What is Cryptocurrency? Everything You Need To Know
Jul 31, 2021
What is a cryptocurrency?
A cryptocurrency is a digital currency which can be used for secure, internet-based payments.
Cryptocurrencies make use of a computer database (sometimes referred to as digital ledger) and strong cryptography to secure transaction records. As a result, cryptocurrency transactions are nearly impossible to counterfeit or double-spend.
Furthermore, cryptocurrency transactions are peer-to-peer which means that cryptocurrencies are sent directly between two parties and without an intermediary (such as a bank).
Unlike fiat currencies such as the US dollar, cryptocurrencies are not issued or controlled by a central authority like a central bank. Instead, cryptocurrencies are global and decentralized which makes them theoretically immune to government interference or manipulation.
Types of Cryptocurrencies
Ever heard of CryCash, Trollcoin or Fujicoin? You haven't? Well, there are more than 2,000 cryptocurrencies.
First Generation Cryptocurrencies
The first and most valuable cryptocurrency by market cap is bitcoin. Bitcoin was launched in 2009 by an individual or group known by the pseudonym Satoshi Nakamoto. Bitcoin pioneered many of the technologies used by cryptocurrencies such as the blockchain.
Many cryptocurrencies, including Litecoin, Dash and Zcash, are based on bitcoin. These coins are so-called forks and reuse large fractions of bitcoin's source code, while aiming to improve on specific features like transaction speed or privacy.
While the exact features of these early cryptocurrencies differ, their main objective is payment processing. Furthermore, most of them rely on a so-called Proof of Work consensus mechanism.
Second Generation Cryptocurrencies
As the technology progressed, blockchain developers focussed on new features. While all of these cryptocurrencies still make use of a token as a means of payment, their primary focus shifted from payment processing, to providing specialized services or computing power.
An example of these specialized services are so-called smart contracts. A smart contract is a computer program intended to automate transactions. For instance, a smart contract could set the terms for a real estate transfer and automatically change ownership in the cadastre when all terms of the contract (e.g. payment) are met.
Another example are so called dApps (distributed apps). Instead of using a centralized server or database, dApps can be used to create web applications that are distributed on thousands of computers worldwide, making them practically unstoppable and uncensorable.
Third Generation Cryptocurrencies
Only recently, a new kind of cryptocurrencies appeared. What's special about these cryptocurrencies is that the usually do not make use of a blockchain, thereby aiming to offer lower fees and infinite scalability.
The most commonly known cryptocurrencies of this generation include IOTA and Nano. However, development of these digital currencies is still in a very early phase which means they are still experimental.
How to Use Cryptocurrencies
Cryptocurrencies have a wide range of applications. The most apparent application is their use as a payment method. However, there are many other use cases such as being a way to automatically bill for goods and services, a store of value, or a hedge against crises.
No matter how you want to use your cryptocurrencies, the first step is to get cryptocurrencies. Once you own cryptocurrencies, you can use it to pay for goods and services, store them long-term, or even lend them to others in return for a small interest.
The easiest way to get crypto is to buy it outright. Other ways to earn crypto, e.g. answering surveys, are in our opinion often not worth the effort.
In principle, the buying process is not much different to buying just any other good online. First, you need to open an account at a so called cryptocurrency exchange. Second, you need to deposit money or select a payment method. And last, you make a purchase.
The only thing that's different, is that you usually need to verify your identity as part of account creation through a document upload or video chat.
Be sure to also read our guide on how to buy bitcoin before you make your first purchase.
Another way to accumulate crypto is to mine cryptocurrency. Mining cryptocurrency, however, requires a higher technical knowledge and is only profitable with state-of-the-art equipment and cheap electricity.
Important part of owning cryptocurrencies is storing it safely. After all, you also wouldn't let your wallet lie around publicly, for anyone to see.
Crypto is stored in a so-called wallet. Each wallet is cryptographically secured and allows you to receive, store and send cryptocurrencies. A wallet also has its own address which is used to receive payments — just like your bank account has a bank account number.
There are many different types of crypto wallets — all of which are covered in our crypto wallet guide.
Making payments with cryptocurrencies
It used to be very difficult to find merchants that accept cryptocurrencies. Fortunately, it is getting easier and easier to use cryptocurrencies to pay for goods and services — both online and offline.
In fact, a 2020 study by HSB, part of Munich Re, has found that 36% of small and mid-sized businesses in the US accept cryptocurrency. Popular merchants that accept cryptocurrency include Microsoft, AT&T, or CheapAir. You can find places near you that accept crypto on Coinmap.
Making payments using is actually quite simple. All you need to do is to tap the send button in your wallet and enter the recipient's wallet address. Some vendors even allow you to simply scan a QR code which automatically transfers the payment details to your wallet — making payments a breeze.
Some cryptocurrencies like Tezos or Polkadot even allow you to lend cryptocurrencies to others in return for an interest. This process is called staking. At the moment of writing, the potential interest ranges between 5% and 8%.
Benefits and Disadvantages of Cryptocurrencies
Cryptocurrencies open up many opportunities to shape the future of business and finance. However, there are also some drawbacks of the technology to consider.
Digital currencies have the potential to make transactions faster, more secure, and lower cost. At the same time, crypto makes money more democratic and reduces the power central governments have on it.
Cryptocurrency payments are peer-to-peer. This means that transactions are made directly between sender and receiver, without a third party like a bank.
Instead of a trusted third party, digital currencies can be trusted because they are irreversible and cryptographically secured.
This is a benefit, because it reduces the cost of transactions and speeds the whole process up.
As of writing of this article, a bitcoin payment worth $1,000,000 would only cost you $0,33 in fees. This is remarkably cheap.
For comparison, many payment networks like VISA or MasterCard charge up to 2% (i.e. in this case up to $20,000) for every transaction.
Security & Confidentialitiy
Cryptocurrencies make use of strong cryptography to secure its network (hence the name "crypto"currencies). As a result, transfers of digital currencies are almost impossible to hack.
Furthermore, cryptos have some level of confidentiality built-in. Instead of using clear names like credit cards, crypto transactions are made using wallet addresses.
However, most digital currencies are not completely anonymous. For instance, if you buy cryptocurrencies on an exchange, your exchange wallet (and wallets receiving payments) can be traced back to your account.
The most popular, completely anonymous digital currency is Monero.
Globally distributed digital currencies cannot be banned or censored. This means that central governments lose power, because they can no longer use monetary policy to control transactions, e.g. to enforce sanctions. This is especially useful for people living in dictatorships or autocracies.
Banking the Unbanked
1.7 billion people globally have no access to a bank account, according to the World Bank.
This is a massive issue, because these people cannot participate in the most basic financial services, like savings, credit or money transfers. Without the ability to build savings or get a loan, the unbanked are those hit hardest by unemployment, accidents or a global pandemic like the coronavirus.
With high-speed internet connections becoming more and more commonplace, even in developing countries, cryptocurrencies enable the unbanked to engage in financial transfers and build savings and wealth, conveniently through their phones. In fact, Africa is the global leader in mobile money accounts.
Money fulfils three major functions: it must be a medium of exchange, a unit of account, and a store of value (i.e. money must hold its value over time).
Unfortunately, digital currencies do not yet fulfil all functions of money to the full extent. More specifically, crypto is not yet accepted universally as a medium of exchange, and the price of cryptocurrencies is too volatile to be a unit of account and short-term store of value.
A major feature of money is that it is accepted universally to purchase goods and services. While 36% of small and mid-sized businesses in the US accept cryptocurrency today, it's still not possible to switch to using digital currencies only.
Even if crypto was universally accepted, there would be another issue: most cryptocurrencies can only process very few transactions per second and cannot be scaled easily.
While decentralization is great to make secure, borderless transactions, it also comes with a lot of added complexity. Centralized payment services like VISA or MasterCard are easier to scale to thousands of transactions per second. With cryptocurrencies, the number of transactions in any given time period is limited, because it would cost too much computing power to process and save every tiny transaction to millions on computers worldwide.
Nevertheless, blockchain developers identified this as a major issue. Therefore, they are working on new solutions, such as third-generation cryptocurrencies or so-called second layer protocols like the lightning network.
Part of the reason why crypto is not accepted universally is price volatility. Price drops or increases of 10% or more within a few hours are not entirely unusual.
It also jeopardizes the story line of cryptocurrencies being a store of value. While in the long-term, the price of many digital currencies has been rising steadily, these volatilities make it a subpar short-term store of value compared to cash.
Last but not least, the learning curve for adopting crypto is still quite steep. Developers need to work on solutions that make it easier to buy, own, and spend cryptocurrencies.
Furthermore, it must become easier for merchants to accept cryptocurrencies. A big step in this direction would be taken if large payment processors like Square would allow its merchants to accept crypto. But this also includes legislation that clarifies how merchants can accept digital currencies.
How to Buy Cryptocurrencies
Cryptocurrencies are bought on so called cryptocurrency exchanges. These are marketplace, just like regular stock exchanges, where buyers and sellers of digital currencies come together to trade.
There are a couple of differences, though. For instance, all cryptocurrency trading happens completely online. There are also no trading hours which means that you can buy crypto seven days a week, 24 hours around the clock.
Just as with stock brokerages like Robin Hood or WeBull, there are many things to consider when chosing a cryptocurrency exchange. Which payment methods do they support? How high are their fees? Are they easy to use? Are they safe and secure?
You can find answers to many of these questions in our detailed bitcoin guide.
Future of Cryptocurrencies
Blockchain technology and cryptocurrencies are still very much in their infancy, comparable to the dotcom scene in the late 90s. Hundreds of tokens compete for the same markets.
Similarly to the late 90s, it is very likely that a lot of crypto projects will fail, leading to a consolidation of the market.
For comparison, just look at the search market. In the late 90s there were many big search engines such as Yahoo, Lycos, Altavista, or Ask.com. All except for Google are nowadays bankrupt or marginalised. Similarly, Amazon is by far the leading e-commerce store globally today.
It is likely that those digital currencies that will thrive in the future, are those which are able to address the most pressing issues of cryptocurrency adoption like scalability.
Digital currencies must be capable of being used by thousands of people at the same time.
And in fact, probably the most important issue that developers of cryptocurrencies like Ethereum, Dash or IOTA currently concentrate on is scalability. Also bitcoin developers are working on ways to increase the number of possible transactions through so called second layer technologies like Lightning Network.
From trading to utility
Another factor that comes into play in the upcoming consolidation phase is the utility of a digital currency: is it easy to use? Can developers build great applications on it? Can it be used for real-world problems?
Therefore, the focus of cryptocurrency users will shift from an investment or speculation point-of-view, to an usage-driven point-of-view. And we're already starting to see this trend, with non-trading activity like staking or crypto debit cards building more and more traction.
Central Bank Digital Currencies (CBDCs)
These government-controlled currencies will be an attempt to stay in control of money supply.
Some governments might even go as far to ban the use of non-governmental cryptocurrencies. However, since cryptocurrencies are purely digital and borderless, such a ban will not be enforcable and potentially even counterproductive.