The ABC of How Cryptocurrency Works

After Elon Musk’s recent statement that Tesla won’t be using Bitcoin for its transactions anymore and the resulting unrest among investors, there is increased chatter on social media about cryptocurrency. Ever since Bitcoin was introduced in 2009, a lot of books, websites and courses have mushroomed on how cryptocurrency works for dummies.

Whether or not you want to invest, it never hurts to be informed. So, let’s dive right into this piece on how cryptocurrency works for beginners. 

What is cryptocurrency?

Cryptocurrency is basically digital currency, whose value falls and rises, just like rupees, dollars and other currencies issued by national governments, or as we call them, fiat currencies. To buy cryptocurrency, you need a wallet, meaning an online app to hold your currency. 

You can buy cryptocurrencies through an online exchange, a cryptocurrency ATM or from other people who own that currency. On the surface, it looks quite similar to fiat currencies.

But there are some key differences between cryptocurrencies and fiat currencies. 

• First, cryptocurrencies don’t have notes and coins, it is all digital, and pieces of code represent it. 
• Second, you don’t need a bank to make a transfer. There is a private key that allows you to send money to other people and authorise your transactions using your digital signature. There is a public key that allows you to receive payments from others. No middlemen are involved, and transactions are anonymous. 
• Third, cryptocurrencies are not issued by the government or any other organization. They operate on a decentralized system.

What is a decentralized system?

Let’s say you sent some bitcoins to your friend. Your transaction will be broadcasted to all the computers in the bitcoin network. After every 10 minutes, all recent transactions will be grouped into a block. These blocks form a blockchain. Hence, the blockchain becomes a ledger where all cryptocurrency transactions are recorded. The number of transactions that are recorded on this ledger every day is huge. 

As of today (May 2021), approximately 2,50,910 bitcoin transactions have taken place the day before. In this online ledger, we must make sure that all recorded transactions are verified. Enter crypto mining. 

What is crypto mining?

Crypto miners run a race to solve extremely complicated computational math problems using specialized software. The first one to solve it gets rewarded in cryptocurrencies, and their ledger, or their version of the transactions, becomes the official one. 

Here, you can see why it is called a decentralized system because there is no one person or device having control and authority over the process. 

Pros and Cons of cryptocurrency

There is not one, but more than 6700 different cryptocurrencies on the market. Bitcoin is undoubtedly the most popular, along with other altcoins, i.e., alternatives to Bitcoin like Ethereum, Litecoin and the beloved Dogecoin, which started as a joke and ended up crashing trading platforms. A lot of cryptocurrencies are improvements and modifications over features of the original bitcoin. 

Pros

Let’s look at some advantages of investing in cryptocurrency. 

• First, cryptocurrencies, having a limited supply, are more resistant to inflation than fiat currencies. However, this does not apply to all currencies, e.g., the supply of Bitcoin has a cap of 21 million coins, while Ethereum has an unlimited supply. 
• Second, they are portable. 
• Third, they are infinitely divisible; you won’t be bugged by the problem of not having loose change. 
• Fourth, crypto transactions are transparent. The blockchain operates on a peer-to-peer system and everything except the identity of buyers and sellers in public. 
• Fifth, cryptocurrencies are universally acceptable. 
• Finally, you don’t need any special permission, license or training to use cryptocurrency. You don’t even need to pay anyone to maintain your account and conduct your transactions. 

Cons

However, every (bit)coin has two sides. Let’s look at some risks and problems involved in cryptocurrency.

Volatility

The price of cryptocurrencies is very sensitive to speculation. While cryptocurrencies can be used to buy some products and services, most people buy cryptocurrencies in the hopes that they can exchange them for big money in the future. So, any sniff of bad news, panic and fear can send the buy-sell cycle on a roller coaster ride. For example, according to the Bitcoin Volatility Index, as of a month from today (May 2021), the value of bitcoin is expected to rise by 4.66%. 

Scams

Scams like pump and dump often involve crypto tokens. Tokens are cryptocurrencies that operate on existing blockchains. They attract investors to put money in and pump demand for currencies that are typically cheaper and less popular. After accumulating investors, the creators of these tokens sell them away, and the demand suddenly fizzles out. 

To sum up, cryptocurrencies are an attractive investment, especially because of speculations about the skyrocketing prices of cryptocurrencies in the future. Riding the hype can be quite irresistible, but it is not a good enough reason to invest. Diligent research about the owners, investors, nature of investment and the stage of development of any cryptocurrency is crucial for smart investment.