Everyone seems to be talking about cryptocurrencies. Whether it is governments warning about the threat posed by cryptocurrencies to fiscal and monetary policy or experts analyzing the 2022 collapse of FTX, these digital coins seem to be unable to stay out of the news.
In 2008, Bitcoin the first cryptocurrency was unveiled via a white paper published by Satoshi Nakamoto. No one then would’ve thought that a bunch of electronic coins would be a cause of so much debate and controversy.
But what exactly is cryptocurrency? How does it work? Read on to find the answer to all your cryptocurrency-related queries.
The Basics of Cryptocurrency
Simply put, cryptocurrency is an electronic currency. It is an alternative method of payment available in a digital form.
Unlike fiat currencies issued by nations, there is no central authority regulating cryptocurrencies.
Cryptocurrency is a highly secure payment method based on blockchain technology.
To better understand cryptocurrencies, it is important to learn about their main characteristics
1. Decentralized
There is no government or other central authority regulating cryptocurrencies. They are based on blockchain technology- an open-source peer-to-peer ledger technology. As a result, there is no need for verification of transactions by a third party.
2. Highly Secure Currencies
Cryptocurrencies are secured using a technology called cryptography. There is something known as a private key that no one except the owner of that key can access. This makes cryptocurrencies immutable and secure.
3. Permanent Transactions
Transactions on the cryptocurrency network are permanent. Once a transaction has been confirmed, no one can reverse it. Since cryptocurrencies work on blockchain, once a transaction is recorded, modifying it is nearly impossible.
4. Limited Supply
Traditional fiat currencies are theoretically unlimited in supply. Central Banks can, if they want, print as much currency as they want.
Cryptocurrencies like Bitcoin are limited in supply since their inception.
There is a limit to which a cryptocurrency can be mined since there is only a fixed number of coins available.
For example, there are only 21 million Bitcoins that can be mined which makes it limited in supply.
What are the Different Types of Cryptocurrencies?
Since the introduction of Bitcoin in 2008, cryptocurrencies have been constantly evolving and subsequently, many different types of cryptocurrencies have emerged. Some of them are:
1. Bitcoin
Since it all began with Bitcoin, it deserves its own category. While Bitcoin and cryptocurrency are often used interchangeably, they are different. Cryptocurrency is a wider term while Bitcoin is a part of it.
In other words, every Bitcoin is a cryptocurrency but every cryptocurrency is not Bitcoin.
2. Altcoins
Altcoins are simply cryptocurrencies that are not Bitcoin. While the basic technology underlying both is the same, there might be some minor differences in the purpose and functions of Bitcoin and various other Altcoins. Many Altcoins are available only on their own blockchain network.
Ethereum, Litecoin, Tron, Cardano, and Dogecoin are examples of popular Altcoins.
3. Tokens
Token is a term that is increasingly being used in Decentralized Finance(DeFi). While coins and tokens look similar at first glance, they are quite different.
The major difference is that while coins have their own blockchain network, tokens are often built upon an existing network.
While they can be held as assets, tokens also perform certain functions such as utility and security.
4. Stablecoins
Stablecoins have been emerging as an important category of cryptocurrencies. They seek to address the extreme volatility of conventional cryptocurrencies.
Stablecoins do so by pegging their value to some external currency like the US Dollar or precious commodities like gold. This helps Stablecoins to maintain their value with minimum fluctuations over a long period.
5. Central Bank Digital Currencies(CBDCs)
CBDCs are fiat currencies in a digital form. They are similar to cryptocurrencies that also function upon blockchain technology. The major difference is that CBDCs are guaranteed by the Central Bank of a country.
They are essentially legal tender in a digital format. The Bahamas was the first to launch its version of CBDC called Sand Dollar. Though China banned cryptocurrencies, it has launched its digital currency known as e-CNY.
India also launched its digital rupee on a pilot basis in December 2022.
The Uses of Cryptocurrency
While cryptocurrencies are popular as trading instruments, they can be used for multiple purposes.
1. Mode of Payment
Cryptocurrencies are primarily meant to be a Medium of Exchange. They can be used to buy and sell goods.
