What is Cryptocurrency? A Detailed Guide for Beginners
Cryptocurrencies actively integrate into everyday life: they are now accepted as payment, more and more users are engaged in trading and investments, and the number of services related to crypto activities is growing. But a lot of people still do not understand well enough what a cryptocurrency is and how it works.
The TGDRatings.com team of experts presents a simple explanation of what is crypto, how it works, where it is used and how to earn money from it.
Let’s begin with what cryptocurrency is, the history of its creation and the fundamental differences between a digital currency and a traditional one.
What is a cryptocurrency?
Basically, cryptocurrencies are used as a means of payment between users and as a tool for investment, but there are many other specific ways of using cryptocurrencies. For example, it is used as: a store of value, means of paying fees for transfers within blockchains, as an asset that gives the right to participate in the government of decentralized organizations, etc.
A brief history of cryptocurrencies
Attempts to organize the transfer of value using the Internet appeared at the dawn of its life. One of the first authors of systems remotely resembling cryptocurrency was the American cryptographer David Chaum. However, his DigiCash project collapsed due to the lack of strong encryption models and the ease with which digital coins could be counterfeited.
The next step was the b-money project of the American programmer Wei Dai. The key features of b-money were the Proof-of-Work (PoW) consensus algorithm, which confirmed transactions, and the decentralized database, which stores information about all transfers on the network.
There was only one step left to blockchain. It was developed by an anonymous Internet user (or group of users) under the nickname Satoshi Nakamoto in 2009. Nakamoto published blockchain principles in the public domain and launched Bitcoin, which became the world’s main cryptocurrency.
Next came the turn of the Canadian programmer of Russian origin Vitalik Buterin. Buterin stood at the origins of the Ethereum blockchain, which allows the use of smart contracts. This technology gave developers the ability to create their own applications based on the blockchain, and the Ethereum network made it easier to launch new crypto assets, acting as an architectural basis for them.
The difference between cryptocurrencies and traditional currencies
Cryptocurrencies have several fundamental differences from traditional cryptocurrencies:
- Relative anonymity. Public information about the owner of funds is represented by only his address (any number of addresses can be created). Without special blockchain analysis tools, it is impossible to identify the owner;
- Lack of physical form. Cryptocurrency is just a piece of software code;
- No single issuer. Cryptocurrency is not issued by the central banks of any country. Blockchain nodes are responsible for issuing coins.
Technologies behind cryptocurrencies
The architecture of cryptocurrencies is based on three technological solutions: blockchain, cryptographic encryption, decentralization. Let’s consider them in more detail.
Blockchain: the basis of cryptocurrencies
A blockchain is a sequence of linked blocks that store encrypted information about transactions. Each node has its own copy of the blockchain. The nodes are also responsible for reaching consensus, confirming new blocks, and relaying this information to the rest of the nodes.
The consensus algorithm is also the mechanism for issuing a new cryptocurrency. Miners are responsible for issuing coins for PoW cryptocurrencies, and validator nodes for PoS cryptocurrencies.
Cryptography and the security of cryptocurrency transactions
Cryptography in cryptocurrencies is represented by hash functions. Hash functions are special algorithms that allow you to turn a data set into a string of pseudo-random numbers – hash. The slightest change in the initial set will cause the hash to change. Each subsequent block in the blockchain is linked to the previous block using a hash (in fact, this string works as a link to the previous block).
To transfer coins within the blockchain ones use addresses – the lines of code of a certain type. Addresses within the blockchain has two types of keys – public and private. The public key is an external address visible to all blockchain users. It uses to for sending coins. The private key is used by the owner to sign transactions (the signature is needed to make it clear from which address to which the coins were sent) and access to the public address.
There are special applications called wallets. Any person can use these app to work with blockchain addresses – they do a lot of work to simplify using of blockchain and make it more comfortable.
The process of transferring cryptocurrency within the blockchain is as follows:
- The user sends to the blockchain information about the transfer amount and destination address: how much and where to transfer;
- This data is verified with private key;
- The transmitted information is included in one of the blocks, which are processed by nodes;
- As soon as the block with the transaction is confirmed by the consensus algorithm, the transaction will be completed and the coins will appear at the transfer address.
