This is a simple overview of cryptocurrency to help you decide if it's right for you.

What Is Cryptocurrency?

The dictionary defines cryptocurrency as a digital form of money in which transactions are stored and verified by a decentralized system (the blockchain) using cryptography, rather than by a centralized authority. Digital currency is nothing new, the vast majority of your wealth is recorded digitally in your conventional bank or investment account. The innovation behind cryptocurrency is the decentralization of the record-keeping. There are now thousands of identical records of the transaction. Blockchains have some confidentiality features that help, but it's not quite as “hidden” as the name would imply.

What Is The Blockchain?

The blockchain is a decentralized ledger that keeps track of cryptocurrency transactions. This typically occurs across a linked network of multiple computers. Essentially it's a distributed database that tries to ensure every record on the blockchain is very difficult to change, hack, or steal. Cryptocurrency is just one use of the blockchain.

Instead of a bank running its own database to record transactions, the database persists on many computers around the world.

What Is A Cryptocurrency Wallet?

A cryptocurrency wallet, like a regular wallet, stores money. However, it only exists electronically. It is a software application. You can move cryptocurrency (really the keys or codes to access the cryptocurrency) from the exchange where you buy, sell, and trade it into your wallet. This prevents you from losing the cryptocurrency should the exchange be hacked. When you are ready to trade it, you can move the cryptocurrency from your wallet back to the exchange.

What Problems with Money Are Cryptocurrencies Supposed to Address?

• The vast majority of money in use in the world today is fiat money, backed by the government that issued it and useful only because the majority of people believe it has value. Fiat money is subject to government mismanagement. Perhaps the biggest temptation for a government is to print more money. This results in inflation, a decrease in the purchasing power of the money you have. Sometimes inflation is well-controlled, for example, the US Federal Reserve aims for inflation of 2% a year.
• Fiat money is centralized, meaning a few people in government have a large amount of control over it. If those people cannot be trusted, the currency cannot be trusted.
• Fiat money and even precious metals are relatively hard to store, hide, and transport. They can be stolen and destroyed, and there are costs to protecting them.
• As money moves through the banking system some of the activity is reported to governments in an effort to prevent criminal activity, but there is a reduction in privacy and an increased the risk of confiscation.
• Sometimes it is very cumbersome and expensive to send money from one place to another. For example, think about the cost of using Western Union or paying your bank a wire transfer fee.
• Fiat currency is subject to counterfeiting. The complexity involved in making a $20 bill to prevent counterfeiting is impressive and expensive, but there is still an estimated $70 million or more in counterfeit US currency in circulation at any given time. Cryptocurrency is far more difficult to counterfeit.

All of these problems have been addressed by one type of cryptocurrency or another so there is the argument that they bring a technological advancement to money, even if you think they also have issues of their own.

How Many Cryptocurrencies Are There?

Somewhere in the range of 8,000-10,000 so far. As of May 2021, over 2,000 cryptocurrencies had failed. Why do some fail and others do not? They may not be very useful, they may have no community supporting them, or they may not be very secure. Or they simply were not the first mover, i.e. the first cryptocurrency with a given advantage. Popularity and marketing matter.

What Is Proof of Work?

Where does cryptocurrency come from? Well, in the case of many cryptocurrencies, it is mined by computers solving mathematical problems that require a great deal of computer resources, time, and energy. Computers are competing with each other to arrive at the solution first. Mining is used to validate blocks of transactions in the blockchain and when a computer gets the solution, it (and by extension the person controlling that computer) is rewarded a chunk of cryptocurrency and the process begins again to validate the next block. This is proof of work. It is massively energy-intensive and unsustainable, though many crytocurrencies are appearing to take steps to address the energy problem.

What Is Bitcoin Halving?

Halving is a Bitcoin specific term for when the reward for mining a new block is cut in half. Originally mining earned 25 Bitcoin, but it is currently down to 6.25 Bitcoin. This produces an artificial rate of inflation until the last Bitcoin is mined, projected not to occur for more than 100 years despite the fact that about 90% of all Bitcoins have already been mined.

What Is Ethereum Gas?

Gas is the dynamic cost of doing a transaction on the Ethereum blockchain. Gas prices are denoted in gwei, where 1 ETH = 1* 10^9 (1,000,000,000) gwei. With a gwei price of 5, a 21,000 gas transaction would cost 21,000 * 5 = 105,000 gwei (0.000105 ETH). The more you pay, the quicker your transaction happens. Miners always record transactions in order of which ones will pay them the most. If you don’t add enough gas, your transaction may not go at all.

How Does Cryptocurrency Gain Value?

