Cryptocurrency Basics: Pros, Cons and How It Works

In this article we cover:

Cryptocurrency (or “crypto”) is a digital currency, such as Bitcoin, that is used as an alternative payment method or speculative investment. Cryptocurrencies get their name from the cryptographic techniques that let people spend them securely without the need for a central government or bank.

• Bitcoin was initially developed primarily to be a form of payment that isn’t controlled or distributed by a central bank. While financial institutions have traditionally been necessary to verify that a payment has been processed successfully, Bitcoin accomplishes this securely, without that central authority.

• Ethereum uses the same underlying technology as Bitcoin, but instead of strictly peer-to-peer payments, the cryptocurrency is used to pay for transactions on the Ethereum network. This network, built on the Ethereum blockchain, enables entire financial ecosystems to operate without a central authority. To visualize this, think insurance without the insurance company, or real estate titling without the title company.

• Scores of altcoins (broadly defined as any cryptocurrency other than Bitcoin) arose to capitalize on the various — and at times promising — use cases for blockchain technology.

People invest in cryptocurrencies for the same reason anyone invests in anything. They hope its value will rise, netting them a profit.

If demand for Bitcoin grows, for example, the interplay of supply and demand could push up its value.

If people began using Bitcoin for payments on a huge scale, demand for Bitcoin would go up, and in turn, its price in dollars would increase. So, if you’d purchased one Bitcoin before that increase in demand, you could theoretically sell that one Bitcoin for more U.S. dollars than you bought it for, making a profit.

The same principles apply to Ethereum. “Ether” is the cryptocurrency of the Ethereum blockchain, where developers can build financial apps without the need for a third-party financial institution. Developers must use Ether to build and run applications on Ethereum, so theoretically, the more that is built on the Ethereum blockchain, the higher the demand for Ether.

However, it’s important to note that to some, cryptocurrencies aren’t investments at all. Bitcoin enthusiasts, for example, hail it as a much-improved monetary system over our current one and would prefer we spend and accept it as everyday payment. One common refrain — “one Bitcoin is one Bitcoin” — underscores the view that Bitcoin shouldn’t be measured in USD, but rather by the value it brings as a new monetary system.

Since its inception, Bitcoin has been regularly derided as dead, worthless or a scam, in part because its price is prone to meteoric rises and dramatic falls. Most recently, when Bitcoin’s price rose to $60,000 in 2021 before collapsing to around $17,000 in 2022, many experts and investors said it wouldn’t recover from this burst.

But as of Feb. 29, 2024, Bitcoin is well on track to do just that: The cryptocurrency is up over 160% from a year ago, once again trading at over $60,000.

The latest surge in price can partially be attributed to approval by the SEC of spot Bitcoin ETFs in Jan. 2024. This gave some of the largest asset managers in the world (think Fidelity and BlackRock) a way to offer their clients exposure to Bitcoin, making it easier for those clients to hold Bitcoin in accounts such as IRAs and taxable brokerage accounts.

But Bitcoin’s 2024 price rise is also due to other factors. Every four years, something known as “Bitcoin halving” occurs. The last halving occurred in 2020, when the reward for mining bitcoin was slashed in half from 12.5 to 6.25. In 2024, that will happen again, cutting the mining reward from 6.25 to 3.125. With fewer Bitcoins entering the market, its possible scarcity could drive up the price, leading to investor speculation today.

What’s more, the surge in interest rates in 2022 that pummeled growth stocks may have had a similar influence on Bitcoin; investors tend to prefer security over volatility during times of uncertainty. But as talk of interest rate cuts in 2024 circulates, some investors may have more appetite for risk assets like Bitcoin, leading them to get back in now.

And lastly, there are still Bitcoin enthusiasts who preach that looking at Bitcoin through the lens of fiat currencies like the U.S. dollar or Great British pound is missing the point entirely, and that its true value lies in being a new monetary system.

