How does cryptocurrency work? | NextAdvisor with TIME

The cryptocurrency market grew from less than $ 200 billion to almost $ 3 trillion in 2021, attracting a flood of new crypto investors in the process.

But then it all fell apart in the first half of 2022. Although the crypto market is still worth around $ 900 billion, the risk has become quite clear in recent months for investors who have been attracted to this emerging asset class.

Therefore, it is more important than ever for investors to do their due diligence and understand what they are investing in. If you are thinking of investing in crypto, you may be wondering: What exactly is cryptocurrency? And how does it work?

Here’s what investors should know about it and how you can be smart with your crypto investments.

What is cryptocurrency?

Cryptocurrency is a form of digital currency that in theory can be used to buy goods and services, but which in practice is more often bought and sold as investments or used to run decentralized finance (DeFi) software projects on various blockchains.

Bitcoin was the first cryptocurrency, and in the years since its introduction, the number of coins available for purchase has grown to more than 19,000. Bitcoin was designed for digital payments, although investors have seen it more as a value store than a convenient digital currency. It is often described as a form of “digital gold.” Bitcoin’s record high price was around $ 69,000 in November 2021, although a sharp fall in 2022 has taken it down to around $ 20,000.

Ethereum is the second largest cryptocurrency, but unlike bitcoin, it functions more as a software platform. Developers are buying into the ethereum network to build crypto-oriented apps and software. Ethereum also reached its record high in November 2021, reaching $ 4,878. But like bitcoin, the value has fallen in 2022 and has recently traded around $ 1,000.

What is Blockchain and how is it related to crypto?

Cryptocurrencies are operated by blockchain networks. A blockchain is actually a digital ledger that consists of expanding data blocks.

With a blockchain distributed ledger, records are stored across multiple computers in a network. Each computer is called a node, and these nodes verify and store the data. As new transactions are completed, they are added to a “block” of data, and then the block is added to the chain. The entire ledger can be updated as new transactions arise.

Many crypto enthusiasts say that blockchain technology has the potential to underpin the next development of the internet, sometimes called web3. It is possible to use blockchain technology for gaming, finance and other purposes. And to complete transactions, you need to be able to pay the appropriate fee in the related cryptocurrency.

What is the value of cryptocurrency and how is it determined?

The value of a cryptocurrency depends on several different factors. With so many cryptocurrencies, it can be difficult to determine which ones are really valuable.

Like many other assets, demand is one of the main drivers contributing to the value of a cryptocurrency. If more people use a coin or a blockchain attached to a coin, it is more likely to see an increase in price.

Well-established cryptocurrencies such as bitcoin and ethereum are used by many, so they have a higher perceived value. Because more people use these networks, the prices of bitcoin and ethereum are higher than other cryptocurrencies. Some experts also point to the first-mover advantage that bitcoin and ethereum have in terms of putting the market in the first place.

Offers can also affect the price of cryptocurrency, or at least investors’ perception of value. Many experts say that bitcoin is more likely to maintain its value because there is a ceiling on how many bitcoins can exist. Only 21 million can exist, so scarcity is believed to contribute to the value, in contrast to a cryptocurrency that does not have an upper limit.

When considering which cryptocurrencies to invest in, it is good to look at coins that have a strong use case and greater likelihood of wider adoption. One of the reasons why ethereum is considered valuable (second only to bitcoin) is because its smart contracting capabilities make it possible to build a variety of applications, including for finance and gaming.

How can you use cryptocurrency?

It is possible to use bitcoin and other cryptocurrencies to buy things in the real world, but experts say it does not make sense to most people. The volatility and fluctuations in the value of crypto mean that the price you pay today can be much higher or lower tomorrow.

In addition to using crypto as an investment, it can also be used to access blockchain networks such as ethereum and other networks that enable developers to build software on.

“It is possible to use cryptocurrency to pay for the use of networks as well,” says Adam Blumberg, CFP, co-founder and president of Interaxis, a company that trains financial advisors on cryptocurrencies. “If I want a smart contract transaction on ethereum, I have to use ether to pay for the use of the network.”

There are also various crypto-debit and credit cards available, linked to exchange accounts, that allow you to integrate real purchases with your crypto portfolio. Even PayPal allows you to use cryptocurrency to pay online.

But the most common use of cryptocurrencies is as investments. And there are signs of increasing mainstream availability of such crypto investments. For example, Fidelity recently announced plans to add bitcoin to its 401 (k) plans. There are also autonomous IRA managers who join a stock exchange such as Coinbase to create a way for you to invest your cryptocurrency in tax pension plans.

How is cryptocurrency recovered?

Cryptocurrency recovery is a process of using computing power to help validate transactions on a blockchain. Miners lend their computing power to the network to help complete transactions. In return, those who solve cryptographic puzzles and do other arithmetic work can be rewarded with more cryptocurrency.

Crypto mining has become increasingly challenging – and competitive – over the years. To provide the computing power needed in an increasingly competitive environment, many miners build or purchase specialized equipment. This can be costly, and it does not guarantee that you will receive the reward for mining. There are also environmental considerations that come with crypto mining, thanks to the enormous amounts of electricity required to operate increasingly sophisticated and powerful mining computers.

How is cryptocurrency stored?

There are different ways to store your cryptocurrency. Many crypto exchanges allow you to store your coins on the exchange. However, if your coins are in exchange, they may be vulnerable to a hack. While some exchanges maintain insurance to reduce losses, it is important to note that cryptocurrencies do not have the same federal protections and guarantees as your conventional equity portfolio.

The safest way to store cryptocurrency is with a crypto wallet. There are two main types of wallets:

• Warm wallets is connected to the internet and can be accessed via the browser or the phone. They are easy to access and you can connect them to various online marketplaces. You can quickly send your cryptocurrency from a stock exchange to a hot wallet, and store them separately. Hot wallets are sometimes called software wallets.
• Cold wallets is not connected to the internet. These are hardware wallets that are similar to a USB drive. Cold wallets are often more expensive than warm wallets, but they are considered safer. Since they are not connected to the internet, they are not as vulnerable to hackers. But it also means that if you lose your cold wallet, you could lose crypto forever.

When choosing between a warm wallet or a cold wallet, it is important to understand the risks associated with each one.

A warm wallet often has a way for you to retrieve lost keys. You can usually use them as another account with a password. As long as you have the right password phrases, you can often get in again. However, you must be willing to take the security risk.

With a cold wallet, you are less vulnerable to hacks, but you may not have the easy recovery. If you forget the keys needed to access your wallet, you may not be able to access cryptocurrencies. In addition, if the hard wallet is destroyed without backup, you may also lose your belongings.

When storing crypto, it is important to find a system that works for you. For trading, it may make sense to keep coins on a stock exchange. However, you may also want a warm wallet for online transactions and moving your cryptocurrencies. For long-term storage, a cold wallet may be the best option, as experts recommend cold wallets for top security. You can use a combination of storage options to get the result you want.

Based on our own research and input from experts, we believe that these are the best cryptocurrencies for most long-term investors: