What is Cryptocurrency and How Does Crypto Works: Complete Guide

Who lives under a pineapple in the sea?

Well, it is you if you have not heard about cryptocurrency yet. What started as a humble seven-page Bitcoin whitepaper in 2008 has now taken the world by storm. However, the irony is that a lot of people still have trouble wrapping their heads around what is cryptocurrency. Of course, words like decentralisation, blockchain technology etc., are thrown around. But how does crypto work?

Well, you are in luck. Because that is exactly what we plan to talk about today. They often say ‘DYOR’ or “do your own research”. Turns out that research starts with understanding the very basics behind cryptocurrency and blockchain technology. Let’s dive in.

What is Cryptocurrency: Digital Money

Let us do a quick exercise. Whenever the term ‘money’ is uttered, what comes to your mind instantly? Is it the Green colour? The paper? The image of a famous personality that features on your currency? What if I told you that you feel so because you were born and evolved with this type of money floating around?

Yes. Conventionally money has taken various shapes and forms like wheat, stones, bottle crowns, gold, silver etc. And we are at the cusp of another shift with crypto. 

Cryptocurrency is the digital form of currency secured and maintained by a decentralised system using cryptography. It is designed in a way that it cannot be counterfeited, double-spent or manipulated—all of this without having an intermediary.

At core, the technology aims to take power away from the hands of a select few and distribute it in the hands of the masses. Think of media outlets. Earlier, an editor had complete control over your perspective of world affairs. This was replaced by Social Media, where information was disseminated peer to peer.

Similarly, cryptocurrencies evolved as a form of ‘state-free’ money. But later, the underlying blockchain technology is used to build the latest avatar of the internet, which is decentralised and censorship-resistant. While automation technologies have worked relentlessly to do away with the peripherals of the system by eliminating execution/labour work, blockchain technology is working on automating the centre. Rather than replacing the driver, Blockchains can potentially eliminate Uber from the ecosystem. 

Cryptocurrencies are a particularly lucrative asset class because of the promise of fair distribution of power. You can use cryptocurrency to interact with decentralised applications while safeguarding your privacy. 

What are the types of cryptocurrencies?

There are 1500+ different cryptocurrencies listed on Coinmarketcap. That is more than the number of different fiat currencies in the world. Based on Blockchain, you could divide these cryptocurrencies into a token or a coin. While coins have their own native Blockchains like Bitcoin, Ethereum and BNB, tokens run on some other Blockchain. E.g. BAT is an ERC-20 token running on Ethereum.

On the basis of function, these cryptocurrencies can also be categorised as follows:

A. Wrapped tokens

As the name suggests, a WRAP token is something that is wrapped around an underlying asset. Think of them as ETFs in traditional finance. Any commodity/currency/stock could be wrapped to run on a blockchain.

Imagine that you want to purchase a stock of Berkshire Hathaway (Tickr: BRK). One share costs $4,17,250 as we write this piece (16th July 2022).

There is no way a retail investor could buy it unless they are a high-net-worth individual. Using wrapped tokens, you could wrap this stock and put it on the blockchain, enabling fractional buying, 24x7x365 trading and maximum retail participation.

B. Stablecoins

Stablecoins are cryptocurrencies pegged to fiat currency like USD, EUR etc. They can either maintain a physical collateral (USDT, USDC) or use algorithms (LUNC, FRAX, DAI) to do this.

Stablecoins are the bridge between traditional and decentralised finance. Think of them as the blockchain variants of the fiat currency. You could hold them to get exposure to crypto by earning some yield on them. Alternatively, you can often switch back and forth between stablecoins and other cryptocurrencies during the headwinds to avoid taxation and excessive exchange fees associated with withdrawals. 

C. Utility tokens –

A utility coin/token is something that powers a particular network. It is the native currency of an ecosystem. For example, BAT or basic attention token can be used to tip creators; fund ad spends within the Brave browser ecosystem.

Brave browser is a fast, private and secure browser that enables incentivisation for ad publishers and the users alike who click on those ads. 

