Crypto 101: Cryptocurrency Explained

Understanding cryptocurrency is possible, and Bitsgap’s comprehensive guide to Crypto 101 is here to help.

So, you've caught wind of bitcoin, and you're eager to dive in, but where do you start? The realm of cryptocurrency is vast, ever-evolving, and packed with intriguing concepts like tokens, blockchains, decentralized finance, and NFTs. While navigating the headlines and jargon alone seems daunting, the fundamentals of cryptocurrency are actually quite accessible.

So if you're looking to learn the basics of this revolutionary new domain, look no further than this beginner's guide to cryptocurrency by Bitsgap.

What Is Cryptocurrency?

Cryptocurrency, also known as crypto, is a form of digital money designed to be secure and anonymous. Unlike government-issued currencies like the dollar or pound, cryptocurrencies are not controlled by any central authority. Instead, crypto uses advanced cryptography to verify and secure transactions, as well as create new currency units. This makes crypto impervious to government manipulation and interference.

Many cryptocurrencies are built on blockchain technology, a distributed digital ledger enforced by a global network of computers. The blockchain allows crypto transactions to be transparent while keeping users anonymous, representing the cutting edge of financial security and privacy.

👉Anonymous, you say? Well, not really. While crypto transactions are certainly more difficult to trace than standard electronic payments, they don't exactly cloak your funds in a shroud of mystery. When we say 'anonymous,' we're actually referring to 'pseudonymous.' In this context, your name, say John Doe, is substituted with the alphanumeric string representing your wallet address. A wallet is the digital storage space for your crypto, accessible only to those with the address and access keys. However, this very feature makes crypto identifiable, as a wallet's address is recorded on a cryptocurrency's blockchain.

Cryptocurrency units can be labeled as coins or tokens, depending on their purpose. Some serve as means of exchange for goods and services, others act as stores of value, and a few can be used in specific software applications, such as games and financial products.

How Does Cryptocurrency Work?

Rather than relying on centralized authorities (like banks or governments), crypto is built on a decentralized technology called blockchain.

👉 In essence, a blockchain is a chain of interconnected information blocks, woven into a digital ledger. Each block brims with verified transactions, independently scrutinized by vigilant validators dispersed across the network. For a new block to be born, every node must confirm its legitimacy, making it nigh impossible to meddle with transaction histories. The online ledger's contents rely on a consensus among the network's individual nodes — the tireless computers that maintain its records. Wanna learn more? Dive deeper: Blockchain Technology Explained.

A prevalent method for creating cryptocurrencies is called mining, as utilized by bitcoin. Bitcoin mining is an energy-intensive process, aka proof-of-work (PoW), where computers crack intricate puzzles to confirm the legitimacy of transactions within the network. In return, the computer owners may be awarded newly generated cryptocurrency.

Other cryptocurrencies employ alternative methods for producing and distributing tokens, often with a considerably reduced environmental impact, like the proof-of-stake (PoS) consensus mechanism. PoS functions through a staking system, in which participants are rewarded for supporting the network by keeping assets in specified wallets. Some PoS cryptocurrencies also support masternodes, which involve a more advanced staking method and often necessitate a minimum coin holding.

Who Controls Cryptocurrencies?

Decentralization is crypto’s essential aspect. Notably, cryptocurrencies operate without central authority, and their supply and demand depend on user actions. Moreover, the intricate protocols embedded in their governing codes handle the governance of cryptocurrencies. Consequently, the community and miners actively engaged in the crypto ecosystem play a crucial role in determining the future direction of the cryptocurrency.

👉 But is crypto truly decenralized? Well, not really. Decentralization, or distribution of power and governance within the system, was indeed the foundation of the original Bitcoin white paper, which proposed a cryptographic solution designed to enable payments without involving financial institutions or other trusted parties. However, Bitcoin quickly became centralized and now relies on a small group of software developers and mining pools to operate. In all honesty, a significant portion of the top 20 cryptocurrencies fail to achieve the desired level of decentralization. Others adopt a "future decentralization" approach, where developers pledge to relinquish control once the system operates smoothly. Is genuine decentralization all but a dream? Find out in this article: Understanding Crypto Decentralization.

