand for cryptocurrency regulation. The United States government has taken steps to regulate the crypto industry to varying degrees of success. For example, in 2019, the world's largest cryptocurrency exchange, Binance, was banned for U.S. citizens on regulatory grounds. Despite this, the Securities Exchange Commission has filed charges against Binance, accusing them of allowing high-value U.S. accounts to continue trading on the platform.
How cryptocurrencies work
The basis of cryptocurrencies and understanding digital currencies is understanding the blockchain. The blockchain is a distributed ledger that records every cryptocurrency wallet or account that has transferred value from one wallet to another. Each "block" in the blockchain is an immutable record containing data on a set of recent transactions confirmed via network nodes.
It is tough to alter or delete once a block gets added to the blockchain. Any change to a single block would require changing all subsequent blocks in the chain, which is computationally infeasible due to the decentralized nature of the network and cryptographic security. This allows crypto wallets and security systems associated with exchanges to be sure how much of each currency is contained at each wallet address.
Adding new blocks to a blockchain varies depending on the blockchain's consensus mechanism. In proof-of-work blockchains like Bitcoin, miners compete to solve a cryptographic puzzle, with the winner having the right to create and add the next block. In proof-of-stake (PoS) and other consensus mechanisms, validators or stakers are responsible for adding new blocks more deterministically, usually by operating a network node.
Types of cryptocurrencies
Since the introduction of Bitcoin, thousands of altcoins have followed. The following are a few major altcoins you might want to consider as an investor and how they vary from the original cryptocurrency.
The pioneering cryptocurrency, Bitcoin remains the most well-known and valuable cryptocurrency. Bitcoin's primary purpose is to serve as a digital store of value and a medium of exchange, allowing users to make secure and censorship-resistant transactions across the globe. Its limited supply of 21 million coins and robust security through proof-of-work mining have made it a preferred choice for investors and a hedge against traditional financial systems. Today, Bitcoin is the largest cryptocurrency, measured by total market capitalization, with a market cap of more than $525 billion.
Ethereum is a decentralized platform that goes beyond digital currency by introducing the concept of smart contracts. Smart contracts enable developers to build decentralized applications (DApps) on its blockchain, utilizing its native cryptocurrency to transact within the network.
Ether, the Ethereum network’s native cryptocurrency, has revolutionized blockchain technology by making it programmable, allowing for a wide range of applications, including decentralized finance (DeFi) and non-fungible tokens (NFTs). Ethereum is currently the second largest crypto, with a total market cap of more than $186 billion.
Ripple is a digital payment protocol that facilitates fast and low-cost cross-border transactions. XRP is the native cryptocurrency of the Ripple network, but it serves primarily as a bridge currency to facilitate transfers between different fiat currencies. Ripple's focus on enabling efficient international remittances has gained attention from financial institutions and banks looking to streamline their payment processes.
Though XRP takes a more centralized approach to cryptocurrency investing, this can be a positive for those looking to future global cryptocurrency adoption. Ripple had a total market capitalization of more than $26 billion in October of 2023, making it the fifth-largest cryptocurrency when measured by market capitalization.
Chainlink is a decentralized oracle network that connects smart contracts with real-world data sources. LINK, the token used by the network, is used to incentivize and reward node operators who provide accurate data and services to smart contracts. This technology is crucial for enabling smart contracts to interact with external information, making it possible to create trustless agreements for various applications, from insurance to supply chain management. This has made LINK an appealing choice for investors looking to further their investment in cryptocurrency and financial inclusion.
Benefits and risks of cryptocurrencies
While crypto technology represents some of the most cutting-edge tech in the banking and currency transfer industries, investments in this asset don't come without risk. Be sure to consider the following cryptocurrency risks and areas of potential before you start investing in digital currencies, including cryptocurrency scams and security.
The benefits include:
- Decentralization: Cryptocurrencies are typically decentralized and operate on blockchain technology, reducing the influence of centralized authorities like banks or governments. This decentralization can enhance financial freedom and reduce the risk of censorship.
- Fast and low-cost transactions: Cryptocurrencies can offer near-instant transactions and reduced fees, especially for cross-border payments. Transferring value using wallet-to-wallet transfers allows users to send and receive money while paying only enough in fees to gas the transactions. This allows users to avoid exchange and transfer fees levied by most transfer systems.
- Transparency: Transactions on a blockchain are transparent and can be audited by anyone. This transparency can help prevent corruption and fraud, especially concerning the immutable blockchain ledger.
- Price volatility: Cryptocurrency market trends are highly volatile, with prices subject to significant fluctuations. While this volatility can present investment opportunities, it also carries a high risk of losing value in a short amount of time.
