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What is a Cryptocurrency?

Jack and Nick Author Pic
Jack Kramer & Nick MartellAugust 26, 2019
Forbes 30 Under 30 in media, appeared on CBS, Cheddar. Registered representatives of Robinhood Financial LLC.
definition

A cryptocurrency, like Bitcoin, is a form of digital currency that typically is based on blockchain technology.

🤔 Understanding cryptocurrency

Bitcoin. Ethereum. Ripple. There is a variety of cryptocurrencies (aka "crypto") that, like the US dollar or Mexican peso, are intended to be used as a form of payment. But some of the things that separates cryptocurrencies from the cash in your pocket are its fundamental digital and virtual elements. Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are based on the blockchain, a system that records transactions across a computer network in order to maintain trackability and security. The blockchain allows crypto to be decentralized so that no individual establishment, like a government or central bank, has to issue them or can alter them. You can trade cryptocurrencies in the market just like you could buy euros or sell yen (although crypto tends to be more volatile). But keep in mind that cryptocurrency trading is very risky (you could lose all the money you put into it) and should only be pursued if you can handle the losses.

example

Bitcoin was the first blockchain-focused cryptocurrency and it's spawned thousands of other forms of crypto (called "altcoins" short for “alternative coins”). It was created in 2008 by an elusive person (or a group of people) named Satoshi Nakamoto who still has never been confidently identified. Bitcoin records transactions on the blockchain and isn't issued by any government (it's decentralized). While Bitcoin has been used to purchase some things, it isn't nearly as commonly accepted as payment as any government-issued currency. It's most known for how it trades (which is extremely volatile), famously doubling in price above $18,000 per coin in the final month of 2017, but falling to lose half its value just a couple months later.

Takeaway

Cryptocurrencies generally want to achieve mainstream use…

but they aren’t there quite yet. While cryptocurrencies like Bitcoin trade on crypto exchanges with wild ups-and-downs, at their core, their goal is to become a secure, digital first, virtual currency. The big question remains — can cryptocurrencies become a standard form of payment? Will the positives outweigh the negatives?

Crypto Illustration

Tell me more...

What is the blockchain?
How does a blockchain transaction happen?
What are some other key cryptocurrency terms to know?
What are the positives of cryptocurrencies?
What are the negatives of cryptocurrencies?
What is Bitcoin?
What are Altcoins?
What are the risks of cryptocurrency trading?
How can investors trade cryptocurrencies?

What is the blockchain?

Blockchain. It’s become almost synonymous with Bitcoin and other cryptocurrencies. Blockchain. Your friends drop the term or it’s weaved into some article on “the future of shipping.” Out of all the terms used in defining cryptocurrencies, blockchain is one that even applies to uses beyond virtual currencies.

At its core, blockchain is a type of digital record-keeping system. You can literally picture it as a chain of virtual blocks that contain data. The digital information stored on each block throughout the chain can contain details like the date, time, amount, or who was a part of a transaction. To differentiate between blocks, each block in the chain has a specific identifier, known as a hash. And since each block can contain a significant amount of information, multiple transactions can be accounted for in each.

Blockchain is a fundamental concept behind Bitcoin and other cryptocurrencies, but it’s not the only one. For a set of other key terms to nail down on cryptocurrencies, we’ve got a list for you below.

How does a blockchain transaction happen?

There are 5 key steps that break down how a new block gets added to the blockchain. If you were to buy or sell a Bitcoin, for example, this is how that process would happen — and we can explain it simultaneously and in much simpler terms as if you’re buying your morning coffee (although cryptocurrency transactions are much riskier than espressos).

