How does cryptocurrency work?

Cryptocurrency is a type of decentralised digital-only cash that uses cryptography to make it difficult to counterfeit or hack.

The idea behind cryptocurrency is that people can transfer value online outside of the control of governments or central banks. Most people who buy crypto assets hope to turn a profit.

However, the collapse of cryptocurrency exchange FTX in November 2022 has highlighted the high degree of risk surrounding the asset, with investors storing their coins on the platform losing a total of around eight billion dollars. They’ve yet to recover them and may never do so.

For those wanting to delve a little deeper then this article explains:

• What is cryptocurrency in simpler terms?
• How does cryptocurrency work?
• Where value comes from with cryptocurrency
• How people potentially make money from cryptocurrencies
• What are the dangers of cryptocurrency?

What is cryptocurrency in simpler terms?

Cryptocurrency is virtual money that is able to circulate without any input from banks.

It is a digital asset, so investors can’t hold it or touch it as one would with pound coins or notes. It is an internet-based medium of exchange.

While cryptocurrencies can be used to buy items in some stores, it is more commonly traded as digital assets as a way to profit from investment returns.

The most recognisable cryptocurrency is bitcoin, which has exploded in popularity.

Bitcoin is created with an encrypted code (basically a string of numbers and letters). Creating new cryptocurrency is known as mining. In order to “unlock” the cryptocurrency one needs the equation to crack the code – it’s a sort of virtual key.

Records of cryptocurrency ownership are held on a computerised database secured by strong cryptography. As codes are used to protect information this is supposed to bring greater security.

All bitcoin transactions are recorded in a database known as a blockchain, which prevents people from spending the same coin twice.

How does cryptocurrency work?

Cryptocurrency is decentralised, meaning it’s not run by a central authority such as governments, central banks or financial institutions.

Instead it operates on a peer-to-peer network, with transactions being recorded on a public ledger using blockchain technology.  (A blockchain is a decentralised database that is maintained across a computer network and can be viewed by anyone at any time; it can’t be hidden.)

This ledger allows data to be shared globally, in order to verify transactions and prevent fraudulent double spending of cryptocurrencies.

Cryptocurrency works by writing blocks and recording transactions to the ledger. Transactions can’t be faked, or overwritten.

The ledger is a database that is:

• Public
• Online 24/7
• Not controlled by any central bank or government

While transactions are recorded on this public ledger, the details of the people trading cryptocurrencies are not – investors remain anonymous, which can be part of their appeal.

It is nearly impossible to counterfeit cryptocurrency. All the computers that store and update copies of the blockchain technology have to “agree” on the correct version of the public ledger.

When investors buy digital currency, they own a private key. This is a piece of code which authorises outgoing transactions on the blockchain network so they can spend the funds.

So if cryptocurrencies aren’t issued by banks or governments, where do they come from?

How is cryptocurrency created?

New bitcoins are created by what’s known as cryptocurrency “mining”. This is where people use computers to solve difficult mathematical puzzles. This uses a huge amount of computing power.

The crypto part refers to the fact that transactions are secured by cryptography —a form of coding —which is extremely difficult to hack or break.

Proof of work and proof of stake are two ways in which cryptocurrency miners can prove their ownership of new crypto assets. Because each equation is unique, once it is solved, the network knows that the transaction must be authentic.

The users who solve the equation win the right to sign off new blocks of transactions to the bitcoin blockchain. As a reward for keeping the blockchain working properly, they get a chunk of bitcoins. Every four years, this amount is cut in half.

Losing one’s private key means losing access to their money — there is no bank to give a replacement.

What is an example of cryptocurrency?

The best-known example is bitcoin. Created in 2009 by Satoshi Nakamoto – who lends his name to “satoshis”, the bitcoin equivalent of pence – it is now the world’s largest cryptocurrency by market cap.