Balenciaga and Gucci are some luxury brands that accept cryptocurrencies for payment.
Shopify, an e-commerce site, has tied up with Crypto.com to enable its merchants to receive payments with cryptocurrencies.
2. Investment Purpose
More than anything else, cryptocurrencies have become a lucrative option to invest in for a lot of people. However, it should be noted that cryptocurrencies are volatile instruments.
Bitcoin, for example, remained above $60,000 in April 2021 while plummeting to a low of below $30,000 in the subsequent June and July.
Hence, one should be aware of the risks before investing in cryptocurrencies.
3. Efficient Money Transfers
Cryptocurrencies provide 24/7 low-cost money transfer facilities. The physical locations of the receiver and sender do not matter much in cryptocurrency transactions, unlike traditional banking channels. Cross-border transfers have become easier since the advent of cryptocurrencies.
4. Alternate Store of Wealth
Citizens of troubled nations find it useful to store their wealth in cryptocurrencies to get some measure of protection against the upheaval in their countries.
What is Cryptocurrency Mining?
The process by which new cryptocurrency comes into circulation is known as cryptocurrency mining. For this, participants known as miners have to solve a complicated mathematical puzzle with their computational power.
Effectively, it becomes a competition among different miners as to who solves the puzzle first. The miner who successfully solves the puzzle is then rewarded for his efforts.
There are different consensus mechanisms to validate a cryptocurrency transaction. The process of cryptocurrency mining is associated with the Proof-of-Work(PoW) protocol.
Cryptocurrency Trading
The process of buying, selling, or speculating in cryptocurrency on an exchange is known as cryptocurrency trading.
Cryptocurrencies are an attractive investment option for many as the sudden and large changes in their price allow for ample opportunities to reap profit.
How Do I Trade in Cryptocurrency?
With the establishment of multiple exchanges, trading in cryptocurrencies has become quite similar to trading in traditional securities.
Step 1: First, you need to create an account on a cryptocurrency exchange. You can do so either by signing up on the exchange’s website or by downloading their app. While certain exchanges don’t require any ID verification, most of them are KYC-compliant.
Step 2: Second, you need to deposit funds in your account. You can transfer funds in your cryptocurrency account by linking your bank account and adding money or via your debit or credit card.
Step 3: Once you have sufficient funds, you can select the cryptocurrency you want to trade in. Several people prefer to start by investing in established currencies like Bitcoin and Ether.
Step 4: You can store your cryptocurrency in wallets. There are two types of wallets- a ‘hot’(online) wallet and a ‘cold’(offline) wallet. These wallets can be accessed only by the owner with the help of a private key.
Cryptocurrency Exchanges
We all are familiar with the concept of stock exchanges. They are platforms that allow users to trade in securities. A cryptocurrency exchange is similar except that it deals with cryptocurrencies exclusively.
A cryptocurrency exchange is like an online marketplace where users can buy and sell cryptocurrencies. Apart from traditionally popular currencies like Bitcoin, exchanges today host a number of alternate currencies including what are known as “meme coins” like Shiba Inu.
The 3 types of Cryptocurrency Exchanges
The three types of cryptocurrency exchanges are:
1. Centralized Cryptocurrency Exchanges(CEX)
CEX are more similar in structure and working to traditional stock exchanges. They act as middlemen between crypto buyers and sellers and charge commission fees for transactions.
Centralized Exchanges often require KYC verification and hence, offer better security of investments. They are also quite beginner-friendly due to their resemblance to conventional stock exchanges.
Coinbase is a good example of a centralized exchange.
2. Decentralized Cryptocurrency Exchanges(DEX)
Decentralized Exchanges can be described as a “free-for-all” platform. As the name suggests, there is no intermediary between buyers and sellers here.
It runs on a peer-to-peer network where participants conduct transactions among themselves. They rely on smart contracts for carrying out transactions.
DEXs are based on the core cryptocurrency ethos of decentralization and privacy.
Since these exchanges generally don’t have any KYC requirements, they offer a high level of privacy and anonymity to users.
Bisq is one of the most known examples of a decentralized exchange.
3. Hybrid Exchanges
As the name suggests, Hybrid Exchanges combine features of both Centralized and Decentralized Exchanges. They focus on privacy like Decentralized Exchanges while also addressing their scalability issues.
Hybrid Exchanges can be described as being the best of both worlds seeking to implement best practices in the world of crypto trading.
Qurrex and Eidoo are some examples of hybrid crypto exchanges.
The Best Crypto Exchanges
Selecting the perfect cryptocurrency exchange might seem like a herculean task due to a number of factors to be considered while making the choice.
Several things like transaction fees supported assets and payment methods come into play when choosing the best cryptocurrency exchange.
While best is subjective, we have compiled a list of crypto exchanges based on major user concerns:
Gemini is the best exchange for users whose top priority is the security of transactions and assets.
It is compliant with major US Regulatory requirements and is the first SOC 1 Type 2 and SOC 2 Type 2 certified crypto exchange and custodian.
Gemini’s maker-taker fee is on the higher side though it is worth it for the platform’s robust security system.
Also Read: How to create an account on Gemini Exchange
Crypto.com is a very convenient platform for crypto trading since it provides a trading ecosystem easily accessible on a smartphone. This is in line with the exchange’s vision of bringing cryptocurrency to every wallet.
Established way back in 2011, Kraken is one of the OGs of the crypto world. It offers a decent selection of more than 120 coins and is highly liquid making it a suitable option for beginners.
This San Francisco-based exchange has two versions- Kraken and Kraken Pro. The pro version offers features like customizable chart analysis tools and detailed insight into the order books.
As per data, Binance is currently the largest crypto exchange by trade volume. It claims of keeping users at the heart of its operations.
It has 24/7 customer support in 40 languages and embeds strict data privacy controls across the entire ecosystem.
Additionally, Binance also offers a learning hub, educating users about blockchain and cryptocurrency in 20 languages.
Also Read: How to create an account on Binance Exchange
Coinbase says that its mission is “to increase economic freedom in the world.” It is available in 100+ countries and with more than 108 million verified users, many investors begin their crypto journey with Coinbase. This platform is committed to providing empowering financial services to everyone in the world.
Also Read: How to create an Account on Coinbase Exchange
Difference between Proof of Work(PoW) and Proof of Stake(PoS)
After talking about cryptocurrency exchanges, it is important to understand how transactions are validated or verified on such exchanges.
Cryptocurrency exchanges are based on blockchain technology which is like an open ledger. The participants or nodes need to approve a transaction for the new block to be added to the existing network.
There exist certain protocols to validate these transactions. These protocols are also known as consensus mechanisms. They are of two types- Proof-of-Work(PoW) and Proof-of-Stake(PoS)
1 Proof-of-Work(PoW)
PoW is the most widely used consensus mechanism for cryptocurrency validation. This process is popularly known as crypto mining.
Whenever a new transaction is initiated, miners compete to solve a difficult puzzle with their computer’s processing power.
When the puzzle is solved, the transaction is verified and a new block is added to the network. The first miner to solve the puzzle is then rewarded for their efforts.
Most popular cryptocurrencies including Bitcoin employ the PoW mechanism. However, this system has been heavily criticized because it consumes extremely large amounts of energy while running operations.
2 Proof-of-Stake(PoS)
PoS has recently been in the limelight as Ethereum merged the Mainnet and the Beacon Chain and shifted to a proof-of-stake consensus. The PoS mechanism is much more energy efficient than PoW.
Here, there are no miners. Instead, there are validators. These validators stake or pledge their coins for validating transactions on the crypto network. Whenever there is a new transaction, the algorithm selects a validator who then verifies that the transaction is correct.
The validator is rewarded with cryptocurrencies after the transaction has been completed.
The Legality of Cryptocurrency
As debates around the utility and risks of cryptocurrencies rage around the world, one is bound to be confused about the legal status of cryptocurrencies.
While countries like El Salvador and the Central African Republic have accorded the status of legal tender to Bitcoin, it is an exception rather than a norm. While crypto trade continues to boom, the legal status of cryptocurrencies remains murky in a lot of places.
