What Is Cryptocurrency and How Does It Work?

Cryptocurrency. It’s causing lots of drama in the investing world these days. It’s way up! It’s way down! It’s making millionaires all around.

But what is crypto really? Ever heard of Bitcoin, Dogecoin, Litecoin, XRP or Ethereum? Nope—they aren’t embarrassing rock band names from the ’90s. They’re actually types of cryptocurrencies. And they’re trending everywhere you look.

It’s all pretty confusing, so here’s our cryptocurrency for beginners guide, starting with: What in the world is crypto?

What Is Cryptocurrency? 

Cryptocurrency is digital money that exists solely in a computer network. You exchange real money, like dollars, to buy “coins” or “tokens” of a certain kind of cryptocurrency. You can hold crypto as an investment or you can buy stuff with it.

Think of it this way: Cryptocurrency is kind of like swapping out your money while visiting a new country. A Benjamin can buy you a nice dinner in the States, but if you want to enjoy fine dining in Italy, you’ll need some euros. We value dollars and euros because we know we can purchase goods or services with them. The same goes for cryptocurrency. You exchange your money for crypto and use it just like real money (at places that accept it as a type of payment). And since the price of crypto goes up and down a lot, you can treat it like an investment—buying low and selling high.

So, where the heck do we get the word cryptocurrency from, anyway? We’re glad you asked. It comes from the word cryptography—meaning the art of writing or solving codes. Sounds like the setup of an Indiana Jones movie, right? Each coin of cryptocurrency is a unique line of computer code. And cryptocurrencies can’t be copied, which makes them easy to track and identify as they’re traded.

How Does Cryptocurrency Work?

Cryptocurrency is exchanged person-to-person on the internet without a middleman like a bank or government. It’s like the Wild West of the digital world—but there’s no marshal to uphold the law.

Here’s what we mean: Have you ever hired a kid in your neighborhood to mow your lawn or watch your dog while you were out of town? Chances are, you paid them in cash. You didn’t need to go to the bank to make an official transaction.

That’s what it’s like to exchange cryptocurrencies. Most are decentralized—which means no government or bank controls how they’re made, what their value is, or how they’re exchanged. Because of that, cryptocurrencies are worth whatever people are willing to pay or exchange for them. Yep, it’s pretty wild.

With us so far? Okay, good. Because we’re about to get into the tech weeds even more.

What is the blockchain?

Cryptocurrencies are based on something called blockchain technology. A blockchain is like a really long receipt that keeps growing with each exchange of crypto. It’s a digital database of all the transactions that have ever happened with a given type of cryptocurrency. These records are called blocks, and they’re connected and secured using cryptography. (More on that next.) Yep, it sounds like it’s straight out of The Matrix.

What is cryptography?

Cryptography is a way to keep information safe by using complex computer codes. So, cryptography keeps your crypto transactions private and makes sure only you can access your money.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

Here’s how it kind of works in real life. Imagine you have a special lock for your digital wallet. This lock has two keys: a private key (only you know) and a public key (you can share this one). When you want to send cryptocurrency to someone, you use your private key to create a unique signature for that transaction. It’s like signing a check with a secret pen that only you have. This signature proves that you’re the one making the transaction.

Your signature, along with the transaction details, is then locked up using complex math puzzles. Only those with the correct private key can unlock and read the transaction.

Once the transaction is locked, it joins a group of other transactions in the blockchain. The blockchain is like a shared ledger everyone can see, but they can’t see the details of your transaction because it’s locked with your secret signature.

How does someone earn crypto?

The most common way to earn crypto is a process called mining. It’s used by big players like Bitcoin and Litecoin. But crypto also can be earned through staking. Let’s take a look at both.

Mining (Proof-of-Work)

You won’t need a pickaxe and a hat with a little flashlight on it to mine crypto. Mining happens when people use their computers to solve super complicated math problems that make sure new crypto transactions are correct. Then, those transactions get added to the blockchain (aka the receipt). As a reward for making sure crypto transactions are legit, miners are paid in newly minted cryptocurrency coins (known as the block reward).

Mining (also called proof-of-work) consumes tons of computational power and electricity, and it becomes progressively more challenging as more miners join the network.

Staking (Proof-of-Stake)

Some cryptocurrencies use a system called proof-of-stake (also called staking) to create coins. With this system, validators (sometimes called minters) put up (or stake) coins as collateral for the right to check transactions and add them to the blockchain.

Validators are rewarded for their service with newly minted coins. But if they do shady stuff, they could lose their stake. Proof-of-stake systems have become more popular recently because they use way less energy than proof-of-work systems. Ethereum is the largest crypto company to use proof-of-stake.

Every type of crypto has rules called consensus protocols or blockchain protocols that regulate the creation of new coins so the market doesn’t get flooded with them. Some coins have a maximum number of coins coded into their protocol. (Bitcoin is capped at 21 million coins.)

What Types of Cryptocurrencies Are There?

Bitcoin is the top dog that everyone knows about, but it’s not the only kind of cryptocurrency out there. There’s Litecoin, Polkadot, TRON, Cardano . . . and, oh, just about 10,000 other kinds of weirdly named coins coming up the ranks. Let’s hit on the top contenders:

Bitcoin 

Yeah, Bitcoin is the household name that most people think of when you talk about cryptocurrency. That’s because it was the first cryptocurrency, and it’s also the largest by market cap (around $550 billion—give or take a few billion). 

Bitcoin was created in 2009 by an unknown person who goes by the alias Satoshi Nakamoto—whoever that is^.1 And that big secret is part of its underground feel that people like. But there’s no denying the fact that everything anonymous is super shady.