Decentralization: a key feature of cryptocurrencies
One of the fundamental features of cryptocurrency is decentralization. Blockchain, as a distributed database, is very resistant to attacks and is practically not subject to external regulation. The more nodes a blockchain supports, the lower its vulnerability to attacks from within the system.
For example, to capture the Bitcoin blockchain, you need either control over 51% of the nodes or the ability to decrypt the hash. The current computer capacities do not allow to do the latter, and the control of 51% of the nodes is a very costly undertaking (there are more than 13,000 of them in Bitcoin).
There are more than 10 thousand cryptocurrencies in the world. They differ in capitalization, architecture, areas of application and degree of popularity. Consider the most popular cryptocurrencies in more detail.
Bitcoin: the first and most valuable cryptocurrency
Bitcoin is the most famous cryptocurrency. It was created as a means of payment, not controlled by traditional financial structures. Due to the features of the architecture, the traditional bitcoin did not fulfill the initial task, but instead launched the cryptocurrency revolution. Its code has become the basis of hundreds of new cryptocurrencies.
The coin is mined using mining and uses the PoW consensus algorithm. BTC often performs the function of “cryptocurrency gold” and is used as an asset for long-term investment. Bitcoin can even be found in the portfolios of investment funds. Interest from private investors and funds, among other things, supports the high price of the coin.
Ethereum: the pioneer of smart contracts
Bitcoin laid down the principles on which working cryptocurrency based. However, it was Ethereum that allowed the cryptocurrencies to grow to its current scale.
Smart contracts – algorithms that perform a specific task within the blockchain, for example, send requests for price changes, send tokens at a given time, adjust stablecoin prices and so on. Ethereum has proposed using EVM (Ethereum Virtual Machine) to process such smart contracts, and own SDK (developer toolkit) to create various kinds of smart contracts.
Ripple (XRP): international payments
At first, the creators of Ripple intended to make life easier for blockchain users by releasing an application for fast payments. But in the end switched to corporate clients, primarily to large international banks. The current goal of Ripple is to support and develop RippleNet. This is a global decentralized network that the company is promoting as a replacement for international payment banking systems like SWIFT.
At the heart of the Ripple architecture is the Decentralized XRP Ledger Network (XRPL). Its main advantage is speed (it takes 3-4 seconds to transfer funds). At the same time, Ripple uses its own RPCA consensus algorithm, and the blockchain is controlled by validator nodes (there are a little more than 130 of them). The unit of calculation within RippleNet is the coin of the same name – XRP.
Other important cryptocurrencies
In addition to coins that have a fundamental impact on the state of the cryptocurrency world, there are several important coins of large projects that are worth paying attention to. Briefly about them:
- BNB. The main coin of the largest and most famous centralized crypto exchange in the world – Binance. Actively used in the exchange ecosystem: commissions payment, staking, trading, accrual of bonuses, etc.;
- USDT. The main stablecoin of the world. By linking the USDT price to the USD price, the project allowed a huge number of users to enter the cryptocurrencies. It is used, among other things, as a means of storing value;
- SOL. The native coin of the Solana blockchain, a direct competitor to Ethereum. Transactions in Solana faster and cheaper than in Ethereum;
- ADA. The native coin of the Cardano blockchain, a competitor to Solana and Ethereum. Also known for its active community;
- MATIC. Second level blockchain coin of Polygon network. Polygon was created to speed up calculations and reduce their cost in the Ethereum network. One of the most successful projects of its kind in the world, with a huge number of applications developed on it;
- LTC. Litecoin blockchain coin (Bitcoin hard fork), which was created as a simpler and cheaper, in comparison with Bitcoin, system of cryptocurrency transfers. Litecoin is called “cryptocurrency silver”.
How to use cryptocurrencies
Cryptocurrencies integration in the real world is still ongoing. So far, we can talk about the following well-established areas of application of the crypt: trading, investing and payments in applications.
Buying and selling cryptocurrencies
You can buy cryptocurrencies in many ways: on CEX and DEX exchanges, P2P platforms, in specialized services (Banxa, Simplex, etc.), in some kind of applications (for example, in games), via telegram bots etc.
