What Is Cryptocurrency? How Does It Work?

The process of creating cryptocurrency units is called "mining”. This process harnesses the processing power of devices to solve mathematical operations - transaction hash calculations.

What Is Cryptocurrency? Explanation & Examples in 2022 | Gridinsoft

Cryptocurrency

November 11, 2022

A cryptocurrency is any currency that exists only in a virtual form and uses cryptography to protect transactions. Because cryptocurrencies have no central issuing or regulatory authority, they use a decentralized system to record transactions and issue new units.

Cryptocurrency is a digital mean of payment, that is backed by decentralised calculations. It acts like peer-to-peer transactions, so it does not rely on banks to verify transactions, allowing anyone to send and receive payments regardless of location. Unlike the physical money we are used to wearing and exchanging in the real world, cryptocurrency payments exist solely as digital records in an online database describing specific transactions. This database is called blockchain. All cryptocurrency is stored in digital wallets.

The name cryptocurrency comes from the use of encryption to verify transactions. Extended encryption stores and transmits cryptocurrency data between wallets and public registries to ensure security and safety. The first cryptocurrency founded in 2009 and remains the most famous today – known as Bitcoin.

How Does Cryptocurrency Work?

Cryptocurrency works in a blockchain - the distributed public ledger. The blockchain stores records of all transactions, updated and held by the currency holders. The process of creating cryptocurrency units is called "mining”. This complex process harnesses the processing power of devices to solve complex mathematical operations - exactly, transaction hash calculations. For each successful hash calculation, miners receive their commission – that is what makes this process profitable. Users can buy currency from brokers and stores and spend it using crypto wallets. As mentioned above, you don't own anything tangible if you own cryptocurrency. Instead, you have a key to move a record or unit from one person to another without needing a trusted third party. Even though Bitcoin has been about since 2009, cryptocurrencies and blockchain technology applications are still gaining technology.

The Most Popular Cryptocurrencies

There are thousands of cryptocurrencies. Some but not all of them have taken off, so let's list the most famous ones:

Bitcoin

Developed by Satoshi Nakamoto back in 2009, it was the first cryptocurrency, and is still the most known one. It is believed that Satoshi Nakamoto is a pseudonym for a person or group of people whose exact identity remains unknown. Market capitalization of BTC peaked around $1.3 trillion in 2021, at a price of nearly $69,000. Despite being not so convenient for daily transactions, it acts rather as a vane for the entire crypto market. Large movements of Bitcoin price always receive a corresponding move in prices of other ones, same as large stock market indexes influence the price of underlying equities.

BTC-USD graphic is familiar even to people who've never touched cryptocurrencies
BTC-USD graphic is familiar even to people who've never touched cryptocurrencies

Ethereum

In 2015, Ethereum was developed as a blockchain platform with its cryptocurrency called Ether (ETH). Next most popular after bitcoin, it is often used in online payments - thanks to fast transaction speed. Additionally, its blockchain technology became a basis for numerous DeFi projects.

Diagram that shows all the projects created on Ethereum blockchain technology
Diagram that shows all the projects created on Ethereum blockchain technology

Litecoin

Similar to bitcoin, it has faster innovations, including more rapid payments and processes that allow more transactions. Because of the simplified mining, it turned into a tool of cybercriminals who spread malware called CPU miners. That, exactly, became one of the reasons for a legal action against LTC in 2021.

Ripple

Ripple is a distributed ledger system that was founded in 2012. In addition to cryptocurrency, XRP allows tracking of different types of transactions. The group behind it has worked with banks and financial institutions. This cryptocurrency also was amidst the scandal in 2021, when SEC (American securities exchange commission) initiated a legal action against its creators. The main accusations were concentrated around the fact that they were selling to investors unregistered securities, backed with Ripple.

How to Buy Cryptocurrency?

There are three steps to consider when buying cryptocurrency. They are usually consequent, even if you don't see them all.

Step 1: Choosing a platform

The first step is to decide which platform to use. This is usually a choice between a traditional broker or a specialized cryptocurrency exchange:

  • Traditional brokers. Brokerage firms offer ways to buy and sell cryptocurrency and other financial assets like stocks, bonds, and ETFs. Often these platforms offer lower trading costs but also fewer crypto features.
  • Cryptocurrency exchanges. Many cryptocurrency exchanges offer different cryptocurrencies, wallet storage, interest-bearing account options, and more. However, many businesses charge fees based on assets.

When comparing different platforms, it's worth considering what cryptocurrencies are offered, commissions, security features, storage and withdrawal options, and any educational resources.