Even though cryptocurrency is rocky, crypto investors seem to like Bitcoin because they think it has a little more strength and stability than the rest. It’s also valued much higher than its competitors (for now). While some cryptocurrencies trade for cents, Bitcoin hit $60,000 back in 2021—though it’s worth about half of that now.

Ethereum

Ethereum is the next most popular cryptocurrency after Bitcoin. And even though Ethereum is like Bitcoin with its crypto coins (called Ether), it’s a little different too. While Bitcoin was created to become an alternative to traditional currencies like the dollar, Ethereum has evolved into a network that can be used to do old things (like buying art) in new ways.

For example, NFTs sparked a cryptocurrency digital art craze where you buy digital art with digital money—NFT stands for non-fungible token . . . seriously, who comes up with these names? NFTs are supported by Ethereum’s blockchain technology, creating a brand-new way for folks to get into (digital) fine art collecting.    

Tether

Tether is what’s known as a stablecoin. It’s pegged (or tethered) to the value of the U.S. dollar, so it has a stable price—one tether token is worth $1. Tether is easier to spend than other types of crypto because its value doesn’t go up and down a ton. Crypto investors can trade Tether for other cryptocurrencies or hang on to it to store their money without the fear of it losing value.

Dogecoin 

Dogecoin (pronounced “dohj-coin”) started as a joke back in 2013 and is now really popular. At the time, there was a meme going around of a Shiba Inu (that’s a kind of dog) who was given the nickname “Doge.” The creators of Dogecoin named their cryptocurrency after the Doge meme, it became their mascot, and the rest is internet history. Oh, we’re serious. You can’t make this stuff up.

So, all of that to say, there’s no shortage of coins to invest in out there in cryptocurrency land. And depending on what’s trending that day (Dogecoin, anyone?), you’ll see the value of these coins go up and down like one of those swinging pirate ship rides at a carnival. If you chase crypto based on what’s hot that day, you’ll probably wind up sick too (just like you would from that dang carnival ride).

How Do You Buy Cryptocurrency?

The most popular way to get your hands on some crypto is to buy it through a cryptocurrency exchange. Think of it kind of like a stock exchange—but instead of thousands of different stocks listed, a crypto exchange has types of crypto that you can buy and sell. When you buy crypto from an exchange, it’s stored in a digital wallet connected to your account.

Coinbase is the largest cryptocurrency exchange in the U.S., but there are tons of others (many aren’t very reputable) out in cyberspace. In fact, FTX, one of the largest crypto exchanges, went belly-up last year and customers were defrauded out of millions of dollars.

If you don’t want to go through a crypto exchange, you can buy some of the more popular cryptocurrencies directly through a digital wallet.

How Do You Store Cryptocurrency?

You store your cryptocurrency in something called a digital wallet—usually in an app or through the vendor where you purchase your coins. Your wallet gives you a private key—a unique code that you enter to digitally sign off on purchases. It’s mathematical proof that the exchange was legit.

What Can You Buy With Cryptocurrency? 

At this point, most people still see cryptocurrency as an investment. But cryptocurrency is quickly gaining speed and becoming more widely accepted as currency. And using crypto in this way could become even more popular as these cryptocurrencies keep gaining trust.

Some major retailers—like Whole Foods, Walmart, Domino’s Pizza, and Lowe’s—let people buy gift cards using crypto. But not many actually take crypto in person. And of course, any two people who value the tokens can exchange them for goods or services with each other.

You can also buy those NFTs we were just talking about with cryptocurrency, if owning the world’s first digital perfume or digital toilet paper with flowers is your thing. Yes, those are “real”—but that’s a story for another day.

Is Crypto Safe?

We’ll just come out and say it: Crypto isn’t very safe. Yes, the blockchain and cryptography secure your crypto transactions, but you’re still susceptible to getting hacked. And unlike when your bank account gets hacked and your bank steps in to make things right, with crypto, you’re just out of luck. Not to mention, crypto isn’t protected by the Federal Deposit Insurance Corporation (FDIC) like money in a traditional bank is.

Pros and Cons of Cryptocurrency

Before you say goodbye to your dollars and hello to Bitcoin, Ether or Doge, there are a few things you need to know up front.

Pro: Cryptocurrency is private.

Crypto transactions are anonymous and not subject to very much government regulation. This appeals to people who have more of a hands-off approach to government.

Con: Cryptocurrency is volatile.

Cryptocurrency prices swing up and down like crazy. Bitcoin dropped about half of its value in the last year. This makes crypto a risky investment. Trading in cryptocurrency is kind of like gambling.

Pro: Cryptocurrency is a global currency.

 People all over the world use crypto, so it’s quick and easy to exchange between countries. And since crypto isn’t connected to the central bank of a country, a government can’t manipulate it.

Con: Cryptocurrency has lots of unknowns.

Only a small percentage of people in the world really understand the crypto system and know how to operate it. Ignorance makes you vulnerable. We always tell people that if you can’t explain your investments to a 10-year-old, you have no business investing in them to begin with.

Why Do People Invest in Crypto?

People have made millions of dollars investing in crypto—so that makes investing in crypto seem exciting. But . . . just as many have lost millions. And maybe you fear you’re missing out by not investing in crypto. Listen, you can try your hand at cryptocurrency if you want. If you have some money you’re willing to lose, money you might have thrown away on a roulette wheel in Vegas instead, knock yourself out. But investing in cryptocurrency isn’t a good way to build wealth for your future.

A Better Way to Invest

Bottom line? The road to building wealth is slow and steady, and there are still way too many unknowns when it comes to cryptocurrency.

Get-rich-quick schemes are just that—schemes. Don’t risk it and pour all your hopes, dreams and money into them. Instead, sit down with a SmartVestor Pro who knows what they’re doing. Let them walk you through a solid strategy for investing that doesn’t involve trying to build wealth through risky investments like crypto.

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.