Considering the buzz around cryptocurrencies, it is unlikely you haven't heard about them until this point. But what exactly are they, and how do they work? This guide explores the ins and outs of cryptos, so keep reading to learn more about them.
What are cryptocurrencies?
Cryptocurrencies are virtual currencies supported by cryptographic systems. They allow you to make an online payment without relying on a mediator. The term 'crypto' refers to cryptographic techniques used to secure transactions and prevent fraud, such as public-private key pairs and elliptical curve encryption. Besides purchasing a digital asset from an exchange, you can also mine it or gain rewards for doing work on the blockchain. Not every e-commerce business accepts crypto payments for purchases, yet digital assets are valuable, making them a popular trading tool.
Cryptocurrencies can serve different purposes, depending on the specific blockchain they are built on and the use case they are designed for. Some cryptos, like Bitcoin, were primarily intended to serve as a decentralized digital currency that can be used for peer-to-peer transactions. The current price of this asset has reached $ 24,597 - higher than the Ethereum price, which is now at $ 1,680. However, Ethereum is also a valuable cryptocurrency, mainly because it has a programmable blockchain that can be used to create smart contracts and decentralized applications. Besides their specific use cases, virtual currencies differ in their governance models, consensus mechanisms, and token economics. For instance, while some cryptos use a proof-of-work consensus algorithm, others are based on a proof-of-stake model.
Blockchain – the driving force behind cryptocurrencies
Cryptocurrencies are enabled by the blockchain, a decentralized and distributed digital ledger that records transactions and other data securely and transparently. The term 'blockchain' refers to storing the data in blocks linked together in a chain-like structure. Each block in the chain includes a set of transactions validated and confirmed by network participants, called miners or validators.
The miners verify the transactions through complex algorithms, creating a digital signature that proves the authenticity of the data. Once a block is added to the chain, it becomes part of the permanent and unalterable record of the blockchain. This means that any attempt to tamper with the data in the block can be quickly detected and rejected by the network, making the blockchain highly secure and reliable for recording and transferring value. Blockchain technology has many use cases beyond cryptocurrencies, such as supply chain management, digital identity verification, and voting systems. Its decentralized and transparent nature makes it an appealing option for industries requiring increased trust and security.
Pros and cons of investing in cryptocurrencies
Cryptocurrencies were designed to revolutionize the financial system, but they come with tradeoffs. Below, we'll look at virtual currencies' advantages and disadvantages.
Pros
Eliminate single points of failure
Traditional financial systems rely on centralized authorities, like governments and banks, to regulate and manage cash flow. This centralization makes the system vulnerable to single points of failure, like a large bank's failure, which can have far-reaching consequences for the whole financial system. One such example is the global crisis in 2008 due to the deregulation of financial derivatives in the US. However, cryptocurrencies rely on a network of nodes to verify and record transactions, making the system more resistant to failures and attacks, as no single point of failure can bring it down.
Enable easier transactions between parties
One key feature of cryptos is their ability to enable peer-to-peer transactions without relying on a trusted third party. The transactions are facilitated by using public and private keys and various incentive systems, like PoW and PoS, securing the network and preventing fraudulent transactions. This feature benefits particularly individuals and businesses that can't access traditional financial services or may want to avoid the regulations and fees involved when using these services.
Generate returns
Cryptocurrencies are appealing investments because they can generate profits. The market's value has skyrocketed considerably in the past few years, reaching nearly $2 trillion at a certain period. While the crypto space is filled with ups and downs, the market's growth potential is undeniable, as the numbers indicate. If you commit to crypto for the long run, there is a high chance to earn significant returns; however, it's vital to make wise moves and approach the market strategically.
Cons
Are characterized by volatility
Despite their growth potential, cryptocurrencies experience considerable price volatility. Their value can rapidly fluctuate based on different factors in the market, resulting in significant losses. For example, Bitcoin's price reached almost $65,000 in late 2021 and dropped by more than half a few months later. This volatility can affect investors' trading decisions while perpetuating the idea that cryptos are a speculative bubble. However, cryptos like Bitcoin and Ethereum have demonstrated their resilience over the years, and volatility doesn't have to be the enemy – the key is to use it in your favor.
Pose off-chain security issues
Even if blockchain technology is considered secure, off-chain storage repositories – like wallets- are vulnerable to hacking. Both crypto exchanges and wallets appeal to bad actors because they hold significant funds. Hacks have devastating effects on individuals and businesses, resulting in the inability to access funds. This is why it is crucial to carefully consider an exchange's security and store your funds in cold storage, which is safer than a hot wallet.
Costly to participate in a network
Mining cryptocurrencies seems simple – after all, you only need a computer and a reliable Internet connection, right? Not really. Things are far more complex than that when it comes to mining, and the energy costs associated with it make it challenging for miners to be competitive. The process requires computation power to verify and add transactions to the blockchain. The difficulty of mining increases along with the number of miners on the network, and the only way miners can stay competitive is by joining mining pools. However, these pools are run by large firms with significant computing power, making it difficult for individual miners to compete on a level playing field.
Last words
Cryptocurrencies are a new technology, and while they can be lucrative, their value can also quickly fluctuate, so it's vital to understand the risks involved before investing in them.