Other popular cryptocurrencies include ethereum, ripple, tether and litecoin. When bitcoin climbs, other cryptocurrencies will often also rise. The reverse is also true, which we saw in 2022 after bitcoin plunged below $20,000.

There are thousands of different types of cryptocurrencies in existence.

In fact, the cryptocurrency market as a whole hit $1 trillion in value at the start of 2021, led by bitcoin, which accounted for 69% of the total market. In November, the market hit over $3 trillion, according to CoinGecko. 

Can I mine bitcoin at home?

In the early days, it was possible to “mine” bitcoin using a home PC but the puzzles get more complicated and harder to solve over time. Now only very specialised equipment has enough computing power to be able to run enough calculations per second to do it.

There are scores of publicly listed cryptocurrency mining companies that run vast farms of computer equipment dedicated to solving these puzzles.

For example, London-listed Argo Blockchain is planning to open a Texas mining facility capable of 200MW of mining — enough to power about 200,000 UK homes.

How is cryptocurrency stored?

When investors buy cryptocurrencies, they will usually hold them in a digital wallet – in essence, an app that works like a bank account.

Here are some points about digital wallets:

1. Access can be gained through your smartphone or other device, depending on the type of crypto wallet
2. Cryptocurrency to pay for goods and services
3. This can be done by scanning a QR code for a retailer that accepts cryptocurrency, for example.
4. For greater security, you can also run a multi-currency or bitcoin wallet on a physical device such as a flash drive.
5. But the security of your money can still be an issue with cryptocurrencies, even when using wallets, because the sector is largely unregulated. In the UK, for example, crypto assets are not overseen by the Financial Conduct Authority and, as such, not protected by compensation schemes if anything goes wrong.

The “crypto” element of cryptocurrencies comes from the fact that a wallet generates a unique cryptographic address that allows users to carry out transactions with the currency.

Should I use a digital wallet for cryptocurrency?

Investors who want to make money out of cryptocurrencies usually trade them on a specialist exchange such as Coinbase – and they could hold their currency there.

The alternative to doing that when you buy, say, bitcoin is to download it and hold it in digital wallets – in essence, apps that work like a bank account. The wallet generates a unique cryptographic address that allows you to carry out transactions with the currency. There are two types:

“Hot” wallets – these are digital wallets that are connected to the internet

“Cold” wallets – digital wallets that are offline and don’t automatically connect to the internet, such as USB drives

So should one store cryptocurrency in a digital (also commonly known as–a hot) wallet? One consideration is security; the crypto exchanges can be vulnerable to hacking attacks, theft and collapse. For instance, when major cryptocurrency exchange FTX collapsed in November 2022, investors lost billions of dollars.

With most wallets, investors are required to create and remember a complex passphrase in order to gain access to their wallet and transfer coins in and out.  

WARNING: Forget the passphrase locks investors out of their wallet meaning access to their cryptocurrency is lost forever

How does cryptocurrency get value?

Out of all the thousands of different cryptocurrencies, bitcoin is the largest and best known:

• The number of bitcoins is finite
• About 89% that will ever exist have already been created
• The limit is 21 million and 18.6 million have been generated to date

As the above suggests, the economic law of scarcity and demand is intended to apply here, with the price of bitcoin being supported by the fact that it is a finite resource whose supply is strictly controlled.

Potentially with more people wanting to own bitcoin, but a limited amount available, the price they are willing to pay can rise, yet to date bitcoin has proven to be unpredictable and highly unstable.

In 2010, soon after the currency was launched, the price of a single bitcoin was 5p, but in March 2022, it was worth about £36,000. But the crypto market is highly volatile and by July 2022 the bitcoin price was about £17,500.

Is cryptocurrency really money?

Cryptocurrencies aren’t yet very “money like” partially because they are not widely accepted. Not many high-street shops, for example, will let buyers use them to pay for goods.

