Cryptocurrency Explained With Pros and Cons for Investment

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Cryptocurrency Explained With Pros and Cons for Investment

What Is Cryptocurrency?

A cryptocurrency is a digital or virtual money that is protected by encryption, making counterfeiting or double-spending practically impossible. Many cryptocurrencies are decentralized networks built on blockchain technology, which is a distributed ledger enforced by a network of computers.

The fact that cryptocurrencies are often not issued by any central body makes them potentially impervious to political meddling or manipulation.

Key Takeaways

  • A cryptocurrency is a kind of digital asset that is built on a network that is dispersed across many computers. Because of their decentralized nature, they may exist independently of governments and central authority.
  • Blockchain and similar technologies, according to some experts, will disrupt numerous sectors, including banking and law.
  • The benefits of cryptocurrencies include cheaper and quicker money transactions, as well as decentralized systems that do not fail at a single point.
  • Cryptocurrency downsides include price instability, significant energy consumption for mining operations, and application in criminal activities.

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Understanding Cryptocurrencies

Cryptocurrencies are digital or virtual currencies that rely on cryptography technologies to function. They make it possible to make safe online payments without the involvement of third-party middlemen. The term “crypto” refers to the encryption methods and cryptographic techniques used to protect these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions.

Cryptocurrencies may be mined or bought on cryptocurrency exchanges. Not all e-commerce sites accept cryptocurrency payments. In reality, even famous cryptocurrencies like Bitcoin are seldom utilized for retail purchases. However, the cryptocurrencies’ rising value has made them popular as trading tools. They are also utilized for cross-border transfers to a limited degree.

Blockchain

Blockchain technology is key to the attractiveness and operation of Bitcoin and other cryptocurrencies. Blockchain, as the name implies, is simply a collection of linked blocks or an online ledger. Each block comprises a collection of transactions that have been independently confirmed by each network participant.

Every new block created must be validated by each node before being confirmed, making forging transaction histories very difficult. The contents of the online ledger must be agreed upon by the complete network of a single node, or computer, that keeps a copy of the ledger.

According to experts, blockchain technology may benefit a variety of businesses, including supply chains, as well as activities such as online voting and crowdfunding. JPMorgan Chase & Co. (JPM) is investigating the use of blockchain technology to reduce transaction costs by speeding payment processing.

Types of Cryptocurrency

The most popular and valuable cryptocurrency is Bitcoin. Satoshi Nakamoto, an unidentified individual, devised it and published it in a white paper in 2008. Thousands of cryptocurrencies are available on the market now.

Each coin claims a unique purpose and specification. Ethereum’s ether, for example, is marketed as gas for the underlying smart contract platform. Banks utilize Ripple’s XRP to ease transfers across various locations.

Bitcoin, which became public in 2009, is still the most extensively traded and reported cryptocurrency. There were about 19 million bitcoins in circulation as of May 2022, with a total market valuation of roughly $576 billion. There will only ever be 21 million bitcoins.

Many new cryptocurrencies, known as “altcoins,” have been established in the aftermath of Bitcoin’s breakthrough. Some of them are Bitcoin clones or forks, while others are whole new currencies. Solana, Litecoin, Ethereum, Cardano, and EOS are among them. By November 2021, the entire value of all cryptocurrencies in existence had surpassed $2.1 trillion, with Bitcoin accounting for around 41% of that total value.

Are Cryptocurrencies Legal?

Fiat currencies are backed by the government or monetary authorities. The Federal Reserve, for example, backstops each $1 note.

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However, cryptocurrencies are not backed by any government or private entity. As a result, making a case for their legal standing in various financial jurisdictions throughout the globe has proved challenging. It doesn’t help that cryptocurrencies have mostly operated outside of most current financial infrastructure. The legal status of cryptocurrencies affects their usage in everyday activities and trade. The Financial Action Task Force (FATF) suggested in June 2019 that cryptocurrency wire transactions be subject to the provisions of its Travel Rule, which requires AML compliance.

El Salvador was the first nation in the world to accept Bitcoin as legal money for monetary transactions as of December 2021. Cryptocurrency legislation in the rest of the world differs by jurisdiction.

The Payment Services Act of Japan declares Bitcoin to be legal property. Cryptocurrency exchanges operating in the nation are required to gather client information as well as wire transfer data. Within its boundaries, China has prohibited cryptocurrency trades and mining. In December, India was rumored to be developing a cryptocurrency framework.

