What is Cryptocurrency and How Does It Work?

Cryptocurrency has exploded in popularity in recent years. Once an obscure digital invention, cryptocurrencies like Bitcoin are now household names. But if you’re new to the world of crypto, you likely have many questions.

In this complete beginner’s guide, we’ll cover everything you need to know to get started with cryptocurrency. We’ll explain what cryptocurrency is, how it works, its history, and real-world applications. Let’s dive in!

What is Cryptocurrency?

“Cryptocurrency is a form of payment that can be exchanged online for goods and services. Many companies have issued their own currencies, often called tokens, and these can be traded specifically for the good or service that the company provides. Think of them as you would arcade tokens or casino chips. You’ll need to exchange real currency for the cryptocurrency to access the good or service.”

At its most basic, cryptocurrency is digital money that is secured by cryptography. This makes it nearly impossible to counterfeit. Cryptocurrency is based on blockchain technology, a distributed ledger enforced by a network of computers. We’ll explore blockchain more later.

Unlike physical money like dollars and coins, cryptocurrency exists purely as digital code. You can’t hold a Bitcoin in your hand like you could a dollar bill. And unlike traditional digital payments like credit cards, cryptocurrencies don’t require an intermediary like a bank.

Instead, users interact directly with each other when transferring cryptocurrencies. This peer-to-peer system eliminates banking fees and processing times.

There are thousands of cryptocurrencies in existence today. Bitcoin remains the most popular, with other major coins including Ethereum, Binance Coin, Tether, and Solana. We’ll highlight some of the top coins later in this guide.

Cryptocurrencies can be used as:

• Digital money to purchase goods and services
• Long and short-term investments
• Assets to trade for profit

Now that we’ve defined what cryptocurrencies are in basic terms, let’s look at the technology that makes crypto work.

How Does Cryptocurrency Work? The Blockchain Explained

Cryptocurrencies wouldn’t exist without the innovative blockchain technology that powers them.

The blockchain serves as a public ledger that permanently records transactions. It’s decentralized, meaning it isn’t owned by a single entity. The ledger is distributed across countless computers around the world. This makes tampering practically impossible.

Here’s a quick overview of how blockchain works:

1. A transaction is requested – Let’s say Billy wants to send Sally 1 Bitcoin. This requested transaction is broadcasted to a peer-to-peer network consisting of computers known as nodes.
2. The network validates the transaction using cryptography – The network of nodes validates the transaction and its sender using known algorithms. Once verified as authentic, the transaction can be added to a block.
3. The transaction is combined with others to create a block of data – New transactions requested on the network are compiled into blocks. Each block contains a cryptographic hash.
4. The block is added to the existing blockchain – Miners add the block to the blockchain by solving complex mathematical puzzles. This process is known as proof-of-work. Successfully adding a block rewards the miner with cryptocurrency.
5. The updated blockchain is distributed across nodes – The public ledger is updated with the newly added block. All nodes have a copy, creating complete transparency.

This entire process happens in just minutes, allowing transactions to occur rapidly. However, the system ensures security and accuracy.

Once data is added to the blockchain ledger, it cannot be altered. The transparent and permanent record of transactions enables cryptocurrencies to work without relying on third-party intermediaries.

Now that we understand the basics of blockchain technology, let’s explore some key benefits of cryptocurrencies.

Advantages of Cryptocurrency

Cryptocurrencies offer many advantages that make them appealing alternatives to traditional government-issued currencies and payment methods. Here are some of the top benefits.

Decentralization and Independence

One of the main draws of cryptocurrency is its independence from governments, banks, and other institutions. The peer-to-peer structure powered by blockchain eliminates intermediaries. Users can transact directly with each other securely and efficiently. This freedom benefits individuals and small businesses.

Security and Anonymity

Unlike credit card purchases which link your identity to transactions, cryptocurrency transactions are anonymous. Your personal information isn’t attached to wallet IDs. This provides security and privacy.

However, anonymity also enables illegal activities. Cryptocurrencies are used to conduct ransomware attacks, buy illegal substances on the dark web, and launder money.

