What is Cryptocurrency?

what is cryptocurrency

Just when I start to think I have a handle on my finances it seems like something new pops up. Sometimes the thing that pops up is a bill I completely forgot about, other times that new thing is growing interest and usage of cryptocurrencies like Bitcoin and Dogecoin – something I barely understand how to pronounce let alone use or invest in responsibly. What is cryptocurrency?

While I’ve known about the existence of cryptocurrencies for about a decade, I really didn’t take the time to learn more about cryptocurrency in the past because I thought they were going to go away. I know what you’re going to say – I judged cryptocurrencies without knowing a thing about them just like Julia Roberts’ character in Pretty Woman was misjudged by the sales attendant on Rodeo Drive. In the end, the sales associate lost out on a lot of money, which “Vivian” notes was a big mistake, HUGE.

Big Mistake... Big... Huge

Did I make a mistake by not investing in a cryptocurrency the first time I heard it existed? Possibly. But I’m not the only one who is confused, overwhelmed, and unsure of cryptocurrencies. There are several financial professionals openly sharing they are just as confused as the rest of the 99 percent of us when it comes to this new, global currency.

So, in the spirit of not digging our heads in the sand when it comes to seemingly big and scary new financial concepts, let’s explore the crypto craze a little deeper.

What is Cryptocurrency?

At its most basic definition, cryptocurrency is digital money bought, sold, and stored online. These virtual currencies can be used to purchase a good or service from a company or an individual and are protected by secure communications known as cryptographic messages. This means crypto monetary exchanges are only possible if you have a key to decode the encrypted information or you solve a particular code.

Think of a cryptocurrency like an arcade token or a casino chip. In order to obtain a cryptocurrency, you will have to exchange the real currency you use to purchase goods and services for the cryptocurrency by using what is called a blockchain. A blockchain is the name given to the virtual public ledger where all the digital currency transactions are recorded.

What is a Blockchain?

Each digital wallet contains encrypted information, called public and private keys, that is used to send and receive digital currency. All digital currency transactions are then recorded in the blockchain which is maintained by digital currency “miners.” These miners can be anyone, anywhere in the world, but they have to be willing to invest in the specialized computer hardware needed to rapidly process complex computations.

In exchange for their work of verifying each transaction and adding it to the blockchain, miners are awarded digital currency like Bitcoin, Ripple, Dogecoin, and Litecoin.

“The blockchain is the real jewel of cryptocurrency,” according to John Puterbaugh, editorial director for NextAdvisor, a personal finance publication in partnership with Time magazine.

“Very smart people create what are essentially these supercomputers to mine new cryptocurrencies, which are organized into blocks that have a unique code,” Puterbaugh said. “They set these supercomputers up. They call them nodes in the network. They use algorithms to process as many of these code possibilities as quickly as possible,” he explained. “Then when they land on these codes, called the hash for a block that organizes Bitcoin or any crypto potentially, it releases new Bitcoin, which then enters the market.”

A blockchain is also known as peer-to-peer because there is no singular authority or one entity that is monitoring or in charge of it like a bank or a government, said Kiana Danial, author of Cryptocurrency Investing for Dummies, and the CEO of Invest Diva on the So Money podcast with Farnoosh Torabi. This is far different from how the U.S. dollar, for example, enters the market.

The Federal Reserve

Currently, in the United States, our monetary system is overseen by the central bank of the United States, The Federal Reserve, commonly known as the Fed.

It’s the role of the Fed to provide the U.S. with a “safe, flexible, and stable monetary and financial system” as well as to foster economic conditions that “achieve both stable prices and maximum sustainable employment, as well as moderating long-term interest rates.”

As the official banker for the U.S. Treasury since 1977, The Fed is tasked with buying and selling U.S. government securities (bills, notes, and bonds) in the open, global financial markets. The Fed also meets eight times each year to discuss the Fed’s monetary policy and determine whether there is a need for any changes such as increases or decreases to interest rates.