Step 2: Fund your account

Once you've chosen your platform, you need to fund your account, so you can start trading. Most cryptocurrency exchanges allow users to buy cryptocurrency using fiat money, such as the U.S dollar, euro, or British pound using debit or credit cards. However, credit purchases of cryptocurrency are considered risky, and some exchanges do not support them. There were dozens of stories when margin trading of any kind of equity lead to margin calls and bankruptcies. As cryptocurrencies are highly volatile, it is incredibly reckless to go into debt or potentially pay high credit card transaction fees for assets.

Some platforms also accept ACH transfers and bank transfers. The payment methods accepted and the time it takes to deposit or withdraw may vary from platform to platform. Similarly, the time it takes to clear deposits depends on the payment method. Fees are an equally important factor to consider. These include deposit and withdrawal fees as well as commissions per transactions. Again, fees will vary depending on the payment method and platform, which you should pay attention to at the outset.

Step 3: Place your order

Now you can place an order via your broker's exchange website or mobile platform. For example, you’re planning to buy cryptocurrency. You can do so by selecting "Buy," setting your order type, entering the amount of cryptocurrency you want to purchase, and then confirming the order. The exact same process applies to sell orders.

However, there are other ways to invest in cryptocurrency. These include payment services PayPal, Cash App, and Venmo, which allow users to buy, sell or store cryptocurrencies. In addition, there are the following investment tools:

  • Cryptocurrency trusts or ETFs: you can buy shares of bitcoin trusts with a regular brokerage account. These instruments give retail investors access to cryptocurrency through the stock market. Such trusts track the price of underlying equity tick-by-tick, so it will thoroughly follow the price of a chosen coin. Unfortunately, there are only a few ones present on common exchanges, so most of such investments involve purchases at OTC markets.
  • Bitcoin mutual funds: there are bitcoin ETFs and bitcoin mutual funds to choose from. These ones are present on regular exchanges, but you cannot close your position before the term specified in a contract. They suppose the return rate that is determined at the end of each period.
  • Cryptocurrency-related stocks: you can also indirectly invest in cryptocurrency through the shares of companies from the cryptocurrency sector. There could be stocks of cryptominers, hardware manufacturers, crypto exchanges, and asset management cos that invest in crypto. Alternatively, you can buy stocks or ETFs from blockchain technology companies.

The best option for you will depend on your investment goals and risk appetite.

Types Of Cryptocurrency

There are quite a few differences between cryptocurrencies today. Some rely on different versions of the original blockchain technology, and some are not designed to work as fiat currencies. They are divided roughly into four types.

  • Proof of Work (PoW): The first type of cryptocurrency started with bitcoin and relies on blockchain technology that uses a concept for transaction processing known as proof of work (PoW).
  • Proof of Stake (PoS): In a PoS system, each node does not have to verify every transaction. Instead, participating nodes must use their cryptocurrency stock as a deposit to join the transaction verification group. It is on this deposit that the concept of share proof gets its name. Any node that attempts to cheat or submit incorrect data to the registry automatically loses its share as a penalty. Those who play by the rules receive interest on the deposits as a reward for their work. In a PoS blockchain, this is a reward system that ensures security and fair operation.
  • Tokens: They differ from traditional cryptocurrencies because they are not meant to be used as general-purpose currency. They are also created on top of existing blockchains like Ethereum and do not exist as standalone systems. To understand this concept, is to compare tokens to casino chips. Although they are cash or other valuable assets, they can only be used in the casino that issued them.
  • Stablecoins: These are cryptocurrencies created for the sole purpose of providing a secure store of value. They originated because standard cryptocurrencies, such as bitcoin and ether (the Ethereum coin), can fluctuate significantly in value over a short time, making them difficult to manage. This is why some crypto investors became multimillionaires overnight, only to see their capital evaporate almost as quickly. Stablecoins are between tokens and standard cryptocurrencies because they are built on existing blockchains but can be exchanged for fiat currency. So, they play a vital role in the marketplace by enabling daily, repetitive transactions free of value fluctuations. Most stablecoins achieve this by tying their value to one or more fiat currencies and holding reserves of those currencies as a guarantee of the token's value.

How To Store Cryptocurrency?

Once you have purchased cryptocurrency, it is crucial to store it securely to avoid hacking or theft. Cryptocurrency is stored in cryptocurrency wallets, physical devices, or online software used to store your private keys to your cryptocurrencies securely. Some exchanges provide wallet services, making it easier to keep directly through the platform. However, not all exchanges or brokers automatically provide you with these services. There are two kinds of wallets, "cold wallet" and "hot wallet," and they have the following differences:

  • Hot wallet storage. "Hot wallets" refer to cryptocurrencies that use online software to protect private keys from your assets. Those are the ones you can meet on different trading platforms, or cryptowallet services.
  • Cold Wallet Storage. Unlike hot wallets, cold wallets (also known as hardware wallets) rely on standalone electronic devices to store your private keys securely. Typically, cold wallets charge a fee, while hot wallets do not.