However, the number of payment processors and online retailers taking bitcoin has increased over recent years – particularly for higher-end items such as watches and electronics – and big brands such as PayPal and credit cards giants Visa and Mastercard seem to be getting on board.

You used to be able to use bitcoin to pay for your Tesla electric car in the US. This decision was reversed on May 12, 2021 after Tesla founder Elon Musk raised concerns about the impact of bitcoin mining on the environment. This news caused the price of bitcoin to fall 10%.

How do investors potentially make money from cryptocurrency?

Investor sentiment largely causes the rises and falls in the cryptocurrency market, as their value isn’t based on anything tangible. Unlike stocks and shares, there are no earnings reports, profits or revenues that can be used as measures of fundamental value.

People hold onto bitcoin, for example, in the hope that someone else will come along and pay more for it in the future.

• April 2011: one bitcoin was worth about $1 (72p)
• November 2021: record high for one bitcoin of $69,044 
• March 2022: falls back to $47,000
• May 2022: further big fall to $29,000 (£24,000)
• November 2022: another drop to around $17,000 after the FTX exchange collapsed
• January 2023: a surge to around $23,000.

Investors who bought 100 bitcoin for $100 in April 2011 and held on to it for ten years would see their stake hit a record high of $6,904,400 in November 2021.

For those who had bought it in 2021, it’s likely that their investment has fallen in value. This highlights the volatile nature of the digital currency.

But if a country bans bitcoin ownership or trading, it can dent the confidence of traders and investors in the currency’s prospects.

Can investors really make money with cryptocurrency?

As the figures above show, it is certainly possible to make money, investors should not invest in cryptocurrency unless they are prepared to lose all their money. The sharp fluctuations in a market based largely on investor sentiment bring pitfalls.

Points to remember:

• The cryptocurrency sector is unregulated
• Cryptocurrencies are highly volatile with huge price swings

People who bought bitcoin very early on and held onto it for a decade or more made massive fortunes. But not everyone has been so fortunate, many investors have lost money.

All investments carry a varying degree of risk, particularly cryptocurrency, and it’s important investors understand the nature of these.

Investors should not invest in crypto unless they’re prepared to lose all their money. Cryptocurrency is an extremely high risk and complex investment and investors are not protected if something goes wrong. Investors should only invest what they can afford to lose.

Bear in mind that we have provided this content for educational reasons only and not to help you decide whether or not to invest in cryptocurrency.

Those considering investing in cryptocurrency or any investment should consider obtaining appropriate financial advice.

How does one buy things with cryptocurrency?

To spend cryptocurrency, one need their private key to unlock the right for them as owner to do the transaction. While private keys are secret, they are paired with public keys that can be shared with others so that they can receive their virtual currency.

For example, a charity was accepting donations in cryptocurrencies – one could put your public key on the charity’s website so people could send money; but to unlock and gain access to those donated funds, one would need a private key.

In theory, this system allows transfers to be done between two parties, and cutting out the middleman such as a bank means lower transaction fees. However,most crypto traders buy and sell cryptocurrency via crypto exchanges there by incurring transaction fees.

Spending records also differ to the main banks:

• So if you spend £5 on a sandwich with your debit card, your bank records the transaction
• But if one spends 100 satoshis online the transaction is recorded in a block of other transactions and added to the blockchain (a decentralised public ledger that is maintained across a computer network and can be viewed by anyone at any time; it can’t be hidden).

Can cryptocurrency be a good investment?

Remember: the value of investments can go down as well as up and it’s possible that investors may not recover all the money they invest. All investments carry a varying degree of risk, especially cryptocurrency, and it’s important to understand the nature of these.

So investors should not invest unless they’re prepared to lose all the money invested. Cryptocurrency is an extremely high risk investment and investors are unlikely to be protected if something goes wrong.