One common criticism of The Fed is that it’s a business that requires a profit to continue operating. Others point out that while many believe The Fed is part of the U.S. government, it’s actually not. It’s THE bank that runs all banks in the U.S., which is why cryptocurrency advocates point out that digital currencies have the potential to disrupt the financial and banking industries – not just change how we purchase goods and services.

Given all of the mounting criticisms surrounding financial institutions since Occupy Wall Street protests picked up steam in 2011, it’s not surprising that cryptocurrencies are increasing in popularity once again. More and more people are finding themselves both distrusting government and corporate-backed financial institutions as well as wanting to find a way to feel financially empowered.

Enter blockchain technology

“I always like to tell this very simple example as Bitcoin is just a byproduct of blockchain,” Danial said. “Bitcoin to the blockchain is like email to the Internet. There are so many things you can do with the Internet. You can go on the internet and you can record a podcast. You can watch movies. You can do all these things.”

But not everyone is as hopeful when it comes to blockchain technology as Danial seems to be.

“We keep hearing that blockchain is transformative, this technology’s going to change everything,” Puterbaugh said. “I’m getting closer to that explanation of how exactly it’s going to change everything… Major banks have blockchain divisions, they have people leading research departments to understand how blockchain can change their systems and their processes to become more efficient, safer, decentralized so that it’s not on a server in one place, or run by one person.”

Some possible uses thrown out so far include online voting, crowdfunding, and JPMorgan Chase says blockchain has the potential to lower transaction costs by streamlining payment processing.

However, as Puterbaugh told Torabi on So Money, most people don’t understand blockchain technology or know what it is, why they should use it, have it or buy it, invest with it, spend with it.

“I think rather than sort of explaining why it’s good in all these different ways, I’m trying to figure out what has to happen to make it accessible, understandable and give people a reason to use it, or buy it or know what they’re supposed to do with it even?”

History of Bitcoin

The most popular cryptocurrency, Bitcoin, was first introduced in 2008 as the first-ever peer-to-peer digital currency by an anonymous group or person who goes by the name “Satoshi Nakamoto.” In order to obtain Bitcoin, people used blockchain technology to try and resolve a mathematical equation. When they did, they were rewarded with Bitcoin tokens, Danial explained to Torabi.

While Bitcoin is now synonymous with cryptocurrencies, its origin story is a little murkier than many would prefer. But for supporters of cryptocurrency like Danial, the uncertainty surrounding Bitcoin’s origins is of less importance than the financial freedoms and empowerment they believe it provides to individuals.

“Why is Satoshi Nakamoto anonymous? We don’t know,” Danial told Torabi. “He could be a Russian spy or a Chinese spy. That is yet to be determined. But, Bitcoins, blockchain itself are not anonymous. There is this myth that ‘Oh my gosh! I’m going to send Bitcoins wherever I want, and nobody is going to know.’ Nope, if you have a powerful enough computer, you can download the whole blockchain,” she noted. “All the transactions are incredibly transparent, and everybody has access to it.  Everybody is kind of the trustee of this blockchain, so it’s actually not anonymous,” Danial explained.

For Danial, cryptocurrencies provide her with a feeling of empowerment and financial security, which she says is huge given one of her earliest money memories is not having money.

“I was born and raised in Iran to a Jewish family,” Danial shared. Prior to the Iranian Revolution, Danial’s father was the CEO of a successful company and he had several assets with the Iranian government, banks, and gold. When the Iranian regime took power, Danial’s father’s assets were seized and/or frozen, leaving the once financially stable family with nothing.

“As I was learning about blockchain and Bitcoin, I was like, ‘Oh my God! I can literally have all of my Bitcoin in this tiny little wallet that nobody can have access to and nobody can actually seize it,’” Danial shared. “If my Dad had even a fraction of his assets in cryptocurrency back then, if it existed, he wouldn’t have had to start over. I didn’t have to be born in this chaos with no money and all the things. To me, that is the power of cryptocurrency that really spoke to me.”

