What Is Cryptocurrency?

Curious about Bitcoin and other cryptocurrency? Here's what you need to know.

By , Attorney (Florida International University College of Law)
Updated by Jeff Burtka, Attorney (George Mason University Law School)

Cryptocurrency is a form of digital cash that can be exchanged for goods and services. It's not backed or regulated by governments like traditional "fiat" currency. Instead, cryptocurrency operates with a "blockchain," also known as a public ledger. Users around the world verify transactions by using their computers to solve complex algorithms.

Cryptocurrency, often referred to as "coins," can be transferred directly from person to person without involving a third party, like a bank. These transactions happen much faster than traditional money transfers and can be done in a matter of seconds.

Unlike traditional currency, cryptocurrencies don't have a physical object that represents value. There aren't actual coins or bills. These currencies exist entirely within the digital realm.

Where Did Cryptocurrency Come From?

Cryptocurrency was developed in the wake of the 2008 financial crisis as an alternative to existing banking. The idea for this new system was developed by a person, or persons, going by the alias Satoshi Nakamoto. In 2009, Nakamoto released a white paper that explained the concept as well as software for the first and most famous cryptocurrency—Bitcoin.

Soon, new cryptocurrencies began to emerge. These Bitcoin alternatives are commonly called altcoins. Today, there are over a thousand different of altcoins. Some tweak Bitcoin's original code, but all function essentially in the same way, by using a blockchain.

Blockchain and Cryptocurrency—How It Works

A blockchain is a decentralized database of transactions, commonly called a distributed ledger. It's like an accounting ledger that records transactions and is available to anyone who wants to download it. This allows a community of peers to verify information instead of a single central authority.

Multiple transactions are grouped together into blocks. These blocks are then verified by a community of users, and all together form a blockchain. The blockchain contains a list of every single transaction involving the coins all the way back to the genesis of that cryptocurrency and is continuously updated as new transactions occur.

Transactions are verified when users in the network use their computers to solve a complicated algorithm within the blocks. The algorithm contains a piece of encrypted information, a "hash," that links a current block to the previous one. This link between blocks means that established blocks can't be altered without changing all subsequent blocks. The public distribution of the blockchain help to prevent tampering because it would be almost impossible to change everyone's ledger.

This system of tracking verified transactions adds stability and legitimacy to cryptocurrencies. It prevents users from double-spending their coins and prevents the creation of fraudulent coins.

Cryptocurrency and Anonymity

Although all transactions are recorded on the blockchain, the personal information of the people exchanging coins isn't.

Cryptocurrency is made up of two parts: a public key and a private key. Both are needed to verify a transaction. The public key is recorded on the blockchain anytime that coin is used in a transaction. The private key is known only to the owner of the coin. It acts as a kind of signature or authorization from the coin owner during transactions, ensuring that the transaction is legitimate.

The use of both public and private keys provides anonymity for users since transactions don't require identity verification, unlike with credit cards and bank accounts. This allows users to have much more anonymity when they want to make private transactions.

Using a Digital Wallet to Get and Store Cryptocurrency

Before you can get cryptocurrency, you need a "digital wallet." A wallet allows a user to store, send, and receive cryptocurrency. These wallets can be on desktop computers, smartphones, online websites, and even on paper; it all depends on a user's preference and needs.

If a private key (discussed above) is stolen, the cryptocurrency associated with it can be transferred without the rightful owner's consent. That's why you should carefully consider the type of wallet you need, who can access it, and how to keep it secure.

Types of Cryptocurrency Wallets

When choosing a wallet, think about your needs. Some wallets make it easier to access cryptocurrency on the go, while others focus on long-term security.

