What is Cryptocurrency And How It Works

What is Cryptocurrency And How It Works

Cryptocurrency, or simply 'crypto', is a digital or virtual currency created using encrypted algorithms. 

You need a digital wallet to access cryptocurrencies. These wallets are offered by cloud-based services and can be stored on any device. 

The first thing that clicks our mind about cryptocurrency is 'bitcoin', which gained popularity in the initial years. 

You must be thinking that investing in bitcoin a decade back could have changed your life. But is it that easy and simple? 

Cryptocurrency- Virtual Digital Asset

Cryptocurrency is a decentralised virtual digital asset. This non-tangible asset is popular for the purpose of trading. 

Presently, cryptocurrency is not backed by any recognised legal entity or the central government, but it does not mean that it is illegal. 

It is encrypted by a highly sophisticated' cryptography method, making the transactions safe and secure. 

The first ever crypto asset was bitcoin, developed in 2008 by Satoshi Nakamoto.

How does it work?

Cryptocurrency, a digital form of an asset, has no physical existence. It functions in accordance with blockchain technology. 

'Blockchain' is an online public ledger which tracks assets and records transactions. 

Each block consists of a history of independent transactions of every verified member on the platform. 

The blockchains are protected from any unauthorised access by cryptography. 

Cryptography secures and encrypts the communication between the sender and recipient by means of advanced mathematical algorithms. 

Encryption of data is essential to avoid security and privacy issues. It protects from data breaches and hence ensures integrity. 

Even if the device containing data is stolen or lost, it can still be protected by proper hard drive encryption beforehand. 

Also, encryption of the data prevents its access from attackers. Only people can read or access sensitive data with the availability of a key. 

[a key in cryptography is a series of characters associated with algorithms which can be used to encrypt or decrypt data]

Cryptography is broadly classified into-

  • Symmetric-key cryptography- in symmetric-key cryptography, a single key is used for the purpose of encryption and decryption. This method makes a common key available to the sender and receiver. The key used here is called the 'secret key'.
  • Asymmetric-key cryptography-  asymmetric key encryption is also called 'public encryption'. It uses two different keys to encrypt and decrypt the data. The key for encryption is public for anybody to use, and is hence called a 'public key'. On the other hand, the key for the purpose of decryption is kept private and is therefore called a 'private key'. It is considered a safer and more secure method to encrypt data compared to symmetric-key encryption.

Hashing is a versatile form of cryptographic algorithm. It can take inputs of any given particular data length and convert them into a unique output of fixed size called a hash value, hash code or simply 'hash'.  

Thus, this digital asset is secured by the means of cryptography for the purpose of trading. 

However, we cannot use cryptocurrency for retail transactions or for purchases from e-commerce websites.

Types of Cryptocurrencies

Over 10k cryptocurrencies are known to date. But majorly, three broad types of cryptocurrencies exist so far. They are-

  1. Bitcoin- it was the first ever cryptocurrency to be developed. The first ever bitcoin to be 'mined' was known as Genesis Block. It is considered to be 'digital gold'. It was designed to provide the people with a system of alternate payments free from the control or intervention of the central government. The volatility associated with it is extremely high and needs to be followed by regular trends or patterns. Investing in it comes with an inevitable 'risk'. People with a high-risk tolerance and strong financial conditions should opt for such investments. The returns are not guaranteed, and you can even lose your invested money. However, the trends are unpredictable. You can even earn unimaginable amounts of profit by investing in cryptocurrencies.

Presently, the market cap of bitcoin is over 440 billion US dollars adding up to the total market cap of crypto over a trillion dollars.

  1. Altcoins- these are nothing but alternate versions of bitcoin. The algorithms associated with altcoins are exponentially different from the bitcoin. Over a thousand altcoins are known today. Some of them are Litecoin, Factom, Ethereum, NEO, etc. Ethereum is a platform and not just a currency. It is where organisations can make different apps based on different blockchains.
  2. Tokens- the tokens are the products of the altcoins. It is a virtual asset which works on an existing blockchain. The tokens are not mined like coins. Also, the value of the tokens is lesser than the bitcoin or altcoins. These transferable units can be issued for different purposes. There are different varieties of tokens, such as utility, security, payment, and equity.

