Key Takeaways
- Cryptocurrencies, like bitcoin and ethereum, are digital currencies that aren't backed by governments or companies.
- Crypto can be used for everyday purchases or as an investment.
- Investing in cryptocurrency comes with high risks and unique tax implications.
From social media to newsfeeds, everyone seems to be talking about the same thing: crypto. And for good reason: As of September 2021, 86% of Americans said they had heard about cryptocurrencies, and 16% said they had invested in or traded crypto, according to a Pew Research Center survey.1 But just because crypto is becoming more well known doesn't mean it's well understood. Here's what you need to know about the basics of cryptocurrency.
What is crypto?
Crypto is a digital currency, meaning it runs on a virtual network and doesn't exist in physical form like paper money or coins. Cryptocurrencies are often built using blockchain technology, which provides a secure recordkeeping and processing system for all of their transactions.
Many crypto analysts think cryptocurrencies are notable for 2 main reasons. First, they can typically be transferred without using a third party, such as a bank. By contrast, popular peer-to-peer payment platforms, like Venmo, PayPal, or Zelle, require connections to bank accounts to run.
Second, they are designed to be decentralized to various degrees, meaning they're generally not backed, controlled, or owned by any government, central bank, or corporation. Instead, decentralized cryptocurrencies operate according to computer software that anyone with internet access can download and use to monitor and verify transactions. The US dollar, on the other hand, is backed by the US government and regulated by the US Federal Reserve.
As of March 2022, there are over 18,000 cryptocurrencies, each of which has different rules and operating standards. And as of August 2022, the value of all cryptocurrencies has grown to just over $1 trillion.2
How does cryptocurrency work?
To help you understand how cryptocurrency works, let's start by looking at its cryptic name. The "crypto" in cryptocurrency refers to the software codes that protect, or encrypt, cryptocurrency networks, allowing them to offer secure transactions and maintain decentralization. Normally, a country's central bank is tasked with regulating its currency to ensure its value, and financial institutions, like banks and credit card companies, help in preventing fraud. Cryptocurrencies use encryption and blockchain technology to perform similar functions.
When a transaction takes place, a network of computers running blockchain software verifies that the payment is possible between the parties involved and then executes it. The blockchain also keeps a log of transactions to help ensure transparency within the network. To encourage people to verify blockchain transactions, those who verify transactions, called miners or validators, receive compensation when new transactions are added to a blockchain transaction log. Once a transaction is validated, recipients can access funds using their private key.
Cryptocurrencies, keys, and encryption
Each user within a cryptocurrency's system has a private and public key. Think of the public key as a combination of the routing and account numbers on a bank account, meaning it's a unique way to send money to you. The private key is how you access your own crypto. It's like the username and password you use to log in to your bank account. However, unlike with regular bank login credentials, you typically don't choose your private key and may not be able to recover it if you lose it.
Keys are important to understand because they enable the encryption that crypto relies on: Transactions are encrypted using a public key and can only be decrypted—and have the funds involved in the transaction accessed—with a private key.
An important note about keys: Here, we're only talking about how cryptocurrency ownership works within its particular software system. If you buy and sell cryptocurrencies through a 3rd party or keep your coins on an exchange, the company facilitating your purchase may hold your coins for you and manage any relevant keys. If you move your coins to a separate off-platform wallet, you may then be responsible for managing these keys.
What is cryptocurrency used for?
As a currency
Increasingly, cryptocurrency can sometimes be used to buy everyday things, similar to US dollars or euros. Today, almost 19% of small businesses in the US accept cryptocurrency.3 Several major brands, like Microsoft and AT&T, allow purchases using crypto.
Consumer uptake of using cryptos in lieu of more traditional currencies, however, has lagged people and companies using them as investments.4 There are many possible causes for this, but one of the largest may be the extreme price swings even the largest digital currencies experience. In February 2021, for instance, bitcoin's price plummeted more than $10,000 in value (17%) within a single day.5 Or in March of 2020, ethereum's price fell from $200 to $132 (33%) within a single day.6 But there have also been swings in the other direction. On July 26, 2021, bitcoin prices climbed a staggering 14%.7 And in a 7 day span from July 20 to July 27, 2021, ethereum's price soared from $1,818 to $2,298 (26%).8
And those are just the moments of more extreme price movements. Between January 2018 and June 2019, bitcoin's value changed day to day 2.67% on average, 6 times more than traditional currencies.9 Such volatility can make it difficult for everyday consumers to plan spending when their crypto holdings' value might fluctuate dramatically over a week.
In addition, using crypto as a stand-in for traditional currency can have unexpected tax consequences. Be sure to check with your accountant or tax advisor for how your crypto usage may affect your taxes.
