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What Is Cryptocurrency? Did you know everything about digital assets?
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Cryptocurrency is going mainstream — and becoming increasingly difficult for investors to ignore.
Coinbase made headlines recently as the first crypto exchange to go public on the Nasdaq, and established firms like Fidelity are adding crypto to their investment offerings. The adoption of online payments using crypto is growing too, thanks to brands ranging from legacy publisher (and NextAdvisor partner) TIME to digital payment facilitator PayPal and international auction house Sotheby’s.
You may be wondering what to make of cryptocurrency and whether it has a place in your portfolio. But if you’re not familiar with digital currencies or blockchain technology, even the basic concept can be overwhelming.
Here’s our guide to crypto, and why so many people are talking about it these days.
What Is Cryptocurrency?
Cryptocurrency is a type of currency that’s digital and decentralized. Cryptocurrencies can be used to buy and sell things, and their potential to store and grow value has also caught the eye of many investors.
There are thousands of different cryptocurrencies available today. The most popular — and the original — is Bitcoin, which was created in 2009. Other common cryptocurrencies include Ethereum, XRP, and Bitcoin Cash. Each of these currencies serves a different purpose, with some optimized for use in place of cash, and others designed for private, direct transactions.
Cryptocurrencies are wholly digital, so there’s no physical coin or bill connected to the crypto you own. Instead, owners hold cryptocurrency in a digital wallet, and buy or sell through an online exchange. Your wallet may be online (some popular exchanges like Coinbase offer an in-app wallet) or stored offline on a hardware device similar to a USB drive.
Decentralization is a primary tenet of cryptocurrency. Whereas most currencies are backed by a central bank — the U.S. dollar, for example, is backed by the “full faith and credit” of the U.S. government — cryptocurrencies are maintained and valued by their users.
Cryptocurrency transactions are recorded on a decentralized ledger. This ledger is called a blockchain. Every time crypto is bought or sold, the transaction is added to the blockchain — a public database of the transactions, which is available to other crypto holders. Anyone can join and participate in the blockchain, but data on individual transactions — and the people involved with them — are secured using cryptography (the basis for the term cryptocurrency). For each transaction added to the blockchain, there’s a digital validation process to verify it and prevent fraud.
What Can You Do With Cryptocurrency?
While it shares characteristics of both currency and investments, there’s still debate among experts about whether cryptocurrency is clearly one or the other.
As its name suggests, you can use cryptocurrency to make purchases. But your purchasing power is limited; crypto isn’t yet widely accepted among retailers and other businesses.
That lack of widespread adoption, plus crypto’s volatility, limits its use as a currency, says Roger Aliaga-Díaz, principal and senior economist with Vanguard Investment Strategy Group.
For many people, crypto is a type of alternative investment. Just as you can buy and trade stock in public companies, you can buy cryptocurrency with the hope that it will increase in value over time, allowing you to cash out for a profit at a later date. Some people invest in crypto less for the belief that it will become a popular currency and more as a bet on the blockchain technology behind it.
But classifying crypto as an investment is complicated, too. It doesn’t quite fit the mold of a traditional stock or bond, and while cryptocurrencies do share characteristics of commodities like gold — they can be bought and sold for cash and as derivatives based on expected future value — they have no inherent physical value or use.
Without a clear track record to assess long-term value, cryptocurrency rises and falls on an unpredictable demand cycle. And for individual investors, the challenge is “you really don’t know where supply and demand can end up,” Aliaga-Díaz says.
Similar to forex — foreign exchange — trading, there can be significant risks involved with a largely unregulated market, and your best bet is to get informed beforehand, and don’t invest any money you can’t afford to lose. Regulators are still trying to figure out how to classify cryptocurrencies, for purposes of trading, payments, antifraud, taxation, and more. Clear regulation may help us understand how to use cryptocurrency and what its future may look like, but we aren’t there yet.
“Where digital assets land, at the end of the day … will be driven in part by regulation, both domestic and international,” Former SEC Chairman Jay Clayton recently told CNBC.
