What is a Cryptocurrency?

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Definition:

A cryptocurrency (like bitcoin) is a digital asset used for investment or payments, which typically is not backed by any government or central bank and is usually based on a blockchain.

🤔 Understanding cryptocurrency

Cryptocurrencies, like bitcoin and ether, fit squarely in the world of alternative finance. They provide users with the ability to make decentralized peer-to-peer transactions — that is, without relying on payment processing companies or banks. This is possible because cryptocurrencies usually operate on blockchains, digital ledgers maintained by global networks of computers.

Example

Often described as “digital gold,” bitcoin is the original cryptocurrency. It was—and is—the first digital payments system based on a blockchain. The idea for bitcoin was first floated on a cryptography mailing list on Oct. 31, 2008 by Satoshi Nakamoto, the mysterious person (or group) behind the cryptocurrency. However, the actual bitcoin network went live later, in January 2009.

For most of its existence, bitcoin traded for less than $1,000. There was a brief spike over $1,000 in 2014, but it wasn’t until 2017 that it really went mainstream. That year, between November and December 2017, bitcoin’s price more than doubled, even as economists and observers grew concerned that it was in a bubble. Bitcoin’s price plummeted just a few months later. You can find its current price here.

Takeaway

Cryptocurrencies aim for financial independence…

In a world where many financial institutions charge their customers exorbitant fees, cryptocurrencies are pretty revolutionary. They offer a digital means to store wealth and transact, in some cases, independently of any company. Whether you buy cryptocurrencies with this in mind (or decide to pass on them altogether), these digital assets are founded on an ethos of decentralization. They strive to put financial power back in the hands of the people.

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How is a cryptocurrency different from a traditional currency?

While the US dollar relies on government institutions (e.g., Congress, the Federal Reserve, and the US Treasury), cryptocurrencies are mostly beholden to code. This means they function based on parameters set by software developers. For instance, bitcoin’s supply is capped at 21 million coins, a limit set by its creator Satoshi Nakamoto. This is in contrast to government-backed currencies like the US dollar, which could theoretically be printed without limitation. As of June 2020, approximately 18.4 million bitcoins have been mined (but more on that later).

A cryptocurrency is only as strong as its community – the stakeholders who maintain, issue, trade, and perhaps regulate it. This may refer to core developers (programmers who update a given cryptocurrency’s protocols), miners (people and groups who validate the associated network’s transactions), exchanges and other trading venues, and of course, users. These stakeholders, in addition to international regulators, all play vital roles in the cryptocurrency markets.

To date, cryptocurrencies broadly lack legal tender status. This means that people and businesses are not legally required to accept cryptocurrencies as a form of payment.

How does a cryptocurrency work?

Blockchain. Blockchain. Blockchain. It’s almost become synonymous with bitcoin and cryptocurrencies. Your friends may have dropped the term in conversation or perhaps you’ve seen it, referenced with the wave of a hand in an article about “the future of shipping.”

At its core, a blockchain is a digital record-keeping system. You might think of it as a distributed database. If you’re having trouble picturing a blockchain, you’re not alone. It might be easiest to think of a blockchain as a giant stone, placed in the middle of a village. Everybody can see what’s written on it and everybody knows who makes a change. It’s all out in the open, available for the public to view and participate — At least, that’s one way of thinking about it.

Closer to the metal, the “blocks” in a blockchain contain granular details, such as timestamps, amounts, and participants in a transaction. And to differentiate between each payment, each one has a specific identifier, known as a transaction hash (TX ID).

Many companies, like Walmart and IBM, have launched products under the banner of “blockchain,” creating distributed systems that are only accessible to select groups of people. However, while bitcoin exists on a public (aka “permissionless”) blockchain, these private versions are known as “permissioned” networks. Many people question whether private networks possess similar benefits to public networks. Others question whether blockchains are useful at all, especially since a blockchain’s data is only as good as its source. As computer scientists say, “Garbage in, garbage out.” Accurate records are crucial.

While blockchain advocates—both corporate and open-source inclined—envision a future ruled by code, there has been little progress aside from cryptocurrencies. To date, distributed file-sharing systems, decentralized (aka “self-sovereign”) identity systems, and blockchain-based music streaming platforms have not taken off. Still, as of July 2020, cryptocurrencies represent a combined market capitalization of more than $270 billion.

What are the types of cryptocurrencies? What are altcoins?

Today, there are thousands of cryptocurrencies listed by price tracking websites, and many were inspired by or even drew directly from Bitcoin’s code. As a whole, these bitcoin descendents are known as “altcoins” or alternative cryptocurrencies. Examples include litecoin and ether.

While some cryptocurrencies tout their enhanced specs—speed, security, and privacy—others were created for fun and entertainment. One example is Dogecoin. Some cryptocurrencies have also been revealed as scams, with buyers losing part or all of their investments.

