Cryptocurrency Concepts Explained

Basic Concepts of Cryptocurrency

Cryptocurrency is a digital currency that exists online, with no physical money involved. Unlike traditional payment methods and currencies controlled by central banks, such as the US dollar or the Euro, this new virtual currency operates through a decentralized system.

No central authority or official financial institution controls the cryptocurrency industry. Hooked together via blockchain technology, secured cryptographic techniques, and verified by peer-to-peer cryptocurrency transactions, the whole system is tough to breach or manipulate.

Traditional government institutions issue physical currencies, and you are trusting that the central bank will guarantee the legal value of your money. On the other hand, cryptocurrencies work through a decentralized structure, with secure transactions made possible through the blockchain, which is a public ledger that records transactions across thousands of computers simultaneously.

This network, with its vast shared computing power and consensus mechanism, will handle the backend for cryptocurrency payments, removing the need for a trusted third party, such as a bank, to verify transactions.

The Bitcoin System – The First Cryptocurrency

Introduced in 2009, the first cryptocurrency was Bitcoin, launched by an anonymous person (or group) using the name Satoshi Nakamoto. The arrival of Bitcoin was revolutionary, becoming the foundation of the decentralized finance that will soon rise, creating a digital currency that can't be duplicated, faked, or controlled by a central authority. Satoshi was the first one to finally solve the "double-spending" problem that plagued earlier attempts to develop a new virtual currency.

Blockchain technology was the answer to this problem, a distributed ledger containing each and every cryptocurrency transaction, spread across peer-connected devices worldwide. This global network uses cryptographic techniques to verify cryptocurrency transactions, a process known as mining.

Utilizing the massive collective computing power, miners solve complex mathematical problems, verify transactions within the cryptocurrency network, and add new entries to the blockchain. All of this is achieved within the Bitcoin system without a central authority like central banks.

One of the main philosophies of Bitcoin as a digital currency is transparency, where anyone can view the blockchain ledger, while remaining private, as no names are ever included in all crypto transactions.

Unlike fiat currencies that can be printed at will by central banks, bitcoin has a fixed supply of 21 million coins, with the implied scarcity making bitcoin a digital asset resistant to inflation. To this day, Bitcoin is still the most popular cryptocurrency and the crypto with the highest market cap.

Virtual Currency vs. Legal Tender

Bitcoin is a virtual currency that exists digitally; you cannot physically own it. Legal tender is the official currency that governments back with their own cash and gold in the central bank system, and the actual money that creditors are required to accept, such as fiat currencies like the US Dollar and the Euro.

While many businesses are now accepting bitcoin and other cryptocurrencies as payment, these digital assets are not considered legal tender. The key difference here is that even if a business or a person is willing to transact using cryptocurrencies, they are not legally obliged to accept these digital assets as payment, the way traditional money is.

One that has recently made headlines around the world is when El Salvador officially adopted Bitcoin as part of the country's official financial system. Most countries, however, still treat cryptocurrencies as financial assets, which can potentially trigger capital gains taxes, the same way stocks or real estate holdings will. While some countries, such as China, are declaring all crypto transactions illegal.

How Cryptocurrency Works (Technical Concepts)

The decentralized nature of cryptocurrencies has revolutionized the financial industry. Traditional payment systems rely on financial institutions like banks to verify and authenticate transactions, whereas cryptocurrencies eliminate the need for third parties through their decentralized structure and cryptographic techniques.

Instead of a central authority keeping track of every transaction, cryptocurrency introduces a decentralized finance network where thousands of computers connected globally share the same transaction ledger and maintain the network's integrity. Encryption algorithms make it next to impossible to hack or cheat the system by double-spending a digital currency within a network.

Blockchain Technology and The Ledger

To operate independently of banks and other financial institutions, cryptocurrencies use blockchain technology, a distributed ledger system in which thousands of copies exist simultaneously across the peer-to-peer network worldwide, rather than relying on a centralized institution.

When dealing with traditional financial assets, the involved parties need a trusted third party, like PayPal or a bank, to make a valid transaction. But with virtual currencies, transactions are grouped together into blocks of data, where each block contains a batch of recorded transactions.

With a unique cryptographic hash included in each block, all transactions are timestamped and chained together, making it resistant to hacking and manipulation, as hackers would have to change all blocks in the chain, making it virtually impossible.

The proof-of-work system introduced by Bitcoin relies on a consensus mechanism in which all connected systems must agree on which transactions are valid, negating the need for a trusted third party. Crypto miners race to solve a complex mathematical problem, and the first miner to solve it is rewarded with cryptocurrency, as they get to add the next block and record transactions.

Cryptocurrency Transactions and Payments

When sending cryptocurrencies, a secure transaction is broadcast to the network with a signed proof using a private key. The entire cryptocurrency network simultaneously validates the transaction before adding it to the blockchain ledger.