Pros and Cons of Cryptocurrency

Cryptocurrencies were developed with the goal of transforming financial systems. However, as with any revolution, trade-offs exist. Currently, there are numerous discrepancies between the theoretical ideal of a decentralized cryptocurrency system and its practical implementation.

Here are some of the advantages and disadvantages of cryptocurrencies:

Advantages of cryptocurrencies

• Cryptocurrencies represent a decentralized financial system that does not rely on traditional intermediaries like banks. In this system, transactions between two parties can be completed without the need for a trusted third party. This eliminates the risk of the entire system collapsing due to the failure of a single large bank.
• Cryptocurrencies make it easier to transfer money directly between two parties without needing a middleman like a bank or credit card company. These decentralized transfers are secured using public and private keys, and incentive systems like proof of work or proof of stake.
• Because they cut out intermediaries, cryptocurrency transfers can be faster than traditional money transfers. Flash loans are an example of near-instant decentralized transfers used in trading.
• The cryptocurrency market has seen huge growth over the past decade. As of July 2023, bitcoin alone was valued at over $585 billion.
• Cryptocurrencies have become increasingly popular for streamlining the remittance economy. They serve as intermediate currencies to facilitate money transfers across borders, making the process more efficient and cost-effective.

Disadvantages of cryptocurrencies

• While cryptocurrencies are often touted as anonymous, they are actually pseudonymous. They record digital trails that government agencies like the FBI can trace. This means governments and others may be able to track cryptocurrency transactions.
• Cryptocurrencies have become popular for criminal activity like money laundering and illegal purchases. The Silk Road marketplace that sold drugs on the dark web is a well-known example. Cryptocurrencies are also often used by hackers for ransomware attacks.
• Though cryptocurrencies are meant to be decentralized, ownership is highly concentrated. For example, just 100 Bitcoin addresses hold about 12% of all Bitcoin.
• Though anyone can theoretically mine cryptocurrencies, mining major cryptocurrencies requires massive amounts of energy, sometimes comparable to entire countries. Expensive energy costs and unpredictable returns have led large mining firms to dominate the industry.
• While cryptocurrency blockchains themselves are very secure, external services like crypto exchanges and wallets are often hacked, resulting in millions of dollars of cryptocurrency stolen.
• Cryptocurrencies traded on public markets are highly volatile. For example, Bitcoin surged to nearly $65,000 in November 2021 before dropping below $20,000 just 18 months later.

Where Is Cryptocurrency Used?

Cryptocurrency can be used globally, and an increasing number of online merchants accept it for goods and services. Even some large retailers like Overstock allow customers to purchase millions of items using Bitcoin or other cryptocurrencies.

Cryptocurrencies can also be used to send remittances to other countries more affordably and quickly compared to traditional methods. Although the recipient may still need to convert the cryptocurrency into their local fiat currency, the process can be more efficient overall.

Cryptocurrencies can be useful for making payments when you want to maintain a degree of privacy. A good example might be purchasing a domain name or VPN service anonymously. While using a credit card requires trusting that the merchant will not reveal your information, cryptocurrencies like Bitcoin offer increased privacy as you don't need to share your personal information.

However, it's essential to remember that most cryptocurrencies are pseudonymous rather than completely anonymous, meaning that transactions can still be traced to a public address on the blockchain.

How to Buy & Store Crypto?

Today, you can purchase cryptocurrencies from various sources, including (de)centralized exchanges, brokers, and individual currency holders, or sell to them. Platforms such as Coinbase, Kraken, Binance provide a convenient method for buying and selling cryptocurrencies.

After acquiring cryptocurrencies, you can store them in digital wallets. These wallets can be categorized as either "hot" or "cold." A hot wallet is connected to the internet, making transactions more accessible but also more susceptible to theft and fraud. In contrast, cold storage is more secure but can make transactions more challenging to execute.

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Can Cryptocurrency Replace Cash?