Cybercrimes and Cryptocurrency Loss

As of June 2021, there are more than 10,000 different cryptocurrencies being traded publicly, according to CoinMarketCap.com. The total value of all cryptocurrencies on May 27, 2021, was more than $1.7 trillion — down from April’s high of $2.2 trillion, according to CoinMarketCap. The total value of all Bitcoins, the most popular digital currency, was pegged at about $735 billion — down from April’s high of $1.2 trillion.

And no, the ups and downs in the cryptocurrency market have been happening a lot longer than just the last few months. For example, in December 2017, Bitcoin traded at close to $20,000. A year later, in December 2018, the value of Bitcoin was about $3,200. By December 2020, Bitcoin traded at record levels.

To say investing in cryptocurrencies is a bumpy ride is an understatement.

Just like our current financial system, cryptocurrencies experience breakdowns, crime, and fraud. In 2020, there were 28 total attacks on crypto exchanges, the largest of which resulted in more than $200 million in cryptocurrency assets stolen from Singapore-based crypto exchange KuCoin.

In total, it was estimated the cryptocurrency sector lost $1.9 billion through fraud and other crimes last year. That’s actually a decrease in the amount lost in 2019, as experts note that increased interest in the crypto sector is resulting in improved infrastructure and security systems.

While security is improving in the crypto sector, it’s important to note that cryptocurrency isn’t backed by any central institution, which means that your cryptocurrency investments are not protected the same way your traditional investments or money in the bank is protected. Even though some exchanges such as Coinbase and Gemini keep the holding in FDIC-insured bank accounts, FDIC insurance does not apply to cryptocurrency balances.

It’s for that reason that many financial professionals encourage those interested in cryptocurrencies to work with larger, more well-known companies.

“Size matters here,” says Douglas Boneparth, a financial advisor and president of Bone Fide Wealth in New York, who noted that Coinbase recently went public on the Nasdaq stock exchange. “There are pros and cons to that, but you now have public financials, you can actually see the health of the company, and that’s important when thinking about using an exchange or investing with any company or product or service that they’re providing.”

Given the regulatory uncertainty with cryptocurrencies, 31 states have begun to institute their own regulations, according to the National Conference of State Legislators. Arguably the strictest laws surrounding cryptocurrency companies is in New York, where cryptocurrency exchange operators are required to obtain a BitLicense before they can operate within the state. Additionally, these exchange companies are only allowed to offer certain approved coins.

Questions to Consider Before Investing in Cryptocurrency

Even with all its issues, Danial still doesn’t want the SEC or the Fed to get involved with cryptocurrencies. To measure the risk of particular cryptocurrency investment, Danial views cryptocurrencies as publicly traded companies – and she seeks to understand what their company mission is, how it’s being run, and then decides if she wants to invest in that “company” and ride that particular wave.

  1. Who owns the company? An easily identifiable and well-known owner is a positive sign.
  2. Are there major investors investing in this particular cryptocurrency? It’s a good sign if other well-known investors want a piece of the pie.
  3. Is the currency already developed? Is the company trying to raise money to develop a currency? The further along a cryptocurrency is, the less risk is involved.
  4. Will you own a stake in the company or just currency? Owning a stake means you get to participate in its earnings (you’re an owner) while buying a token means you’re entitled to use them like using tickets in an arcade.

There are additional factors you can consider based on your own preferences, Boneparth says, like customer support, whether a platform offers a mobile app, and how easy the exchange is to use overall.

For some, learning how cryptocurrency mining works is enough of a reason to not invest.

“It’s reasonable why there would be a question and a concern that it could be harmful to the environment,” Puterbaugh notes. “These nodes require significant amounts of power to run their operations.