Here are some altcoins with large market capitalizations:

  • Litecoin (LTC): Created by an MIT alum in 2011, litecoin was one of the first cryptocurrencies to come into existence after 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 and litecoin, the ethereum network was launched in 2015. In addition to its native currency, “ether,” the network is distinguished by its potential for decentralized applications (“Dapps”).
  • XRP: Launched in 2012, XRP (often referred to as “Ripple”) is the digital currency associated with the XRP network. It is meant to enable immediate and low-cost payments worldwide. That touted use case has made it particularly relevant to banks looking to settle cross-border transactions using Ripple’s ledger. Unlike bitcoin, XRP doesn’t require mining, so some in the crypto community dispute whether XRP qualifies as a cryptocurrency.

Other altcoin continue to pop up. For instance, in June 2019, Facebook announced Libra, a proposed cryptocurrency to allow users to send and receive money through the social network. As of June 2020 though, Libra has not launched.

Don’t forget, like bitcoin, altcoins can be extremely volatile. It can even be hard to find buyers or sellers, and it’s possible to lose your entire investment if you purchase them (no matter the cryptocurrency).

It’s important to note that Robinhood carries a crime insurance policy that protects a portion of the crypto assets held across our custody system against losses from theft, including cybersecurity breaches. The policy is underwritten by certain underwriters at Lloyd’s, the world’s leading insurance marketplace, and placed by Lloyd’s registered broker, Aon. Learn more about crypto custody.

What are privacy coins?

Privacy coins are one significant subset of cryptocurrencies, and as suggested by their name, they aim to enhance user privacy by concealing transaction participants and amounts. Examples include Monero and ZCash. But you should know—even though they’re billed as “privacy-protecting” digital currencies, their anonymizing measures may be unraveled by researchers and law enforcement agencies. Another privacy coin, Grin, has also attracted scrutiny for allegedly not fulfilling its privacy claims.

What are stablecoins?

Stablecoins attempt to peg their price to a specific value, such as the US dollar. This is sought in two ways: 1) by tying the coins to a pool of reserve assets or 2) by algorithmically controlling the stablecoin’s supply. At various points though, some stablecoins have deviated from their intended values, in some cases resulting in losses for investors. You might also recognize that reserved-backed stablecoins—the first variety—are different from traditional cryptocurrencies, since their value is dependent upon another, existing asset. One reserve-back stablecoin, Tether, has achieved notoriety because some investors worry that its parent company, iFinex, might not possess corresponding reserves of US dollars.

Algorithmic stablecoins have sometimes raised regulatory concerns, and in at least one instance, millions of dollars in seed money was returned to investors, among them GV and Bain Capital, when the project was cancelled. One algorithmic stablecoin project that has persisted is MakerDAO. Operating on the Ethereum network, it features a blockchain-based currency called DAI, which is soft-pegged to the US dollar.

What are colored coins?

Colored coins are tokens on blockchain networks, which are supposed to represent tangible assets, such as gold or real estate. Once again, these are different from traditional “cryptocurrencies” — They can be digitally traded, but there’s little to guarantee that underlying assets will be delivered to their purchasers. While blockchain-based transactions may reduce processing fees and middlemen (and provide a publicly available chain of ownership), there’s little recourse if a deal goes awry.

What are central bank digital currencies?

Central bank digital currencies, or CBDCs, are often erroneously described as cryptocurrencies. However, CBDCs (which largely remain theoretical) need not operate on a blockchain network. While some countries have reportedly explored blockchain-based CBDCs (for example, China’s Digital Currency/Electronic Payment), there are also projects underway that have virtually nothing to do with bitcoin and its brethren.

Regardless of whether a CBDC is actually a digital bearer instrument (meaning that the code itself is the currency), central banks have expressed interest in expediting payment systems. For instance, in the US, the Federal Reserve is developing FedNow, a real-time settlements system that it hopes to make available to all banks by 2023-2024. Many crypto industry participants believe that CBDCs may serve to increase understanding of digital assets overall, and ultimately lead to greater adoption of traditional cryptocurrencies over time.

Is (insert coin name) a cryptocurrency?

Well, it depends how you define cryptocurrency. To be certain, some “cryptocurrencies” might not resemble a traditional cryptocurrency, like bitcoin. That’s because they might rely on non-blockchain storage mechanisms or use wholly different consensus mechanisms (bitcoin uses proof-of-work) to create and share records across their networks.

For example, Hedera’s digital currency, the HBar, relies on something called hashgraph. (The company claims this makes it more efficient than a blockchain-based cryptocurrency.) Another project, Algorand, uses a lottery-based consensus protocol, a variant on proof-of-stake for its digital currency.

What is cryptocurrency mining?