Accessibility

Anyone with an internet connection can access cryptocurrencies. There are no restrictions on purchases and you don’t need a bank account to store your assets. This global accessibility opens up financial opportunities for underserved populations.

Lower Fees

By eliminating intermediaries like banks, cryptocurrencies reduce the processing fees associated with digital payments. Transactions only incur minimal network costs, regardless of the amount being sent. This makes micropayments more feasible.

Immutable Ledger

Once data is written to the blockchain, it can’t be altered or deleted. The permanent ledger provides transparency and prevents fraud. Users can view transaction histories to verify payments.

Potential Returns

The volatility of cryptocurrency prices allows for potential high returns as an investment. Traders enjoy strong gains during positive market swings. Investing in crypto emerged as an alternative to stocks for wealth growth.

Of course, extreme volatility also means potential for losses. The high-risk nature of crypto investments makes it unsuitable for conservative investors.

Now that we’ve covered the blockchain basics and advantages of cryptocurrencies, let’s look at how governments are responding.

Cryptocurrency Regulation and Taxation

Government oversight of cryptocurrencies varies substantially worldwide. Overall, regulation remains minimal compared to longstanding regulations imposed on banks and traditional stocks.

Some key aspects to understand:

• No government backs crypto – Cryptocurrencies have no central issuing or regulating authority. They rely solely on decentralized networks.
• Oversight is increasing – Growing crypto adoption compelled governments to address risks. Some countries banned crypto, while others enacted basic investor protections.
• Tax obligations exist – Despite the “Wild West” nature of crypto, most countries view profit from investments as taxable income. Failure to report can mean harsh penalties.

Let’s expand on crypto’s fuzzy tax obligations. The rapid emergence of cryptocurrencies caught most tax agencies off guard. But it’s important to understand crypto isn’t exempt from taxation. Here are some key principles to avoid penalties:

• In the U.S., crypto is treated as property for tax purposes. Capital gains taxes apply based on how long you held the asset. Short-term gains under a year are taxed as ordinary income, while long-term gains are taxed lower.
• Trading one crypto for another is taxable. For example, exchanging your Ethereum for Bitcoin triggers a taxable event.
• Mining and staking rewards are considered income. The fair value in dollars at the time of receipt must be reported.
• Losses can be claimed as deductions to offset gains.
• Cryptocurrency tax software can track your transactions and produce required tax forms.
• Keep detailed records of your purchases, sales, trades, mining income, and wallet addresses.

Thorough record-keeping is key to staying compliant with cryptocurrency taxes. Consider enlisting an accountant experienced in crypto accounting to ensure accurate reporting. With crypto investments on the rise, tax agencies are growing increasingly savvy.

How is Cryptocurrency Created?

For beginners, the concept of creating cryptocurrency can be confusing. Unlike printing traditional money, generating crypto requires complex computing processes.

New coins are created through two primary methods:

Mining – Miners use high-powered hardware and software to verify transactions and add blocks to the blockchain. As compensation, they receive newly minted crypto coins. For example, successfully mining a Bitcoin block earns 12.5 BTC. However, mining requires substantial resources and has environmental impacts.

Alternative mechanisms – Some newer cryptocurrencies use staking, burning, and other solutions to generate tokens as an alternative to resource-heavy mining. Distribution models vary substantially between different cryptocurrencies.

Additionally, new types of crypto can be created from existing blockchains through forks:

• Hard fork – A rule change that creates an entirely new blockchain with a shared history. Any owners of the original coin now also own the new forked coin. For example, Bitcoin Cash forked from the main Bitcoin blockchain.
• Soft fork – A backward-compatible rule change to the blockchain protocol. Unlike a hard fork, only one coin exists after a soft fork.

Now that we understand where cryptocurrency comes from, let’s see how it compares to traditional currency and payment options.

How is Cryptocurrency Different Than Traditional Currency?

Cryptocurrencies have significant differences from government-backed currencies like U.S. dollars and Euros. Understanding these distinctions is key to seeing the advantages and risks of crypto.

