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27
Nov
cryptocurrency

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What is cryptocurrency?

Cryptocurrency is a digital currency that utilizes cryptography and uses a decentralized database. There are different types of cryptocurrencies on the market. From a technical perspective, 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. There are several ways to invest in the cryptocurrency market these days. It is important to remember that every cryptocurrency investor is responsible for filing a tax report each year.

Cryptocurrency is a broad umbrella covering thousands of cryptocurrencies, technologies, mining, and staking.

Cryptocurrency is a digital currency

Cryptocurrency is a digital currency that utilizes cryptography and uses a decentralized database. Cryptocurrency works only digitally and cannot be converted into bills or coins. The word cryptocurrency is shortened colloquially and in social media discussions to crypto.

There is not yet a standardized definition of cryptocurrency. Most cryptocurrencies on the market are not digital money per se but have different roles and functions. Crypto classifications will be reviewed in more detail in the next chapter.

The following are the main features of cryptocurrencies:

  1. Cryptocurrency is an entirely digital currency that uses cryptography
  2. Cryptocurrency uses a distributed database solution (e.g., blockchain)
  3. The maintenance of its distributed database is done in a distributed manner
  4. Cryptocurrency is disconnected from the traditional monetary system
  5. Anyone can perform crypto transactions without being censored or blocked

It is essential to understand that the history of digital currencies goes back to the 1980s. The 1990s also saw several different experiments, some gaining significant popularity. The spread of the internet influenced this. However, every digital currency failed for one reason or another.

Satoshi Nakamoto was the first to create a decentralized cryptocurrency that became a global success story. Nakamoto utilized the inventions of previous pioneers and created a system where technology replaced centralized operators. A truly decentralized digital currency called Bitcoin was born.

Different types of cryptocurrencies

There are different types of cryptocurrencies on the market. 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. We divide cryptocurrencies into three categories: currencies, platforms, and tokens.

  1. Currencies include Bitcoin, Litecoin, Monero, Bitcoin Cash, and Dash. These are designed for digital value transfer and storage and have no other significant features. In the early days, cryptos used to be just currencies.
  2. Platforms are innovative operating systems for smart contracts and decentralized apps (dapps). You can think of them as iOS or Android. The most popular smart contract platform is Ethereum, and other well-known platforms include BNB Chain, Solana, and Cardano.
  3. Tokens are launched on an existing platform, such as Ethereum. Tokens are often associated with a specific dapp. Chainlink, Aave, and Uniswap are examples of tokens.

In addition to this, a fourth group can also be distinguished: stablecoins. These are currencies pegged to fiat (USD, EUR, etc.), which means they work very well as a means of payment. They are also needed in DeFi applications as collateral.

Read more about stablecoins from our comprehensive guide: What is a stablecoin?

Tens of thousands of cryptocurrencies can be traded on the market today. They all fall into one of the categories described above. Colloquially, the word cryptocurrency or crypto means all of these. Over time, new terminology will undoubtedly be found to describe different cryptos better.

Cryptocurrency from a technical perspective

From a technical perspective, cryptocurrency is a decentralized network of servers running a client program. This idea may sound abstract, but let’s investigate this topic more. It is impossible to lump all cryptocurrencies together so we will make rough generalizations here.

Each crypto has its software. It is developed either by a decentralized community or a technology company. It’s 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 levels of actors in the network, called nodes. Some nodes act in a monitoring role, relaying transactions and storing blockchain data. In addition to this, every cryptocurrency has validators or miners that build the decentralized database.

Cryptocurrencies use a decentralized database. It mainly contains transaction data, i.e., information about how many cryptos have been sent from address A to address B. Each block is like its own file or transaction list.

Blockchain is the most popular type of distributed database. Some cryptocurrencies on the market also use DAG technology, which resembles a tree structure instead of a blockchain.

A typical cryptocurrency is pseudonymous. This means the transaction data is visible, but the sender and the receiver cannot be interpreted from the data. You can only see the addresses and amounts being sent.

The image below shows Ethereum network transactions from the popular website Etherscan.

etherscan

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 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. 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. It’s just entries in a decentralized ledger called a blockchain. A significant difference to fiat money is that cryptocurrency only exists digitally.

If you want to learn more about a specific coin, our website has detailed beginner guides to dozens of cryptocurrencies.

Cryptocurrency consensus algorithms

At the heart of every cryptocurrency is a consensus algorithm. This means it’s time to take a more profound step into the technology part. What is a consensus algorithm?

Every cryptocurrency needs a consensus algorithm to run. As the name suggests, an algorithm tells how the consensus is determined. The consensus is about how the network operators store the transaction data. At every second, a consensus must be formed on whether the new transaction data is valid and how hostile actions are handled.

Regarding consensus algorithms, cryptocurrencies can be divided into two categories: Proof of Work and Proof of Stake. The first has become famous 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 prove 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 have the ETH token.