Mining is the process of verifying records and adding transactions to a blockchain network. People who mine cryptocurrency often use specialized hardware, including application-specific integrated circuits (ASICs) and graphics processing units (GPUs) to optimize their profitability. In exchange for securing and maintaining cryptocurrency networks, miners can be eligible to receive block rewards (more on that below).

How long does it take to mine bitcoin?

A new block is added to the bitcoin blockchain roughly once every 10 minutes. This results in a payout of the block reward, which is 6.25 bitcoins as of May 2020. Before your eyes light up with dollar signs though, you should know — for an individual miner, the odds of successfully mining a block are extraordinarily low. That’s why many miners join mining pools. (You might think of this like joining your office’s lottery pool.)

Is bitcoin mining profitable?

It’s hard to say whether mining bitcoin, or any other cryptocurrency, is profitable. That’s because it depends on a number of factors, including the coin’s price, the cost of your mining equipment, and your ongoing electricity costs. Since cryptocurrency prices can swing wildly, this calculation is dynamic and you might want to adjust your expectations. If you hope to mine cryptocurrency, you’d do well to minimize your energy costs, which can eat into any profits. As of May 2020, bitcoin’s “block reward” — the payout for successfully adding a block to the bitcoin blockchain — is 6.25 bitcoins. Oftentimes, this amount is divided among participants in mining pools, groups of miners who combine their processing power.

What are the potential benefits of cryptocurrencies?

Cryptocurrencies have won praise for facilitating relatively fast and secure transactions. This can be especially helpful to people sending money abroad. These are some of the core benefits that cryptocurrencies hope to offer now and in the future:

  • Eliminating 3rd parties: Cryptocurrencies and blockchain technology attempt to make the transfer of assets as seamless as possible. Currently, when you swipe your credit card, there can be multiple middlemen who are part of the transaction—they exist to ensure you have the ability to pay and the merchant has the ability to accept your payment. But that verification and settlement costs money, meaning that merchants often pay processing fees for accepting credit card payments.
  • Reducing transaction fees: Cryptocurrency transactions can help eliminate (or reduce) these transaction fees, a benefit that often arises when discussing cross-border payments. However, as cryptocurrency interfaces have been built by exchanges and wallet services, for most users there could still be fees involved (i.e., they’re not submitting their transactions directly to the network, there’s still a broker of some sort).
  • 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.
  • Avoiding Inflation: Since there are no centralized authorities managing most cryptocurrencies, there isn’t a government or company that can change the supply of the underlying cryptocurrency.
  • Diversification: Depending on your portfolio and risk tolerance, cryptocurrencies could offer a measure of diversification. Some crypto proponents claim that cryptocurrencies are a safe haven asset, meaning that their value is fairly stable during an economic downturn. Many have cast doubt on this claim.

What are the potential risks of cryptocurrencies?

Investors and popular culture have flooded the cryptocurrency ecosystem over the last several years. While there are potential benefits associated with the adoption of cryptocurrencies, they also come with risks that any reader, fan, trader, or investor should be aware of:

  • Price Fluctuations: Like stocks and bonds, cryptocurrency prices are based on supply and demand from investors. However, bitcoin and other cryptocurrencies tend to experience significant volatility and their global markets are often lacking in regulatory oversight.
  • Liquidity: Because there may be few holders of a particular type of cryptocurrency, 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 cryptocurrency market’s lack of transparency, the trading process can be affected by market manipulation — individuals and misinformation can cause prices to rise or fall sharply. This may result in flash crashes or price swings that can cause you to lose all the money you invested.
  • Hacks: Blockchains are not perfect. While cryptocurrencies are often touted for their network security, they are not impervious to bad actors. It’s possible for malicious people to take over a network and post fraudulent transactions (something known as a “51% attack”).
  • Theft and loss: Cryptocurrency exchanges have been targeted by hackers, resulting in the loss of billions of dollars. Additionally, if you (or your provider) lose your private keys, it’s possible that you will permanently lose access to your crypto funds. It’s important to note another key difference between cryptocurrencies and traditional payment systems. While traditional payment rails provide for rules that allocate the risk of loss, depending on the nature of the loss and the function facilitated by the parties involved, cryptocurrencies typically provide no such safeguards.
  • Regulation: Cryptocurrencies are being scrutinized by governments concerned about investor protection. For now, there is little consensus about their regulatory treatment, which leaves some uncertainty over their future and where they can be traded.

Cryptocurrencies are a risky asset class, which should be carefully researched and evaluated by anyone thinking about purchasing a particular cryptocurrency.

How can a person trade cryptocurrencies?

There are numerous cryptocurrency trading platforms available to investors, including Robinhood Crypto, which provides commission-free cryptocurrency trading on a state-by-state basis for a variety of cryptocurrencies. To see if your state or a particular coin are available, you can check out the options on Robinhood Crypto here. Keep in mind, cryptocurrency investment and trading isn’t for everyone — there are plenty of risks involved, and you should 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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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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