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Home / Markets / Cryptocurrency /  What is cryptocurrency, and how does it work?

Cryptocurrencies have become an investing mania again, which means—because I cover the topic for The Wall Street Journal—I field questions from a lot of people I don’t usually hear from. Most recently, a high-school friend I haven’t talked to in years pinged me. He has started investing in cryptocurrencies, but was looking for some guidance.

“Would welcome tips on where to find good info, particularly geared for the newbie," he wrote.

As an asset class, crypto is so new even some people inside it don’t understand it. And the boom-bust, Wild West, no-holds-barred-nature of the market attracts some bad players.

How do you navigate all that? Carefully. With this in mind, we answer some commonly asked questions about cryptocurrencies.

What is ‘crypto’ and why does bitcoin matter?

“Cryptocurrency" is a name given to a broad group of digital assets that started in 2009 with bitcoin. There are thousands, but only a dozen or so have any appreciable size and potential future.

There is a lot of hype around bitcoin. Some people claim it will become the world’s reserve currency. Some fashion it as the new gold. Some people simply think it will keep rising in value and make anybody who holds it rich. Some people think it’s a fad or Ponzi scheme.

Setting aside for a moment bitcoin’s fundamental value or use case, the primary reason it matters is this: Bitcoin allows any two people, anywhere in the world with an internet connection, to make a transfer of value in a few minutes without any middleman.

With bitcoin, you could send $1 million to somebody, pay a small transaction fee, and have the exchange settled in 10 minutes or less. No banks, no foreign exchange. With this technology, anything that can be digitized can be exchanged cheaply and quickly.

How does cryptocurrency work?

The basic idea is that cryptocurrencies operate on software networks, where myriad computers run separate copies of the same program. The computers are linked, but no one computer controls the network. In bitcoin parlance, it’s a “decentralized" network.

These computer networks have two main functions: One is to process transactions, the other is to maintain the database that records and stores those transactions. In general, transactions are batched into “blocks," which are then connected in chronological order in a long, unbroken “chain." This is why the software became called “blockchain."

Who controls the computers?

Anybody can download and run these software programs; they are “open source" programs. The database where transactions are recorded, usually called the ledger, is therefore visible publicly to anybody.

This ensures that nobody on the network is counterfeiting the currency or double-spending the same bitcoins. The transaction history is collectively agreed upon by every computer, so it can’t be later changed. Transactions are permanent.

The people running these programs have an incentive: a competition with a monetary reward. They race against each other to batch together a block of transactions. The first block to be recognized by the network earns the winning computer a batch of newly minted bitcoins. Currently, the reward is 6.25 bitcoins, meted out roughly every 10 minutes. These are bitcoin’s “miners," a nickname given because what they’re doing is like mining for gold.

This competition does two things: provides an incentive for people to maintain the network, and is the mechanism through which new bitcoins are created.

How did this all start?

On Oct. 31, 2008, somebody using the pseudonym Satoshi Nakamoto released a nine-page paper describing a new system of “electronic cash" called bitcoin.

What bitcoin promised was an alternative to the existing financial system, and it struck a nerve with a lot of people in the wake of the global financial crisis. “Bitcoin" became as much a social movement as a piece of technology. That’s one reason it has such a passionate following; crypto’s adherents believe they are willing a financial revolution into existence.

Moreover, because bitcoin was released as open-source software, anybody can take the code and create their own version of it. They could tweak it to operate differently, or alter it for an entirely different use case. This is why there are thousands of different crypto platforms doing different things, everything from decentralized versions of operating systems (Ethereum), digitized banking services (DeFi), supply-chain networks (IBM and others), even new kinds of collectibles and art (NFTs, or nonfungible tokens). It’s a massive, live experiment in applying a new technology.

The first thing an inquisitive investor should do is read Nakamoto’s original “white paper." It’s technical but not inaccessible and it explains quite clearly how the bitcoin network operates.

Bitcoin has become so expensive. How can I afford it?

Bitcoin rose to almost $70,000 in 2021 from about $30,000 at the end of 2020. However, every bitcoin is divisible out to the eighth decimal place, meaning there are 100 million little units (nicknamed Satoshis) within one bitcoin. Therefore, you can buy pretty much any amount of bitcoin you want.

How do I buy one?

Originally, the idea behind bitcoin was that you downloaded the software itself and ran your own version of it, “mining" new bitcoins yourself. You were your own banker, a “self-sovereign."

In practice, however, that’s too unwieldy—and expensive—for most people. The most common way to buy bitcoin now is through a crypto exchange like Coinbase or Gemini, or a mobile broker like Robinhood, PayPal or WeBull.

If you have a financial adviser, they might buy it directly for you, or put you into one of the new bitcoin exchange-traded funds. In the U.S. at least, these ETFs are based on bitcoin futures, not bitcoin itself. There are some bitcoin ETFs that trade outside the U.S.

Exchanges and other intermediaries often act as custodians for your funds. This means they are responsible for safeguarding your account—to a degree. If you allow access to your account to somebody in a phishing scam for instance, that person can drain your funds, probably permanently. In bitcoin, there is no way to reverse a fraudulent transaction.

What should I be on guard against?

A lot. Because crypto is such a new area, and has largely been unregulated or only lightly regulated, cons and frauds are rife. The Federal Trade Commission warns investors to steer clear of any opportunities that promise you can earn lots of money in a short time, or that ask you to recruit other investors, that offer guaranteed money or free money, or that make exorbitant claims short on details.

In general, it’s best to steer clear of any investment offer via social media, especially if it comes to you. I regularly get emails from readers who don’t heed this warning and got scammed. And do your research on any investment manager or offer. If you can’t learn enough to feel comfortable, move on.

How do I make money?

Buying bitcoin is not like buying a stock or bond. When you hold bitcoin, you don’t own a piece of a company. You make money with bitcoin in one way: by selling it to somebody else for more than you bought it for.

There is one burgeoning part of the crypto market called “defi," short for decentralized finance. These are banklike services that allow you to lend out or borrow against your crypto holdings. If you lend, you can earn interest that typically ranges from 5% to 20%. If you borrow, you can take the borrowed crypto and invest it elsewhere in the market, again hoping to sell it for more than you bought it for.

However, defi is a new field, with virtually no business standards. Almost once a week, there’s a loss of funds. Very often, some malicious coder finds a flaw in a defi program and drains accounts. Sometimes, bad software crashes and erases transaction histories. Sometimes, the platforms were set up just to steal money (a so-called “rug pull"). The research firm Elliptic estimates that about $10 billion has been lost in 2021 on defi platforms. This is a buyer-beware environment.

Ultimately, you can make a profit in crypto, but know that you are putting money into a largely unregulated area with a lot of opaque corners and volatility. The billionaire hedge-fund manager Paul Tudor Jones understood this when he got into the market, calling bitcoin “a great speculation." That’s about the best description of it I’ve heard.

 

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