CRYPTOCURRENCY is a digital currency that uses blockchain technology and cryptography. There are different types of cryptocurrencies on the market today – many of them are not even currencies in the true sense of the word! From a technical point of view, cryptocurrency is a decentralized network of servers running a client program. At the heart of every cryptocurrency is a consensus algorithm. Mineable cryptocurrencies are popular as well!
The volatility of cryptocurrency prices is a popular topic in the industry. Due to the high volatility, cryptos are a tricky asset class even for experienced investors. Nowadays it’s possible to invest in the crypto market in many different ways. It is important to remember that every crypto investor has the responsibility to file a tax report each year.
The term cryptocurrency is a broad umbrella covering thousands of different cryptocurrencies, technologies, mining, and staking.
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Cryptocurrency is a digital currency
Cryptocurrency is a digital currency that uses blockchain technology and cryptography. Many feel that cryptocurrency is also about the digital revolution of money. Let’s being the learning process by going briefly through the history of cryptocurrencies.
It is important to understand that the first digital currencies were created already in the late 1980s. The 90s also saw several experiments in this field. Some of these digital coins even gained significant popularity. This was influenced by the growth of the internet. However, every crypto failed in one way or another before Bitcoin.
Satoshi Nakamoto was to first to create a cryptocurrency that became a global success story. Nakamoto used the inventions of the previous pioneers and created a system where centralization was replaced with technology. A truly decentralized, open-to-all, digital currency was born.
How is the term cryptocurrency defined? There is still no 100% consensus. You will learn in the next chapters that there are different types of cryptocurrencies on the market. Many of them are not even currencies in the true sense of the word.
In English, the word cryptocurrency has been shortened to crypto in recent years, i.e. the currency part has been dropped out.
The term cryptocurrency could mean the following things:
- A cryptocurrency is a completely digital currency that uses cryptography
- Cryptocurrencies are outside of the traditional banking system
- Monetary policy is built into the code and cannot be changed by a single person
- Cryptocurrencies use a blockchain or similar distributed ledger
- The maintenance work of the blockchain is distributed to miners or validators
- Anyone can do transactions in the network without being censored
Some of these definitions are a bit vague. A good example of this is decentralization, of which there are many levels. Decentralization is not a black-and-white definition even if many want to feel that way. In the background of almost all cryptocurrencies is also a tech company, which is responsible for developing the program code.
You shouldn’t forget the first half of the word cryptocurrency, i.e. cryptography. It is used for confirming transactions and encrypting user accounts. Cryptocurrencies use the so-called public key encryption, which is decades old as technology.
Different types of cryptocurrencies
There are different types of cryptocurrencies on the market today – many of them are not even currencies in the true sense of the word! More and more technically advanced solutions have entered the market in recent years. The word cryptocurrency is already becoming old-fashioned and does not describe the market correctly.
Let’s take a look at what kinds of cryptocurrencies there are. AboutBitcoin.io divides cryptocurrencies into three categories: currencies, platforms, and tokens.
Cryptos such as Bitcoin, Litecoin, Monero, Bitcoin Cash, and Dash are currencies. These are designed as digital money. They are used for digital value transfer and storage and have no other significant features. A coin like this is a cryptocurrency in the true sense of the word.
Platforms are operating systems for smart contracts and decentralized applications (dApps). You can think of them as iOS or Android. The most popular smart contract platform is Ethereum. Other platforms include BNB Chain, Solana, and Cardano.
The third group is tokens. The difference between tokens and currencies is that tokens are created on smart contract platforms, i.e. they don’t have a blockchain. Tokens are often associated with a specific software or service. There are two types of tokens: utility tokens and governance tokens. Chainlink (LINK) is a popular utility token.
It probably makes sense to make a fourth group as well. Cryptocurrency can also store stable value, in which case we talk about stablecoins. These are currencies pegged to the dollar or other fiat currencies. Stablecoins are very useful as means of payment. They are also needed in DeFi applications.
Tens of thousands of cryptocurrencies can be traded on the market today. They all fall into one of the categories mentioned in this chapter. Colloquially, the word cryptocurrency or crypto means all of these. Over time, new terminology will be created to better describe the different types of cryptos.
Cryptocurrency from a technical point of view
From a technical point of view, cryptocurrency is a decentralized network of servers running a client program. This idea may suddenly sound a bit abstract, but let’s dig into this topic in more detail. It is impossible to lump all cryptocurrencies together, so we will make rough generalizations here.
Each crypto has its own software. It is developed either by a decentralized community or a technology company. It’s a bit the same thing as P2P file-sharing programs, such as BitTorrent. The more people run the client program, the more decentralized the cryptocurrency is.
There are often two types of operators in the cryptocurrency network. They are often referred to as nodes. Some act in a supervisory role, relaying transactions and storing blockchain data. In addition to this, every crypto has validators or miners that maintain the ledger.
Cryptocurrencies use a decentralized database called a blockchain. It contains transaction data, i.e. information about how many cryptos have been sent from address A to address B. You can think of each block as a text file full of transactions.
There are also cryptocurrencies that use DAG technology, which resembles a tree structure instead of a blockchain. We won’t go deeper into this topic in this article. You can learn more about DAG cryptos from other articles.
A typical cryptocurrency is pseudonymous. This means that transaction data is open for everyone to read but the sender and receiver are protected with encryption. Below is an example image from the popular Etherscan site.
Addresses are character strings that don’t reveal the owner. The technology used is called public-key cryptography. Each address is created with a public key that is used to prove that you have the private key to control the funds in that address. The public key provides the proof but no one can extract your private key from it. The private key is like your password.
Cryptos are stored in crypto wallets. A crypto wallet can be a mobile, desktop, or browser application. It is a graphical user interface (GUI) for the blockchain. A crypto wallet looks pretty much like your standard online bank application.
The concept of cryptocurrency may seem a bit abstract at first. At the end of the day, it’s just entries in a decentralized ledger called a blockchain. A big difference to fiat money comes from the fact that cryptocurrency only exists digitally.
If you want to learn more about a specific coin, there are detailed beginner’s guides to dozens of cryptocurrencies at AboutBitcoin.io.
Cryptocurrency consensus algorithms
At the heart of every cryptocurrency is a consensus algorithm. This means that it’s time to take one step deeper into the technology part. What is a consensus algorithm?
Every cryptocurrency needs a consensus algorithm to run. As the name suggests, it is an algorithm that tells how the consensus is determined. The consensus is about how the network operators store the transaction data. A consensus must be formed at every second on whether the new transaction data is valid and how hostile actions are handled.
When it comes to consensus algorithms, cryptocurrencies can be divided into two categories: Proof of Work and Proof of Stake. The first of these has become popular through Bitcoin and the latter has conquered the market more broadly in recent years.
Proof of Work, or PoW, requires physical mining equipment to function. The blockchain validators are called miners in this case. Miners provide proofs that they have done enough computational work to be allowed to update the blockchain. The more computing power you sacrifice to the network, the more likely you will be chosen to create a new block. This means you’ll also receive block rewards.
Proof of Stake or PoS does not require physical miners. Thanks to this, the electricity consumption of the PoS network is more than 99.99% lower than the corresponding PoW system. You can become a validator by holding (locking) significant amounts of the coins in question. For example, Ethereum validators must hold the ETH token.
The image below shows data from Cardano (12-2022), which is a popular Proof of Stake cryptocurrency. The Cardano network has more than 3000 staking pools with a total of almost 900,000 delegators. These are entities that delegate their own cryptocurrency to the network’s validators.
The PoS system is based on the idea that no cryptocurrency validator wants to knowingly destroy the value of their own holdings. This creates an incentive to support the network.
There is only a handful of popular cryptos that use Proof of Work consensus. These are mainly cryptocurrencies created more than five years ago. The second largest cryptocurrency on the market, Ethereum, moved to the Proof of Stake consensus as well in the fall of 2021.
It is also good to note that there are already dozens of different variations of Proof of Stake. Almost every PoS system is slightly different from the others.
Mineable cryptocurrencies
Mineable cryptocurrencies are popular as well! This is despite the fact that Proof of Stake cryptos have become increasingly popular. However, there has been a drastic concentration, and the events that took place in the autumn of 2021 changed the crypto market further.
Ethereum used to be an important mineable cryptocurrency with Bitcoin. It was good for the market economy that Ethereum was profitable to mine with GPU rigs. Bitcoin, on the other hand, can be only mined with very expensive ASIC devices.
Ethereum moved away from mining with The Merge update. It was a process that had been prepared for years. So, what did these crypto miners do? Some switched to mining other cryptocurrencies and some simply sold their devices.
The image below shows a GPU mining rig that is used to mine cryptocurrencies.
Cryptocurrency mining hasn’t died or disappeared. There are still mineable smaller cryptos too such as Bitcoin Cash, Litecoin, Dash, Ravencoin, and Dogecoin. However, one can ask the question of the relevance of mining for these coins.
They chose the same path as Bitcoin years ago when Proof of Stake wasn’t a popular consensus option. Now, mining feels like a burden for a meme coin like Dogecoin. It wouldn’t be a shock to see Dogecoin shift to Proof of Stake too in the future.
If you want to learn more about this topic, read our in-depth article about cryptocurrency mining.
The high volatility of cryptocurrencies
The volatility of cryptocurrency prices is a popular topic in the industry. Cryptocurrencies have become popular investments precisely because of drastic price movements. Where exactly does this volatility come from? Can cryptocurrencies become a “boring” asset class in the future and even be comparable to government bonds?
Cryptocurrency prices have high volatility because of three major reasons:
- The crypto market lacks regulation
- The crypto market is small compared to other asset classes
- Too much use of leverage
An unregulated market means that cryptocurrency exchanges are not subject to similar oversight as stock exchanges. The market isn’t monitored with the same intensity either. This is about to change, though. Both the US and the EU are currently preparing a comprehensive regulatory framework for cryptocurrencies.
Because the crypto market has low liquidity it doesn’t take a lot of money to move prices. At least when compared to the liquidity of an average stock on the Nasdaq exchange. A small and unregulated market also makes it easier to manipulate prices.
The popularity of leverage trading increases volatility. When the price of a cryptocurrency moves fast in one direction or another it starts to liquidate leveraged traders. This leads to new forced selling (or buying, if it’s shorting), which gives momentum to the price move.
There is still no evidence that volatility has disappeared even for the major cryptocurrencies. Cryptos that are worth tens of billions of dollars can move tens of percent in one day or more than a hundred percent in a week.
If you invest in cryptos, we recommend following the market much more actively than you are used to with stocks. The AboutBitcoin.io has its own page where you can see the prices of the most popular cryptocurrencies: cryptocurrency prices. Cryptocurrency prices are followed globally in dollars.
Cryptocurrency as an investment
Due to the high volatility, cryptos are a tricky asset class even for experienced investors. It is a very special asset that is still in its infancy. Such a market involves a wide variety of risks, which the investor must be aware of.
The first issue was already mentioned in the previous chapter: the high volatility of cryptos. Cryptocurrency prices move very fast in both directions. Few experienced investors are used to such volatility. In fact, even seasoned crypto investors have a tough time “controlling their stomachs” in this market.
Even if the crypto market follows the stock market pretty closely, there are some crypto-only triggers that move the market up and down. A good example of this is the collapse of the FTX exchange in November 2022.
In addition to FTX, the year 2022 has also seen numerous large-scale bankruptcies. Many crypto investors have lost their money in services considered safe. You can protect yourself from these risks by preferring cryptocurrency brokers that are under your local jurisdiction and regulation.
So, there is extreme volatility and bankruptcies involved with crypto. Surely there is some upside as well because hundreds of millions of investors are involved in this market?
Many feel that the risk/return ratio of cryptocurrencies is excellent when all things considered. There are exceptional opportunities in crypto compared to traditional markets. Anyone can beat the richest and smartest gurus on Wall Street in crypto.
There are also a lot of small coins that the whales can’t properly invest in. In addition, crypto investments can be leveraged with DeFi services to accumulate interest. Not to mention the NFT world, where millions of dollars have been made out of nothing.
AboutBitcoin.io has a separate article where this subject is reviewed in more detail. Learn all about cryptocurrency investing today!
How to buy cryptocurrencies?