The table below shows data from Cardano, a popular Proof of Stake cryptocurrency. Delegators are the entities that delegate their cryptocurrency to the network’s validators.

Cardano stakingInfo
Delegators 925,504
Pools 3,114
Staking ratio 65%

The PoS system is based on the idea that no cryptocurrency validator knowingly wants to destroy their holdings’ value. This creates an incentive to support the network.

Only a handful of popular cryptos 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 in the fall of 2021.

It is also good to note that there are already dozens of variations of Proof of Stake. Almost every PoS system is slightly different from the others.

Read more from our in-depth guide: Cryptocurrency consensus algorithms explained.

Mineable cryptocurrencies

Mineable cryptocurrencies are popular as well. This is even though Proof of Stake cryptos have become increasingly popular. However, there has been a drastic concentration, and the events in the autumn of 2021 changed the crypto market further.

Ethereum used to be an essential 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 only be mined with costly 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 sold their devices.

The image below shows a GPU mining rig used to mine cryptocurrencies.

crypto mining rig

Cryptocurrency mining hasn’t died or disappeared. There are also mineable smaller cryptos, 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 in the future.

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:

  1. The crypto market lacks regulation
  2. The crypto market is small compared to other asset classes
  3. Too much use of leverage

An unregulated market means 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. The US and the EU are preparing a comprehensive regulatory framework for cryptocurrencies.

Moving prices doesn’t take much money because the crypto market has low liquidity. 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 worth 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. AboutBitcoin.io has a 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 an exceptional asset that is still in its infancy. Such a market involves various risks, which the investor must know.

The first issue was 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. Even seasoned crypto investors have difficulty “controlling their stomachs” in this market.

Even if the crypto market follows the stock market closely, some crypto-only triggers move the market up and down. An excellent example of this is the collapse of the FTX exchange in November 2022.

In addition to FTX, 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 under your local jurisdiction and regulation.

So, there is extreme volatility and bankruptcies involved with crypto. Surely there is some upside because hundreds of millions of investors are interested in this market?

crypto investor

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 brightest 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 from nothing.

AboutBitcoin.io has a separate article where this subject is reviewed in more detail. Learn all about cryptocurrency investing today!

How do you buy cryptocurrencies?

There are several ways to invest in the cryptocurrency market these days. You can traditionally buy crypto or invest through futures, options, and ETF funds. Ten years ago, you had to buy cryptocurrency “physically” in your 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 deliver the coins to your account. In exchange, investors buy and sell the coins, and the exchange only facilitates the trades. A broker typically has higher fees and is more designed for beginners.

If you want to buy cryptocurrencies in the “traditional way,” you must also think about storage. Crypto investors shouldn’t store long-term coins in an exchange or a broker. You should learn how to store crypto yourself. Read our article on cryptocurrency wallets to learn more.

More and more crypto buyers come from the traditional investing world. These people don’t want to be bothered with wallets. They 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, futures are available for the most prominent cryptocurrencies. These contracts can be leveraged up to 100X. We 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. There might be other 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 is responsible for filing a tax report each year. Many feel this is painful, but nowadays, the workload can be significantly reduced with helpful 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 goods or services.

It is a taxable transaction if you sell, e.g., your Litecoin for dollars. If you trade Litecoin for Ethereum, it is a taxable transaction. It is taxable if you buy a cup of coffee with Litecoins. 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 using cryptocurrency as a 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. Selling part of your stock portfolio for simple purchases would make as much sense.

Why do many investors see taxation as a big problem? Crypto exchanges don’t automatically send your tax information to the authorities. Each transaction must be recorded, and capital gains must be calculated individually. This can quickly become a massive 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

Cryptocurrency is a broad umbrella covering thousands of 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 research. Both YouTube and Google are full of great information.

Generally, it is good to understand that the crypto industry is constantly changing. Technologies are developed, the market matures, new regulations emerge, 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 current on all the most important events.

We hope this article gave you a good start in cryptocurrencies.

Cryptocurrency scams

Cryptocurrency scams have become an increasing problem in the 2020s as the popularity of cryptocurrencies has grown. There are many types of scams the fraudsters are using, such as phishing, e-mail scams and trading platform scams.

WhatsApp, Telegram and Discord have also become more dangerous. Scammers are targeting novice users every day. The problem is global and shows no signs of going away.

We have written an in-depth beginner’s guide about crypto scams. The article covers all basic scams and advises how to avoid them. We recommend this article strongly for novice users!

Antti Hyppänen

Antti Hyppänen is the founder and editor-in-chief of AboutBitcoin.io. Antti has written articles about cryptos since 2017. He follows the crypto market every day of the year and is responsible for the daily operations of AboutBitcoin. Antti is not a maximalist regarding any cryptocurrency but looks at the industry objectively. Antti’s investment profile is “buy & hold,” i.e., he does not trade or use leverage. His crypto portfolio consists of mainly Bitcoin and Ethereum. Antti also follows macroeconomic events. In addition to cryptos, his interests include gold, silver, and the US stock market.