Cryptocurrency Basics: Pros, cons and how it works

Cryptocurrency, also known as "crypto," is an electronic currency that can be used to purchase goods and services or invest for profit. Among the various cryptocurrencies, bitcoin is the most widely known.

Interesting facts

• Cryptocurrencies are usually used to pay for services or as speculative investments.
• Cryptocurrencies are powered by a technology known as blockchain.
• Cryptocurrency prices are extremely volatile and the industry itself is full of uncertainty.
• Buying and selling cryptocurrencies has tax implications.
• Bitcoin is still the dominant cryptocurrency, followed by Ethereum.

What is a cryptocurrency?

A cryptocurrency, or "crypto," is a digital currency, like bitcoin, that serves as an alternative means of payment or speculative investment. It gets its name from cryptographic technologies that provide security and independence from central institutions or banks.

Examples include:

• Bitcoin, originally conceived as a decentralised means of payment that bypasses the control of central banks. Unlike traditional financial institutions required to validate transactions, bitcoin provides security without the involvement of central authorities.
• Ethereum, which uses the same blockchain technology as bitcoin but is designed to conduct transactions on the Ethereum network. This network allows financial ecosystems to be created without the need for centralised authorities. For example, you can imagine insurance without insurance companies or real estate property registration without title companies.
• Altcoins, which are a wide range of cryptocurrencies other than bitcoin, created for different uses of blockchain technology, often promising innovative approaches.

Why do people invest in cryptocurrencies?

People invest in cryptocurrencies for the same reason they invest in anything - in the hope of growth and profit. When demand for bitcoin increases, its value can rise because of the interaction of supply and demand. If people start using bitcoin widely for payments, the demand for it will increase and its price in dollars could rise. So, theoretically, if you had purchased bitcoin before demand increased, you could have sold it for more dollars and made a profit.

The same applies to Ethereum. Ether is the cryptocurrency of the Ethereum blockchain, which is used to create financial applications without the involvement of third-party financial institutions. Developers must use ether to run applications on Ethereum, and the more applications that are created on this platform, the higher the demand for ether.

It is important to note that cryptocurrencies are not always seen as investments. Some bitcoin enthusiasts see it as a better monetary system, favouring its use in everyday life.

Why is bitcoin still popular?

Bitcoin's history is full of twists and turns, and it has been declared dead or fraudulent on several occasions. In 2021, its price rose to $60,000 before collapsing to $17,000 in 2022, raising doubts about its recovery. However, bitcoin hit record highs in early 2024 thanks to the approval of ETFs by the U.S. Securities and Exchange Commission, making it easier for investors to access bitcoin. In addition, a reduction in bitcoin mining fees in 2024 has reduced its supply and consequently increased its price.

A sharp rise in interest rates in 2022 could also affect bitcoin as investors often look for safe assets in times of uncertainty. It is anticipated that a relaxation of monetary policy in 2024 could lead to an increase in risk appetite and push investors towards bitcoin.

However, volatility will remain an inevitable feature of bitcoin. For now, the bullish trend seems dominant, but short-term fluctuations in the price remain unpredictable.

How does cryptocurrency work?

Cryptocurrencies operate on a technology known as blockchain, which provides a secure and immutable record of transactions, tracking asset ownership. This solves the problem of double-spending of assets that has hindered the development of purely digital currencies previously.

Cryptocurrency units can be called coins or tokens, depending on their functionality. Some are designed to be used in exchange for goods and services, others serve as a means of storing value, and still others are used to participate in various programmes such as games or financial products.

How are cryptocurrencies created?

The process of creating a cryptocurrency such as bitcoin is often done through mining, which is an energy-intensive process where computers solve complex mathematical problems to authenticate transactions on the network. For this, participants can be rewarded in the form of newly created cryptocurrency. However, there are other methods of creating and distributing cryptocurrency that have a much smaller environmental impact.

For most people, the easiest way to obtain cryptocurrency is to buy it on an exchange or from another user.

Why are there so many types of cryptocurrency?

It is important to realise that bitcoin only represents a fraction of the cryptocurrency market, which includes over two million different coins, as data from market research website CoinMarketCap shows.

While some cryptocurrencies have a huge market value, others remain obscure and have little to no value. Therefore, if you are about to start your introduction to cryptocurrencies, it is wise to start with one that has a wide trading presence and has proven its reliability in the market. Usually, such coins have the highest market capitalisation.

However, it should be remembered that even a thoughtful choice of cryptocurrency does not guarantee success in such a dynamic and unstable space. Sometimes, issues related to the crypto industry as a whole can have a significant impact on asset values.

For example, in November 2022, the market was hit hard due to liquidity issues on cryptocurrency exchange FTX, which led to a sharp drop in the prices of many cryptocurrencies, both large and small.

Are cryptocurrencies financial securities like stocks?

The question of whether cryptocurrencies are securities is becoming a growing issue in the financial world. In the context of finance, a "security" is generally defined as an asset that has value and is tradable. For example, stocks represent ownership in a company, while bonds represent debt obligations.

Regulators are increasingly suggesting that cryptocurrencies should be subject to the same rules as other securities such as stocks and bonds. However, many academics, lawyers and members of the crypto industry believe that the rules that apply to traditional securities do not necessarily apply to cryptocurrencies.

The Securities and Exchange Commission (SEC) is actively considering this issue and has expressed concern about certain activities in the cryptosphere, such as skimming and the operations of large cryptocurrency companies.

The SEC's decision on whether cryptocurrencies will be treated as securities could have a significant impact on the regulation of cryptocurrencies and determine the future development of this asset class.

