Cryptocurrency Fundamentals: Benefits, Drawbacks, and How it Works

Cryptocurrency (or “crypto”) is a digital money, such as Bitcoin, that serves as an alternate payment mechanism or speculative investment. Cryptocurrencies are named after the cryptographic algorithms that allow users to spend them securely without requiring a central government or bank.

Here are some instances.

• Bitcoin was originally designed to be a means of payment that is not controlled or distributed by a central bank. While financial organizations have always been required to verify that a payment was successfully handled, Bitcoin does it safely and without a central authority.
  
• Ethereum has the same basic technology as Bitcoin, but rather than exclusively peer-to-peer payments, the cryptocurrency is used to pay for transactions on the Ethereum network. This network, based on the Ethereum blockchain, allows entire financial ecosystems to function without a central authority. Consider insurance without the insurance company, or real estate titling without the title business.
  
• Scores of altcoins (broadly defined as any cryptocurrency other than Bitcoin) have emerged to capitalize on the

Why are people investing in cryptocurrencies?

People invest in cryptocurrencies for the same reasons they invest in any other asset. They hope its worth will rise, resulting in a profit. If demand for Bitcoin increases, for example, the interaction of supply and demand may raise its value.

If people began to use Bitcoin for payments on a large scale, demand for Bitcoin would increase, and its price in dollars would rise. So, if you had acquired one Bitcoin before the surge in demand, you might conceivably sell it for more US dollars than you paid for it, generating a profit.

The same ideas apply to Ethereum. “Ether” is the coin used on the Ethereum blockchain, which allows developers to create financial apps without the requirement for a third-party financial institution. Developers must spend Ether to create and run Ethereum apps, therefore the more that is built on the Ethereum blockchain, the higher the demand for Ether.

However, it is crucial to understand that some people do not consider cryptocurrencies to be investments. Bitcoin proponents, for example, regard it as a vastly superior monetary system to our current one and would rather that we spend and accept it as regular payment. One prominent refrain — “one Bitcoin is one Bitcoin” — emphasizes the belief that Bitcoin should be measured in terms of the value it offers as a new monetary system rather than in dollars.

Why is bitcoin still popular?

Bitcoin has been dismissed as dead, useless, or a hoax since its birth, owing in part to its volatility. Most recently, when Bitcoin’s price climbed above $60,000 in 2021 before plummeting to roughly $17,000 in 2022, many experts and investors predicted that it would not recover from this explosion.

However, it did achieve a series of record highs in early 2024. As of this writing, the cryptocurrency is up over 250% from a year ago.

The recent price spike can be due to the SEC’s approval of spot Bitcoin ETFs in January 2024. This allowed some of the world’s leading asset managers (such as Fidelity and BlackRock) to provide their clients with exposure to Bitcoin, making it easier for such clients to keep Bitcoin in accounts like IRAs and taxable brokerage accounts.

However, other factors have contributed to Bitcoin’s price increase in 2024. Every four years, something known as the “Bitcoin halving” happens. The last halving took place in 2020, when the reward for mining bitcoin was cut in half from 12.5 to 6.25. In 2024, this will happen again, with the mining reward reduced from 6.25 to 3.125. With fewer Bitcoins entering the market, it is conceivable.

Furthermore, the rise in interest rates in 2022 that hammered growth companies may have had a similar impact on Bitcoin; investors choose security over volatility during times of uncertainty. However, when rumors of interest rate decreases in 2024 emerges, some investors may have a greater appetite for risk assets such as Bitcoin, prompting them to reinvest now.

Finally, some Bitcoin advocates believe that viewing Bitcoin through the lens of fiat currencies such as the US dollar or the British pound is completely misguided, and that its actual value rests in its status as a new monetary system.

However, if there is one thing about Bitcoin that is predictable, it is that it will remain volatile. In the relatively short term, both camps are likely correct: Bitcoin will rise and fall. However, it looks that the Bitcoin bulls are currently winning.

How does cryptocurrency work?

Blockchain technology supports cryptocurrency by maintaining a tamper-resistant record of transactions and keeping track of who owns what. The use of blockchains addressed a difficulty encountered in prior attempts to create fully digital currencies: prohibiting users from producing duplicates of their holdings and attempting to spend them twice.

Individual units of cryptocurrency can be referred to as coins or tokens, depending on their usage. Some are designed to be used as units of trade for goods and services, while others serve as value storage and can be used to participate in specialized software programs such as games or financial products.

How are cryptocurrencies created?

Mining is a typical method for creating currency, and Bitcoin is one such example. Bitcoin mining is an energy-intensive process in which computers solve complicated problems to verify the legitimacy of network transactions. As a reward, the owners of these computers may earn newly minted cryptocurrency. Other cryptocurrencies utilize other techniques to manufacture and distribute tokens, and several have a much lower environmental impact.

Why are there so many types of cryptocurrency?

It’s vital to realize that Bitcoin is not the same as other types of cryptocurrency. While Bitcoin is the original and most valuable cryptocurrency, the industry is vast.

CoinMarketCap.com, a market research website, reports that there are over two million different cryptocurrencies in circulation. While some cryptocurrencies have market capitalizations in the hundreds of billions of dollars, others are obscure and virtually worthless.

If you’re thinking about investing in cryptocurrencies, it can be beneficial to begin with one that is widely traded and reasonably well-established in the market. These coins often have the highest market capitalizations.
However, carefully selecting your coin does not ensure success in such a volatile market. Sometimes an issue in the tightly interconnected crypto business might spill over and have far-reaching consequences for asset values.

For example, in November 2022, the market suffered a significant setback as the cryptocurrency exchange FTX struggled to deal with liquidity concerns during a surge in withdrawals. As the consequences spread, the value of cryptocurrencies, large and small, plummeted.

Are cryptocurrencies financial securities, such as stocks?

It is currently unclear whether cryptocurrency is a security. To clarify, a “security” in finance is anything that has value and can be sold. Stocks are considered securities because they reflect ownership in a public firm. Bonds are securities because they represent an obligation owed to the bondholder. Both of these securities can be traded in public marketplaces.

Regulators are increasingly signaling that cryptocurrencies should be regulated similarly to other securities, like as equities and bonds. However, this viewpoint is being challenged by researchers, legal companies, and some of the largest participants in the crypto business, who say that the regulations that apply to stocks and bonds, for example, do not apply as broadly to cryptocurrency.

The Securities and Exchange Commission has focused on the sector in general. The agency has expressed worries about activities such as crypto staking, as well as the operations of some major cryptocurrency companies.

Whether the SEC will classify cryptocurrencies, or specific types of cryptocurrencies, as securities will be at the forefront of crypto regulation, with significant ramifications for the asset class in the foreseeable future.

Advantages and disadvantages of cryptocurrency

Cryptocurrency elicits strong responses from a wide range of investors. Here are a few reasons why some people believe it is a transformative technology, while others fear it is a fad.