These crypto transactions first go into a holding area called a mempool while waiting for confirmation. This network validation system ensures that all crypto transactions are legitimate, making sure the coin has not been spent elsewhere. A transaction will be immutable and cannot be reversed once confirmed, unlike credit card transactions with a bank.

This consensus mechanism eliminates the need for a third-party observer. This revolutionary payment system has significantly lower fees, faster cross-border transactions, all without the need for traditional financial institutions.

Wallets and Private Keys

Before a trader or investor can interact with blockchain networks, they will need a cryptocurrency wallet to store private keys. The wallet acts as the public address, like an email address people use to buy or sell cryptocurrencies. However, losing the unique key will make your crypto assets gone forever, since cryptocurrencies don't have a "forgot password" option.

Your crypto wallet uses your own digital key to create a virtual signature that authorizes the trade. These private keys are complex and random strings of characters that prove you own the specific cryptocurrency asset, and with the built-in encryption algorithms, it is computationally impossible to hack or reverse-engineer the private key from publicly accessible information.

To own cryptocurrency, an investor has two options: either store it inside a crypto exchange or inside the investor's own personal wallet. Putting crypto assets inside a personal wallet gives you complete ownership and control.

• Hot wallets: Connected to the internet, convenient for active trading, but the exchange holds the keys
• Cold wallets: Offline storage devices (like Ledger or Trezor), completely disconnected from the internet, ideal for long-term storage

There is a saying in the cryptocurrency industry: "not your keys, not your coin." If you don't store your virtual currencies inside your personal wallet, you could lose access to your digital assets if an exchange gets hacked, goes bankrupt, or worse.

The Cryptocurrency Market and Industry

From a tech experiment by activist geeks, cryptocurrencies have now exploded into a multi-trillion-dollar crypto industry. Bitcoin was the first cryptocurrency, and since then, the crypto ecosystem has grown to include thousands of cryptocurrencies, and many cryptocurrency exchanges continue to add to the hundreds already operating. Millions of traders worldwide trade all the popular cryptocurrencies, with a total crypto market cap at one point reaching as high as 4 trillion dollars.

Market Cap and Market Data

Cryptocurrency is a digital asset that can bypass the central authority, ushering in the era of decentralized finance. In order to succeed in crypto investing, you need to understand the market data that comes with these financial assets. These include metrics like market cap, which allows traders to gauge the size and stability.

To get a cryptocurrency's market capitalization, simply take the price of a particular coin and multiply it by the total coins in circulation. A coin priced at $0.50 may appear cheap, but if there are billions in circulation, the market cap can be potentially huge.

Established cryptocurrencies like Bitcoin and Ethereum typically have higher market caps, greater liquidity, and are relatively stable compared to other cryptocurrencies with smaller market caps. Popular cryptocurrencies usually have more liquidity, but coins with a lower market cap may offer greater upside but also carry greater risk.

Aside from market cap, cryptocurrency investors also look at trading volume (an indicator of health with higher volume indicating tighter spreads), price charts with technical indicators, and data from cryptocurrency aggregators like CoinGecko and CoinMarketCap.

Central Bank Digital Currency (CBDC)

With cryptocurrency growing rapidly and massively, governments around the world have become increasingly nervous. The rise of decentralized finance has also led to fears that central banks will lose control over monetary policy.

In their attempts to control the situation, governments have started to introduce their own versions of virtual currencies – central bank digital currencies, or CBDCs. Basically, the digital version of a country's fiat currency, like a digital dollar or euro, issued and controlled by the central bank.

While these CBDCs exist digitally like cryptocurrencies, they are fundamentally different from decentralized crypto assets. Designed to slot seamlessly into the traditional financial systems, CBDCs may allow for faster and cheaper payment systems, without the anonymity of cryptocurrencies, and still be directly controlled by the government.

For the crypto industry, this is designed to introduce legitimacy to official digital assets while offering competition to cryptocurrencies. CBDCs may offer efficiency, but those benefits are offset by the loss of anonymity and independence from a central governing body.

Investing and Trading Concepts

Crypto investing and trading are two distinct concepts. Buying cryptocurrency for long-term investment or trading it actively are both valid approaches, but require completely different strategies, market psychology, and different crypto trading platforms.

Cryptocurrency Investments vs. Crypto Trading

Most people will freely interchange investing and trading, but they are two massively different concepts. Cryptocurrency investing is usually for traders following a long-term strategy, with the online trading community lovingly calling themselves "HODLers" who believe in the project's long-term potential. Investors build their portfolios through several months, or even years, riding out historically big drawdowns.

For those looking for more action and taking advantage of the volatility of cryptocurrency trading, actively buying and selling can yield significant profits. Crypto traders look at price charts, emerging trends, and ride the extreme volatility. They can profit multiple times a day by riding small price swings, but this strategy requires constant monitoring of market data.

Tax profiles for crypto trading and investing also differ dramatically. The Internal Revenue Service treats cryptocurrency and digital assets as property. This means that every selling transaction is potentially a taxable event, subject to capital gains rules. Long-term investors may get better tax treatment by holding for over a year, while active trading generates more short-term capital gains tax at higher rates.