Pros and Cons of Cryptocurrencies

The advantages of cryptocurrencies are-

  • DecentralisedDecentralised system- any recognised legal entity or the central government does not control cryptocurrency. This protects it from monopoly as no dominant power could decide its worth. 
  • A cost-effective approach for cross-border transactions is one of the most important advantages of using cryptocurrencies. You can easily transfer money across borders with almost negligible extra fees. This also eliminates the requirement of transaction verification, unlike other third-party apps.
  • Maintenance of Value- currencies loses their value with time because of inflation. However, the quantity of a cryptocurrency is specified at the time of its development. Only 21 million bitcoins were mined on the planet. Therefore, its value increases with the increase in demand. 
  • Private and Secure- security is among the most important things to consider regarding important transactions. Decoding blockchain technology is a challenging task. Encryption by means of cryptography protects the data from breaches and thus ensures safety and security. It is therefore safer than ordinary transactions.

The disadvantages of cryptocurrencies are-

  • No refund or cancellation policy- the transaction carried out mistakenly cannot be reversed. There is no way for a sender to retrieve the amount if sent to the wrong wallet address. 
  • Illegal Transactions- all the transactions associated with cryptocurrencies are encrypted. It takes a lot of work for the government to track these transactions. Bitcoin was used to exchange money for many illegal deals like buying drugs. People have also used cryptocurrency to hide the source of their illegally acquired money. All these instances of illegal transactions are highly secure and easy to make. Therefore, it is very difficult for the government to keep a check on any of these activities.
  • Instability- the power lies in the hands of the inventor of the cryptocurrency or a group of people. They can easily manipulate the coin's value, and the price fluctuation is highly unpredictable. 
  • Higher Utilisation of Energy- the process of mining cryptocurrencies require an ample amount of electricity input. Ordinary computers need to perform this task properly. Especially mining bitcoin requires highly advanced computers, which need plenty of power. Bitcoins are majorly mined in China where electricity is generated by means of coal. High electricity usage for this purpose has increased China's carbon footprint over the last few years.
  • Higher Risk- it is true that the communications and transactions are encrypted, but if you lose your wallet's private key, you cannot get it back. Your wallet will be locked with any amount of coins, and you will lose access to your own data.

Crypto vs Stocks

Cryptocurrency has revolutionised the concept of digital assets, especially over the last few years. 

Investors have started thinking about replacing the stocks in their portfolios with cryptocurrencies. But it is very important to learn the difference between the two before making any decisions. 

The ownership of the stocks lies in the hand of a firm which is backed by a company's assets and cash flow. 

On the other hand, cryptocurrency is developed by an individual or a group of individuals and is not backed by any government or other organisation support. 

An investor needs to conduct great research before making any investment. Analysing the risk and rewards for the best possible outcomes is important. 

Volatility is linked with both stocks and crypto. But stocks are less volatile than cryptocurrencies. 

Investing in stocks is beneficial in the long run as it can stabilise your portfolio. 

While cryptocurrency tends to bring greater risks. The changes are usually sudden and unimaginable when it comes to crypto. 

You should only go further in investments if you can afford to lose money, but the risk with crypto is very high. 

Taxation of Crypto in India

In the 2022 budget, the government of India has officially termed the crypto assets "Virtual Digital Assets". 

This includes Bitcoin, Ethereum, NFTs etc. The tax imposed on the income generated from crypto is 30% which is charged at the end of each financial year.

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Cryptocurrency, a virtual digital asset, works with the technology of blockchains. 

It is secured by cryptography. The risk associated with investments is very high. 

It is, therefore, necessary to understand the speculative nature with proper research. 

However, the pros and cons are linked with everything. Crypto holds power to fluctuate at unthinkable rates in a given period of time. It can be good or bad for you. 

Are you planning to invest in crypto any sooner? Especia provides the best consultation and advisory services along with facilities of taxation for all your financial needs.

FAQ’s Related to Cryptocurreency

1. What is cryptocurrency?

Cryptocurrency is a decentralised virtual digital asset. This non-tangible asset is popular for the purpose of trading.

2. Should I invest in crypto or stocks?

You can make choice according to your needs and availabilities. Stocks can provide stability and are beneficial in the long run. But crypto has the power to provide incredible returns in a shorter period. However, the risk associated is greater, and you can even end up losing everything. 

3. Is crypto illegal?

Crypto is not illegal. But it is not backed by an authorised power. You can still invest, but any facilities or stability that comes with the government's support are impossible.

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