Whether one believes cryptocurrency is a passing fad or the future of money, it is a fascinating sector. For investors who want to be involved trading crypto, we believe it’s important to remember:

• It’s easy to get carried away when prices are soaring
• Crashes are inevitable
• And don’t bet more than you can afford to lose

We can help weigh up the pros and cons: should I consider investing in bitcoin?

Times Money Mentor has provided this content for educational reasons only.

Should you decide to invest in cryptocurrency or in any other investment, they should consider obtaining appropriate financial advice.

How to invest in cryptocurrency

In order to buy and sell cryptocurrencies, usually one can set up an account with a cryptocurrency exchange or broker and fund it with real money – then investors can trade whichever cryptocurrencies that exchange offers.

One can buy less than one crypto coin; for example, one would currently pay about tens of thousands of pounds for a single bitcoin, but an investor could buy a fraction of one if they only wanted to invest a small amount.

What are some of the dangers of cryptocurrency?

Before investing these are a few of other important things to note about investing in cryptocurrencies.

1. It’s terrible for the environment

Investors are thinking more carefully about the environmental and social impact of where they put their money.

It takes a huge amount of computing power to “mine” or create virtual currencies, resulting in a big carbon footprint.

Bank of America found that bitcoin uses as much energy as a small country, while each $1bn inflow into the digital currency uses the same amount of power as 1.2 million cars.

As the price rises, so do the emissions produced.

2. Scams are rife

As cryptocurrency prices rise, they become more attractive to cyber-criminals. There are many different types of scam out there, such as:

• Fake celebrity endorsements on social media
• Bogus exchanges
• Phishing scams designed to steal keys to cryptocurrency digital wallets

You might want to read: Cryptocurrency scams and how to avoid them

3. Crypto is not protected by the regulator

Cryptocurrencies are not regulated. In fact, UK consumers have been warned that they should be prepared to lose all their money invested in crypto assets.

How risky is cryptocurrency?

The UK watchdog the Financial Conduct Authority has repeatedly warned over the dangers of cryptocurrency.

In October 2020 the FCA banned the sale of certain high-risk types of cryptocurrency investments to retail investors.

• Compensation schemes
  • UK bank deposits are almost always covered by protective schemes such as the Financial Services Compensation Scheme, but this is not the case for cryptocurrency investments
  • If a cryptocurrency exchange goes bust, investors are unlikely to get their money back

• Security
  • Cryptocurrency itself is extremely difficult to hack and the public ledger almost impossible to alter, but this is not true for cryptocurrency exchanges. One of the biggest cryptocurrency exchanges, FTX, collapsed in November 2022 causing investors all over the world to suffer significant losses.
  • As of 2021, more than 30 worldwide exchanges had been hacked or disappeared entirely; the most high profile of these include Tokyo’s Coincheck, which lost in excess of $500m in 2018.

• Volatility
  • Extreme volatility is a defining feature of cryptocurrency.
  • The bitcoin price is currently down nearly 70% from its peak in November.

• Double-spending
  • This happens when a blockchain network is disrupted
  • The cryptocurrency is, in essence, stolen
  • The thief sends a copy of the transaction data to make it look legitimate, or might delete the transaction altogether
  • It’s rare but it can happen

There are thousands of cryptocurrencies. To read more about the alternatives to bitcoin, check out our article on the other cryptocurrencies.

How to try buy cryptocurrency safely

1. Hackers commonly target crypto exchanges, so choose one that is large and well-established, where you can hopefully expect a high level of security
2. Check the trading costs and commission that the platform charges on purchases and withdrawals
3. You can’t hold cryptocurrencies in an ISA, which means you will usually have to pay tax on any gains you make.

And, again, remember that the cryptocurrency sector is unregulated and not protected by compensation schemes. This means that investors won’t get your money back if a crypto exchange collapses.

However, some exchanges offer their own insurance against hacks and security breaches.^.

Investors might want to read: Six cryptocurrency tips (and five mistakes to avoid)

What can cause cryptocurrency price fluctuations?

