What Is Cryptocurrency and How Does It Work?

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What Is Cryptocurrency and How Does It Work?

You may have already heard about Bitcoin, Ethereum, Dogecoin, Cardano, Litecoin and Polygon.  These are all cryptocurrencies. Currently, there are over 19,000 different cryptocurrencies, with the most popular being Bitcoin and Ethereum. However, if you are not familiar with the term yet and are thinking on further investing in the market, you may be thinking what really is cryptocurrency and how does it work.

What is Cryptocurrency?

Cryptocurrency is basically decentralized digital money, which is encrypted, and works as a medium of exchange and trading. In comparison with currencies such as the U.S. Dollar, the Pound, the Euro, etc., where there is a central authority managing the value of the currency, cryptocurrency is broadly distributed among internet users across the world that have the transactions verified and recorded on a blockchain.

A blockchain is similar to a ledger but in digital form (also known as Distributed Ledger Technology (“DLT”)). It is a shared digital database that stores data in “blocks” which are linked via cryptography and chained in chronological order as new data is entered in the system.  Its main goal is to record and distribute information in a digital form that cannot be edited, deleted, or destroyed.

How is Cryptocurrency Validated?

Given the points above, how can you trust cryptocurrency’s accuracy? There are two (2) consensus mechanisms that are commonly used in order to verify a transaction before it is added to a blockchain.  These methods are called: proof of work and proof of stake. 

At a high-level, Proof of Work requires members of a network to solve arbitrary mathematical puzzles in order to prevent bad actors from tampering with the system. Note, however, the drawback and environmental impact is quite high, given the cost of electricity and energy it takes to power millions of computers around the world 24/7 (365 days a year), and even more so as new users enter the system.  Proof of Stake is one of several new consensus mechanisms created as an alternative given the high energy costs of Proof of Work.

These users that verify transactions are rewarded as well with cryptocurrency for their efforts. This is commonly known as “mining”.

How Do You Invest in Cryptocurrency?

Even though you can use crypto (in limited circumstances and where acceptable) to buy goods and services, the vast majority of individuals and corporations are investing in cryptocurrencies, like stocks and other precious metals.  As with individual stocks, cryptocurrencies area risky assets and given their volatility and their evolving nature you should become knowledgeable before entering the market. Also, beware of deciding to invest upon hyped returns and/or celebrity endorsements of this type of investment. As with any investment, do your research, educate yourself and make sure you do not over invest too quickly.  Cryptocurrency is subject volatility similar to the stock market and you have to be aware that it has the potential to be a rollercoaster ride in the current economic climate.

Please note that this blog must not be considered as financial advice and should be read for informational purposes only. If you have any questions or require additional information, please contact our office. Stay tuned for our next blog on Non-Fungible Tokens (NFTs)!

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