The idea that cryptocurrencies will replace cash anytime soon is rather optimistic. While cryptocurrencies offer some advantages over traditional currencies, there are also a few issues that would need to be resolved first:

• One of the major challenges facing cryptocurrencies is their volatility. Cryptocurrency prices often fluctuate wildly, making them impractical as a stable means of exchange or store of value.
• Many cryptocurrencies also struggle with scaling, as their networks can become congested during periods of heavy use, leading to slowed transactions and increased fees.
• The regulation of cryptocurrencies varies between countries, and this uncertainty hinders mainstream acceptance.
• Moreover, cryptocurrencies remain relatively complex, making them difficult for many people to comprehend, securely hold, and use, especially compared to cash and traditional payment methods.
• Finally, some cryptocurrencies, such as Bitcoin, rely on energy-intensive consensus algorithms like proof of work, raising environmental concerns.

For a comprehensive understanding of the differences between centralized and decentralized currencies, don't hesitate to explore this informative primer: The Battle of Currencies: Fiat Money vs Cryptocurrency

Can Cryptocurrency Be Manipulated?

Cryptocurrency markets are vulnerable to manipulation, especially given their decentralized nature and smaller size relative to traditional markets. Manipulators employ various tactics to influence crypto prices artificially, including:

• Pump and dumps: Groups buy and promote a low-liquidity cryptocurrency to inflate its price, then sell quickly for a profit, crashing the price and harming investors.
• Wash trading: Simultaneously buying and selling the same cryptocurrency creates the illusion of high volume, attracting investors. Though illegal in traditional markets, this occurs on some crypto exchanges.
• Spoofing: Placing large buy or sell orders with no intention to fill them falsely signals supply or demand, moving prices so manipulators can profit.
• Front-running: Those with inside knowledge of pending large orders trade ahead of them, manipulating the price.
• Social media hype: Influencers spread misinformation or hype on social media to temporarily pump or crash cryptocurrency prices.

Regulators and investors worry about such manipulation. Many countries are tightening rules to protect investors and support fair markets. Investors should exercise caution, research thoroughly, and know the risks before investing in cryptocurrencies.

Why Is Cryptocurrency Going Up and Down?

Crypto is a highly volatile market for a few good reasons.

Firstly, a large portion of cryptocurrency investors are speculators. This frenzied trading amplifies price fluctuations, making it a wild ride for all involved.

Then, the crypto market isn't exactly known for its size or depth, with some coins barely making a splash. This lack of liquidity means even the smallest trades can send prices careening, opening the door for manipulation and dramatic price swings.

Cryptocurrencies also enjoy their fair share of media hype. One whiff of unfavorable news, such as security breaches or regulatory shakedowns, can send investors into a selling frenzy.

Overall, crypto markets are nothing if not moody. Market sentiment plays a starring role in cryptocurrency prices, with optimism sending them skyward and pessimism crashing them back down to Earth.

👉 Dive deeper into volatility by exploring this guide to the Thrills and Spills of Crypto.

Can Cryptocurrency Be Hacked?

Some cryptocurrencies have indeed experienced security issues due to vulnerabilities in their code, including problems with smart contract implementations or other aspects of their underlying technology. These vulnerabilities can lead to theft, unauthorized mining, or other forms of malicious activities.

It is true that cryptocurrencies can evolve, and developers can address these vulnerabilities by updating the codebase. However, it's important to note that such changes might require consensus from the network participants, especially when it comes to major changes or hard forks. In some cases, addressing vulnerabilities can lead to a split in the community, as was seen with Ethereum and Ethereum Classic after the DAO hack.

Is Cryptocurrency Regulated?

On one hand, we have the trusty old fiat currencies, backed by the might of governments and monetary authorities, like our good friend the dollar bill, supported by the ever-reliable Federal Reserve. On the other hand, we have crypto mavericks that refuse to be tied down by any public or private entities. Establishing their legal status across the globe has been, well, a bit of a pickle. Let’s see how crypto is faring across the world.

By July 2023, only El Salvador and the Central African Republic had embraced bitcoin as legal tender for monetary transactions. The rest of the world? A delightful patchwork of regulations.

While Japan has welcomed bitcoin as legal property under its Payment Services Act, China has shut the door on cryptocurrency exchanges and mining, and India is said to be cooking up its own cryptocurrency framework.