Crypto Exchanges – Buying Real Assets

For those looking to really own cryptos, the first step is to find a cryptocurrency exchange. This is the platform that will allow you to buy cryptocurrency using fiat currencies like the US Dollar, Euro or the Yen. Investors can then either store bitcoin and other cryptocurrencies on the exchange itself or transfer them to their digital wallet.

Using a cryptocurrency exchange lets you swap cash from your bank accounts for virtual currencies. Exchanges allow the trader to gain access to the broader cryptocurrency ecosystem, opportunities to stake their coins to earn competitive yields, or participate in numerous decentralized finance activities.

While cryptocurrency exchanges may charge fees for their services, you are still ultimately in charge of your virtual currencies' security. The tradeoff for trading and DeFi convenience is that cryptocurrency exchanges can be hacked, just like what happened to the Mt. Gox exchange. Still, most exchanges are now safe and secure.

CFD Brokers – Speculating on Price

Some crypto participants care only about the actual trading and profit potential that comes with it, without dealing with wallets, personal keys, or blockchain technology developments. For them, financial products like contracts for difference (CFDs) are perfect. Crypto CFDs allow them to speculate on the price of cryptocurrencies without ever buying the virtual currency.

Traders are essentially making a bet with the CFD broker, whether the crypto price will go up or down, using traditional fiat currency to settle trades. This trading setup is perfect for pure traders. Without physically owning coins, traders can go long, betting that prices will rise, or go short when they think crypto prices will fall. CFD traders don't need to deal with digital wallets.

Other key benefits of using CFD brokers include the availability of leverage. This allows traders to trade larger positions than their capital would allow. An account with 1:10 leverage will be able to trade up to $10,000 worth of cryptocurrencies, even with only an account of $1,000. This gives the trader a 10x profit potential but also dramatically increases the potential for loss.

Prop Trading – Accessing Funded Capital

A third option has recently burst onto the cryptocurrency scene: prop trading. For the skilled trader with a proven strategy but lacking capital, prop trading offers a unique opportunity.

If you can pass their evaluation challenge, proving you can trade profitably while staying disciplined in managing risks, you can get access to a funded account. With this account, you can trade with the prop firm's capital without risking your entire bank account, and get to keep a large percentage of the profits, often around 80%.

Prop trading fixes one of cryptocurrency trading's biggest barriers to entry: the lack of trading funds. Skilled and qualified traders for a funded account can scale their trading accounts potentially up to $50,000, $100,000, and with some prop firms offering in the millions, with only a minimal fee to take the "challenge" as the only risk.

The requirements will vary across prop firms, but the common theme is a focus on risk management, not just profitability. They only want to fund traders that can consistently hit profit targets, usually around 8%, while keeping drawdowns low, usually at around 5% daily, and at around 10% max.

Is Cryptocurrency Safe? Risks and Regulation

From a technological point of view, the blockchain technology behind cryptocurrency is incredibly secure. The decentralized nature of these virtual currencies makes hacking the network virtually impossible. However, the human or the social aspect of this industry is where things get risky. There have been many publicized hacking issues in the past, particularly the Mt. Gox cryptocurrency exchange hacking, and more recently, the FTX scandal.

Because transactions on the blockchain are irreversible, if you send cryptocurrencies to the wrong address, there is no way to get them back, as there is no government agency or central authority to reverse the transaction.

Regulation and The SEC

Gone are the days when the crypto space was the Wild West of finance. Governments are now stepping up efforts to bring order to the cryptocurrency market, with the USA's Securities and Exchange Commission (SEC) taking an active role in ensuring fair market operations and protecting all parties involved.

There has been an active debate over whether certain coins should be considered securities, with the SEC arguing that many ICOs are acting similarly to unregistered stock offerings. Bitcoin appears to be safe, with both the SEC and CFTC stating that BTC is a commodity. Ethereum remains in a gray area, but recent statements suggest it will be classified as a commodity as well.

At the same time, the Internal Revenue Service (IRS) has indicated that traders and investors cannot hide their cryptocurrency gains, effectively treating crypto as property for tax purposes. Every transaction involving crypto is a taxable event, and failure to report can result in heavy fines.

Volatility and Financial Risks

The cryptocurrency market is not for the faint of heart, with the industry known for its volatility compared to traditional financial instruments. Double-digit moves in either direction are relatively common, moves that would cause massive panic in the stock market.

When valuing stocks, one can look at earnings performance, dividend yield, and financial statements. But with cryptocurrencies like Bitcoin, there is no definitive way to measure intrinsic value, other than supply and demand and market sentiment. This makes price discovery erratic, leading to big volatility moves and bubble pops over the years.

The potential for high returns is definitely there, as this is what draws people in, but the risk of loss is just as substantial. Whether cryptocurrency is safe ultimately boils down to one's personal risk tolerance and market understanding.