In the European Union, cryptocurrencies are legal. Derivatives and other products based on cryptocurrencies must be classified as “financial instruments.” In June 2021, the European Commission issued the Markets in Crypto-Assets (MiCA) regulation, which establishes regulatory safeguards and rules for companies or vendors providing financial services based on cryptocurrencies.

Crypto derivatives such as Bitcoin futures are accessible on the Chicago Mercantile Exchange in the United States, the world’s largest and most sophisticated financial exchange. Previously, the Securities and Exchange Commission (SEC) held that Bitcoin and Ethereum were not securities; however, SEC Chair Gary Gensler announced in September 2022 that cryptocurrencies are securities. This attitude suggests that the legal status of bitcoin may be vulnerable to regulation.

Although cryptocurrencies are classified as money, the Internal Revenue Service (IRS) classifies them as a financial asset or property. And, like with most other assets, if you benefit from selling or trading cryptocurrencies, the government wants a cut. On May 20, 2021, the United States The Treasury Department unveiled a plan that would compel taxpayers to record each bitcoin transaction valued at $10,000 or more to the IRS. The IRS would tax the revenues differently depending on whether they were capital gains or regular income.

Are Cryptocurrencies Safe Investments?

Due to large investor losses as a consequence of frauds, hacks, and flaws, cryptocurrencies have earned a reputation as risky investments. While the underlying encryption is largely safe, the technical sophistication of utilizing and keeping crypto assets may pose a significant risk to inexperienced users.

Cryptocurrency investors should be aware of the following risks, in addition to the market risks associated with speculative assets:

  • In contrast to conventional banking, there is no way to reverse or cancel a bitcoin transaction after it has been delivered. According to some estimates, almost one-fifth of all bitcoins are currently unavailable owing to forgotten passwords or wrong transmission addresses.
  • Regulatory risks: The legal status of several cryptocurrencies is still unknown, with many countries attempting to classify them as securities, currencies, or both. A unexpected regulatory crackdown might make selling cryptocurrencies difficult or result in a market-wide price collapse.
  • Counterparty risks: Many investors and merchants store their cryptocurrencies with exchanges or other custodians. One of these third parties’ theft or loss might result in the loss of one’s whole investment.
  • Management risks: There are minimal safeguards against fraudulent or unethical management activities due to a lack of consistent standards. Many investors have lost significant amounts due to management teams that failed to produce a product.
  • Programming risks: To regulate the transfer of customer money, several investing and lending platforms employ automated smart contracts. An investor who uses one of these platforms accepts the risk that a defect or vulnerability in these programs may result in the loss of their money.
  • Market Manipulation: Market manipulation continues to be a significant issue in the cryptocurrency field, with certain exchanges accused of manipulating prices or trading against their consumers.
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Despite these hazards, cryptocurrency values have skyrocketed, with the overall market capitalization exceeding $1 trillion. Despite the asset’s speculative character, individuals have made considerable fortunes by assuming the risk of investing in early-stage cryptocurrencies.

Advantages and Disadvantages of Cryptocurrency

Cryptocurrencies were designed to transform financial infrastructure. However, like with every revolution, there are compromises. There are several gaps between the theoretical ideal of a decentralized system with cryptocurrencies and its actual application at the present level of development for cryptocurrencies.

The following are some of the benefits and drawbacks of cryptocurrencies.

Advantages

  • Cryptocurrencies offer a new, decentralized money paradigm. Centralized middlemen, like as banks and monetary organizations, are not required under this system to enforce trust and regulate transactions between two parties. Thus, a cryptocurrency-based system reduces the prospect of a single point of failure, such as a huge bank, triggering a global crisis, such as the one generated in 2008 by the collapse of institutions in the United States.
  • Cryptocurrencies promise to make it simpler to move payments directly between two people, eliminating the requirement for a trusted third party such as a bank or credit card firm. These decentralized transactions are protected by the use of public and private keys, as well as various incentive schemes like as proof of labor or proof of stake.
  • Cryptocurrency transfers between two transacting parties are quicker than traditional money transfers since they do not employ third-party middlemen. Flash loans are an excellent illustration of such decentralized transfers in decentralized finance. These loans, which are conducted without the requirement of security, may be completed in seconds and employed in trading.
  • Cryptocurrency investments may be profitable. Over the last decade, the value of cryptocurrency markets has surged, reaching over $2 trillion at one time. Bitcoin was worth more over $550 billion in crypto marketplaces as of May 2022.
  • One of cryptocurrency’s most notable use cases is the remittance industry. Currently, cryptocurrencies such as Bitcoin act as intermediary currencies to facilitate cross-border money transfers. As a result, a fiat money is changed to Bitcoin (or another cryptocurrency), then transmitted across borders and converted back to the target fiat currency. This approach simplifies and reduces the cost of money transfers.