The European Union has also jumped in on the action, legalizing cryptocurrencies and requiring derivatives and related products to qualify as "financial instruments." In June 2021, the European Commission unleashed the Markets in Crypto-Assets (MiCA) regulation, providing a safety net for regulation and laying down the law for companies or vendors dabbling in cryptocurrency-based financial services.

Meanwhile, across the pond in the United States, the bustling world of crypto derivatives like Bitcoin futures can be found on the Chicago Mercantile Exchange. But overall, the U.S. has displayed a somewhat ambivalent stance toward regulating the crypto industry. While some forward-thinking folks in Congress dream of a comprehensive framework that would let the industry flourish, financial market regulators are busy playing whack-a-mole with concerns about money laundering, scams, and cybercrime.

In a plot twist, the Biden administration signed an executive order in March 2022, summoning federal regulators to weigh the pros and cons of cryptocurrencies. By January 2023, a roadmap emerged to tackle crypto risks, nudging regulators to "ramp up enforcement" and coaxing Congress to "expand regulators' powers." Soon after, the Federal Deposit Insurance Corp. (FDIC), the Federal Reserve, and the Office of the Comptroller of the Currency (OCC) joined forces to issue a statement spotlighting the risks crypto assets pose to banks. Though the statement doesn't ban banks from dipping their toes into crypto services, it does drop a hint that engaging in crypto is “likely to be inconsistent with safe and sound banking practices."

At the heart of the U.S. vs. Crypto pickle lies the question of whether cryptocurrencies should be deemed securities. As debates rages on, all we have to do is …well, wait.

Oh, and let's not forget the taxman! Although cryptocurrencies might feel like money, the Internal Revenue Service (IRS) classifies them as financial assets or property. So, if you're making a pretty penny from your crypto endeavors, don't be surprised when Uncle Sam comes knocking for his share. The IRS will tax your digital assets as either capital gains or ordinary income, depending on how long you held onto the cryptocurrency and how you used it.

Bottom Line

In wrapping up, think of cryptocurrencies as a groundbreaking leap forward, providing a decentralized, borderless currency system that's shaking up the old order of banks and governments. Yet, with this untamed liberty comes the shadow side of unpredictable price swings and a tendency to buck regulations. As this disruptive technology matures and morphs, it's vital for everyone to grasp its inner mechanics and steer it with wisdom. The saga of cryptocurrency is still being written, its ink barely dry, yet it's clear that it's poised to etch a significant mark on the canvas of our 21st-century financial landscape.

FAQs

Cryptocurrency without Blockchain

Well, technically yes, but they'd need to get creative with alternative ways of maintaining their distributed ledgers. You see, blockchain is just one flavor of distributed ledger technology (DLT) that fuels cryptocurrencies like our good ol' pal Bitcoin. But lo and behold, there are other DLTs and consensus mechanisms waiting in the wings, ready to shake up the world of digital currencies. Among the blockchain alternatives are Directed Acyclic Graph (DAG), hashgraph, and holochain.

Now, while these blockchain alternatives can certainly support cryptocurrencies, let's not forget that blockchain has already won the popularity contest. It's the most well-known and battle-tested method for creating digital currencies. But who knows? As the distributed ledger technology universe continues to expand, we might just stumble upon new and innovative solutions that give cryptocurrencies a run for their (digital) money—without relying on blockchain.

Cryptocurrency without Mining

While all cryptocurrencies do need to "confirm" transactions, not all of them rely on "mining." Proof of Stake (PoS) is a more energy-efficient alternative that doesn't demand massive hardware resources to perform the same tasks as mining.

However, PoS has its fair share of critics, mainly due to concerns about its security. Further development and refinement may be necessary before PoS can truly surpass mining.

Additionally, there are cryptocurrencies that are "issued" rather than mined. These can be distributed through airdrops or sold in crowdsales. Some of these digital currencies might have their own chains, which are confirmed using PoS or nodes, while others may operate on parent chains like Ethereum, piggybacking on the transaction confirmations of the base currency.

Can Cryptocurrency Totally Crash?

While it's theoretically possible for the entire cryptocurrency market to experience a severe crash, it's highly unlikely that cryptocurrencies would become entirely worthless or disappear altogether.