  1. Transaction: The first step is something actually happening, like buying your small almond milk latte (to-go). You step up to the counter, drop you name, and place the order. For a cryptocurrency like Bitcoin, that would occur on a cryptocurrency exchange or when you transfer Bitcoin between cryptocurrency wallets (when you purchase on an exchange, your funds are likely mixed in with others and the exchange records who owns what instead of making a record on the blockchain — but when you transfer a cryptocurrency between wallets, then it will likely be recorded on the blockchain).
  2. Verification: For many types of transactions, there’s an authority figure in charge overseeing the transaction. When you swipe your card for that latte, the info is going from your credit card company to the coffee shops payment processor to make sure it’s legit. Or if you pay with a $50 bill, the cashier may wave General Grant in the air to make sure it’s real. With cryptocurrencies, a decentralized computer network worldwide is verifying the transaction as you transfer the crypto between wallets (this is one of the ways many cryptocurrencies are decentralized — through the verification process). This process is completed by “miners,” which we’ll get into in a bit.
  3. Recording: That coffee shop has to keep track of all the lattes they’re selling and money they’re bringing in for it, so they add it to their record books. Blockchain transactions have the same need, so the info from the transaction (the amount, the time) is recorded on the block. In fact, many transactions like yours can be recorded on a single block within the blockchain.
  4. Identification: That coffee shop record book isn’t much help if it’s not organized, so the store owner probably keeps them in a stack with the dates clearly labeled. Or if they use a computer system, they’ve got each month’s financial info neatly identified on each file. For blockchain, with so many virtual blocks covering every transaction, the ability to identify each is critical, so each one is given a hash — its own special identifying code.
  5. Storage: With each passing month, the coffee shop will then stick their physical record books in a back room for safekeeping or may place all their digital files of transactions in a single computer file. For blockchain, once each block earns its hash, it is placed into the blockchain as a record of all the five steps we just went over.

As you finish up that small almond milk latte and get on with your day, keep in mind this isn’t a perfect analogy — the main risk to your coffee is spilling, while cryptocurrencies carry a lot more downside potential. The cryptocurrency trading process is more complicated, and can often take time if buyers or sellers aren’t available (unlike your fast coffee swipe transaction). And unlike a coffee, cryptocurrency trading can be extremely volatile, with price spikes and drops that can result in losing your entire investment.

What are some other key cryptocurrency terms to know?

We just covered blockchain and the 5 key steps to a blockchain transaction, like when you buy or sell a Bitcoin (a process, though riskier, analogous to your morning coffee purchase). But here are a few other key crypto terms to keep in mind if you’re jumping into conversation with a friend who knows the material well (and we all have that friend who’s been talking about cryptocurrencies for years).

  • Altcoins: Bitcoin is considered the first blockchain-based cryptocurrency, which inspired a series of other cryptocurrency types. These are all considered altcoins.
  • Bullish/Bearish: Traders can be bullish or bearish on not just cryptocurrencies, but other types of investments or markets (stocks, bonds, the stock market as a whole, or even cryptocurrencies — a bullish person thinks the Bitcoin will go up, a bearish trader thinks its price will go down.
  • Bitcoin: The first cryptocurrency ever created on the blockchain, Bitcoin is also one of the most well known and popular. It was launched in 2008 by a mysterious person (or, potentially, group of people — it’s never been confirmed) who goes by Satoshi Nakamoto to become a blockchain-based digital currency system.
  • Blockchain: The digital ledger that verifies, records, identifies, and stores the critical information on cryptocurrency transactions in individual blocks using a decentralized worldwide network of computers (we walk through how a blockchain transaction works up above).
  • Central ledger: This is the opposite of a decentralized ledger system that cryptocurrency uses — instead of a network of computers worldwide tracking the transaction, a single authority manages this. A central ledger of financial records is how a bank operates.
  • Ethereum: As of June 2019, Ethereum was one of the three largest cryptocurrencies in the world based on value by market capitalization.
  • Crypto exchange: Just like stocks trade through exchanges like the New York Stock Exchange or Nasdaq, cryptocurrencies are traded on platforms that connect buyers and sellers. There are different fee structures and rules for different exchanges that allow you to buy or sell cryptocurrencies.
  • Fiat currency: Whip open your wallet — that’s your fiat currency. It’s the common type of cash or legal tender issued and recognized by governments, like the US dollar, euro, or Mexican peso.
  • Forking: Sometimes cryptocurrencies are literally split in two, a process called forking. It happens when the code within the cryptocurrency is changed, and can be either considered “hard” (the two new software underlying the cryptocurrency aren’t compatible) or “soft” (the cryptocurrency forked, aka split, but the software underlying each are compatible). The result of the fork is two different versions of the blockchain. A common example of a hard fork was Bitcoin Cash, which split off from Bitcoin to become a whole new crypto with a whole new value — If you have Bitcoin Cash, you can’t send it to the regular Bitcoin blockchain during a transaction.
  • Genesis blocks: The first few blocks that form a blockchain get their own special name. With each additional transaction and addition of blocks, the blockchain can grow beyond the genesis blocks.
  • Halving: Bitcoin miners earn Bitcoin as they dig new ones into circulation, filling up blocks in the blockchain. Since the total amount of Bitcoin that will exist in the world is finite (it’s capped at 21M), the amount of Bitcoin earned by each miner for filling up one block in the blockchain is halved after the block is completed.
  • Hash: Since data kept on the blockchain must be identifiable, hashing makes this possible. Any piece of data on a block can be hashed, no matter the size or what it covers.
  • Initial coin offering (ICO): Cryptocurrencies can be created and used to raise capital, similar to a company pursuing an initial public offering (IPO). There are key differences between an IPO and an ICO, like the level of regulation, security, volatility, risk, and oversight, but the core idea is the same — a crypto creator raises funds by offering an initial batch of the new coins to be bought by investors.
  • Ledger: One core element of the blockchain is its use as a ledger to record financial transactions. Ledgers can’t be changed, but can be added to with new transactions that a cryptocurrency experiences, like additional buying and selling.
  • Mining: It’s often pictured literally as going into a computer to dig up new Bitcoin, but mining is actually more related to the blockchain. Crypto mining is the process of verifying multiple types of transactions on the blockchain and adding them to this critical digital ledger after going through challenges (like encrypting challenges). To incentivize miners to be a part of the process, which involves a significant amount of special computing hardware and power, crypto miners can earn fractions of the cryptocurrency they’re mining. To maximize their payouts, miners often merge their resources in “mining pools” and agree to divide up their earnings afterword.
  • Satoshi Nakamoto: The mysterious, unknown creator of Bitcoin, the first blockchain-based cryptocurrency. It’s not known if this was one person, or a group of people, or even if the name is real, but he, she, or they have developed a cult-like following.
  • Smart contracts: Contracts that are self-executing, with computer program code manage the terms between the two parties trading. The different lines of code occur without the need for a central authority on the blockchain so that they’re fully recorded.
  • Token: The coin within each cryptocurrency is considered a token. More literally, each of these coins (tokens) is digital code representing a fraction of a cryptocurrency that is traded.
  • Wallet: To use Bitcoin or any cryptocurrency, you need a digital wallet. For cryptocurrencies, a wallet is a publicly-available digital address within the blockchain. Inside each wallet is more detailed and private information — a series of keys indicates the owner and amount of what’s held on that black. Think of the cryptocurrency wallet as software that stores critical public and private keys that work with other parts of the blockchain that allow the owner’s cryptocurrencies to be bought of sold.