Pros and cons of cryptocurrency

Cryptocurrencies divide investors and experts, generating both passion and controversy. Here are a few reasons why some see them as having revolutionary potential, while others are cautious about this new asset class.

Pros of cryptocurrencies:

• Decentralisation and independence from central banks: Some people welcome the lack of central bank control, allowing cryptocurrencies to avoid the inflation problems associated with traditional fiat currencies.
• Accessibility to uncovered markets: Cryptocurrencies represent an opportunity for those excluded from the traditional financial system to access financial services.
• Blockchain technology: The blockchain technology behind cryptocurrencies is an innovative decentralised system of record keeping that can be more secure and transparent than traditional methods.
• Passive income opportunity: Some cryptocurrencies offer the ability to earn passive income through staking, which can help increase cryptocurrency holdings without the need for additional purchases.

Cons of cryptocurrencies:

• Uncertainty and risks: Many cryptocurrency projects have not stood the test of time, and the market as a whole remains volatile and unpredictable.
• Price Volatility: Cryptocurrency prices can change rapidly, which presents risks for both short-term and long-term investors.
• Environmental Impact: Mining cryptocurrencies, especially bitcoin, consumes a significant amount of energy, which has a negative impact on the environment.
• Regulatory risks: Governments have not yet established clear rules to regulate cryptocurrencies, which may lead to unpredictable regulatory changes and market restrictions.

Legal and tax issues related to cryptocurrency

Cryptocurrencies are considered legal in the United States, unlike in China where they are mostly banned. However, the situation may be different in each country. The main issue is not only their legal status, but also their tax obligations and the possibility of using them in everyday life.

It is important to understand that cryptocurrencies are not universally recognised as legal tender, unlike traditional currencies. For example, in the US, it is up to the merchant to decide whether to accept cryptocurrencies as payment.

The issue of taxation of cryptocurrencies is also important. In the US, cryptocurrencies are taxed as property, not currency. This means that when you sell cryptocurrency you will owe capital gains tax, and if you receive cryptocurrency as payment or remuneration, you are taxed on its value at the time of receipt.

Is cryptocurrency a good investment?

Cryptocurrencies are a high-risk investment, regardless of one's point of view. In general, high-risk investments should occupy a small portion of your portfolio - the generally accepted benchmark is no more than 10%. Before investing in cryptocurrencies, it may be more important to take care of retirement savings, consider paying down debt, or invest in less volatile instruments such as stocks and bonds.

There are various ways to manage the risk in your cryptocurrency portfolio. For example, you can diversify your cryptocurrency holdings by investing in several different cryptocurrencies. This will help you protect yourself to a certain extent against potential losses in one of your assets.

However, the most important aspect of investing, regardless of the asset you choose, is to do your due diligence. This is especially important in the case of cryptocurrencies, which are often linked to the development or introduction of specific technology products. When you invest in stocks, you are dealing with a company that is subject to certain financial standards and regulations. However, the situation is different with cryptocurrencies and you must be prepared for a higher level of uncertainty.

Cryptocurrencies are relatively less regulated in the U.S., which makes identifying viable projects even more challenging. If you have a financial advisor who specialises in cryptocurrencies, seek their advice.

For novice investors, it is also important to assess the extent to which cryptocurrency is widely used. Most reputable crypto projects provide publicly available metrics reflecting the number of transactions on their platforms. An increase in the use of a cryptocurrency may indicate its strength in the market. White papers that describe how the project works and the principles of token distribution are also usually available.

FAQ

Q: How does blockchain work?
A: Most cryptocurrencies are based on blockchain technology, a network protocol by which computers can work together to keep a shared, tamper-proof record of transactions. The challenge of the blockchain network is to make sure that all participants can agree on the correct copy of the historical ledger. Without a recognised way of confirming transactions, it will be difficult for people to trust that their assets are safe. There are several ways to achieve "consensus" on the blockchain network, but the two most widely used are known as "proof of work" and "proof of stake."

Q: How do you mine cryptocurrency?
A: Cryptocurrency mining is generally only possible for a proof-of-stake cryptocurrency such as bitcoin. And before you get too far ahead of yourself, it's worth noting that the barriers to entry can be high and the probability of success relatively low without a large investment.

While the first bitcoin users were able to mine the cryptocurrency using ordinary computers, the task became increasingly difficult as the network evolved. Now most miners use special computers whose only task is to perform complex calculations related to mining every day. And even one such computer does not guarantee you success. Many miners use entire warehouses full of mining equipment in their quest for rewards.

If you don't have the resources to compete with the heavyweights, one option is to join a mining pool where users share the rewards. This reduces the amount of reward you'll receive for a successful block, but increases the likelihood that you'll at least recoup some of your investment.

Q: How do I withdraw my money from cryptocurrencies?
A: As with buying cryptocurrency, there are several options for converting your cryptocurrency assets into cash. While decentralised exchanges and peer-to-peer transactions may suit some investors, many prefer to use centralised services to withdraw their assets.

With a centralised exchange, the process is essentially the reverse of buying. But if you own cryptocurrency, one of the advantages is that you likely already have everything set up. Here are the steps:

• Connect the wallet that holds the cryptocurrencies you want to sell, and make sure the exchange you choose supports both that wallet and the corresponding asset.
• Transfer your cryptocurrency to the exchange.
• Sell your cryptocurrency.
• Transfer the proceeds back into your bank account.

Each exchange handles such transactions differently, so you should familiarise yourself with your particular provider's fees and processes. Also keep in mind that you may have tax obligations when selling digital assets.