Similarly, ETH and SOL are the only coins that can be used to pay for the gas fee within their respective networks.

D. Governance tokens

Governance tokens offer voting rights to their holders within an ecosystem. For example, UNI, the native token of Uniswap, a decentralised exchange, allows users to vote on proposals regarding the project’s future.

How is the value of cryptocurrency calculated?

The basics of economics apply here. The value of a cryptocurrency is primarily determined by supply and demand in the short term. If demand > supply, the price rises and vice versa.

In the tangible world, the cost of production would also impact the prices as a product cannot be produced out of thin air. However, that is not true in the case of cryptocurrencies. Depending on the model, cryptocurrencies can be fixed in supply (Bitcoin) or can be produced within seconds at a click of a button through a pre-decided rule. Therefore, one must go through the token distribution and maximum supply before determining the value of a crypto.

Apart from that, the prices of cryptocurrencies also fluctuate based on their availability on multiple exchanges, competition, governance and regulations. If you wish to dive deeper into the valuation and pricing of cryptocurrencies, here’s a post that talks about it in detail.

What can you buy with a cryptocurrency?

Given the regulatory uncertainty around cryptocurrencies, many businesses refrain from accepting crypto as payments. However, in the past, a lot of brands backed up cryptos as a mode of payment. Back in 2021, Tesla announced that they would accept Bitcoin as a payment for the cars, only to take a U-turn later. Currently, they accept Dogecoin for some merchandise.

Apart from that, some brands offer real estate (Bithome), sporting events (tickets to Mark Cuban’s Dallas Mavericks matches via Bitpay), and Travel packages (CheapAir) in exchange for Bitcoin.

Within the crypto ecosystem, you can buy NFTs (Opensea) and domain names (ENS) using crypto.

Is cryptocurrency illegal?

Is drinking coffee illegal? It isn’t right? No laws state that drinking coffee will put you behind bars. Similarly, no law prohibits buying, selling and holding of cryptocurrencies.

People often get confused by the legality aspect of cryptocurrency when the government says it is not legal tender. A legal tender is anything that the government recognises as a mode of payment—for instance, Fiat. When the government says that cryptocurrency isn’t a legal tender, it means you cannot force a seller to accept it as a mode of payment while purchasing goods.

In a fundamental sense, the government does not want crypto to compete with INR/USD etc. Which we believe is a fair demand. However, that does not make it illegal for any individual/company to deal in trading/investing in cryptocurrencies. 

How Does Cryptocurrency Work?

Imagine there is a 7 year old boy called Timmy. Timmy wants to get a dog for his Christmas present. So he writes a letter to Santa Claus and asks him to bring him a dog. Then he seals that letter and asks his dad to deliver it to Santa Claus. But his dad opens up the letter. And since he does NOT want a dog in the house, he changes it to a book. 

Of Course, it is a bummer for Timmy on the day of Christmas. 

Next year, Timmy still wants a dog. So this time, he writes a letter and uploads it on the North Pole blockchain. This blockchain is set up by Santa Claus, and all the parents and kids are a part of this blockchain. Every time a kid uploads a letter, everyone receives a copy of it. 

Once again, Timmy’s father receives this letter and yet again tries to change the dog to a guitar. 

However, this time he is caught. Why? Because his letter is different from the copies of all other participants. 

So finally, Timmy gets his dog.

If you understand the above example, it is very easy to translate it to an adult version. All the parents and kids in the North Pole blockchain are ‘nodes’. Each node has a copy of what is happening in the system and can validate it. Whenever someone tries to manipulate, they are caught instantly, and hence the network is secured at all times.

Replicating the above in the Bitcoin blockchain, we can understand that multiple nodes in the ecosystem validate all the transactions coming through. Also, there is no incentive for cheating or defrauding the system because you will get caught. 

How is cryptocurrency encrypted?

Encryption is the process of converting data to a non-readable format which can be brought back to its original form using a key. This makes sure that the data is only accessible to authorised personnel.

Blockchains and cryptocurrencies achieve this by using asymmetric encryption. This means that the encryption key for this data is publicly available, but only the authorised holder of the private decryption key can access the decoded plaintext.  

