What Is Cryptocurrency And How Does It Work?

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Cryptocurrency is decentralized digital money that is based on blockchain technology and secured by cryptography. To understand cryptocurrency, one needs to first understand three terminologies – blockchain, decentralization, and cryptography. 

In simple words, blockchain in the context of cryptocurrency is a digital ledger whose access is distributed among authorized users. This ledger records transactions related to a range of assets, like money, house, or even intellectual property. 

The access is shared between its users and any information shared is transparent, immediate, and “immutable”. Immutable means anything that blockchain records is there for good and cannot be modified or tampered with – even by an administrator.

Centralized money refers to the regular money that we use, which is governed by authorities like the Reserve Bank of India. Decentralization in cryptocurrency means there is no similar authority that can be held responsible for supervising the rise and fall of a particular cryptocurrency. This has many benefits over centralized money. 

Some of these benefits include the following:

  • There is no need for currency owners to “trust” a single governing entity, as everyone in the network has access to the same information that cannot be altered.
  • Data remains accessible only to the users of the network and it is heavily secured. Shared ownership also means all users sign off on how accurate the data is, which means there is very little scope for data mismanagement or miscommunication. Think of it as a democracy.
  • Security, which is a fundamental part of a blockchain. 

Cryptography is the method that secures data from unauthorized access by the use of encryption techniques. Most of the claims that blockchain makes, like privacy and immutability, are enabled through cryptography. 

The roots of cryptocurrency technology can be traced back to the 1980s with the invention of what is called a “blinding algorithm”. The algorithm is all about secure and immutable digital transactions. It remains fundamental to the modern-day digital currency. 

In 2008, a group of people (currently known under the pseudonym Satoshi Nakamoto) created the guiding principles of the first and leading cryptocurrency in the market today, Bitcoin. In 2009, Bitcoin was launched to the world. But it would be years before it was formally recognized as a means of payment among leading merchants, starting with WordPress in 2012.

The underlying blockchain technology is today used in banking, insurance, and other business sectors. Growing at a compounded annual growth rate of 12.8% since 2021, the cryptocurrency market is estimated to reach $4.94 billion by 2030, thanks to the need to improve the efficiency of today’s payment systems, rise in global remittances and increased need to secure data.

How Does Cryptocurrency Work?

Cryptocurrencies are not controlled by the government or central regulatory authorities. As a concept, cryptocurrency works outside of the banking system using different brands or types of coins – Bitcoin being the major player. 

1. Mining

Cryptocurrencies (which are completely digital) are generated through a process called “mining”. This is a complex process. Basically, miners are required to solve certain mathematical puzzles over specially equipped computer systems to be rewarded with bitcoins in exchange. 

In an ideal world, it would take a person just 10 minutes to mine one bitcoin, but in reality, the process takes an estimated 30 days.

2. Buying, selling, and storing

Users today can buy cryptocurrencies from central exchanges, brokers, and individual currency owners or sell it to them. Exchanges or platforms like Coinbase are the easiest ways to buy or sell cryptocurrencies. 

Once bought, cryptocurrencies can be stored in digital wallets. Digital wallets can be “hot” or “cold”. Hot means the wallet is connected to the internet, which makes it easy to transact, but vulnerable to thefts and frauds. Cold storage, on the other hand, is safer but makes it harder to transact. 

3. Transacting or investing

Cryptocurrencies like Bitcoins can be easily transferred from one digital wallet to another, using only a smartphone. Once you own them, your choices are to: 

a) use them to buy goods or services 

b) trade in them 

c) exchange them for cash

If you are using Bitcoin for purchases, the easiest way to do that is through debit-card-type transactions. You can also use these debit cards to withdraw cash, just like at an ATM. Converting cryptocurrency to cash is also possible using banking accounts or peer-to-peer transactions. 

