Cryptocurrencies have been around for over a decade, but these new digital assets have confused many investors. Investors can easily understand tangible assets, such as real estate and company shares. Virtual currencies do not have the tangible element, but their returns have outpaced most investments. As a result, some people believe they have missed the crypto opportunity, while others may have concerns about some of the pump-and-dump schemes in the crypto space. This simplified crypto explanation will help you understand the basics of cryptocurrencies.
Cryptocurrencies are decentralized assets that emerged when Satoshi Nakamoto launched Bitcoin in 2009. The popular cryptocurrency was a direct response to the financial crisis, which exposed flaws in the financial system. Lacking a central authority gives consumers more control over digital currency like Bitcoin. The Federal Reserve and other central authorities pumped money into the global economy in recent years, and those actions contributed to the worst inflation in over 40 years. Cryptocurrencies do not suffer from this problem. A group of people makes decisions about the blockchain network instead of a single entity. Some cryptos have fixed supplies. Other cryptocurrencies use a consensus mechanism that lets coin holders vote on the future direction of the blockchain. Investors can choose from thousands of cryptocurrencies that belong to three groups.
Bitcoin is the original cryptocurrency that made its debut in 2009. This cryptocurrency has provided generational returns for early adopters and attracted many people to crypto and blockchain technology.
Altcoins are a large group of cryptocurrencies that came after Bitcoin. Ether is the most established altcoin and has the second-largest market cap of any crypto. Several altcoins have relevant applications, such as smart contracts, but some of these cryptos are pump-and-dump schemes.
Tokens are a type of cryptocurrency that represents a tradable asset. You can buy and sell tokens as you would with any other asset. Some companies offer utility tokens that provide special perks. Token holders may get access to discounts, exclusive content, and other rewards for using and holding onto their tokens.
How Cryptocurrency Works
Before we understand crypto, we must first understand blockchain technology. Every cryptocurrency relies on a blockchain to conduct transactions. Each transaction gets put on a blockchain’s ledger. Several transactions go into a block, and enough blocks make up a chain. Transactions are immutable and cannot be changed by a central authority.
A cryptocurrency uses cryptographic codes for each transaction, effectively encrypting the identities of buyers and sellers. This dynamic helps people conduct crypto trades anonymously. Privacy has become a concern for many consumers. Some people do not want others to know how they use their money. Other people are wary of cyberattacks. When hackers infiltrate corporations, they can access the personal details of millions of customers. Those hacks can reveal some of your sensitive data, ranging from your name and email address to your home address and credit card number. Of course, consumers don’t want that information falling into the wrong hands, but centralized data hubs always create that risk. Cryptocurrencies remove that risk with their decentralized structure.
You store physical money and legal documents in your wallet. It’s a valuable resource that most people carry with them when they leave the house. Since crypto is a virtual currency, it won’t have a place in your physical wallet. Investors store crypto in a crypto wallet. These wallets have varying levels of protection and convenience, but you often trade one for the other.
Hot wallets offer greater convenience but have more risks. Hot wallets are connected to the internet, making buying and selling crypto easy. Most day traders use crypto wallets for their simplicity. It’s less of a hassle to trade crypto with a hot wallet than with cold storage. However, staying connected to the internet keeps your crypto on the grid. Hackers target crypto companies and purge hot wallets of their resources. If someone obtains your wallet’s keys, they can access all of your cryptos and steal your funds.
Decentralized finance has many benefits, but it currently operates like the Wild West. For example, the FDIC will not bail you out if you lose your crypto from a cyberattack. Some cryptocurrency exchanges have crypto insurance that can offer some aid, but crypto hacking is a serious concern.
A cold wallet offers more protection. It’s similar to hiding your money under the rug. You take your crypto off the grid, so hackers can’t steal your funds. You can get a hard drive wallet and store your crypto in this wallet. You will have to plug the hard drive wallet into your computer to access your funds, creating a slight inconvenience. However, you are immune from cyber attacks when your crypto is in your disconnected hard drive. Unfortunately, you will lose your fortune if you lose the hard drive.
Some investors opt for paper wallets. For these wallets, you have to type your crypto keys on a piece of paper. Hackers can’t get into your wallet by hacking it online, but anyone with the paper wallet’s details can access your crypto. Most investors write their key numbers on several pieces of paper, creating multiple paper wallets. Multiple wallets offer protection in case your main paper wallet gets lost or damaged.
Crypto exchanges have made cryptocurrencies more accessible. They remove many of crypto’s complexities. You don’t have to create a wallet or worry about storing crypto. The crypto exchanges store crypto for you and let you buy and sell crypto through their brokerage platforms. Some exchanges give you the flexibility to add a wallet for more control over your crypto. You should review several crypto exchanges and check their fees. Some exchanges charge excessive fees that can wipe out profits from trading crypto.
Benefits and Risks of Cryptocurrency
Cryptocurrencies have benefits and risks, just like any investment. Cryptocurrencies have generated substantial returns for long-term investors that have outpaced index funds and most asset classes. Staking crypto can also generate high-interest rates. Some cryptocurrencies can generate yields over 10% just by holding onto them.
The main risk with cryptocurrencies is their volatility. Bitcoin is down more than 50% from its all-time high, but that’s nothing out of the ordinary. Bitcoin has endured several crashes during its short history. The cryptocurrency can quickly shoot up 100% and similarly fall 50%. Early investors who continued holding onto Bitcoin have made wonderful returns, but anyone who bought a few months ago is likely sitting in the red.
The risks and potential rewards extend when you browse through altcoins. Some altcoins do not provide any utility and are speculative investments. These cryptocurrencies have higher deviations than Bitcoin. Although Bitcoin is over 50% down from its all-time high, Dogecoin is down over 90% from its all-time high. Long-term Dogecoin holders made more money than Bitcoin holders in 2021 and even rivaled Bitcoin’s returns from the early days. However, the altcoin took a substantial hit in 2022. Crypto is a high-risk investment with a high potential payoff. Volatility defines the crypto investing experience.
What Can You Do with Cryptocurrency?
Cryptocurrency owners have several choices for how to use their assets. We explore basic concepts and options below.
Buying cryptocurrencies gives you more exposure to the crypto market. You can sell crypto to reallocate your portfolio or purchase goods and services. More companies are warming up to crypto, with thousands of merchants accepting Bitcoin as an alternative form of payment.
Not every long-term investor can stomach the volatility of cryptocurrencies, but day traders thrive in this environment. Traders capitalize on price fluctuations and analyze charts to predict short-term price movements. If you want to trade cryptocurrencies, look for an exchange with low or zero trading fees.
Some crypto investors mine crypto using advanced technology. Bitcoin mining isn’t for everyone, as the most serious investors have entire warehouses filled with computers for the sole purpose of mining crypto. Crypto mining applies to cryptocurrencies that use a proof of work system. The proof of stake system is a more environmentally friendly approach that more cryptocurrencies have adopted. Proof of stake uses existing crypto instead of algorithmic codes to reward blocks of crypto to investors.
The proof of stake system distributes blocks that contain crypto. The more crypto you have, the more likely you will qualify for one of these blocks. Some people want to borrow your crypto to increase the odds of qualifying for a reward. Long-term investors let other people stake their crypto and earn interest payments for doing so. While established cryptos have lower interest rates, you can find some cryptos that yield over 10% per year.