Nowadays it’s possible to invest in the crypto market in many different ways. You can buy crypto in a traditional way or invest through futures, options, and ETF funds. Ten years ago you had to buy cryptocurrency “physically” in your own cryptocurrency wallet, but now it is also possible to benefit from the price action through derivatives.
Buying cryptocurrencies has traditionally been done through crypto marketplaces. These are either brokers or exchanges. Coinmotion is an example of a broker. Binance, on the other hand, is an example of an exchange.
The difference is that a broker will buy the cryptos for you at the promised price and delivers the coins to your account. In exchange, it’s investors who buy and sell the coins and the exchange only facilitates the trades. A broker has typically higher fees and it’s more designed for beginners.
If you want to buy cryptocurrencies in the “traditional way”, you have to also think about storage. Crypto investors shouldn’t store coins long-term in an exchange or in a broker. You should learn how to store crypto yourself. Read our article on cryptocurrency wallets to learn more.
There are more and more crypto buyers who come from the traditional investing world. These people don’t want to be bothered with wallets. They just want to be part of the price action. EFTs will give you this option. Your portfolio gets the same upside but you don’t have to worry about hacks or safe storage of your coins.
In addition to EFTs, there are also futures available for the biggest cryptocurrencies. These contracts can be leveraged up to 100x. We absolutely do not recommend playing with futures or derivatives unless you are a professional. A crypto investor should also be aware of the tax treatment of different instruments. It might be there are different tax codes for futures and CFDs compared to spot trading.
If you want to learn more about the buying process, we have made an in-depth article about it. Read more about how to buy crypto and what steps this process includes.
Taxation of cryptocurrencies
It is important to remember that every cryptocurrency investor has the responsibility to file a tax report each year. Many feel this is painful, but nowadays the workload can be significantly reduced with useful tax tools.
So, how does crypto taxation work? In simplified terms, you have to calculate capital gains each time you make a transaction. Whether you sell your cryptos to fiat (EUR, USD, SEK, NOK, etc), trade your coins for another crypto, or use crypto for purchasing of goods or services.
If you sell e.g. your Litecoin for dollars, it is a taxable transaction. If you trade Litecoin for Ethereum, it is a taxable transaction. If you buy a cup of coffee with Litecoin…yes, a taxable transaction. This is how it works in most countries. You should always get familiar with the tax laws of your own country before buying and selling crypto.
These tax laws also prevent the use of a cryptocurrency as means of payment, even if it would be accepted at your local store. You should pay with fiat money and keep crypto in your wallet. It would make as much sense to sell part of your stock portfolio for making simple purchases.
Why do many investors see taxation as a big problem? This is because crypto exchanges don’t automatically send your tax information to the authorities. Each transaction must be recorded and any capital gains calculated individually. This can easily become a huge task if you do day trading.
It’s a good idea to use crypto tax software like Koinly. It’s localized for many languages and helps you to print the required forms.
The best thing about Koinly is that all you have to do is enter the transactions. Koinly handles the calculation of capital gains for you. Of course, it is smart to double-check the information and update it every 1-2 months. Also, remember to take screenshots of the crypto exchange trades and your wallet transactions. You might need them in the future if the tax authorities require proof.
Cryptocurrency summary
The term cryptocurrency is a broad umbrella covering thousands of different cryptocurrencies, technologies, mining, and staking. In addition to this, investing in crypto can be done in many different ways. Don’t forget wallets and taxation either!
The purpose of this article is to provide a proper summary of the term cryptocurrency. It provides an overview of crypto for beginners. You can jump deeper into the rabbit hole and read in-depth articles on each sub-topic.
Remember that there are beginner’s guides to dozens of cryptocurrencies at AboutBitcoin.io! Click crypto -> crypto guides from the main menu. These articles will give you an in-depth overview of each coin. We always recommend doing your own research. Both Youtube and Google are full of great information.
On a general level, it is good to understand that the crypto industry is constantly changing. Technologies are developed, the market matures, new regulation emerges, new tax laws are introduced, better wallet software is introduced, new crypto exchanges enter the market, etc.
A stock investor can check his portfolio once a year and make the necessary changes. We recommend checking the status of your crypto portfolio once a week. At least read our news and market overviews, and you will stay up to date on all the most important events.
We hope this article gave you a good start in the world of cryptocurrencies.