The major crytocurrencies are currently instruments of speculation. They go up in value because someone else is willing to pay you more for them because they believe that, down the line, someone else will pay them more. The entire premise relies on the Greater Fool Theory, i.e. there is someone who is an even greater fool who will pay more for this than I did. Crytocurrencies produce no earnings, no interest, and no rents and are not associated with physical assets. Like empty land, gold, silver, or Beanie Babies, they are worth only what they can be sold for, and there is no objective way to value them.

Is Cryptocurrency Useful as a Medium of Exchange?

Cryptocurrency attempts to be money. However, just because you can find a handful of websites or even brick-and-mortar businesses that will accept a cryptocurrency or two as payment does not mean that cryptocurrency is ready for prime time. When you can use a cryptocurrency for your daily transactions (gas, groceries, lunch, etc.) then you can consider it "real money". Until then, it remains an instrument of speculation. The speed of cryptocurrency transactions is also very slow compared to the speed of current financial systems and they would like crumble under the strain of processing all daily transactions in the US if we hypothetically swapped out the current financial system for a blockchain based one.

Is Cryptocurrency Useful as a Store of Value?

The problem with using cryptocurrency as a store of value is that most are entirely too volatile for that purpose. A 2021 paper concludes that Bitcoin, currently the most popular cryptocurrency, is 10 times more volatile than typical currency exchange rates. For a cryptocurrency to be used as a store of value, the volatility must be much lower than what is seen with the most popular cryptocurrencies out there (with the exception of the “stable coins”).

Why Is Cryptocurrency So Volatile?

Simple: no one is really sure what it is worth, so traders and gamblers are constantly speculating and affecting the price.

Consider marketable assets, such as the stock of a blue-chip company. There is a reasonable way to value the company and its stock. You simply take its earnings and multiply it by a reasonable factor for its industry and the current market, and that gives you a value.

With cryptocurrency there is no way to value it. It is just guesswork. When there is no consensus as to the value of an asset, its price is going to be volatile. Likewise, it will not take much to move that price substantially, such as celebrities Tweeting.

What Is A Stablecoin?

Stablecoins are designed to solve the volatility problem of cryptocurrency by tethering the price of the currency to something that is more stable, such as a more traditional fiat currency. The most common one is the US dollar. They may also be tied to the price of gold or another precious metal or commodity. Fiat currencies are more stable due to reserves (often of gold) that back them and due to the actions of those that control them, like the US Federal Reserve.

The reduced volatility of a dollar-backed stablecoin is nice, but to get it, you have to give up one of the primary benefits of cryptocurrency (decentralization) to start with! Think of it as a bridge asset between traditional fiat currencies and cryptocurrencies. This bridge position does cause somewhat higher scrutiny among regulatory authorities, given the increased potential to affect the fiat currency markets and the overall economy.

What Can Cryptocurrency Be Used For?

Just because cryptocurrency is not useful for the primary functions of money does not mean it has no uses at all. Here are some of the most common uses of cryptocurrency:

• Speculation
• Gambling
• Concealing illegal business activity
• Squirreling money out of a country during a crisis
• Impressing others and having fun
• Assisting with some underdeveloped world banking activities

The vast majority of those who own cryptocurrencies are simply speculating. They believe the value will go up in the future and that they can sell it for far more than they paid for it. So far, that has mostly been true with the most popular cryptocurrencies, but only time will tell if that will continue.

Is Cryptocurrency Legal and Safe?

Yes, buying, selling, trading, and spending cryptocurrency is perfectly legal. There are government rules that you are supposed to comply with, and there are penalties for those who are caught breaking those rules. The very nature of cryptocurrency makes it a little easier to skirt government rules, but governments are rapidly finding ways to catch and punish the lawbreakers.

How Is Cryptocurrency Taxed?

The IRS has decided to treat cryptocurrencies as investments and not currencies. That means when you sell it, you will either have a capital gain or a capital loss, which you must pay taxes on. There is even a specific question at the top of your IRS Form 1040.

If you go out and buy a candy bar with Bitcoin, even that $1 transaction is going to end up on Schedule D at the end of the year. If you trade frequently, or buy a lot of candy bars, you might up with a large, unexpected tax bill. So treat it like an investment with infrequent trades, not daily uses.

If you own it for less than a year, you're going to be paying short-term capital gains rates on those gains. It's better than a loss, but if it makes sense to hold for at least a year, your tax bill will be lower.

Should I Invest in Cryptocurrency?

If you are considering investing real, serious money into cryptocurrency, you need to spend some serious time thinking about if you actually should. If you cannot make a clear, logical case for it improving your portfolio performance, then I would suggest you avoid it.

Since cryptocurrencies fluxuate in value and there is a lot of speculation, it is of course possible to make money, even just with pure luck if you happen to buy in a dip, but that does not mean every one will, and most won't, and you should be prepared to potentially lose a lot of money.

You have to decide whether the volatility is too much for you. As an advocate of simple, index based investing, I currently don't buy crytocurrencies.