This isn’t a complete list of all the possible cryptocurrency related terms — plenty more exist, and many are created each day as the usage of cryptocurrency grows. Think of this as a starter kit to knowing some of the basic concepts. Just like anything in life, the more research you do, the more knowledgeable you’ll become on this topic.

What are the positives of cryptocurrencies?

Cryptocurrencies have gained attention for their potential — enabling transactions to happen digitally, seamlessly, quickly, and securely. As the new concept of crypto is fleshed out and grows, there are significant risks that come along with it. These are some of the core benefits though that crypto aims to offer now and in the future:

  • Eliminating 3rd parties: A key goal for cryptocurrencies is to make a transfer of an item between two groups as seamless as possible. Currently, when you swipe your credit card, there can be multiple middlemen or third parties who are part of the transaction, ensuring you have the ability to pay and the merchant has the ability to accept. The wallets used in cryptocurrency transactions can help eliminate these middlemen, which could cut down on certain transaction fees. This benefit is often discussed when applying cryptocurrencies to international cross-border payments. However, there still may be fees involved with cryptocurrencies, like the ones some exchanges apply when you buy or sell a cryptocurrency.
  • Security: By using blockchain technology, cryptocurrencies seek to ensure all digital transactions are recognized and stored on a public ledger. Each new transaction leads to more data being stored on more blocks. The risk is that since crypto is purely digital, a crash across a system could eliminate your holdings if there is no backup.
  • Decentralized: Since there is no centralized authority governing most cryptocurrencies, there isn’t an individual government or company that can manipulate the underlying cryptocurrency. No single group is issuing the new cryptocurrency, changing its value, or accessing your personal data. However, the lack of an individual authority also means that there is no individual accountability if something goes wrong.

What are the negatives of cryptocurrencies?

Significant investor and pop culture interest has poured into cryptocurrencies over the years. While there are some potential benefits to the future usage and adoption of cryptocurrencies, they come with significant negative elements that any reader, fan, hater, trader, or investor should be aware of.

