In the simplest terms, cryptocurrency is internet money and digital assets. Cryptocurrencies have made headlines for eye-popping valuations — and crashes. Bitcoin soared to all-time-highs of $69,000 last November, but has free-fallen to around $22,000. Long term crypto bulls, nicknamed maxi’s — short for maximalists — believe the technology will revolutionize how we bank and conduct business. But bears argue it’s a vehicle for illegal activity, susceptible to scams and detrimental to the environment.
All cryptocurrencies are decentralized, intended to be free from government regulation and built on blockchain technology. They fall into two categories depending on their purpose. Coins, like Bitcoin, are currencies to replace fiat money. Tokens, like Ether, are programmable assets which exist strictly on the blockchain.
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What Is The Blockchain Technology And How Does It Work?
The three main components of cryptocurrencies are the blockchain, the blockchain network, and the network cryptocurrency. The blockchain is the base technology for cryptocurrency networks. It’s a distributed ledger that records and maintains transactions using cryptography, which is the practice of encoding and decoding data.
The data is stored in groups called blocks. When a block reaches its maximum storage capacity it’s closed and linked to the previously filled block, forming a data chain.
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There are different types of blockchains. Public blockchains allow anyone to join and review and transfer data via a peer-to-peer network of computers and data centers across the globe. Private blockchains operate on closed databases and require an invitation to participate. Some companies, like Meta Platforms‘ (META) Facebook, launched their own blockchain divisions to keep up with the new tech competition, but their networks are typically private. Permissioned blockchains are a hybrid of public and private blockchains, where anyone can join the network as long as they meet certain criteria.
A blockchain network includes the blockchain ledger and everyone that contributes to the ledger. Most cryptocurrencies use public blockchains with decentralized networks. They’re not maintained at one location or issued by a central authority. Because of this, the method for updating the ledger depends on the blockchain’s consensus protocol.
What Is A Blockchain Protocol?
A blockchain’s consensus algorithm, also known as the blockchain protocol, is the method for validating data and updating the ledger. Overall, there are five types of consensus protocols. But the two most widely used are Proof of Work and Proof of Stake.
The Bitcoin network was the first successful cryptocurrency payment system built on the blockchain back in 2008. An anonymous person or group known as Satoshi Nakamoto created it. The goal of Bitcoin is to become an international currency. It has a finite supply of 21 million coins that are awarded by mining. Mining is the process of validating blocks and verifying transactions on the blockchain.
Bitcoin: Proof Of Work
Bitcoin uses a proof of work consensus algorithm, meaning only verified miners can update the ledger. Proof-of-work protocols award miners for processing and validating transactions, which is done by solving complex math problems that require a massive amount of computing power.
Computer nodes bundle and store transaction data in blocks. Each block is encrypted using a hashing function which assigns it a specific hash value. Miners compete to be the first to discover the correct hash value, thereby validating the block. Once the other nodes in the network confirm the solution, the block is added to the ledger. The winning miner receives fees for processing the transactions or bitcoin awards in the case of newly minted coins.
Transaction fees vary depending on network congestion, and bitcoin’s fees can be as low as a few U.S. cents. The block reward for newly minted coins is currently 6.25 BTC. That number is halved every four years to slow supply and help increase demand, in a process known as halving.
The fierce competition for bitcoin mining spiked demand for computing components called graphics-processing units. That led to a global shortage in those units in 2021. Bitcoin mining operators like Marathon Digital Holdings (MARA) run their systems 24/7 which wears down GPUs. That was a major boon to components suppliers like Nvidia (NVDA) and Advanced Micro Devices (AMD), which saw their stock prices soar to all-time-highs last November.
Beyond Bitcoin: What Are Altcoins?
Altcoin is the umbrella term for any cryptocurrency other than bitcoin. There are 20,292 cryptos currently listed on CoinMarketCap, and Ethereum’s Ether is the largest altcoin. Altcoins can differ in their objective, whether it be providing utility, being a store of value or medium of exchange. Bridges connect different blockchains as a way to transfer coins between their native networks.
