Cryptocurrency: What It Is and How It Works
What is cryptocurrency?
A cryptocurrency (or “crypto”) is a digital asset that can circulate without the need for a central monetary authority such as a government or bank. Instead, cryptocurrencies are created using cryptographic techniques that enable people to buy, sell or trade them securely.
How does cryptocurrency work?
Bitcoin and most other cryptocurrencies are supported by a technology known as blockchain, which maintains a tamper-resistant record of transactions and keeps track of who owns what. The creation of blockchains addressed a problem faced by previous efforts to create purely digital currencies: preventing people from making copies of their holdings and attempting to spend it twice.
Individual units of cryptocurrencies can be referred to as coins or tokens, depending on how they are used. Some are intended to be units of exchange for goods and services, others are stores of value, and some can be used to participate in specific software programs such as games and financial products.
How are cryptocurrencies created?
One common way cryptocurrencies are created is through a process known as mining, which is used by Bitcoin. Mining can be an energy-intensive process in which computers solve complex puzzles in order to verify the authenticity of transactions on the network. As a reward, the owners of those computers can receive newly created cryptocurrency. Other cryptocurrencies use different methods to create and distribute tokens, and many have a significantly lighter environmental impact.
For most people, the easiest way to get cryptocurrency is to buy it, either from an exchange or another user.
» Ready to invest? How to buy cryptocurrency
Complete list of cryptocurrencies
Below, you can find all of the major cryptocurrencies listed by market capitalization.
How to choose a cryptocurrency
It’s important to remember that Bitcoin is different from cryptocurrency in general. While Bitcoin is the first and most valuable cryptocurrency, the market is large.
Nearly 20,000 different cryptocurrencies are traded publicly, according to CoinMarketCap.com, a market research website. And cryptocurrencies continue to proliferate. The total value of all cryptocurrencies on June 13, 2022, was about $970 million, having fallen substantially from an all-time high above $2.9 trillion late in 2021.
While some of these have total market valuations in the hundreds of billions of dollars, others are obscure and essentially worthless.
If you’re thinking about getting into cryptocurrency, it can be helpful to start with one that is commonly traded and relatively well established in the market (though that’s no guarantee of success in such a volatile space).
NerdWallet has created guides to some widely circulated cryptocurrencies, including Bitcoin and some altcoins, or Bitcoin alternatives:
- Bitcoin is the first and most valuable cryptocurrency.
- Ethereum is commonly used to carry out financial transactions more complex than those supported by Bitcoin.
- Cardano is a competitor to Ethereum led by one of its co-founders.
- Litecoin is an adaptation of Bitcoin intended to make payments easier.
- Solana is another competitor to Ethereum that emphasizes speed and cost-effectiveness.
- Dogecoin began as a joke but has grown to be among the most valuable cryptocurrencies.
- Stablecoins are a class of cryptocurrencies whose values are designed to stay stable relative to real-world assets such as the dollar.
» Learn more: How to invest in BitcoinADVERTISEMENT
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Are NFTs cryptocurrencies?
NFTs, or non-fungible tokens, are digital assets that convey ownership of what could be considered an original copy of a digital file. They share many similarities with cryptocurrencies, and they can be bought and sold in many of the same marketplaces.
However, NFTs are different from cryptocurrencies due to that unwieldy word in their name: non-fungible.
Cryptocurrencies are fungible, so any unit of a specific cryptocurrency is basically the same as any other. My one Bitcoin has the same value as your one Bitcoin.
» Ready to invest? Here are our picks for best cryptocurrency exchanges.
Pros and cons of cryptocurrency
Cryptocurrency inspires passionate opinions across the spectrum of investors. Here are a few reasons that some people believe it is a transformational technology, while others worry it’s a fad.
» Learn more: FUD: Fear, uncertainty and doubt in investing
- Supporters see cryptocurrencies such as Bitcoin as the currency of the future and are racing to buy them now, presumably before they become more valuable.
- Some supporters like the fact that cryptocurrency removes central banks from managing the money supply since over time these banks tend to reduce the value of money via inflation.
- In communities in that have been underserved by the traditional financial system, some people see cryptocurrencies as a promising foothold. Pew Research Center data from 2021 found that Asian, Black and Hispanic people “are more likely than White adults to say they have ever invested in, traded or used a cryptocurrency.”
- Other advocates like the blockchain technology behind cryptocurrencies, because it’s a decentralized processing and recording system and can be more secure than traditional payment systems.
- Some speculators like cryptocurrencies because they’re going up in value and have no interest in the currencies’ long-term acceptance as a way to move money.
- Some cryptocurrencies offer their owners the opportunity to earn passive income through a process called staking. Crypto staking involves using your cryptocurrencies to help verify transactions on a blockchain protocol. Though staking has its risks, it can allow you to grow your crypto holdings without buying more.