  • Illegal activities: Since cryptocurrency records exist on the blockchain, owning them can be a fairly anonymous experience. As a result, Bitcoin and other cryptocurrencies have been used in a variety of illegal online and offline issues, from tax evasion to money laundering to becoming a default form of payment for an illegal business run by criminals.
  • Fluctuations: Cryptocurrency prices are based on supply and demand, just like stocks or bonds may trade. But Bitcoin and other cryptocurrencies tend to experience significant volatility, changing prices in rapid ways.
  • Liquidity: Cryptocurrency trading is frequently not as easy as trading stocks — because there may be few holders of a particular type, selling or buying it can take time. This is a liquidity challenge, meaning it can be harder to convert cryptocurrencies into cash.
  • Market manipulation: Given the lack of transparency in much of cryptocurrency trading, the trading process can be affected by market manipulation — individuals or misinformation can drive up prices suddenly. The results can be flash crashes or price swings that can cause you to lose all the money you put into the cryptocurrency very fast.
  • Hacks: Cryptocurrencies pride themselves on the security provided by their blockchain foundations that track, record, and maintain transaction records. But other elements of your cryptocurrency experience may not be as safe because of cybersecurity risks. Cryptocurrency exchanges and wallets can be subject to hacks — some have, with hacks ranging in the millions of dollars in coins stolen.
  • Regulation: Cryptocurrencies are currently undergoing intense focus by governments over how they will be regulated in order to best protect consumers. Right now, there is little consensus by governments worldwide on how exactly to do this, which leaves some uncertainty over the future of cryptocurrencies and where they can be exchanged. Overall, regulations are intended to ensure consumers are as safe as possible.
  • Decentralized: While one of a cryptocurrency’s strengths is its decentralized nature, that also can be a weakness. For instance, if something goes wrong with your credit card (like a fraudulent charge), your bank can jump in as a third-party to fix the situation. But with cryptocurrencies, there is no central authority to intervene if there is an issue like a hack. Third-parties or central control in a system like a currency can act as a stabilizer if things get turbulent.
  • Appropriateness: Given these risks and concerns, cryptocurrency trading is generally not suggested for some critical types of investments in your life, like retirement savings or accounts for your student loans, mortgage, or emergency funds.

What is Bitcoin?

The OG. Bitcoin (nicknamed BTC) is considered the first blockchain-focused cryptocurrency — and the concept it pioneered has led to thousands of other cryptocurrencies known as "altcoins." The origins of Bitcoin in 2008 (when the domain was registered) are as mysterious as its creator, Satoshi Nakamoto. That person (or group of persons) has never been identified, but remains a cult-like figure in the cryptocurrency community.

Here’s the core of how Bitcoin works. The cryptocurrency’s most basic element is that it verifies, records, identifies, and stores transactions on a blockchain, adding blocks as transactions accumulate. It isn't issued by any government, which is why it’s considered “decentralized.” Despite the publicity and hype around Bitcoin as a potential payment tool of the future, it currently isn’t accepted as payment as most government-issued currency (aka “fiat currencies”) are.

You’ve probably noticed Bitcoin for the attention it earns for how it trades, which is volatile. At the end of 2017, it famously doubled to reach over $18,000 per coin — just months later in early 2018, Bitcoin prices fell to lose half its value. As of Monday, July 15, 2019, as tracked on Robinhood, Bitcoin was going through another volatile stretch and had reached $10,893 at one point while trading, then losing 10% the following day.

Just like other currencies, Bitcoin contains some key risks to keep in mind. There’s the primary risk of how the price fluctuates significantly as it trades. Then there’s also the external risk of how it will be regulated, since it’s such a new concept that governments worldwide want to ensure is safe for consumers. These are just a couple of the risks, but it’s critical to keep them in mind whenever you’re thinking of investing in cryptocurrencies.

What are Altcoins?

Influenced by Bitcoin, a bouquet of other cryptocurrencies has blossomed over the last few years — and these “altcoins” carry similar crypto characteristics and risks. Like Bitcoin, Altcoins are digital currencies carrying different names that can be traded on many crypto exchanges. The most common element to cryptocurrencies like Bitcoin is that they are decentralized, typically using a blockchain to record and store transactions, after they’re issued through a mining process.