- Regulatory uncertainty: The regulatory landscape for cryptocurrencies varies by country and is still evolving. Regulation changes can impact the legality and use of cryptocurrencies, leading to significant losses if government regulation reduces the future use of cryptocurrencies.
- Scams and rug pulls: Scams and price manipulation are one of the most visible risks in cryptocurrency investments. For example, investors lost about $3.3 million in a "rug pull" price manipulation scam in 2021, when investors became duped by a fake "Squid Game" coin named after the hit Netflix drama was released. Investigate coins and tokens fully before buying to avoid sudden price drops.
Cryptocurrency investment strategies
There are two primary investment strategies that cryptocurrency investors use to see returns on their initial holdings — long-term buying and selling and short-term trading. Long-term investors should look at the mechanisms that control the crypto assets they're interested in investing in to determine how they set themselves apart from existing coins and tokens. You might also want to consider viewing each project's whitepaper, a free document that lays out the objectives and structure of the project. Diversification is crucial for successful, long-term crypto investment as well.
Short-term investors put more weight on technical indicators when selecting investment options. Look at recent price volatility to determine a coin suitable for frequent trading — most cryptocurrencies have higher daily price swings than stocks, so you'll have your pick. Watch price movements over time and choose a price point to enter the market. Be sure to set a stop-loss order to prevent excessive losses if the market moves in a direction you didn't anticipate.
Cryptocurrency regulation and legal issues
Global cryptocurrency regulations are a complex and evolving landscape. While some countries have embraced cryptocurrencies and enacted favorable regulatory frameworks, others have expressed concerns and implemented stricter measures to control crypto usage.
The challenges and controversies surrounding cryptocurrency legality include issues related to anti-money laundering, know-your-customer compliance and tax considerations. The decentralized nature of cryptocurrency makes it inherently difficult to attach an identity to each value transfer, presenting significant tax difficulties. The tension between regulating cryptocurrencies to mitigate risks and fostering innovation in the blockchain and financial technology remains a subject of ongoing debate and policy development worldwide.
To ensure that you stay on the right side of the law when investing in cryptocurrency:
- Start by familiarizing yourself with local laws and regulations.
- Learn which exchanges your local government authorizes, and limit trading to these platforms.
- Avoid attempting to circumvent location-based restrictions — remaining on monitored platforms promotes a safer and more transparent ecosystem while protecting you from potential legal consequences.
Proper tax reporting and payment of cryptocurrency-related gains are vital to avoid legal issues with tax authorities, as most jurisdictions treat cryptocurrencies as taxable assets. Failing to comply with tax laws can result in penalties, fines and legal complications. Keep a ledger recording your losses or gains after each transaction — this will make calculating and reporting total income or losses easier when tax season rolls around.
Future trends in cryptocurrencies
Investing in cryptocurrency online has never been easier, and investors are looking to potential future projects to determine what's next. Some emerging trends in the crypto sphere include the following.
- DeFi: DeFi has been a game-changer in the crypto world, introducing a wide array of decentralized financial services like borrowing and yield farming. Decentralized exchanges like PankakeSwap and Uniswap have also become popular, offering blockchain-based conversions with lower fees. DeFi projects are often open-source and aim to eliminate intermediaries, providing more accessible and inclusive financial services. The potential impact of DeFi lies in its ability to disrupt traditional financial institutions and democratize access to financial products.
- NFTs: NFTs are another popular use of crypto technology, representing ownership or proof of authenticity of digital or physical items. NFTs have the potential to revolutionize ownership and provenance, enabling creators to monetize their work directly. However, there are concerns about copyright issues and the impact of high-energy blockchain usage on the environment.
- Central bank digital currencies (CBDCs): Many central banks are actively exploring and piloting CBDCs, digital versions of their national currencies. CBDCs could modernize payments and provide greater financial inclusion, but they also raise questions about privacy and the potential to disintermediate commercial banks.
Many upcoming projects also focus on interblockchain operability to allow different projects’ blockchains to "talk" to one another. This would enable coins and tokens operating on different blockchain systems to transfer assets and data. Though successful interblockchain operation has not yet been achieved, it has the potential to revolutionize DeFi and the crypto industry as a whole.
Entering the cryptocurrency market
If you're looking to start investing in some of the market’s hottest cryptocurrencies, it's important to have a home research base to analyze potential coins and tokens. MarketBeat offers a variety of market analysis tools you can use to spot potential opportunities in the crypto market before the competition. We recommend bookmarking our real-time market newsfeed and revisiting it regularly to keep your knowledge current and to track the future of cryptocurrencies.
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