But, if there’s anything about Bitcoin that appears to be predictable, it’s that it will continue to be volatile. In the relative short-term, both camps are likely right: Bitcoin will rise and Bitcoin will fall. But at the moment, it appears the Bitcoin bulls are winning out.

Cryptocurrencies are supported by a technology known as blockchain, which maintains a tamper-resistant record of transactions and keeps track of who owns what. The use of blockchains addressed a problem faced by previous efforts to create purely digital currencies: preventing people from making copies of their holdings and attempting to spend it twice^[0]

Individual units of cryptocurrencies can be referred to as coins or tokens, depending on how they are used. Some are intended to be units of exchange for goods and services, others are stores of value, and some can be used to participate in specific software programs such as games and financial products.

One common way cryptocurrencies are created is through a process known as mining, which is used by Bitcoin. Bitcoin mining can be an energy-intensive process in which computers solve complex puzzles in order to verify the authenticity of transactions on the network. As a reward, the owners of those computers can receive newly created cryptocurrency. Other cryptocurrencies use different methods to create and distribute tokens, and many have a significantly lighter environmental impact.

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

It’s important to remember that Bitcoin is different from cryptocurrency in general. While Bitcoin is the first and most valuable cryptocurrency, the market is large.

There are more than two million different cryptocurrencies in existence, according to CoinMarketCap.com, a market research website^[0]

If you’re thinking about getting into cryptocurrency, it can be helpful to start with one that is commonly traded and relatively well-established in the market. These coins typically have the largest market capitalizations.

Thoughtfully selecting your cryptocurrency, however, is no guarantee of success in such a volatile space. Sometimes, an issue in the deeply interconnected crypto industry can spill out and have broad implications on asset values.

For instance, in November of 2022 the market took a major hit as the cryptocurrency exchange FTX struggled to deal with liquidity issues amid a spike in withdrawals. As the fallout spread, cryptocurrencies both large and small saw their values plummet.

Whether or not cryptocurrency is a security is a bit of a gray area right now. To back up a little, generally, a “security” in finance is anything that represents a value and can be traded. Stocks are securities because they represent ownership in a public company. Bonds are securities because they represent a debt owed to the bondholder. And both of these securities can be traded on public markets.

Regulators are increasingly starting to signal cryptocurrencies should be regulated similarly to other securities, such as stocks and bonds. But this take is receiving pushback; scholars, legal firms and some of the biggest players in the crypto industry have argued against this, claiming the rules that apply to stocks and bonds, for example, don’t apply as broadly to cryptocurrencies.

The Securities and Exchange Commission has set its sights on the sector generally. The agency has raised concerns about activities including crypto staking, and well as the operations of some large crypto companies.

Whether the SEC will treat cryptocurrencies, or specific types of cryptocurrencies, as securities will be at the forefront of crypto regulation, and could have major implications for the asset class in the near future.

Cryptocurrency inspires passionate opinions across the spectrum of investors. Here are a few reasons that some people believe it is a transformational technology, while others worry it’s a fad.

• Some supporters like the fact that cryptocurrency removes central banks from managing the money supply since over time these banks tend to reduce the value of money via inflation.

• In communities that have been underserved by the traditional financial system, some people see cryptocurrencies as a promising foothold. Pew Research Center data from 2021 found that Asian, Black and Hispanic people “are more likely than White adults to say they have ever invested in, traded or used a cryptocurrency^[0]

• Other advocates like the blockchain technology behind cryptocurrencies, because it’s a decentralized processing and recording system and can be more secure than traditional payment systems.

• Some cryptocurrencies offer their owners the opportunity to earn passive income through a process called staking. Crypto staking involves using your cryptocurrencies to help verify transactions on a blockchain protocol. Though staking has its risks, it can allow you to grow your crypto holdings without buying more.

• Many cryptocurrency projects are untested, and blockchain technology in general has yet to gain wide adoption. If the underlying idea behind cryptocurrency does not reach its potential, long-term investors may never see the returns they hoped for.

• For shorter-term crypto investors, there are other risks. Its prices tend to change rapidly, and while that means that many people have made money quickly by buying in at the right time, many others have lost money by doing so just before a crypto crash.

