An Introduction to Cryptocurrency

By now, we have all heard about cryptocurrency, whether it’s Bitcoin, Ethereum, or one of the other over 5000 different types of cryptocurrencies that are currently in circulation. Although there has been a lot said about cryptocurrency, do you really know what it is and how it works?

Cryptocurrency is decentralized, digital money that is based on blockchain technology. This means that there is no central authority that manages and maintains the value of cryptocurrency, like the U.S dollar or the Euro. Instead, this responsibility is distributed among the cryptocurrency’s users via the internet.  The cryptocurrency payment system is based on cryptographic proof, which comes in the form of transactions that are then verified and logged on blockchain. 

How does it work?

Blockchain is similar to an open checkbook, where every transaction is recorded in code. Each transaction is recorded in “blocks” that are all linked together in a “chain” with the previous transactions. Anyone who uses a cryptocurrency has their own copy of the blockchain “checkbook” and whenever a transaction happens it is recorded and updated simultaneously on every copy of the blockchain. This way all the entries are kept identical and accurate.

The way fraud is prevented is by checking every transaction by using either proof of work or proof of stake validation. These are used to make sure a transaction is verified before it is added to a blockchain that would then reward the verifier with more cryptocurrency.

Proof of work vs Proof of stake

The first validation technique, proof of work, is completed by having computers (you may have heard these referred to as “miners”) race to solve a mathematical problem that is provided by an algorithm. This mathematical puzzle helps verify a group of transactions, referred to as a block, and then adds them to the blockchain ledger (that “checkbook” we mentioned earlier). The first computer that can solve the puzzle is awarded a small amount of cryptocurrency for its work. When you take into consideration the amount of computer power and energy that is necessary to be in the running to win that small amount of cryptocurrency, we find that many of these “miners” may barely break even after everything is said and done.

The second validation method is proof of stake. This method does not rely on the large amounts of computer power needed in proof of work and instead relies on each person to “stake” some of their own cryptocurrency, almost like bank collateral. The odds you will be chosen to verify a transaction increase with the amount of crypto you decide to put up front. When a stake owner is chosen to verify a transaction or group of transactions, they will be rewarded with cryptocurrency. If they are found to be verifying invalid transactions, they will forfeit a part of what they have staked. 

While each of these methods uses an individual to verify transactions, the transactions will also then be verified by a consensus mechanism. This mechanism requires that each verified transaction be checked and approved by the majority of ledger holders. This limits fraud by requiring at least 51% of the ledgers to match, which would be very difficult for a hacker to do.

How can you use it?

While you can use crypto to buy normal goods and services, the payment method has not quite reached mainstream status and only a handful of online retailers currently accept it as a form of payment. You can exchange cryptocurrency for gift cards and you may be able to load it onto a debit card, with some fees attached. Most people, though, invest in cryptocurrencies as they would with other assets like stocks. If you are considering purchasing cryptocurrency, you should keep in mind that it can be risky and takes quite a bit of research to fully understand how each system works.

We always recommend speaking with your financial advisor before making any investment decisions.

Insight Wealth Strategies, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Insight Wealth Strategies, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Insight Wealth Strategies, LLC unless a client service agreement is in place.

Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.