As an investment
Due to some cryptocurrencies' historical price performance and potential to provide diversification among traditional assets, like stocks and bonds, cryptocurrencies have caught the eye of millions of individual investors: Over 1 in 10 Americans of all ages say they've invested in or traded crypto, though that number rises to almost 1 in 3 for Americans between 18 and 29.10
Financial institutions, like large investment funds, brokerages, and banks, have also been leaning into crypto. According to research from Fidelity Digital Assets' 2021 Institutional Investor Digital Study, 71% of US and European institutional investors surveyed intend to allocate to digital assets in the future.
As an intermediary store of value
Crypto can also facilitate the flow of money from people in one country to those in another as anyone with internet can send it at any time for a very low cost without worrying about business hours, traditional currency conversions, or international wires.
This flexibility can be particularly helpful in arranging international donations or in helping refugees retain easy access to funds.
Largest cryptocurrencies
Bitcoin
Bitcoin, also known by the abbreviation BTC, is generally the most well-known and as of October 13, 2022, the largest cryptocurrency in the world by market cap. Launched in 2009 by Satoshi Nakamoto, a pseudonymous person or group of people, it was the first cryptocurrency that allowed peer-to-peer transactions using blockchain technology. Bitcoin (with a capital B) refers to the network that bitcoin (with a lowercase b) runs on.
Bitcoin uses a proof-of-work system to validate transactions on the network. This means that transaction verifiers, or miners, compete to solve a mathematical puzzle using specialized computers through a process called "bitcoin mining." The reward for being first to solve the puzzle and mine a block of bitcoin is a predetermined amount of bitcoin. Bitcoin has a fixed supply of 21 million and a deflationary "halving" feature. With this halving feature, the reward for mining a block of bitcoin is cut in half approximately every 4 years.
Bitcoin's price has risen from $0.09 at its founding to over $20,000, as of August 2022, though that journey upward has been far from steady. Between late 2021 and mid 2022 alone, for example, its peaks were as high as almost $70,000 in November and as low as just under $18,000 the following September.
Ethereum
Like bitcoin, ethereum is both a software and a cryptocurrency (ETH) powering that software's network. It is considered by many to be the most popular altcoin (short for "alternative coin," a.k.a., any non-bitcoin cryptocurrency).
Ethereum software enables many blockchain innovations, like smart contracts, non-fungible tokens (NFTs), and decentralized apps (dApps). While ethereum (the cryptocurrency) was designed to facilitate transactions on products built on and transactions occurring within the Ethereum network, some have turned to it as an investment.
From its initial price of $0.31 in 2014, ethereum's value peaked at over $4,800 in November of 2021. Like bitcoin, it has experienced large swings along the way, landing at around $1,600 as of August 2022.11
Stablecoins
As their name implies, stablecoins were developed in response to the volatility other cryptos experience. Most stablecoins peg their value to existing currencies, like the US dollar—and some even keep a dollar in reserve for each stablecoin in existence and are audited by reputable third parties.
It's important to note, though, that not all stablecoins are created equally: In the past, some less trustworthy stablecoins' values have fallen below that of the currency they are supposed to track—or even lost all of their value—proving that some of these coins can be volatile even though they may be marketed otherwise.
The most widely used stablecoins include Tether (USDT), Dai (DAI), Binance USD (BUSD), and USD Coin (USDC).
Risks of cryptocurrency
While the eye-popping short-term returns of some cryptos can make them seem like appealing ways to turn a profit, it's important to know the risks when buying, selling, and spending cryptocurrencies.
In addition to significant and unexpected price swings, the laws surrounding cryptocurrencies are constantly evolving and often vary on a state-by-state level.
For example, current US tax code requires you to report transactions involving crypto, such as when you sell it for a profit and even when you exchange it to receive a good or service. If your crypto has increased in value since you purchased or received it, your transaction becomes a taxable gain that you must report to the IRS on your tax return. This could make buying everyday items with crypto at large scale unwieldy and cumbersome. There's still much that remains to be determined with crypto, from how people treat it—whether it's a store of value like a currency or an investable asset like a stock—to how governments view it. Future legislation may ultimately determine which way people use crypto as regulations may make certain uses impractical.
New legislation could also upend or have a significant impact on the price of any cryptocurrency. Crypto holdings are not insured, like money in a bank account, and therefore could be lost.
Platforms that buy and sell bitcoin may be unregulated, can be hacked, may stop operating, and some have failed. In addition, like the platforms themselves, digital wallets can be hacked. As a result, consumers can—and have—lost money.
Consider how many of these risks you are willing to take on before you purchase any cryptocurrency.