• Those wild shifts in value may also cut against the basic ideas behind the projects that cryptocurrencies were created to support. For example, people may be less likely to use Bitcoin as a payment system if they are not sure what it will be worth the next day.

• The environmental impact of Bitcoin and other projects that use similar mining protocols is significant. A comparison by the University of Cambridge, for instance, said worldwide Bitcoin mining consumes more than twice as much power as all U.S. residential lighting^[0]

• Governments around the world have not yet fully reckoned with how to handle cryptocurrency, so regulatory changes and crackdowns have the potential to affect the market in unpredictable ways.

There’s no question that cryptocurrencies are legal in the U.S., though China has essentially banned their use, and ultimately whether they’re legal depends on each individual country.

The question of whether cryptocurrencies are legally allowed, however, is only one part of the legal question. Other things to consider include how crypto is taxed and what you can buy with cryptocurrency.

• Legal tender: You might call them cryptocurrencies, but they differ from traditional currencies in one important way: there’s no requirement in most places that they be accepted as “legal tender.” The U.S. dollar, by contrast, must be accepted for “all debts, public and private.” Countries around the world are taking various approaches to cryptocurrency. For now, in the U.S., what you can buy with cryptocurrency depends on the preferences of the seller.

• Crypto taxes: Again, the term “currency” is a bit of a red herring when it comes to taxes in the U.S. Cryptocurrencies are taxed as property, rather than currency. That means that when you sell them, you’ll pay tax on the capital gains, or the difference between the price of the purchase and sale. And if you’re given crypto as payment — or as a reward for an activity such as mining — you’ll be taxed on the value at the time you received them.

Cryptocurrency is a relatively risky investment, no matter which way you slice it. Generally speaking, high-risk investments should make up a small part of your overall portfolio — one common guideline is no more than 10%. You may want to look first to shore up your retirement savings, pay off debt or invest in less-volatile funds made up of stocks and bonds.

There are other ways to manage risk within your crypto portfolio, such as by diversifying the range of cryptocurrencies that you buy. Crypto assets may rise and fall at different rates, and over different time periods, so by investing in several different products you can insulate yourself — to some degree — from losses in one of your holdings.

Perhaps the most important thing when investing in anything is to do your homework. This is particularly important when it comes to cryptocurrencies, which are often linked to a specific technological product that is being developed or rolled out. When you buy a stock, it is linked to a company that is subject to well-defined financial reporting requirements, which can give you a sense of its prospects.

Cryptocurrencies, on the other hand, are more loosely regulated in the U.S., so discerning which projects are viable can be even more challenging. If you have a financial advisor who is familiar with cryptocurrency, it may be worth asking for input.

For beginning investors, it can also be worthwhile to examine how widely a cryptocurrency is being used. Most reputable crypto projects have publicly available metrics showing data such as how many transactions are being carried out on their platforms. If use of a cryptocurrency is growing, that may be a sign that it is establishing itself in the market. Cryptocurrencies also generally make “white papers” available to explain how they’ll work and how they intend to distribute tokens.

If you’re looking to invest in less established crypto products, here are some additional questions to consider:

• Who’s heading the project? An identifiable and well-known leader is a positive sign.

• Are there other major investors who are investing in it? It’s a good sign if other well-known investors want a piece of the currency.

• Will you own a portion in the company or just currency or tokens? This distinction is important. Being a part owner means you get to participate in its earnings (you’re an owner), while buying tokens simply means you’re entitled to use them, like chips in a casino.

• Is the currency already developed, or is the company looking to raise money to develop it? The further along the product, the less risky it is.

It can take a lot of work to comb through a prospectus; the more detail it has, the better your chances it’s legitimate. But even legitimacy doesn’t mean the currency will succeed. That’s an entirely separate question, and that requires a lot of market savvy. Be sure to consider how to protect yourself from fraudsters who see cryptocurrencies as an opportunity to bilk investors.