What Is Cryptocurrency and How Does It Work? Your Guide

Cryptocurrency is a digital payment mechanism based on the concept of decentralization — meaning it is not regulated by a central authority, like a government — which sets it apart from traditional currency. It exists on an immutable and transparent computer database called a blockchain, which serves as a public ledger of transactions.

See: Demand for Gold is Up. Here’s Everything You Need to Know.

Whether you’re interested in cryptocurrency as an investment or as a tool to launch a blockchain-based project like an NFT or DeFi app, you won’t succeed if you haven’t mastered the fundamentals. Most people by now are probably familiar with bitcoin, blockchains and celebrity NFTs — at least on a casual basis.

But what is cryptocurrency, how does it work, and how can you make money by investing in it?

How Does Cryptocurrency Work?

The government prints and mints the U.S. dollars in your wallet, and banks validate and record transactions that your money facilitates. Cryptocurrency, on the other hand, does not rely on central authorities like banks or governments. Instead, the responsibilities of supervision, decision-making and maintenance are distributed across the network, not consolidated within a central authority.

What Is Cryptocurrency in Simple Terms?

At its most basic, cryptocurrency is digital money. It gets complicated fast from there — most people have never seen a blockchain database and wouldn’t know how to validate transactions through algorithmically programmed nodes or what any of that even means.

At its root, cryptocurrency is a currency: a method of payment, though it varies widely in value and utility.

Where Does Crypto Come From?

Only the government can print money, but anyone with sufficient technical knowledge can produce their own cryptocurrency — there are currently roughly 23,000 of them on the market.

Bitcoin, the original cryptocurrency, is generated through a complicated computational process called mining, which can be slow, expensive and environmentally exhaustive. More recently, many blockchains have instead shifted to a proof-of-stake (PoS) consensus mechanism, which rewards network participants with “staked” cryptocurrency for validating transactions, just as proof-of-work (PoW) protocols reward successful mining.

You’ll learn more about staking farther down the page.

Cryptocurrency for Beginners

The best way to understand crypto as a beginner is to focus on what it does and how you can use it rather than how it works on a technical level.

Where To Buy Crypto

You can’t buy cryptocurrency on stock exchanges. Instead, you’ll have to create an account on a cryptocurrency exchange, like Coinbase or Binance.US. If you have a particular crypto in mind, make sure the exchange you choose supports it — popular cryptocurrencies like bitcoin and ethereum are widely available, but the more niche coins aren’t available on every exchange.

You’ll also need to set up a cryptocurrency wallet to purchase tokens, but your wallet doesn’t actually store your holdings — it safeguards the private keys you need to access them on the blockchain.

When you have chosen your exchange and a compatible wallet, simply fund your account and make your purchase.

How To Use Crypto

Cryptocurrency has some functional utility. There are a few ways to use it:

Security and Risks of Cryptocurrency

Crypto is inherently risky. The reality of owning cryptocurrency is that digital assets are speculative, highly volatile and subject to more risk than even many stock traders can stomach.

Additionally, you and you alone are responsible for safeguarding the private keys secured in your wallet. If you lose them, they’ll be lost forever.

Finally, make sure you do your research and invest carefully. Crypto fraud is out there, and even crypto players that seem legitimate can fail.

Is Crypto Real Money?

Most cryptocurrencies don’t have the same utility as “real money” — they are largely not accepted as payment for goods and services.

Some crypto, however, can be used as a purchasing medium to buy things online and in a growing number of physical stores. The first and still most famous is bitcoin, which you can spend as you would money at places like Home Depot, Burger King and AMC. According to Bitpay, more than 250 stores and companies now accept at least 10 of the most popular cryptocurrencies.

Some Tokens Serve as Money Only in Their Blockchain Ecosystems

Many cryptocurrencies have utility as currency within their blockchain ecosystems. Blockchain projects create their own native tokens to facilitate transactions between users, ensure smart contracts, pay staking rewards and compensate users who perform validation and other network maintenance.

Just because users can use native tokens to pay gas fees within a specific blockchain network doesn’t mean they can use them to buy a latte at Starbucks — although Starbucks does accept bitcoin.

How Does Cryptocurrency Make Money?

There’s more than one way to make money through cryptocurrency investing. The three most common are:

Appreciation

Staking

Mining

Of course, there are at least as many ways to lose money with crypto.

1. Like Traditional Investments, Crypto Can Appreciate

The first way is through a concept that’s familiar to anyone who’s ever bought a home, a gold coin or a share of stock in the hopes that it would grow in value — appreciation.

There was a time when bitcoin traded for just a few pennies, but if you had bought a single coin on Nov. 20, 2015, when BTC was trading for $327, you would have gained nearly 20,000% by holding it for six years and selling when it peaked at $64,400 on Nov. 12, 2021.

The potential for that kind of wild appreciation is part of what triggered crypto’s meteoric rise — but the swings go both ways, and you could just as easily watch your investment crash and burn with the same terrifying speed.

2. You Can Earn a Yield By Staking Your Holdings

As previously discussed, PoS is phasing out the slow, cumbersome and energy-hogging practice of crypto mining — but it requires users to lock their assets into the network for a set period of time. The process is called staking, and it’s not much different than locking your money into a short-term CD.

You agree to stake some of your crypto, which the network uses to incentivize validators, and in exchange, the network pays you a yield. Staking can generate a passive income stream that doesn’t require you to perform any blockchain maintenance.

3. You Can Validate Blockchain Transactions Through Mining To Earn Crypto

It’s expensive to get started and highly competitive, but you can earn crypto by mining: validating blockchain transactions with your computer’s power. You’ll need specialized hardware — a high-power computer and high-tech computer chips — to get started, and you’ll need to pay the utility bills for your increased power use, so crypto mining isn’t for everyone.

Start Small — and Keep It That Way

Whether you hold your digital assets or stake them, crypto investing is a high-risk, high-volatility endeavor. Most experts recommend mitigating your exposure by limiting your crypto holdings to 5% of your portfolio or less. The rewards could be great, but never risk more than you can afford to lose.

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This article originally appeared on GOBankingRates.com: