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How cryptocurrency works

Created on 27 Mar 2020

Wraps up in 4 Min

Read by 2.3k people

Updated on 31 Jul 2021

“I can say almost with certainty that they will come to a bad ending.” These words by Warren Buffett have made investors a lot more skeptical about crypto investment. Well, not only him but many great investors have spoken against crypto. But one thing is for sure; you cannot ignore cryptos!

In fact, this crazy bandwagon has more people on board than the latest version of the Apple iPhone and more fans than most of the Bollywood stars. But, what purpose does it serve to hold an iPhone with no knowledge to operate it? It is futile, right? On similar lines, to make sense of whether you should put your hard-earned money in cryptos, you need to first understand how it works and the factors that influence the crypto market.

So, let’s understand the world of crypto from the very basics, shall we?

What are Cryptocurrencies?

Cryptocurrencies are decentralized currencies that work on “Blockchain technology.” This certainly means that unlike in any legal tender, there isn’t a single regulatory authority making decisions for the success of the same. 

Being a digital currency, It is now used for several transactions and offers high security. Some of the most popular names we hear daily include Bitcoin, Ethereum, Dogecoin, etc. Over time, cryptocurrencies have developed and transformed to match investor needs. Now we have coins operating on fiat(legal tender backed), another crypto, and algorithms. While the names have changed, the mechanism remains stable.

So, crypto is assumed to be the new norm of payment that is slowly taking over many industries and -

  • Offers faster transaction facility especially when the amount involved is huge

  • Prevention from fraud

  • Secure and easy

Truth be told, contrary to many great investors, many experts believe that crypto and related currencies will bring about a revolution in the financial sector. And this brings us to the next important question of how bitcoins works?

How do Cryptocurrencies work?

Bitcoin mostly relies on the peer-to-peer (P2P) network. This is similar to that local What's App group where everyone is an admin. The only difference is that there is a string of data operations underlying the mechanism protecting any duplication.

Let us understand this with an example:

Let’s say A, B, C, D are four friends who have a ledger. They make a note of all transactions that occur among them. On occasion, A gives B 3 coins. He creates an entry into the ledger by making the other two friends aware of the transaction. And in that way, they update their respective ledgers.

Take the same story on a global level. While many transfers and receive money, thousands of volunteers keep a close eye on the transactions and make a note of them. Each transaction will form a block, and when many of them are combined, it forms a chain. To transact, you will need to tell your account number, the receiver's account number, and finally, the amount.

You might be wondering what if A had only three coins and sent the same three coins to B and C? That’s where the complex mechanism comes into play. It automatically checks the previous transactions to make sure the wallet is updated. Further, once you create a wallet, you are offered a private key and a public key. The private key authorizes your transaction, and the public helps others to verify it. Thus, protecting A by sending money by the name of B. 

Another important question that might pop up is -

What do these volunteers get out of it?

Simple... rewards!

Volunteers who are known as miners are awarded Bitcoins in return for their service. The crypto technology is enabled so that the miners have to solve a complex math problem to add a block (in layman terms, an entry into the excel sheet). It is costly and extremely difficult. Whoever solves the problem first gets to add the blocks. This is known as mining.

There is also a limit to the maximum coins that can be mined. That number hovers around 21 million, and it will take years to reach that. So that’s not a worry at all. 

Is it all good?

Well, NO. Following are the disadvantages of cryptos:

  • As you can see, there is high volatility in the sector. One day it is breaking new records, and the next day it’s going on a free fall. This might sound like a perfect vehicle for speculators, but it is an adverse situation for investors. 

  • Governments fear that it will fuel black market transactions. Hence, many, including the Indian government, are looking upon ways to regulate it. 

  • From the above read, we know there are only two keys, the first being the private key and the second is the public key. Losing the key means you will not have access to a huge amount of money. 

  • Sometimes growth itself is a question, particularly in cryptos like Dogecoin, which is a meme. As in such cases, you are not investing in the fundamentals but on a trend that may or may not be fruitful to you as an investor.

The bottom line

While it all seems cool and attractive, the crypto investment inhibits huge risks. While many people call it a bubble, some look at it as a vehicle of the future. The truth is something that only time can answer. Until then, we will look eagerly as big hands drag it up and down.

However, be mindful not to be blindly influenced by the bitcoin frenzy. This isn’t something you can absolutely nail at, especially as a newbie. Rather first gain knowledge, get trained and only then, proceed with the investment. Remember this advice from the notable American investor Peter Lynch --

Invest in what you know.

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Ayushi Upadhyay

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A Keen Learner. Tiny, brainy, and studious, this quiet one stays in her zone until she pops. And once she does, boy, are her comebacks snappy! There is no financial question that she can't answer through her magical blog-writing. 

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