Types of Cryptocurrencies

There are tens of thousands of cryptocurrencies available today with the figure pegged at 10,000 in 2022. Major cryptocurrencies include the following:

Bitcoin is the world’s first widely accepted form of cryptocurrency. Bitcoin is so popular, there was a time when its name was synonymous with cryptocurrency. But potential investors need to know bitcoins have become very expensive. In 2021, the cost of one Bitcoin was $68,000. But the good news is, you don’t always have to buy an entire coin, you can buy smaller fractions of it.

Altcoin is the term used for any alternative digital currency to bitcoin. The most popular in this ecosystem is Ethereum – one of the fastest-growing cryptocurrencies in the market. There is also a range of other altcoins in the market today such as Luckyblock, Shiba Inu and Terra.

The concept of crypto coins vs tokens can be confusing to many. At first glance, coins and tokens appear the same. However, the two have many differences 

  • Coins can be mined, but tokens cannot be mined. 
  • Coins are linked to blockchains, tokens are not. 
  • In terms of utility, they vary in the type of product or service they allow users to purchase. 

Should You Invest In Cryptocurrency? 

There are many advantages to dealing in cryptocurrencies, and a fair share of disadvantages as well. Here are the top three reasons that work in favor of and against cryptocurrencies.

Advantages:

  • They are private and secure: The blockchain technology that fuels cryptocurrencies ensures user anonymity. It also assures high levels of security through cryptography, which we discussed before. 
  • They are decentralized, immutable, and transparent: The entire system functions on shared ownership, where data is available to all permissioned members and is tamper-proof.
  • They are a hedge against inflation: Cryptocurrency makes for a great investment in times of inflation. For example, investors often compare cryptocurrency to gold. One of the reasons behind this is that, just like gold, they are in limited supply, as there is a cap on mining any type of cryptocurrency. 

Disadvantages:

  • They are not widely understood: They are a relatively new concept and the long-term sustainability of cryptocurrencies remains to be seen.
  • They are prone to high risks: Needless to say, cryptocurrencies bring in as many rewards as risks. Their highly volatile and speculative nature makes them prone to sharp downward spirals. Investing in cryptocurrency can be risky for many reasons. 
  • A major deterrent could be the fact that digital currency seems to have no inherent or underlying value. There is a supply-demand type of equation that is used to determine the value of cryptos like bitcoins. 
  • Plus, it is easy to see how simple speculations over the internet can result in a substantial rise or loss of value of these coins. 
  • Also the fact that cryptocurrencies are banned or their usage restricted in a lot of countries plays out as a significant risk. Their legality is debatable in countries like India. 
  • Scalability is a problem: This is a complex issue, which has more to do with the technology side of the blockchain. Simply put, the sluggish nature of the blockchain makes it prone to transactional delays. This has the tendency to make crypto payments inefficient when compared to modern-day electronic payment techniques.

Cryptocurrency in India

Until the 2022 Union Budget announcement, the fate of cryptocurrency in India was largely undecided. 

In the Budget, the Indian Finance Minister’s announcement on levying a 30% tax on gains on the transfer of virtual digital assets, which includes cryptocurrency, was initially seen as an endorsement of cryptocurrencies. It set off the debate on whether or not the tax on cryptocurrency indicates the government has recognized it as a legitimate form of currency. 

However, this isn’t true and there have also been speculations that a ban on private cryptocurrencies would follow the launch of the RBI’s own official digital currency. Something to this effect was openly stated by RBI Deputy Governor T Rabi Sankar in February 2022, when he said it was advisable for India to ban cryptocurrency. Will this turn out to be similar to the government’s ban on cryptocurrency in 2018 (which was overturned by India’s Supreme Court in 2020) remains to be seen.

Bottom Line

Whether cryptocurrency is the future of money or not, one thing is clear: It is not advisable for anyone to invest in it without doing enough research. Investing in cryptocurrencies is not a new phenomenon. But with the recent surge in popularity and value, coupled with falling returns on bank deposits, more people are looking for cryptocurrency advice. 

If you have decided to invest in cryptocurrencies, ensure that you start with the leading cryptocurrencies like bitcoin, as newer ones may not have sufficient liquidity (you may not be able to sell them when you want to). The market is rife with…



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