These differences show why cryptocurrencies enable accessible cross-border transactions while introducing risks of volatility and scamming. Overall, crypto’s advantages stem from its separation from traditional finance.

Now that we’ve covered the basics, let’s highlight some leading cryptocurrencies.

Major Types of Cryptocurrency

With over 10,000 cryptocurrencies on the market, it can be overwhelming for beginners to know where to start. While we can’t cover them all, knowing these major categories and coins gives you a solid foundation:

Bitcoin (BTC)

The original and most widely adopted cryptocurrency. It pioneered blockchain technology and operates on the largest, most secure network. However, it also suffers from high fees and slow transaction times compared to newer coins.

Ethereum (ETH)

Second largest coin by market capitalization. It expanded capabilities beyond payments to allow decentralized finance apps and smart contracts to run on its blockchain. Ethereum aims to be the foundation for a new decentralized version of the Internet.

Stablecoins

Cryptocurrencies pegged to stable assets like the U.S. dollar. This reduces volatility, allowing utilization for payments and transfers. Examples include Tether (USDT), USD Coin (USDC), and Binance USD (BUSD).

Meme Coins

Viral cryptocurrencies without serious long-term utility. They are highly speculative. Popular examples include Dogecoin (DOGE) and Shiba Inu (SHIB) based on viral dog memes.

Altcoins

The term for all cryptocurrencies besides Bitcoin. Altcoins aims to improve upon Bitcoin’s limitations or target specialized use cases. Leading altcoins include Cardano (ADA), Solana (SOL), and Polkadot (DOT).

Central Bank Digital Currencies (CBDCs)

Digital forms of fiat money issued by governments. They represent a government-backed alternative to decentralized cryptocurrency. Many countries are piloting and researching CBDCs.

This list gives you a preview of crypto’s diversity. Understanding these major categories prepares you to enter the expansive landscape of digital currencies as an informed beginner.

How to Get Started with Cryptocurrency

Once you understand cryptocurrency basics, you’re ready to start purchasing and using it. Here’s a step-by-step guide to getting started:

1. Choose a Crypto Exchange or Broker

Cryptocurrency exchanges allow you to buy, sell, and store coins. Top exchanges include Coinbase, Binance, Kraken, and Gemini. Some brokers like Robinhood also let you trade top cryptos.

2. Sign Up and Verify Your Identity

Exchanges and brokers require personal details to verify your identity and check customer backgrounds. The process involves submitting ID documents and answering questions about income sources.

3. Fund Your Account

Deposit U.S. dollars or your local currency into your exchange account. Popular funding options include bank transfer, debit card, PayPal, and wire transfer.

4. Place Your First Trade

Use the exchange interface to purchase cryptocurrency with your deposited funds. If the platform supports it, you may also exchange between cryptocurrencies.

5. Withdraw Assets to a Secure Wallet

For optimal security and control, withdraw purchased crypto from the exchange to a private wallet you control. Top options include hardware wallets like Trezor and software wallets like Exodus.

And you’ve completed your first crypto transaction! With a verified account and wallet set up, you can start routinely buying, trading, and transacting.

Be sure to implement security best practices like enabling two-factor authentication on your accounts and safely backing up your wallet. Researching investment strategies will allow you to trade crypto markets more profitably.

Expanding Your Cryptocurrency Knowledge

The information in this beginner’s guide equips you with a foundation to enter the cryptocurrency space. But there is always more to learn about this rapidly evolving industry.

We recommend these additional resources to deepen your crypto knowledge:

• Cryptocurrency for Dummies Book – Accessible guide to blockchain, Bitcoin, mining, and more
• Harvard Online Cryptocurrency Course – Free intro course from Harvard professors
• Binance Academy – Crypto and blockchain tutorials from leading exchange Binance
• Coinbase Earn – Earn free crypto while learning about new coins on Coinbase

Conclusion

Cryptocurrency represents a revolutionary technology that is reshaping finance and money. While adoption is still early, Bitcoin and blockchain are transforming payments, investments, banking, and more. We hope this complete beginner’s guide provided you with the full context needed to join the crypto and blockchain movement. The possibilities are endless within this innovative landscape. Happy investing!