Disadvantages

  • Cryptocurrencies are pseudonymous, despite their promise to be an anonymous means of trade. They create a digital trail that may be deciphered by entities such as the Federal Bureau of Investigation (FBI). This provides the door to governments or federal agencies monitoring regular persons’ banking activities.
  • Cryptocurrencies have grown in popularity among criminals for dubious purposes such as money laundering and illegal purchasing. The instance of Dread Pirate Roberts, who maintained a drug trade on the dark web, is widely known. Cryptocurrencies have also become popular among hackers, who use them to carry out ransomware attacks.
  • In principle, cryptocurrencies are supposed to be decentralized, with their value divided among numerous parties through a blockchain. In practice, ownership is very concentrated. According to an MIT analysis, only 11,000 individuals controlled nearly 45% of Bitcoin’s soaring value.
  • One of the conceits of cryptocurrencies is that anybody with a computer and an Internet connection may mine them. However, mining popular cryptocurrencies demands a significant amount of energy, perhaps as much as whole nations spend. Mining has been concentrated among huge corporations with revenues in the billions of millions due to high energy costs and the unpredictability of the industry. According to an MIT research, 10% of the mining capability is accounted for by 10% of the miners.
  • While cryptocurrency blockchains are very secure, other crypto repositories, such as exchanges and wallets, may be compromised. Many cryptocurrency exchanges and wallets have been hacked over the years, with millions of dollars in “coins” taken in certain cases.
  • Price volatility affects cryptocurrencies traded on public marketplaces. Bitcoin’s value has fluctuated dramatically, reaching as high as $17,738 in December 2017 before plummeting to $7,575 in the months that followed. As a result, some economists believe that cryptocurrencies are a passing fad or speculative bubble.
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$576 billion

Total market cap of Bitcoin, as of May 2022.

How Do You Buy Cryptocurrencies?

Any investor may buy bitcoin via renowned crypto exchanges like Coinbase, applications like Cash App, or brokers. Another popular method to invest in cryptocurrencies is via financial derivatives like CME’s Bitcoin futures or other securities like Bitcoin trusts and Bitcoin ETFs.

What Is the Point of Cryptocurrency?

Cryptocurrencies represent a new financial paradigm. Their objective is to simplify current financial infrastructure in order to make it quicker and less expensive. Their technology and design decentralize current monetary systems, allowing transacting parties to exchange value and money without the need for intermediate entities like banks.

Can You Generate Cryptocurrency?

Mining is the process through which cryptocurrencies are created. Bitcoin, for example, is created via Bitcoin mining. The procedure entails downloading software that has a partial or complete history of network transactions. Though everyone with a computer and an Internet connection may mine bitcoin, the sector is dominated by huge organizations due to the energy and resource-intensive nature of mining.

What Are the Most Popular Cryptocurrencies?

By far the most popular cryptocurrency is Bitcoin, which is followed by Ethereum, Binance Coin, Solana, and Cardano.

Are Cryptocurrencies Securities?

Previously, the SEC said that Bitcoin and Ethereum, the leading two cryptocurrencies by market capitalization, were not securities. SEC Chair Gary Gensler announced in September 2022 that cryptocurrencies are securities and has directed SEC staff to begin working with crypto creators to register their coins. He did, however, clarify that he was not speaking on behalf of the SEC and was simply speaking for himself. He urged individuals just getting started in the crypto field to register their coins since “it’s significantly less expensive to do so from the start.”

The Bottom Line

Cryptocurrencies are digital assets that are protected by encryption. As a relatively new technology, they are very speculative, and it is critical to understand the dangers before investing.

Investing in cryptocurrencies and other initial coin offerings (“ICOs”) is very dangerous and speculative, and this article is not a suggestion by Investopedia or the author to do so. Because each person’s circumstance is unique, it is always best to talk with a knowledgeable specialist before making any financial choices. Investopedia makes no guarantees or warranties about the accuracy or timeliness of the information provided on this site.

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