  • Mobile wallets are popular with people who use or exchange cryptocurrency often. These wallets can be installed like an app on smartphones. Although convenient, this type of wallet may not be the best option to store large amounts of cryptocurrency. Lost, stolen, or hacked phones can easily compromise the security of a digital wallet.
  • Cryptocurrency exchanges are websites that allow people to exchange traditional fiat currency for cryptocurrency for a fee. Exchanges aren't actually wallets, but many include a wallet feature. Exchanges are very convenient, but the security depends on the exchanges themselves. These websites can be, and have been, hacked. When this happens, users may lose all cryptocurrency kept on those sites.
  • Desktop wallets store private keys on an individual computer by downloading specific software. This type of wallet is more secure than mobile wallets, but only as long as the computer is not infected with any malicious virus or software.
  • Hardware wallets store private keys on an external storage device, like a USB. This type of wallet is good for security because the private key is stored offline and less likely to be hacked.
  • Paper wallets are often considered the most secure way to store cryptocurrency. The private key is printed out on a sheet of paper. The user can then keep this paper in a bank safety deposit box, safe at home, or another secure location. This method is more secure because the key is not held on a platform that can be accessed through hacking.

The challenge of picking a wallet is finding the right balance between accessibility and security. Many people use a combination of wallets. For example, small amounts of cryptocurrency can be stored in mobile wallets for daily use, and larger amounts can be stored on more secure wallets for longer investments.

Obtaining Cryptocurrency

After setting up your digital wallet, there are several different ways to get cryptocurrencies:

  • Gifts: Someone can give you coins; it's like being gifted cash, but instead of receiving physical coins or bills, the cryptocurrency is sent directly to your digital wallet. This is one of the few free ways to get cryptocurrency.
  • Purchasing: Most people buy or exchange fiat currency, such as the dollar or yen, for cryptocurrency. Online exchanges allow users to buy coins with their credit or debit cards. Bitcoin also has a limited number of physical ATMs that will send cryptocurrency directly to your wallet in exchange for traditional cash.
  • Receiving Payment: Another way to obtain coins is to accept cryptocurrency as a form of payment. Anyone can perform a service or offer a product and accept cryptocurrency in return. However, cryptocurrency price swings can be volatile, which might make this a risky option for small business owners. In addition, the IRS has certain tax rules for people who receive cryptocurrency as a form of income.
  • Mining Coins: Tech savvy users can "mine" coins by using their computing power to verify blocks. Typically, the first user to solve a block's algorithm is rewarded with coins. Mining coins is highly competitive, and not a practical option for most people. Miners often spend thousands of dollars upgrading their computers to boost their processing power for a better chance to solve the algorithm first.

No matter how you obtained your cryptocurrency, you should think about keeping it secure from theft.

Keeping Your Cryptocurrency Secure

As the value of cryptocurrency has increased so has the incentive of hackers to steal it. As a result, hacks and scams are becoming more sophisticated. Here are several steps you can take to help secure your digital wallet:

  • Don't share access to your wallet with anyone else. Adding another person that can directly access your account adds another vulnerability for someone else to exploit. Instead, create a written plan for someone to access your wallet in the event of an emergency. This plan can be kept with your other estate planning documents, such as your power of attorney.
  • Create a new email address dedicated just for your cryptocurrency affairs. Emails are easy targets for hackers. The more traffic an email address has, the easier it is for malicious emails to slip through. All it takes is clicking on an emailed link to give someone a backdoor into your computer. This is a common way wallets are breached. Using a dedicated email just for cryptocurrency will limit traffic on the account and will make it easier to spot suspicious emails.
  • Use a strong password. Passwords are the first line of defense against someone breaking into your account. Never reuse an existing password to secure your wallet. If an account with a recycled password is ever breached, all other accounts that use that password are vulnerable.
  • Be wary of accessing your wallet when connected to public Wi-Fi. Most free Wi-Fi spots are not secure, making it possible for someone to monitor your activity and all data exchanged. Instead, keep your connection secure by using trusted sources of Wi-Fi, your phone's data, or a VPN.

Does Cryptocurrency Have a Future?

Some people use cryptocurrency as a cash alternative. Others think of coins as a type of digital gold. Most financial professionals are still skeptical about investing in these coins, but the use of cryptocurrency is growing. As more institutions begin to accept these coins as payment, at least some types of cryptocurrency are likely to be around for the foreseeable future.

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