Here are some sample Altcoins to keep in mind that also have large market capitalization:

  • Litecoin (LTC): Created by an MIT alum in 2011, Litecoin was one of the first cryptocurrencies to come into existence after Bitcoin. Unlike Bitcoin, Litecoin is known for generating new blocks (which form the blockchain) at a faster pace, allowing for faster transactions.
  • Ethereum (ETH): Younger than Bitcoin or Litecoin, Ethereum was created in 2015 and is similarly decentralized. What separates Ethereum is that it also runs applications (called DApps, or “distributed applications”) that depend on a type of token unique to Ethereum called ether. Ether itself is a piece of code that acts like a currency, wanted by app developers or investors because it’s the digital payment required to “pay” for running an application or program.
  • Ripple (XRP): Launched in 2012, Ripple is more of a network that allows for immediate and minimal-cost payments worldwide — its focus is sending money globally. That core us has made it particularly relevant for banks looking to settle cross-border transactions using Ripple’s ledger that records transactions. Unlike Bitcoin, Ripple doesn’t require mining, so it draws on less computing power than some other Altcoins.

Other Altcoins are continuing to pop up. For instance, in June 2019, Facebook announced it was launching Libra, its own cryptocurrency to allow sending money internationally more easily through the social network. Another Altcoin, “Dogecoin,” was created in 2013 with the logo of a Japanese Shiba Inu dog, but it’s become popular for its small transaction fees and times compared to other virtual currencies.

These are just a few of the names to know if you’re curious about Altcoins — many more exist and are being created frequently. But don’t forget that, like Bitcoin, they can trade with significant volatility — in fact, since some of these Altcoins are much smaller than Bitcoin, it can even be hard to find buyers or sellers on an exchange, and it’s possible to lose your entire investment if you purchase them (no matter the cryptocurrency).

What are the risks of cryptocurrency trading?

Cryptocurrencies are a complicated, interconnected, and technical concept whose value is still being proven. Above, we jumped on some of the drawbacks to cryptocurrencies, such as their use for some illegal activities by criminals. Even if you’re not a criminal, there are still critical risks to recognize when trading cryptocurrencies. For example, cryptocurrency prices can change radically in a trading day given how few places there are to trade them and their uncertain value and regulatory status. Crypto exchanges are also sometimes vulnerable to hacks in which coins are stolen, which has happened before to some notable exchanges.

Purchasing cryptocurrencies comes with a number of risks, including volatile market price swings or flash crashes, market manipulation, and cybersecurity risks. In addition, cryptocurrency markets and exchanges are not regulated with the same controls or customer protections available in equity, option, futures, or foreign exchange investing.

Cryptocurrency trading can be extremely risky. Cryptocurrency trading may not generally be appropriate, particularly with funds drawn from retirement savings, student loans, mortgages, emergency funds, or funds set aside for other purposes.

Cryptocurrency trading can lead to large and immediate financial losses. Under certain market conditions, you may find it difficult or impossible to liquidate a position quickly at a reasonable price. This can occur, for example, when the market for a particular cryptocurrency suddenly drops, or if trading is halted due to recent news events, unusual trading activity, or changes in the underlying cryptocurrency system.

How can investors trade cryptocurrencies?

Just like with stocks or bonds, you need to find an exchange in order to trade cryptocurrencies. Exchanges are marketplaces, acting as platforms to connect buyers and sellers. One of the earliest large exchanges was Coinbase. Robinhood Crypto, LLC offers a means of commission-free cryptocurrency exchange that allows customers to trade on a state-by-state basis on a variety of cryptocurrencies (other fees may still apply. Please see our commission and fee schedule to learn more). To see if your state or a particular coin are available, you can check out the options on Robinhood Crypto here. But like we’ve mentioned before, keep in mind that cryptocurrency trading isn’t easy and isn’t for everyone — there are plenty of risks involved, and you should you make sure you understand them before jumping in.

Cryptocurrency trading offered through Robinhood Crypto, LLC. Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services and is not a member of FINRA or SIPC. Cryptocurrencies are not stocks and your cryptocurrency investments are not product insured by either FDIC or SIPC.

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This information is provided for educational purposes only and is not and should not be construed as an offer to sell or a solicitation of an offer to buy any security. In addition, this information is not intended to serve as a recommendation to buy or sell any security or other investment product. This information is not individualized, does not constitute a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security, or financial product does not guarantee future results or returns. Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals and/or an investment adviser for advice that is specific to your situation. Securities offered through Robinhood Financial LLC, member SIPC and FINRA. The information used to create this content is based upon information reasonably available to Robinhood Financial LLC as of the date of publication. © 2019 Robinhood Markets, Inc. Robinhood® is a trademark of Robinhood Markets, Inc.