Cryptocurrency Fraud And Scams

Unfortunately, cryptocurrency crime is growing faster than the popularity of crypto. Such scams may be of any possible form, but crooks defined several ones with the biggest efficiency.

Fake websites. Those pages with counterfeit reviews and crypto jargon promising huge guaranteed returns if you keep investing. In fact, you'd receive nothing besides bare promises and an empty wallet. Such scams usually have a short lifetime – until the website is getting reported and shut down. That's why, exactly, those pages are often hosted on dubious URLs, or even on site constructors.

Safemoon giveaway scam is an example of such website
Safemoon giveaway scam is an example of such website

Virtual Ponzi Schemes. History repeats itself. As a result, scammers promote non-existent digital currency investing opportunities and create the illusion of huge profits by paying off old investors with money from new investors. One such scam operation, BitClub Network, raised more than $700 million. Then in December 2019, its founders were indicted.

Celebrity endorsement. Scammers impersonate billionaires or celebrities online and promise to boost your investment in virtual currency. As a result, they steal everything you send. They may also use messaging apps or chat rooms to spread rumors that a famous businessman supports a particular cryptocurrency. Then, after they induce investors to buy and raise the price, the scammers sell their stake, and the currency drops in value.

Elon Musk is among the most popular celebrities whose name is chosen for a scam disguise
Elon Musk is among the most popular celebrities whose name is chosen for a scam disguise

Romance scams. The FBI warns of a trend in online dating scams in which scammers convince people on dating apps or social media to invest or trade in virtual currencies. In the first seven months of 2021 alone, the FBI's Internet Crime Complaint Center received more than 1,800 reports of crypto-oriented romance scams, with losses reaching $133 million.

In other cases, scammers pose as legitimate virtual currency dealers or create fake exchanges, tricking people into giving them money. Another cryptocurrency scam involves fraudulent offers to sell individual retirement accounts in cryptocurrencies. Then there is cryptocurrency hacking, where criminals hack into digital wallets where people store their virtual currency to steal it.

Cryptocurrencies & Cybersecurity

At a glance, cryptocurrency may have only positive ties with cybersecurity. It is anonymous, relies upon hash calculations and protected transactions, application software for crypto usually features a lot of security features - all for users’ good. However, some of these qualities act like two-edged swords, and make a lot of headache to analysts, executive authorities and others involved in cybercrimes investigation.

The aforementioned anonymity made a great favor to malware developers once. In the late ‘00s – early ‘10s, most malware was bringing profits to their developers in a very easy scheme - by simple bank card transfer. In a group of countries all over the world the banking secrecy laws were forbidding even law enforcements from getting detailed information about the transactions on a certain account. Aside from making money on malware, that was a great opportunity for money laundering. But things changed around 2012, when most of those countries brought transactions out of the protection of banking secrecy. Cybercriminals were stunned, as it was pretty risky now to get payments from affiliates or other malware-related sources.

Shortly after, in 2013, Bitcoin came into view. The first cryptocurrency saw its first huge gains, rising from $13 to $1100 on its peak. Such a surge also attracted more and more miners, who made the coin way easier to use (more miners = less transaction time). And if an anonymous way to store and send money that cannot be tracked by anyone and is not regulated by any government is not a perfect option for hackers - so what is it?

Bitcoin price surge in 2013. Such a pattern is familiar, isn't it?
Bitcoin price surge in 2013. Such a pattern is familiar, isn't it?

Since then, a lot of time passed, and other cryptos popped out. In particular, there were the ones that had a way easier mining, so you should not use so complicated high-performance machines for this task. That gave a push to the idea of exploiting someone’s other hardware to mine coins and receive commission into your wallet. The most popular cryptos for such a sly task are Monero (XMR) and Litecoin. The malware that is used for this target is called coin miner trojan, or a CPU miner. Oftentimes, it features parts of code of some legit miners, or sometimes even are entirely built on them – the open-source ones, apparently.

In some terms, cryptocurrencies got the same ill fame as the Darknet did. Sure, it's not that bad, especially after several countries in the world approved Bitcoin as a legit payment method. But being the bay for crooks, and, what is worse, the point of crooks’ interest makes it even a more scary thing. These days, the news on crypto-related scams appear almost daily, and the scale of losses due to them is calculated in billions of dollars. Sure, executive authorities have ways to find & catch the crooks even though they are thoroughly hiding their trails, but cryptocurrencies are still a great pain in the neck.

Is Cryptocurrency Safe?

