What is Cryptocurrency & How Does it Work?

Cryptocurrency is exclusively a virtual currency, implying that you don’t get to handle physical cryptocurrency notes or coins.

After the launch of the first crypto in 2009, this asset class has emerged as a potential investment mania for numerous individuals. Hence, it is imperative to be aware of all the vital details related to cryptocurrencies. This article illustrates the basic details of this asset class and how it works. 

What is cryptocurrency?

Cryptocurrency is a decentralised virtual or digital currency that allows secure online payments without third-party intermediaries. It is secured by cryptography, thereby making it almost impossible to double-spend or counterfeit. 

Generally, central authorities do not issue cryptocurrencies, making these currencies theoretically immune to government manipulation or interference.

How do cryptocurrencies work?

The decentralised structure of cryptocurrencies enables them to exist outside the control of central authorities and governments.

Instead, they operate on a peer-to-peer network, and transactions are recorded on a public ledger technology known as “blockchain”. However, the details of the individuals trading them do not get recorded. In simple words, you will stay anonymous when you trade crypto.

Given below is a detailed illustration of the way cryptocurrency works:

1. Mining

Cryptocurrency is created through a complex procedure known as “mining”. This process involves solving complicated mathematical problems using specially equipped computer systems. In return, miners who solve these puzzles receive coins as rewards.

Ideally, it should take about 10 minutes for an individual to mine one bitcoin. In reality, the procedure takes approximately 30 days.

1. Buying, selling and storing

You can buy cryptos from brokers, individual currency owners, or central exchanges. After buying, you can store cryptos in digital wallets. Also, you can sell coins to them. You can easily buy or sell coins via platforms or exchanges like Coinbase.

1. Investing or transacting

Once you own a cryptocurrency, you can opt to exchange it for cash, use it to purchase services or goods or trade in it. 

Advantages of cryptocurrency

Listed below are some of the top benefits of dealing in cryptocurrency:

• Transparent, decentralised and immutable

The complete system runs on shared ownership, where all authorised members have access to the data. Also, it is tamper-proof in nature.

• Secure and private

Blockchain technology assures a high degree of security via cryptography and ensures user anonymity.

• Useful as a hedge against inflation

Investing in crypto can prove to be an excellent investment in times of inflation. For instance, investors often compare cryptos with gold. The primary reason for this is that similar to the yellow metal, cryptos have a limited supply since all types of cryptocurrency come with a cap on mining.

How are cryptocurrencies valued?

As cryptos are generally decentralised, the following factors come into play when deriving their value:

• Availability on exchanges – Smaller tokens are only available on selected platforms, limiting their access to potential investors. On the other hand, mainstream cryptos trade on multiple exchanges, thus increasing investors’ reach and raising demand.
• Supply and demand – The core principle of demand and supply applies here – a cryptocurrency gains value when demand exceeds supply. 
• Cost of production – With an increase in mining costs, the value of a cryptocurrency also rises.
• Competition – Numerous new tokens and projects launch every day. If a new crypto gains momentum, it sends the price of existing tokens down by taking value from them. At the same time, it witnesses its price shoot higher. 

Besides these, internal governance, legal requirements and regulations play a role in determining the value of cryptocurrencies.

Major cryptocurrencies in the world

Bitcoin is the world’s first cryptocurrency. Apart from it, the other individual cryptos are called altcoins (derived from “alternative coin”). Some of the major coins, along with their total market value (as of CoinMarketCap data from 4^th March 2022), are given below:

Risks associated with cryptocurrencies

Besides the advantages of dealing with cryptos, there are several risks involved as well. These include:

• Lack of regulations

Currently, cryptocurrencies are unregulated by central banks and governments. Proper regulations will help lower risks in the long term and improve investor protection.

• Volatility

The risks of crypto trading are primarily linked to volatility. Unexpected changes in market sentiment can result in sudden and sharp price movements.

• Market risks

Similar to other commodities; cryptocurrencies are exposed to risks associated with market movements. Systematic and unsystematic risks are the two types of risks related to crypto trading. The former is present in every crypto as it is inherent in the cryptocurrency markets. The latter is particular to a single cryptocurrency asset and can involve a change in the organisation’s fundamentals.

Future of cryptocurrency

The entire cryptocurrency space is constantly evolving. This is one of the reasons why a high for a particular coin can be followed by a massive plunge easily. 

The reality is crypto investments are still new and speculative, and there isn’t much history to base predictions strongly. No one can state with certainty where a particular coin is headed to. Experts are constantly paying attention to crypto regulation, broader institutional adoption, and other factors to understand the space better.

Thus, crypto enthusiasts, especially beginners, must consider the aforementioned details related to cryptocurrency. Though investing in cryptos is a risky venture, picking the right coins can go a long way to generate life-changing wealth for any investor.