What Are the Cryptocurrency Terms You Should Know?
- Blockchain: A blockchain is a type of database in which a cryptocurrency’s digital transaction records are stored in groups, or blocks. New blocks are continually created as extensions of the previous block, forming a chain. These blockchains build upon themselves within the database, storing an ever-increasing amount of data about the transactions for a specific cryptocurrency.
- Decentralized: In the context of cryptocurrency, the term decentralized means the currency isn’t backed by a central bank or other financial institution.
- Distributed ledger technology (DLT): A decentralized digital record. Unlike typical databases, there’s no central authority; the record is stored across multiple locations simultaneously and once a transaction is recorded it’s permanent. Blockchain is a type of DLT, but the technology can serve a number of purposes beyond cryptocurrency trade.
- Bitcoin: The first cryptocurrency, and still the most popular today.
- Altcoins: Any cryptocurrency that is not Bitcoin. Some popular altcoins today include Ethereum, Dogecoin, and Litcoin. These altcoins each have different features and purposes.
- Exchange: A marketplace where you can buy and sell cryptocurrency.
- Wallet: A place to store your crypto currency holdings. Many exchanges offer digital wallets.
Is Crypto Safe?
The blockchain technology backing cryptocurrency is inherently secure, thanks to the decentralized — and public — nature of distributed ledger technology and the encryption process every transaction undergoes.
But that doesn’t mean it’s completely secure in the same way most people consider the U.S. dollar or other established currencies to be secure. Since cryptocurrency isn’t backed by any governmental authority, it doesn’t have the same protections as many standard currencies throughout the world.
Unlike the money you save in a bank insured by the Federal Deposit Insurance Corporation (FDIC), “If a virtual currency company fails – and many have – the government will not cover the loss,” the Consumer Financial Protection Bureau warned in a 2014 notice about cryptocurrency (its most recent guidance).
The CFPB names more specific risks that consumers should be prepared for, including volatile exchange rates, potential high fees on exchange platforms, and fraud risk. If your funds are lost or stolen, they can be especially difficult to recover, thanks to the decentralized nature of blockchain and lack of any governmental oversight.
And, importantly, just because cryptocurrency is secure does not make it safe. As much as some of the recent popularity of cryptocurrency is driven by investors’ belief in its value, that value is still based on speculation. For those who invest in crypto, it will be among the riskiest investments they make.
“I believe everyone should have a diversified portfolio,” says Daniel Johnson, a financial advisor and founder of RE|Focus Financial Planning in Asheville, North Carolina. Any investment you make should be appropriately weighted against the rest of your portfolio as well as the overall market. Just as you wouldn’t invest all your money in one company, it’s unwise to put every dollar you have into crypto.
What Does the Future Hold for Cryptocurrency?
But whether that growth is sustainable, and what it means long-term, is still in question. “This crypto, blockchain technology, the public interest in it right now is being driven by a kind of speculative fever,” says Dr. Richard Smith, executive director of the Foundation for the Study of Cycles, a nonprofit organization dedicated to studying recurring patterns throughout economies and cultures.
Still, an increasing number of big, powerful players are validating crypto’s potential.
“Every single day, the concept that it could be worth something, it could be a store of value is being continually approved by more large, powerful entities,” Johnson says, pointing to established financial institutions holding digital currencies and large corporations adding them to their corporate balance sheets. “The idea that it’s actually worth something is continuing to grow as adoption and acceptance continues to grow as well.”
Ultimately, the future of cryptocurrencies — their value, security, and staying power — is still up in the air. But the experts we spoke to believe owning some crypto could create value over time. Whatever your interest or motivation, experts stress the importance of making sure you understand the unique volatility and risk factors of cryptocurrency before investing.
“I think it’s really important to keep your eyes open,” Johnson says. “Don’t get the FOMO at a fever, because it’s very volatile. No one should invest anything that they can’t afford to lose, and that’s the same advice I give for any kind of an investment.”