» Learn more: What is blockchain, and how does it work?
- Many cryptocurrency projects are untested, and blockchain technology in general has yet to gain wide adoption. If the underlying idea behind cryptocurrency does not reach its potential, long-term investors may never see the returns they hoped for.
- For shorter-term crypto investors, there are other risks. Its prices tend to change rapidly, and while that means that many people have made money quickly by buying in at the right time, many others have lost money by doing so just before a crypto crash.
- Those wild shifts in value may also cut against the basic ideas behind the projects that cryptocurrencies were created to support. For example, people may be less likely to use Bitcoin as a payment system if they are not sure what it will be worth the next day.
- The environmental impact of Bitcoin and other projects that use similar mining protocols is significant. A comparison by the University of Cambridge, for instance, said worldwide Bitcoin mining consumes more than twice as much power as all U.S. residential lighting. Some cryptocurrencies use different technology that demands less energy.
- Governments around the world have not yet fully reckoned with how to handle cryptocurrency, so regulatory changes and crackdowns have the potential to affect the market in unpredictable ways.
Your decision: Is cryptocurrency a good investment?
Cryptocurrency is a relatively risky investment, no matter which way you slice it. Generally speaking, high-risk investments should make up a small part of your overall portfolio — one common guideline is no more than 10%. You may want to look first to shore up your retirement savings, pay off debt or invest in less-volatile funds made up of stocks and bonds.
There are other ways to manage risk within your crypto portfolio, such as by diversifying the range of cryptocurrencies that you buy. Crypto assets may rise and fall at different rates, and over different time periods, so by investing in several different products you can insulate yourself — to some degree — from losses in one of your holdings.
» Learn more: How to diversify your crypto holdings
Perhaps the most important thing when investing in anything is to do your homework. This is particularly important when it comes to cryptocurrencies, which are often linked to a specific technological product that is being developed or rolled out. When you buy a stock, it is linked to a company that is subject to well-defined financial reporting requirements, which can give you a sense of its prospects.
Cryptocurrencies, on the other hand, are more loosely regulated in the U.S., so discerning which projects are viable can be even more challenging. If you have a financial advisor who is familiar with cryptocurrency, it may be worth asking for input.
For beginning investors, it can also be worthwhile to examine how widely a cryptocurrency is being used. Most reputable crypto projects have publicly available metrics showing data such as how many transactions are being carried out on their platforms. If use of a cryptocurrency is growing, that may be a sign that it is establishing itself in the market. Cryptocurrencies also generally make “white papers” available to explain how they’ll work and how they intend to distribute tokens.
» Learn more: 3 questions to ask before you buy cryptocurrency
If you’re looking to invest in less established crypto products, here are some additional questions to consider:
- Who’s heading the project? An identifiable and well-known leader is a positive sign.
- Are there other major investors who are investing in it? It’s a good sign if other well-known investors want a piece of the currency.
- Will you own a portion in the company or just currency or tokens? This distinction is important. Being a part owner means you get to participate in its earnings (you’re an owner), while buying tokens simply means you’re entitled to use them, like chips in a casino.
- Is the currency already developed, or is the company looking to raise money to develop it? The further along the product, the less risky it is.
It can take a lot of work to comb through a prospectus; the more detail it has, the better your chances it’s legitimate. But even legitimacy doesn’t mean the currency will succeed. That’s an entirely separate question, and that requires a lot of market savvy. Be sure to consider how to protect yourself from fraudsters who see cryptocurrencies as an opportunity to bilk investors.
Cryptocurrency legal and tax issues
There’s no question that cryptocurrencies are legal in the U.S., though China has essentially banned their use, and ultimately whether they’re legal depends on each individual country.
The question of whether cryptocurrencies are legally allowed, however, is only one part of the legal question. Other things to consider include how crypto is taxed and what you can buy with cryptocurrency.
- Legal tender: You might call them cryptocurrencies, but they differ from traditional currencies in one important way: there’s no requirement in most places that they be accepted as “legal tender.” The U.S. dollar, by contrast, must be accepted for “all debts, public and private.” Countries around the world are taking various approaches to cryptocurrency. El Salvador in 2021 became the first country to adopt Bitcoin as legal tender. Meanwhile, China is developing its own digital currency. For now, in the U.S., what you can buy with cryptocurrency depends on the preferences of the seller.
- Crypto taxes: Again, the term “currency” is a bit of a red herring when it comes to taxes in the U.S. Cryptocurrencies are taxed as property, rather than currency. That means that when you sell them, you’ll pay tax on the capital gains, or the difference between the price of the purchase and sale. And if you’re given crypto as payment — or as a reward for an activity such as mining — you’ll be taxed on the value at the time you received them.