“When you think about the logistics of it, big, huge powerful computers, many of them, lots of power. Anyone who’s seen a server room and the air conditioning that goes into keeping it cool, imagine that. It’s reasonable to question the merits and the value of this as an operation when you think of all the power that’s going into that.”

How to Get Started with Cryptocurrency

What should you have in place before you buy crypto or do anything with crypto? How much of it should you put into your portfolio? Does it belong in the portfolio?

  1. Educate Yourself on Cryptocurrency

Don’t just invest in any cryptocurrency because you heard someone mention it in a podcast, a book, or a YouTube video. Take your time and learn about the cryptocurrency you’re considering buying and see if this is something you want to financially back the way you would want to research a stock before buying it.

For example, some cryptocurrency investments are tied to larger projects in healthcare or the environment, which makes the investment more attractive to some and less attractive to others.

“You probably should spend more time learning about this space,” Boneparth says. “You’re putting risk on your money in a pretty wild environment. It’s one thing to haphazardly put money into more stable markets, it’s another thing to throw money into volatile markets. So, it’s important to get educated, especially when you’re going to deal with something that’s perhaps more volatile than other risky assets.”

  1. Understand Your Risk Tolerance

While it may be tempting to throw every penny you have into any cryptocurrency investment and wake up the next morning a millionaire, the truth is not every cryptocurrency exchange leads to financial gains. When you’re investing in a cryptocurrency, a good rule of thumb is that you only want to invest an amount that you would be comfortable losing because the growth of these cryptocurrency values is speculative.

“It’s kind of like the dot com bubble,” Danial said. You don’t want to risk not being able to afford your mortgage payment or wonder how you’ll afford groceries.

  1. Open an Account with an Exchange

Danial recommends Coinbase because it’s easier to use and is regulated by the SEC, which makes it safer than other exchanges. For anyone seriously considering using this exchange, Danial recommends Coinbase Pro, noting you’ll have the ability to do more with your cryptocurrencies.

Make sure to do your research before opening an account or purchasing cryptocurrency from an organization, even if it comes highly recommended or you’ve heard of it before. While a growing number of companies, like Robinhood, allow consumers to purchase cryptocurrencies through their platform, not all organizations let consumers hold on to or store their own crypto money. You don’t want to find yourself in a situation where you didn’t exactly read the rules and now, you’re not able to move your money.

  1. Secure a Digital Wallet

Coinbase offers digital wallets, which Danial notes is positive because this company is regulated by the SEC. These digital wallets are insured for up to $250,000, which means for anyone investing below that threshold, you can leave your cryptocurrency investment in your Coinbase account. Danial says she keeps up to $250,000 in her Coinbase account and transfers the rest to her digital wallet, which looks similar to a USB. Transferring your cryptocurrency to a digital wallet is very similar to wiring money from a bank account. You’ll enter a passcode and the money should transfer to where you told it to go in 48 to 72 hours.

  1. Track Your Investments in U.S. Dollars

If you invest in cryptocurrencies, you will need to report your crypto trades as capital gains on your tax return. That means you’ll need to know the value of every crypto investment you make both when you buy it in U.S. dollars, as well as the value of it when you sell in U.S. dollars.

This is because your gains and losses are not being tracked by anyone except for you. Robinhood, which only allows users to conduct transactions on its own platform, will provide a Form 1099-B tracking your gains and losses, but that’s not the case on more traditional exchanges.

“When you use cryptocurrency exchanges like Binance, Kraken, CoinBase, etc., they don’t give you that form,” says Shehan Chandrasekera, CPA, head of tax strategy at CoinTracker.io, a crypto tax software company. That’s because exchanges that allow you to move your holdings off their platform can’t track everything in your personal wallet or trades you make on other exchanges. “That’s when it becomes tricky and when those users have to use a tool to reconcile their entire picture, get the data, and then file their taxes.”

What do you think about the crypto craze? Share with us in the comments below!

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