Cryptocurrency has exploded onto the financial market in recent years and the discussion around it is can be confusing, given that it's a radically different way to purchase or engage in investing. With all the discussion and interest around cryptocurrencies, it's important to understand what it is and how it works, especially if interested in joining in on this new digital payment system.
So, what is cryptocurrency?
The best place to start is defining what cryptocurrency is. Essentially, it is a digital payment system that doesn't rely on banks in order to verify a transaction. Think of it as a peer-to-peer system, one that enables anyone to send and receive payments from anywhere. This virtual currency is secured by cryptography, making it nearly impossible to counterfeit or double-spend while also being decentralized. Cryptocurrency achieves this by using blockchain technology and only exists as digital entries in an online database that describes specific transactions. This means that when you transfer any cryptocurrency funds, the transactions are recorded in a public ledger and are stored in digital wallets.
If you're concerned that anyone can read your transactions, don't be. Cryptocurrency earned the name "crypto" because advanced coding is involved in storing and transmitting the cryptocurrency data between wallets and public ledgers, encrypting to provide security and privacy.
Cryptocurrencies and Blockchain
To understand what cryptocurrency is and how it works, you need to know, what blockchain technology is. One of the biggest appeals of cryptocurrency is that it uses blockchain technology to function and it essentially is a set of connected blocks or an online ledger. Each block holds a set of transactions that have each been independently verified by each member of a network.
To enhance our explnation, you'll also need to be made aware of what a node is. A node is a computer maintaining a copy of the ledger and every new block that is generated must be verified by a node before being confirmed, making it next to impossible to forge transaction histories. What a blockchain does is create an online ledger that must be agreed upon by the entire network of an individual node as a requirement of its legitimacy.
Types of Cryptocurrency
There are thousands of cryptocurrencies that exist now, too many to list here. Some of the best-known types of cryptocurrency as of this article are:
- Bitcoin: the first cryptocurrency, founded in 2009, and is the most commonly traded type.
- Ethereum: also known as Ether or Ethereum, or ETH, it was developed in 2015 as a blockchain platform and has its own cryptocurrency. It's the second most popular type at the time of this writing, after Bitcoin.
- Litecoin: this cryptocurrency type is the most similar to Bitcoin, but is becoming more individualized by further innovations, such as faster payments and processes for more transactions.
- Ripple: while a type of cryptocurrency, it's also a distributed ledger system that can be used to track different kinds of transactions, currently however it only tracks cryptocurrency.
How Does Cryptocurrency Work?
This is usually where people get most confused about cryptocurrency, after all- owning cryptocurrency means not owning anything tangible. Here is how it works:
Cryptocurrencies run on the blockchain, which is a record of all transactions updated and held by the holders of the currency.
Each unit of cryptocurrency is created through a process called "mining." This is using computer power to solve complicated mathematical problems that generate coins. You can also purchase cryptocurrency from the currency's brokers, then store and spend them using the wallets.
It's better to think of cryptocurrency units as keys that allow you to move a record or a unit from one person to another, without a trusted third party like Paypal or Venmo does.
Is Cryptocurrency Safe?
From a fraud standpoint, cryptocurrency is secured by cryptography and is generally considered secure. Each transaction requires a two-factor authentication process and the blockchain technology itself is fairly complex and technical. While it isn't unhackable, it's very difficult to tamper with. Where the risk comes in is investing, as it's a new technology and highly speculative. This currency isn't backed by the government and is completely driven by supply and demand.
Department of Financial institutions Director Charlie Clark is quoted in this article on the department's site, stating, “As with any investment, there are those whose cryptocurrency investments do well. There are also many whose do not, and others left with empty wallets when a company goes bust. Now, more than ever before, it is critical investors do their research before investing and understand the risks associated with the investments they choose.”
For further information, you can review this fact sheet recently issued by the FDIC.
We at Canopy Credit Union work to educate our Spokane neighbors and do our best to keep you informed on what's going on in the financial world. We encourage you to reach out to us with any questions or concerns and speak with one of our associates!