Like all financial markets, cryptocurrency moves up and down. But the cryptocurrency market differs from the stock market in the degree of volatility in that it moves very fast.

Here are some of the main catalysts for price changes:

• Media coverage: many crypto traders are avid readers of press coverage of their coins. Either positive or negative news can cause them to buy or sell coins, causing the market to move very quickly.
• Integration: cryptocurrencies are becoming a more common medium of exchange for buying goods. And as they are accepted by more outlets and are integrated into more banking and payment systems, the prices tend to rise.
• Wider events: political events and government decisions relating to cryptocurrencies also move the market. For example, when China put in more stringent rules on bitcoin mining the price of the currency fell dramatically.

We have done some analysis on whether tougher times are looming for bitcoin.

Unlike the stock markets which only trade on weekdays during certain hours, bear in mind that cryptocurrency can be traded 24/7.

Want to learn more about investing? Read our simple guide.

What crypto trading strategies are there?

Investors who try to make money trading cryptocurrencies have many different strategies.

Some of the main ones are as follows:

1. Day trading

This is a fast-paced form of cryptocurrency trading where people buy and sell cryptocurrencies within a day to try to take advantage of short-term price movements.

However, this may not be an appropriate way of trading bitcoins for beginners. This is because there is a significant risk of loss when trying to time the market.

2. Hedging

Hedging is where one of your investments cancels out some or all of the risk of losses with another. It is a strategy used by some crypto traders who want to hold the coins while avoid being over-exposed to volatile movements.

You can hedge cryptocurrencies using financial instruments such as contracts for difference or futures. These effectively allow you to bet on the future price of the currencies.

This is a tricky strategy that should only be used if you understand exactly what you’re doing.

3. HODLing

Those who “hodl” a cryptocurrency keep hold of it through thick and thin.

If it sounds like a typo, that’s because it originally was – the term originates from a typing mistake on an early bitcoin forum. But it is often retrospectively explained as standing for Holding on for Dear Life.

With traditional investments it’s common for investors to adopt what’s known as a buy and hold strategy.

4. Trend trading

Trend trading is where crypto investors decide to buy or sell particular currencies based on whether their price is moving up or down.

There are many more complex theories on how to identify a trend, or when it is going to change. But the basic theory is that these cryptocurrency traders buy in a market that is going to rise and sell when it is going to fall.

The difficulty comes in identifying which is which.

Whichever strategy you employ, it is important to be aware of the large number of cryptocurrency scams that exist on the internet and elsewhere.

The Financial Conduct Authority, which regulates UK investments, recently warned on the high number of crypto scams and gave suggestions on how to avoid them.

Don’t invest unless you’re prepared to lose all the money you invest. Cryptocurrency is an extremely high-risk and complex investment, and you are unlikely to be protected if something goes wrong.

Times Money Mentor has provided this content for educational reasons only and not to help you decide whether or not to invest in cryptocurrency. Should you decide to invest in cryptocurrency or in any other investment, you should always consider obtaining appropriate financial advice and only invest what you can afford to lose

What is cryptocurrency lending?

Decentralised Finance, or DeFi, is another way to make money with cryptocurrency that has only appeared in the past couple of years.

There are a vast array of applications for DeFi, but the breakout star to date is cryptocurrency lending:

1. Users lend out their cryptocurrency for others to borrow
2. In return they receive an annual percentage yield, on top of their original stake being returned to them when the lending period is over
3. No third-party central authority is involved in backing or guaranteeing these transactions

According to industry data website DeFiPulse.com, the total value in these cryptocurrency financial contracts grew:

• From $800 million in April 2020
• To $54 billion in April 2021

What are the risks of cryptocurrency lending?

While DeFi is similar in principle to peer-to-peer transactions involving companies such as Zopa and Funding Circle, there are greater risks to consider.

Independent financial advisers often caution against people investing more in cryptocurrency than they can afford to lose.