The cryptocurrency market has grown from less than $200 billion to nearly $3 trillion in 2021, attracting a flood of new crypto investors.
But then it all came crashing down in the first half of 2022. While the crypto market is still worth about $900 billion, the risks have become clearer over the past few months for investors drawn to this burgeoning asset class.
That's why it's more important than ever for investors to do their due diligence and understand what they're investing in. If you're thinking about investing in cryptocurrencies, you might be wondering: What exactly is cryptocurrency? And how does it work?
Here's what investors should know about it and how to be smart with your crypto investments.
What is cryptocurrency?
Cryptocurrency is a form of digital currency that can theoretically be used to purchase goods and services, but in practice is commonly bought and sold as an investment or used to power decentralized finance (DeFi) software projects on various blockchains.
Bitcoin was the first cryptocurrency, and in the years since its introduction, the number of available coins has grown to more than 19,000. Bitcoin was designed for digital payments, although investors have come to see it more as a store of value than a practical digital currency. It is often described as a form of "digital gold". Bitcoin's all-time high was around $69,000 in November 2021, though a sharp decline in 2022 brought it down to around $20,000.
Ethereum is the second largest cryptocurrency, but unlike Bitcoin, it functions more like a software platform. Developers are buying into the ethereum network to create cryptocurrency-oriented apps and software programs. Ethereum also reached its all-time high price in November 2021, reaching $4,878. But like Bitcoin, its value has declined in 2022 and has recently been trading around $1,000.
What is blockchain, and how does it relate to cryptocurrencies?
Cryptocurrencies are powered by blockchain networks. Blockchain is essentially a digital ledger made up of expanding blocks of data.
With blockchain's distributed ledger, records are kept on multiple computers in the network. Each computer is called a node, and these nodes authenticate and store data. As new transactions are completed, they are added to a "block" of data, and then that block is added to the chain. The entire ledger can be updated as new transactions appear.
Many crypto enthusiasts say blockchain technology has the potential to fuel the next evolution of the Internet, sometimes called web3. Blockchain technology can be used for gaming, finance and other purposes. And in order to transact, you must be able to pay the appropriate fee in the associated cryptocurrency.
What is the value of cryptocurrency, and how is it determined?
The value of a cryptocurrency depends on several different factors. With so many cryptocurrencies out there, it can be difficult to figure out which ones are truly valuable.
Like many other assets, demand is one of the main drivers that contribute to the value of a cryptocurrency. If more people use a coin or the blockchain associated with a coin, it is more likely to see an increase in price.
Established cryptocurrencies like bitcoin and ethereum are used by more people, so they have a higher perceived value. Because more people are using these networks, the prices of Bitcoin and Ethereum are higher than other cryptocurrencies. Some experts also point to the first-mover advantage that Bitcoin and Ethereum have when it comes to setting the market in the first place.
Supply can also affect the price of a cryptocurrency, or at least how investors perceive its value. Many experts argue that bitcoin is more likely to hold its value because there is a limit to the number of bitcoins. There can only be 21 million, so scarcity is believed to contribute to its value, unlike a cryptocurrency that has no upper limit.
When considering which cryptocurrencies to invest in, it's a good idea to look at coins that have a strong use case and a greater likelihood of wider adoption. One of the reasons ethereum is considered valuable (second only to bitcoin) is that its smart contract capability enables the creation of a variety of applications, including financial and gaming applications.
How can you use cryptocurrency?
It's possible to use Bitcoin and other cryptocurrencies to buy things in the real world, but experts say it doesn't make sense for most people. The volatility and fluctuations in the value of cryptocurrencies means that the price you pay today could be much higher or lower tomorrow.
In addition to using cryptocurrencies as an investment, they can also be used to gain access to blockchain networks such as ethereum and other networks that allow developers to build software.
“Cryptocurrency can also be used to pay for network usage,” says Adam Blumberg, CFP, co-founder and president of Interaxis, a firm that educates financial advisors about crypto assets. "If I want a smart contract transaction on ethereum, I have to use ether to pay for using the network."
There are also various crypto debit and credit cards linked to exchange accounts that allow you to integrate real-world purchases into your crypto portfolio. Even PayPal allows you to use cryptocurrencies to pay online.
But the most common use for cryptocurrencies is as an investment. And there are signs of increasing mainstream availability of these crypto-investments. For example, Fidelity recently announced plans to add bitcoin to its 401(k) plans. There are also self-service IRA custodians that connect to an exchange like Coinbase and create a way to invest your cryptocurrency in tax-advantaged retirement plans.
How is cryptocurrency mined?
Cryptocurrency mining is the process of using computing power to help verify transactions on the blockchain. Miners lend their computing power to the network to help complete transactions. In return, those who solve cryptographic puzzles and do additional computational work can be rewarded with more cryptocurrency.
Cryptocurrency mining has become increasingly challenging – and competitive – over the years. In order to provide the necessary computing power in an increasingly competitive environment, many miners build or purchase specialized equipment. This can be expensive and does not guarantee that you will be rewarded for mining. There are also environmental concerns associated with cryptocurrency mining, thanks to the vast amounts of electricity required to power increasingly sophisticated and powerful mining computers.
How is cryptocurrency stored?
There are various ways to store your cryptocurrency. Many crypto exchanges allow you to store your coins on the exchange. However, if your coins are on an exchange, they can be vulnerable to a hack. While some exchanges maintain insurance to help mitigate losses, it’s important to note that crypto investments don’t have the same federal protections and guarantees as your conventional stock portfolio.
The most secure way to store cryptocurrency is with a crypto wallet. There are two main types of wallets:
- Hot wallets are connected to the internet and can be accessed via your browser or your phone. They are easy to access, and you can connect them to various online marketplaces. You can quickly send your cryptocurrency from an exchange to a hot wallet, storing them separately. Hot wallets are sometimes called software wallets.
- Cold wallets aren’t connected to the internet. These are hardware wallets that look similar to a USB drive. Cold wallets are often more expensive than hot wallets, but they are considered more secure. Since they aren’t connected to the internet, they aren’t as vulnerable to hackers. But that also means if you lose your cold wallet, you may lose your crypto forever.
When choosing between a hot wallet or cold wallet, it’s important to understand the risks associated with each.
A hot wallet often has a way for you to retrieve lost keys. You can usually use them like another account with a password. As long as you have the right pass phrases, you can often get back in. However, you have to be willing to take on the security risks.
With a cold wallet, you’re less vulnerable to hacks, but you might not have the ease of recovery. If you forget the keys needed to access your wallet, you might not be able to get to your crypto assets. Additionally, if the hard wallet is destroyed with no backup, you could also lose your assets.
When storing your crypto, it’s important to figure out a system that works for you. For trading, it can make sense to keep coins on an exchange. However, you might also want a hot wallet for online transactions and moving your cryptocurrencies around. For long-term storage, a cold wallet could be your best bet, as experts recommend cold wallets for top security. You can use a combination of storage options to get the result you want.
Based on our own research and input from experts, we think these are the best crypto wallets for most long-term investors:
You must be logged in to post a comment.