Tokens are often built on existing blockchains. Because they’re programmable, tokens can be utilized for decentralized finance (DeFi) and decentralized applications (dApps). They can also represent asset ownership, facilitate services and financial transactions or create products and digital art, known as NFTs.
What Is Ethereum?
Ethereum currently uses a proof-of-work protocol, but it’s merging to a proof-of-stake system this summer. Instead of mining, POS algorithms validate transactions via peer review. The idea is to be faster and more energy efficient.
POS mechanisms require validators to stake a certain number of tokens as collateral to earn rewards. The system randomly selects multiple validators to verify a block before it’s closed and the ledger is updated. In return for processing transactions and storing data, validators receive a percentage in return annually. If a bad actor tried to manipulate the ledger by falsifying data, the discrepancy would be caught by the others. The perpetrator would then lose their staked tokens and be banned from updating the ledger.
Unlike Bitcoin, Ethereum has an open-ended network. That allows third parties to program their own decentralized apps and projects. It uses smart contracts to automatically process conditional transactions between two parties. But the benefit of speed comes at the cost of what are called high gas fees — transaction processing fees that fluctuate based on demand.
Many token projects and altcoins grabbed attention for posting incredible returns with affordable price points. But massive hacks, rug-pulls and phishing scams have made many investors skeptical.
Pay-to-earn video game maker Axie Infinity had $615 million stolen from its Ronin Network on March 23. Hackers gained access by an exploit in the Ronin Bridge, which allowed users to transfer their tokens between the Ronin Network and Ethereum. Bored Ape Yacht Club, which creates the famous monkey NFTs, has had more than $13 million of digital assets stolen through phishing scams after its Discord and Instagram accounts were hacked.
What Are Stablecoins?
You can’t judge cryptocurrency fundamentals in the same way you do stocks. Instead, their fundamental metrics are the numbers of wallets, transactions and users, which can cause huge, unpredictable price swings.
Stablecoins are altcoins whose value is pegged to some other asset as a means of combating crypto volatility. Stablecoins are typically pegged to the U.S. dollar. And they maintain their pegs in different ways. The two largest, Tether (USDT) and USD Coin (USDC), both keep a reserve of U.S. dollars to back their value and are overcollateralized. Others, like Maker’s DAI, use ETH-based assets as collateral and smart contracts to maintain the peg.
Algorithmic stablecoins rely on smart contracts to hold their prices. They don’t hold reserves and are uncollateralized. Instead, they rely on the relationship between two tokens, the stablecoin and another altcoin, to maintain value.
Smart contracts regulate the relationship between the two depending on supply and demand to keep the stablecoin’s price target in check. Algorithmic stablecoins are incredibly risky, as demonstrated by the implosion of LUNA and terraUSD.
LUNA Crash Explained
Terra’s stablecoin, terraUSD (UST), stabilized its price according to its sister token, terra (LUNA). However, if UST fell below its peg, investor panic would cause LUNA to fall as well. This led to a death spiral. In February, the Luna Foundation Guard, launched by Terra CEO Do Kwon, raised $1 billion for reserves through LUNA sales, led by Three Arrows Capital. In mid-April, UST became the third-largest stablecoin and LUNA hit $90. But it didn’t last long.
The stablecoin fell to 98.5 cents on May 8 after an $85 million UST swap for USDC. By May 12, LUNA was less than 10 cents. And the Terra blockchain was halted multiple times. The crash wiped out more than $40 billion in value and started a snowball of liquidations and bankruptcies for crypto brokers and lenders, including major player Celsius. Many investors, such as Three Arrows Capital and Voyager Digital, are still feeling the effects from Terra’s crash.
How To Invest In Cryptocurrency
Cryptocurrency can be purchased on cryptocurrency exchanges, like Coinbase (COIN) or BlockFi, and stored in digital wallets. Exchanges are platforms and apps where you can buy, sell and trade cryptocurrency. Similar to Robinhood, users can link their bank accounts to their profile transfer deposit and transfer funds between the exchange and their bank account.
