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Someone in your life is talking about cryptocurrency — maybe your partner or best friend. Or maybe you’ve seen it in the news or on social media. Either way, you want to understand this new technology that people are telling you to invest in.
Below, Select dives into what makes up a cryptocurrency, and what to look for before you invest.
At its most basic, a cryptocurrency is a digital asset that utilizes computer code and blockchain technology to operate somewhat on its own, without the need for a central party — be that a person, company, central bank or government — to manage the system.
A blockchain is a ledger which keeps track of cryptocurrency transactions. This ledger of transactions is maintained across computers that are linked across a distributed network. Transactions in cryptocurrency protocols are combined into blocks, and these blocks are then linked together in a historical record of everything that’s happened on that blockchain.
Bitcoin, the first cryptocurrency created, was developed initially to act as a payment mechanism native to the online world. Faster, cheaper, censorship resistant and not beholden to any government or central bank’s whims.
Today, there are thousands of cryptocurrencies. These still act as payment mechanisms but have also been developed for other use cases, such as lending and borrowing or digital storage. And one of the broadest use cases for this technology is speculation, buying in the hopes that the price will go up and the holders can make a profit.
The vision behind cryptocurrency is one of a peer-to-peer electronic currency system that is not controlled by a central authority and therefore, is fast, cheap and invulnerable to censorship (for instance, PayPal blocking gun sales) and other forms of corruption or control.
While the definition is fluid, there are several features that typically make up a crypto asset:
- Cryptography: This is where the term “crypto” comes from. A cryptocurrency (or crypto for short) utilizes cryptography, which are techniques for securing information or communications. Cryptocurrencies use what’s called public key cryptography. In systems using public key cryptography, there is a public key, which can be shared with others; in cryptocurrency, this is the key you share with people so they can send you crypto. There is also a private key, which you do not share with others. Think of the private key as a password. It secures your crypto holdings and is used to sign transactions that you’re initiating to others.
- Transparency: The ethos of crypto is one of transparency. Much of the code these protocols are built on is open source, made freely available for redistribution and modification. Plus, every crypto transaction is timestamped to the blockchain, which creates a public provenance or chronology of ownership or custody of the assets.
- Incentives: Cryptocurrency protocols are designed with game theory components in an effort to make sure all users of the system act in a way that keeps the system running. For example, Bitcoin miners must use computer power to verify blocks of transactions. To compensate for the work miners do, newly minted coins are automatically distributed to miners when they verify a block of transactions. In this way, miners are incentivized to continue putting power toward verifying transactions.
Coins, tokens and crypto assets
In the crypto space, many terms are used interchangeably, which of course, makes the conversation confusing for newcomers. But broadly, there are three categories of crypto:
- Crypto assets/digital assets: This is the catchall term for all of the unique assets that have sprung out of the blockchain revolution and use cryptography. Both cryptocurrencies and crypto tokens fall under this category.
- Cryptocurrency: These crypto assets are also called crypto coins and are those native to blockchains. So for instance, bitcoin (BTC) is the native cryptocurrency of the Bitcoin blockchain and ether (ETH) is the native cryptocurrency of the Ethereum blockchain. These coins are used to pay the transaction fees and also compensate miners, or the users who verify transactions.
- Crypto tokens: These are crypto assets that don’t have their own blockchain. Crypto tokens run on top of an existing blockchain. Ethereum is the most popular blockchain on which to build tokens, but there are other blockchains that can support this. For instance, the art NFT from Beeple, which sold for a whopping $69 million, was built on top of the Ethereum blockchain. Decentralized Finance (DeFi) tokens are also part of this category.
From its beginnings in 2009, the ecosystem surrounding cryptocurrency and blockchain technology has ballooned into a billion-dollar industry, while cryptocurrencies have a total market cap over $1 trillion.
The technology has led to some serious innovation, both internally and externally, pushing financial services providers and other industries to update their processes to better reflect people’s expectations for transacting and communicating online. For instance, the speed and low cost of cross-border crypto transactions has led many to begin re-evaluating the remittance industry and other payment networks, i.e. Western Union.
Being an open system, one of the goals of cryptocurrency is to expand access to financial service tools to many people who are barred from entering the traditional banking system. And the industry encourages self-sovereignty, the ability for individuals to maintain control over their data, be it identity information or their money.
Still, there are risks involved when getting involved with cryptocurrency and financial systems that aren’t regulated by the government, including hacks and lost wallet passwords, where people get completely locked out of their accounts and/or lose their money. Remember: These accounts aren’t FDIC insured.
Because cryptocurrency is outside of the control of government, it allows individuals and organizations to skirt laws, restrictions and regulatory oversight. Early in bitcoin’s history, it was used to send donations to WikiLeaks, after the U.S. government pressured the card networks, Visa and Mastercard, to cut off transactions to the organization. More recently, some Venezuelans have turned bolivars into bitcoin as a way to store value, since bolivars have been inflated to near worthlessness by the Venezuelan government. However, cryptocurrencies have also facilitated illicit activities like money laundering.
There are many ways to analyze crypto assets and projects, although there is no single silver bullet to finding the next big thing. Here are some things to consider while researching cryptocurrencies:
- Data: Because it’s built on transparency, the industry cranks out a huge amount of data. Market capitalization, or the total value of all the coins or tokens that have been minted, is a serious indicator in the space. You can compare cryptocurrency data on sites such as CoinGecko and CoinMarketCap.
- Use cases: Understanding how many active users a network has and what those users are doing on the network is helpful. Is the project tackling a real problem? How much adoption could a protocol see, both from individual users and businesses?
- Developer activity: Separately, protocols with a large developer ecosystem are typically seen as better projects, since this means that there are many people maintaining the codebase and working on making it better.
- The team: Investigating the team behind a cryptocurrency project can be useful, but it’s also challenging. Since there’s an ethos of privacy in the crypto ecosystem, many users, developers and even the C-suite likes to stay anonymous, using only a pseudonym. And that doesn’t always mean the projects are not to be trusted.
Remember cryptocurrencies and crypto tokens are a new category of investment, only a little more than a decade old. These digital assets are built with new, experimental technology, plus there’s thin and constantly changing regulatory oversight on the industry. As such, crypto assets are seen as a riskier bet than more traditional assets, like stocks and bonds.
Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.