Cryptocurrencies are built using blockchain technology, describing how transactions are recorded in "blocks" and time stamps. This is quite a complex technical process and results in a digital ledger of cryptocurrency transactions that is difficult for hackers to crack. In addition, the transactions require a two-factor authentication process. Unfortunately, this does not mean that cryptocurrencies cannot be hacked. In 2018, hackers stole money from Coincheck - around $534 million, and BitGrail - for almost $195 million, making them the two largest cryptocurrency hacks.

Furthermore, unlike government-backed money, the value of virtual currencies is entirely determined by supply and demand. This can cause huge fluctuations, bringing investors significant profits and large losses. Also, cryptocurrency investments are subject to far less regulatory protection than traditional financial products like stocks, bonds, and mutual funds.

Is Cryptocurrency a Good Investment?

Cryptocurrency is a good investment, but you must understand it is a high-risk gamble. It may pay off, but there's a good chance you'll lose all your money. If you invest in cryptocurrency, do so based on facts, not hype. Cryptocurrency exchanges are vulnerable to hacking and are sometimes targets of criminal activity. Security breaches can lead to significant losses for investors who have had their digital currencies stolen. Many cryptocurrencies, such as Bitcoin and Etherium, are launched with lofty goals that can be achieved in the long term. Although unfortunately, no one can guarantee the success of any cryptocurrency project, early investors in a crypto project that achieves its goals can be generously rewarded in the long run. However, any cryptocurrency project needs widespread adoption to be considered a long-term success.

Some tips for investing in cryptocurrency safely

Consumer Reports notes that all investments involve risk. However, some experts consider cryptocurrency one of the riskiest investment options. Follow recommendations to help you make an informed choice if you plan to invest in cryptocurrencies.

Research the Exchange

Before you invest, learn more about cryptocurrency exchanges. Research this information, read reviews, and talk to more experienced investors before moving forward.

Learn how to store your digital currency

When you buy cryptocurrency, you have to store it properly. You can keep it either on an exchange or in a digital wallet. While there are different wallets, each has advantages, technical requirements, and security features. As with sales, you should research your storage options before investing.

Diversify your investments

Diversification is integral to a reasonable investment strategy, which is true when you invest in cryptocurrency. However, you shouldn't support all of your money in bitcoin just because the name is familiar to you. There are many other options you can allocate your investments to.

Get ready for volatility

Because the cryptocurrency market is highly volatile, be prepared for solid ups and downs. You will see dramatic price fluctuations. If your mental well-being or investment portfolio can't handle it, cryptocurrency may not be your smartest choice. Cryptocurrency is in vogue now, but remember that it is still in its infancy and considered highly speculative. Investing in something new is always fraught with problems, so be prepared. If you plan to participate, do your research and invest conservatively, to begin with. Also, one way to keep yourself safe online is to use a comprehensive antivirus. For example, Gridinsoft AntiMalware protects you from malware, spyware, and data theft.

Frequently Asked Questions

What is the main purpose of cryptocurrency?
Cryptocurrency was originally created as an anonymous and decentralized mean of payment. Its idea was to be able to earn money and use them for buying goods in any part of the world - the only requirement here was the readiness of both parties. These days, you can see the claims about the potential substitution for fiat money. However, these statements are barely able to get real - just because it has too much questions to its standardization. Moreover, governments are not happy to see the non-controlled array of money - that’s why only a few countries accepted it as a legit way of payment.
Can crypto be converted to cash?

Yes, in several different ways. You can perform a regular wireout transaction from the wallet, if you have connected it to a cryptotrading platform. It will automatically sell your crypto at market price and complete the transaction to your bank account. Alternatively, you can transfer your cryptocurrency to the exchange (it is usually over-the-counter) and get a payback on your card or directly in cash, if such is possible.

In some countries, you can withdraw money from cryptocurrency wallet directly, using special ATMs. Such a service is available only in the countries which applied cryptos as a legal tender – such as El Salvador.

Which crypto will boom in 2022?
Its barely predictable, especially when there is a bear market. 2022 became a hard year for all markets - most of them witness the gaps and moves that were considered impossible a couple years ago. Cryptocurrency market is heavily correlated with stock market, and the latter is now oppressed by the hawkish Federal Reserve policy. Quantitive Tightening (QT), growing account rate, high inflation - all these things create a lot of uncertainty for investors. Thus, waiting for the rapid growth is definitely not a question of the next 6 month.
Will cryptocurrency substitute fiat money?
Not likely, at least within the technologies of modern days. There are two points of concern that makes crypto an unwanted guest for governments - anonymity and impossibility of implementation of any monetary control tools. Anonymity goes against the intention of all governments to track the money flows and thus avoid frauds, money laundering and tax evasion. Monetary control, on the other hand, is an essential tool that allows the country to solve the financial crisis for a price of further, less critical issues. Cryptocurrency may be applied as a payment method that has similar legitimacy status with fiat currencies, but that will be something new, developed exclusively for governmental usage.