Should you Invest in Cryptocurrency?

While it is subjective and a personal finance decision that you have to make for yourself, allocating a small percentage of your portfolio to risky assets like cryptocurrencies could go a long way.

While it is advised to conduct your due diligence and risk management and invest only what you can afford to lose, let’s find out some of the benefits of investing in cryptocurrencies.

Advantages of cryptocurrency investment:

A. Transformational technology

Cryptocurrency (Blockchain) is a novel technology. There is just too much happening each day. If you manage to stay up to date, the benefits are way beyond money. They often say that a month in crypto is equivalent to three months in the normal world. That is how fast-paced the cryptoverse is. 

B. Ownership

Blockchains enable true ownership of your assets. Let me explain. When you post an image on social media, are you the owner of that image? Well, in principle, yes. But do you really own it? What if Facebook decides to take it down as it violates their policies? What if Facebook deletes it accidentally from their servers. What if someone else copies and claims it. How do you prove that you were the original owner?

In the blockchain realm, you own your assets which are stored as records on the blockchain. Since these records are immutable, you can verify ownership at any time. 

C. Hedge against inflation

This applies to Bitcoin only. Fiat Currency loses value, i.e.; Over time, their purchasing power reduces due to the economic policies of governments. For example, governments printed excessive money during the pandemic to kickstart the economy, which is now coming back to bite us in the form of inflation. The US recently posted inflation at 9.1%. This means whatever you purchased for $100 is now worth $109.1 

In other words, your $100 is now worth $91 only. Therefore, the value of your money deteriorated due to ruthless printing.

Since BTC is capped in supply at 21M, it acts as a hedge against inflation.

P.S. If you want to invest in cryptocurrencies, check out our Coin Sets.

D. Secure

Transactions are encrypted, and records are immutable on the blockchain, thus disallowing any alterations or changes to be made.

Disadvantages of cryptocurrency investment:

Not so soon. Before you YOLO your life savings, let us quickly understand a few disadvantages involved in investing in cryptocurrency.

A. Extremely risky

Though it is a novel technology, crypto is risky for two reasons. Firstly, it is very volatile, and secondly, there is still a lot of regulatory uncertainty surrounding crypto.

B. Volatile

Only invest what you do not need in the short term. Cryptocurrencies can have swings as crazy as 80% on either side in a cycle. So avoid putting in money you may have to take out in the short term. 

Legal and Tax Regulations of Cryptocurrency

Most countries across the globe are trying to dabble with the mammoth task of regulating cryptocurrencies. They could very well control the KYC-enabled platforms like centralised exchanges, but it is tough to figure out a way to regulate decentralised finance at scale. 

Also, almost everyone in the industry wants the regulations to kick in as soon as possible. After all, a lack of regulations leads to fraudsters and scammers getting away with no accountability whatsoever.

With that being said, a lot of conversations have begun around this space. Governments worldwide have started by formulating a tax policy for VDA or virtual digital assets. 

FAQs

1. Can you convert crypto to cash?

Crypto platforms do allow you to convert your crypto to cash and vice versa. 

2. Why is the crypto supply fixed and limited?

Cryptocurrencies are based on blockchains which run on the principle of ‘code is law’. Once the supply is coded in a code, there is no way to change it without taking consensus from all the nodes in the ecosystem. Therefore, the supply for certain cryptos is fixed. However, some cryptocurrencies also have an unlimited supply, like Dogecoin, Ethereum etc.

3. How to choose a cryptocurrency? 

It is an art to pick a cryptocurrency to invest in. The best way to approach this is to conduct thorough research on key parameters like revenue, history, algorithm (code), social parameters etc., and then decide where you want to put your money.

4. What is crypto mining?

Since cryptocurrencies are decentralised, they are maintained by a network of computers spread across the globe called miners. These miners deploy electricity and computational power to validate all the transactions happening in the network. In return, they are rewarded with some cryptocurrency. This process of earning cryptocurrency by validating transactions is called mining. The people who do it are called miners. 

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