The most common method for this is buying on CEX – centralized crypto exchanges. Such platforms are characterized by high liquidity, favorable rates, clear interface and convenience, high security level, a large number of coins available, available ways to earn extra money and so on. The most famous centralized cryptocurrency exchanges are: Binance, Kucoin, Bybit and others.
Cryptocurrency storing: wallets and security
Large cryptocurrency exchanges have many settings related to ensuring the security of user accounts. In particular, these include: passing KYC procedures (user identification), two-factor authentication, setting passwords for user accounts and wallets, anti-phishing codes, device management and other protection methods.
However, with all their security advantages, storing a purchased cryptocurrency on an exchange is considered an unreliable method, because they can be hacked. For purposes of storing it is recommended to use special software and hardware crypto wallets.
Software wallets are the applications for smartphones and personal computers that allow user to manage their cryptocurrency while connected to the Internet. Such wallets include, for example, Trust Wallet and Exodus. Due to the constant connection to the network, such wallets provide faster access to cryptocurrency, but are less secure than hardware counterparts. As a result of hacking, attackers can get an access to the private keys of wallets. Therefore, the user himself is responsible for security: sets a complex password, monitors the safety of the secret phrase and the use of private keys.
Hardware wallets are physical devices for storing cryptocurrency. To do anything with coins, you need to connect the device to the Internet. This type of device includes, for example, Ledger or Trezor wallets. Hardware wallets are considered the most secure way to store cryptocurrencies. Private keys are stored on the wallets themselves, so only the owner of the device has access to them.
Using cryptocurrencies for transactions and payments
With cryptocurrencies you can pay for some services and goods. From the latest examples, you can pay for purchases with cryptocurrency in Gucci and Balenciaga stores. However, this applies to cryptocurrencies from the top 10 or 20 by capitalization. The same applies to cryptomats (analogues of ATMs but for crypto), which allow you to withdraw fiat money in exchange for a crypt (usually for Bitcoin).
More often, cryptocurrencies are used in internal ecosystems of games, sports clubs, metauniverse projects, etc. For example, this type includes the AXS coin, the native coin of the Axie Infinity game, which performs not only the function of the game currency (purchase / sale of items), but is also a govern token of the gaming platform and available for staking.
Due to the high volatility of most coins (sudden price movements), investing in cryptocurrencies for a short period can be extremely risky.
From an investment point of view, long-term ownership of cryptocurrencies is more acceptable. Among active crypto users, this approach is called HODL or hodling (because of the simple “buy and hold” mechanism, it is often recommended for beginners).
An important component of successful investment in cryptocurrencies is also the presence and adherence to investment strategies.
How to invest in cryptocurrency
To start investing in cryptocurrencies, you need free funds, a reliable platform for buying cryptocurrencies and the right coins to build a portfolio. Let’s consider these components in more detail.
Earlier in the article, exchanges were already mentioned as the most convenient, safe and easy way to buy cryptocurrencies. This is the recommended method for most users. Before choosing any exchange:
- Get familiar with its interface. It should be convenient and understandable;
- Read the reviews. Pay special attention to negative reviews with justified claims. Study how the support service (for example, on trustpilot) reacts and reacts to negativity in open areas;
- Read about the methods of protecting accounts and wallets on the exchange, study the history of hacks (if any) and the behavior of the site during them, find information about the current amount of funds in the insurance funds of the exchange;
- Examine list of available coins;
- Learn deposit/withdrawal methods (fiat and cryptocurrencies), fees, limits applied on the exchange;
- Clarify necessity of KYC.
Risks and rewards of investing in cryptocurrencies
Cryptocurrency is a fairly young industry. Investing in it can be considered as an investment for the future, which opens up potential opportunities to receive high returns in the long term.
The other side of such opportunities is big risks. In 2022-23 the collapse of the Terra blockchain and the FTX exchange, the bankruptcy of Silvergate and Signature banks serving crypto projects, pressure from US regulators on key platforms and their founders, caused damage to investors and the industry. Such events are actually unpredictable, so it is unrealistic to insure against losses.