The main purpose of wallets is storage and security. A wallet can be a software program or physical device like a USB drive. There’s two main types, hot and cold. Hot wallets link to the internet. Cold wallets are not. Personal wallets can connect to many exchanges, similar to bank accounts. While many exchanges offer their own wallet services for investors. Other platforms, like OpenSea, specifically store, trade and sell NFTs and other digital assets.
Cryptocurrency Stocks and Bitcoin ETFs
Many companies are investing in bitcoin, DeFi or blockchain technology, including Walmart, Amazon and MicroStrategy. Publicly traded exchanges like Coinbase which had to cut its staff by 18% at the end of June, provide cryptocurrency investment options without needing to buy individual tokens. As well as publicly traded mining companies including HUT8 (HUT), Riot Blockchain (RIOT) and Marathon Digital are also options for cryptocurrency investment vehicles.
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Major Companies Investing In Cryptocurrency
In addition to individual coins and tokens, Bitcoin and crypto-focused investments have numerous actively-managed ETFs and multi-asset funds. ProShares, Grayscale and VanEck all offer publicly traded Bitcoin strategy ETFs. ProShares is even trying to play both ways, having launched its Short Bitcoin Strategy ETF in June.
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How To Sell Cryptocurrency
Bitcoin ATMs or online through brokerages and exchanges all provide access to cryptocurrencies, after which users can transfer the funds to a traditional bank account. And some wallet services also have sell functions that convert to U.S. dollars. Instead of cashing out of cryptocurrencies completely, investors can also trade different tokens on exchanges.
What Can You Buy With Bitcoin?
There still aren’t many places that accept bitcoin or cryptocurrencies for payment in the United States, but adoption has grown to reach nearly every industry. Some major retailers and service providers like Walmart, Shopify and AT&T have started accepting bitcoin for online purchases. The most common way to buy things with bitcoin is to use it to purchase a gift cards for everyday transactions. Some credit card companies like Visa (V) provide crypto services. Exchanges like Crypto.com offer cards that function similarly to debit cards. And a recent Deloitte survey indicated that 75% of merchants plan to accept cryptocurrencies or stablecoins within the next two years.
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How To Track Cryptocurrency Prices
Another critical difference between gauging cryptocurrencies and stocks is that cryptocurrencies don’t have earnings. As mentioned previously, their metrics include the numbers of wallets, transactions and users. Experts say the fundamentals for cryptocurrencies in general are trending in the right direction, even in the midst of the current cryptocurrency downturn.
Institutional support is growing as well. Currently, more than one-third of all traditional hedge funds are investing in some sort of digital asset, according to this year’s Global Crypto Hedge Fund Report from PricewaterhouseCoopers.
However, despite their original intent, cryptocurrencies have not acted as hedges against inflation. Instead, they’ve trended with the broader stock market indexes.
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What Are The Risks Of Cryptocurrency?
The massive volatility and history of failed cryptocurrency projects make it clear there’s plenty of risk in the space. Projects built on bad blockchain technology, or which offer unsustainable returns as part of their operating plans (known as tokenomics), have caused major losses for many investors. Crypto’s interconnected ecosystem means major problems can compound, as seen with the LUNA wipeout.
And it can be hard to find reliable, up-to-date data on current prices, transaction volume, utility, etc. The current lack of regulation means cryptocurrency investors are vulnerable to bad actors that have been making headlines by wrecking havoc on the industry. And as with all sorts of investing, trading on emotion is also a risk. Many retail cryptocurrency traders have mistimed advances out of FOMO — fear of missing out — and poor risk assessment.
Before buying into any specific cryptocurrency, investors should read that currency’s white paper and really learn the tokenomics and tech behind a project before deciding to buy in. It’s best to use established exchanges for trading and keep all wallet logins and passwords secured. Be wary of startups, scams and potential pump-and-dump schemes, especially in the current crypto market. Institutional backing can also indicate legitimacy. Experts recommend allocating 1% to 5% of portfolios to Bitcoin or cryptocurrencies, depending on personal financial situations and risk tolerance.
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