What is cryptocurrency?
In earlier times of human history, financial exchanges were accomplished through barter ("hey, Joe, I'll give you one of my chickens for that really cool flint spearhead you made"). But barter doesn't scale well, and as communities expanded, money developed as a necessary medium of exchange. Minted coins and eventually printed currency allowed individuals to transact business more easily. Recent years have seen a shift from physical to digital possession of money — most of us don't keep our savings in vaults in our home; instead our money is represented in digital form, in accounts at financial institutions.
Whether payments are made with a debit card or a credit card, or simply transferred from one account to another, physical currency is typically absent from many of our regular financial transactions. Digital transfers work because financial institutions function as trusted intermediaries — they police the transactions and offer reassurance and some degree of protection to all parties involved.
Many people see cryptocurrency as the next step in currency evolution. It takes the existing digital transaction system and removes financial institutions as the trusted intermediaries. Of course, without some central authority to police the transactions, how can you trust that a transaction is legitimate? The answer to that question is largely based on a technology called "blockchain."
What is blockchain?
Blockchain is a decentralized network of digital ledgers that contain all the transactional data associated with a cryptocurrency. Blockchain technology actually has applications well beyond cryptocurrency — the digital ledgers can track activity and data for countless purposes, including real estate transactions and medical records. The purpose of this discussion is to focus on cryptocurrency applications.
Digital ledgers make up the individual "blocks" in a blockchain. Think of each block as a ledger page; the larger the block, the more data it can contain. Some aspects of the block are transparent — anyone can view the blocks to see the balance in an account. But no one can actually access the funds without the corresponding key or password.
Each block gets a unique digital signature (called a "hash") that's created by an algorithm. Essentially, block data is converted into a unique text string. Each block also includes the digital signature, or hash, of the previous block, so every block contains information from the previous block as well. This is the "chain" in a blockchain. This is incredibly important, because if anyone were to tamper with the data in a block, the digital signature for that block would be changed, and all subsequent blocks would be invalid.
Since there's no central authority, blockchain relies on a decentralized network to validate transactions. Cryptocurrency blockchains typically have thousands of participants ("recordholders" or "nodes"). Each time a new block is created, every node gets a copy and has to verify that the block is valid. Each node has a full, complete copy of the blockchain. Someone tampering with a block would not only need to overcome the digital signature issue described above, but would need 51% of the nodes to agree that the tampered changes were valid in order to be successful.
Types of cryptocurrency
Bitcoin, launched in 2009, was the first cryptocurrency and probably remains the best known. But there are thousands of cryptocurrencies today. Like Bitcoin, many of these cryptocurrencies were created with the purpose of operating just like traditional currencies, facilitating financial transactions — but without any central governing authorities. In other words, they consider themselves first and foremost to be a method of saving and payment.
Some cryptocurrencies are more than just digital currency — they provide the foundation and supporting infrastructure for creating and maintaining applications on a blockchain platform. The cryptocurrencies associated with these platforms facilitate the use of the platforms, for example to compensate the "nodes" that maintain the blockchain architecture. One of the best-known of this type is Ethereum — Ethereum's Ether cryptocurrency supports a platform that enables the creation of decentralized applications including smart contracts.
There are other types of cryptocurrencies and other ways to categorize them. One specific category of cryptocurrency worth mentioning is "stablecoins." Stablecoins try to reduce price fluctuations. They may do so by attempting to peg their value to either a government-backed currency like the U.S. dollar or to some other external benchmark. These cryptocurrencies may maintain a reserve of the currency or benchmark assets they are tied to, or may attempt to maintain stability by using algorithms to control supply of the cryptocurrency.
Exchanges and wallets
Many people acquire and/or trade cryptocurrency through a cryptocurrency or digital currency exchange. There are two general types of exchanges.
Centralized cryptocurrency exchange (CEX).These exchanges work much like a traditional broker. You open an account just as you would with a traditional broker and deposit funds into the account. The exchange acts as an intermediary. You can generally purchase cryptocurrency from the exchange at the price listed, but the exchange itself is the owner of record in the cryptocurrency blockchain — your ownership is only reflected in the exchange's database.
Decentralized cryptocurrency exchange (DEX).These exchanges utilize blockchain technology to eliminate the intermediary and allow you to trade directly with other individuals on a peer-to-peer basis. Decentralized exchanges typically facilitate trading different cryptocurrencies, but not purchasing cryptocurrency with U.S. dollars.
Cryptocurrency transactions require a special wallet. A crypto wallet has a unique address, like an account number. The wallet doesn't actually store cryptocurrency; instead, it stores two passwords, or "keys." The first key is a public key — this key is available to anyone and allows cryptocurrency to be credited to your account or wallet; it's really just a "hashed" version of your wallet address. The second key is a private key and is essentially your personal password, showing that you're the owner of the account, wallet, and public key. Your wallet may connect and read the cryptocurrency blockchain to provide you with your current cryptocurrency balance.
Crypto wallets can be software-based; these wallets are typically connected to the Internet, which presents both advantages and disadvantages. Wallets can also be hardware-based (e.g., a USB drive); these wallets are typically kept offline when not in use. There are even paper-based wallets, which may seem confusing but they really just refer to a physical place to access the public and private keys.
Cryptocurrencies are not a traditional investment, are highly speculative, and carry higher risk and volatility. Cryptocurrencies are not typically subject to the same reporting and data integrity requirements that apply to more traditional investment products. The IRS is treating cryptocurrency as an asset subject to capital gains taxation rather than as a currency. The reserves of stablecoins may not be subject to rigorous audits, and the quality and quantity of collateral may not, in some cases, correspond to the issuer's claims. Stablecoins that maintain their value through algorithmic mechanisms are potentially subject to failure due to market pressures, operational failures, and other risks.
All investing involves risk, including the possible loss of principal, but new technology ventures are especially risky. Some of the blockchain projects in development may turn out to be viable and profitable, but many others could fail. It is important to be skeptical when evaluating a claim made by a company about its entry into this arena. Steer clear of unsolicited and Internet-based investment offers — and never wire money to pay for an offer or service.
Understanding the "crypto" in "cryptocurrency"
Cryptography is a process that secures the transmission of information in order to prevent someone other than the intended recipient to access the information. In the context of cryptocurrency, algorithms are applied to transform, or "encrypt," associated data. The data can be accurately accessed only by someone with an appropriate "key" allowing decryption.