1. Is Cryptocurrency Legal?
The legality of cryptocurrencies varies from place to place. While some outright ban them, others are cautiously optimistic about allowing wider use of cryptocurrencies.
China, for example, has taken a harsh stand on cryptocurrencies and outright banned cryptocurrencies and crypto mining in 2021. Cryptocurrencies are also illegal in places like Turkey, Egypt, Algeria, Bolivia, and Indonesia, all of which have taken a tough stance against them.
In contrast, countries like Singapore, the USA, Canada, Australia, and Japan have adopted a friendlier approach to cryptocurrencies. “Crypto-assets” are defined in Japan’s Payment Services Act and there are no restrictions per se on owning and investing in cryptocurrencies. USA’s Internal Revenue Service(IRS) has classified Bitcoin as property for taxation purposes.
In India, cryptocurrencies exist in a sort of grey area. Financial Institutions and Payment Service Providers were outright prohibited by the Reserve Bank of India(RBI) from dealing with virtual currencies in 2018. The Supreme Court later ruled the ban unconstitutional in 2020.
In December 2022, the RBI launched Central Bank Digital Currency(CBDC) or Digital Rupee on a pilot basis. Also, a Draft Digital Currency Bill seeks to ban all private cryptocurrencies in the country. So, while cryptocurrencies are not legal in India, they are not exactly illegal either.
2. Is Cryptocurrency Taxable?
A number of countries treat cryptocurrencies as digital assets and they are as such, subject to the taxation laws of that particular country.
Is Cryptocurrency Taxable in the United States of America(USA)?
USA’s Internal Revenue Service(IRS) considers cryptocurrencies to be property and accordingly imposes taxes.
Is Cryptocurrency Taxable in India?
In early 2022, India announced a 30% tax on income from Virtual Digital Assets. Additionally, 1% TDS on the transfer or consideration of every Virtual Digital Asset was imposed from 1 July 2022.
Is Cryptocurrency Taxable in Italy?
Reports emerged in late 2022 that Italy was considering a 26% capital gains tax on cryptocurrency gains above 2,000 euros.
Is Cryptocurrency Taxable in Japan?
Japan, which has been gradually loosening licensing norms for cryptocurrency exchanges is quite clear with its tax regime.
Since cryptocurrencies are viewed as property in Japan, they are taxed as Miscellaneous Income under the country’s Payment Services Act(PSA) and the Financial Instruments and Exchange Act(FIEA).
Any gains above 200,000 JPY on crypto trading need to be disclosed in Income Tax returns.
Is Cryptocurrency Taxable in El Salvador?
El Salvador, the first country to make Bitcoin legal tender, is keen to market itself as a cryptocurrency tax haven. For this, the Latin American nation has exempted foreigners from any tax on gains from Bitcoin trading and speculation.
Investing in Cryptocurrencies
Investing in cryptocurrencies seems to be a lucrative option for a lot of people. Despite regulatory uncertainty, interest in crypto-assets continues to grow. But is investing in cryptocurrency a wise choice? Let us try to answer that.
Should I Invest in Cryptocurrency?
Like any asset, investing in cryptocurrencies depends on your means and goals. It is important to remember that cryptocurrencies are highly volatile making them rather risky investments. While the gains could be immense, the losses could be too.
In November 2022, the leading exchange FTX’s implosion had a ripple effect on the crypto market. While concerns about crypto scams grow, the evolving legal landscape and certain governments taking steps to recognize crypto-assets provide relief to investors.
It would be prudent to consult with a professional and understand the intricacies of cryptocurrencies before dabbling into them.
Conclusion
Perhaps even Stuart Haber and W. Scott Stornetta did not imagine that their introduction of Blockchain in 1991 would eventually lead to the creation of groundbreaking technologies like cryptocurrencies.
Cryptocurrencies paved the way for a world where fast and efficient transfer of funds without the involvement of an intermediary is possible.
While cryptocurrencies have been used for nefarious purposes like money laundering, they have also improved access to financial services. While the crypto market may be going through a bear phase currently, there are hopes that it will eventually bounce back.