In addition to infrastructure problems, sudden price fluctuations, potential exchange hacks, regulatory restrictions in certain jurisdictions, etc. await investors.
Cryptocurrency portfolio diversification
The risks listed above could be partly avoided by portfolio diversification. Diversification is an approach that involves the distribution of risks by adding to the portfolio projects that are unrelated or have minimal relations. This approach allows to avoid critical losses, stay afloat for a long time and constantly increase profitability.
The future of cryptocurrencies and blockchain technology
Cryptocurrencies and blockchain technology are actively developing and are being used in the real economy. Many trading platforms, organizations developing technologies, gradual acceptance by traditional institutions and organizations indicate that cryptocurrencies are with us for a long time.
The evolution of cryptocurrency regulation
At the initial stages of the development of cryptocurrencies and blockchain, they were not taken seriously. Some experts still express doubts about the viability and sustainability of the industry. However, since 2014-2015, sectoral legislation has gradually begun to develop.
The first regulation acts were intended to define cryptocurrencies within existing laws in order to make them a means of payment (or vice versa – prohibit) and thus legalize the use of cryptocurrencies and start collecting taxes. On the other hand, legislators tried to protect investors and provide at least some kind of guarantees for users of cryptocurrencies, and also began to fight money laundering with the help of crypto.
Evolutionary processes in the legislation continue. But the rules for using cryptocurrencies in many countries remain vague. At the same time, international exchanges have to comply with various requirements: from the most complete freedom of use (as, for example, in Salvador or the UAE) to a complete ban (as in China) or constant pressure from regulators (as in the US).
Examples of using cryptocurrencies
- Payments – cryptocurrencies can be used to pay for goods and services;
- Trading and investment – cryptocurrencies can be bought and sold, earning on the price difference, and also used as a means of investment;
- Stablecoins are cryptocurrencies with a value pegged to the value of a fiat currency. As a rule, to the US dollar at a ratio of 1:1;
- Wrapped cryptocurrencies – cryptocurrencies that allow you to use the coins of one blockchain in another blockchain;
- Governance tokens are special coins that give the right to vote or control in DAO or DeFi;
- and others.
Challenges and opportunities for cryptocurrencies
The main challenges for modern cryptocurrencies:
- Uncertaint attitude towards cryptocurrencies from regulatory organisations in different countries;
- Probable competition with CBDCs (central bank digital currencies) in the next 5-10 years;
- Possibility of unexpected negative events, like the collapse of FTX, undermining the stability of the industry.
Key takeaways for beginners
Cryptocurrency is an interesting and promising asset that promises high returns. At the same time, this is a very risky tool due to the youth of the industry, the specifics of regulation, price fluctuations and a number of other reasons. However, this only means that you need to use it carefully and wisely.
If you decide to invest in crypto, do not rush, do not invest all available funds and do not expect quick success. Study the projects and products that they offer, study the principles of operation of cryptocurrencies and blockchain. A slow and measured approach should bring good results.
Cryptocurrencies are issued by miners (blockchain participants who mine new coins) or stakers (blockchain participants who store and process transactions). To work with cryptocurrencies, private and public addresses are used. The first ones give access to the account of user and allow you to confirm the ownership of the transaction, the second ones are used for direct transfers of coins between blockchain users.
So, it is difficult to say cryptocurrencies are “real” money, but they are actively used as a means of payment.
To transfer cryptocurrency from one user to another you do not need an intermediary in the form of a bank. To do this, cryptocurrencies use blockchain - a chain of information blocks.
- Investing - buying and holding a cryptocurrency with the expectation that the price of a coin will rise over time;
- Trading – buying and selling cryptocurrencies with the expectation of gaining from price differences;
- Mining - ensuring the operation of the blockchain by mining PoW cryptocurrencies in exchange for a reward;
- Staking is the PoS networks method of blocking coins on public adressess to keep the blockchain running. Works on the principle of a bank deposit;
- and many others.
For example, in 2020, the S&P 500 index (the index reflects the weighted average price of the shares of the 500 largest US companies) shows the growth in 18.4%. In the same year, Bitcoin returned 301% and Ethereum returned 464%.