Article | 4:02 min read

What is Cryptocurrency and How Does it Work?: Part 1

Investing

What is cryptocurrency, how does it work, is it legal? In this series, we’ll break down (most) of the pressing questions you have about crypto!

Close up of crypto coins on a metallic black background

Cryptocurrency is a hot topic right now. While virtual currency existed in different forms since the 1980’s, it’s becoming more mainstream today. So what is cryptocurrency, how does it work, and is it legal?

What is Cryptocurrency?

Cryptocurrency is a type of currency that uses digital files as money. That seems easy enough, right? It’s decentralized, which means no one person or entity controls it. This type of currency is secured by cryptography, making it nearly impossible to counterfeit or double-spend. There are a few popular cryptocurrencies you might have heard of, like Bitcoin or Ethereum.

Many cryptocurrencies are decentralized networks based on blockchain technology. Blockchain is a ledger database, or record-keeping technology. These blockchains keep track of the existence of cryptocurrencies. It stores information differently than a typical database. Blockchains store data in blocks, and chains them together. Think about it like this: as new data enters, it goes into a block. When that block is filled up with data, it’s chained onto the previous block. So it stores the information chronologically, or in the right order. Since it’s decentralized, no one person or group has control over it, but rather all users collectively retain control. The data entered into blockchains is permanent and irreversible. For cryptocurrencies, this means transactions are permanently recorded and anyone can view it.

Is Cryptocurrency Legal or Safe?

Yes, crypto is both legal and secure. As mentioned earlier, cryptocurrencies are usually built on blockchain technology. Since these blockchains are decentralized and the information is added chronologically, it’s very difficult to alter the contents of a block unless the whole group agrees. Each block contains it’s own “hash,” which is a math function made of letters and numbers, a timestamp, and hash of the block before it. If any data were to change inside the block, the hash would change, too.

Why is that important to security? For instance, if a hacker tried to change the blockchain, and changed a single data block, it wouldn’t align with everyone else’s copy. Everyone else could cross-reference their own copies with each other, and would easily see it’s fraudulent. Cryptocurrencies face criticism for a few reasons, including illegal uses, exchange rate volatility, and infrastructure vulnerabilities. On the flip side, it receives credit for its portability, divisibility, inflation resistance, and transparency.

So, is crypto legal? Overall, it’s important to look at cryptocurrency laws per country for specific information. Taking Bitcoin for example, it was legal in February 2020 in the United States, Japan, the U.K., and most developed countries. In the U.S., the Internal Revenue Service (IRS) refers to cryptocurrency as “virtual currency,” and issued guidelines for taxpayers. The IRS also states virtual currency transactions are taxable by law just like transactions in any other property. Taxpayers transacting in virtual currency may have to report those transactions on their tax returns. For specific tax information about virtual currency, check out the Virtual Currencies Center on the IRS website.

Where Did Cryptocurrencies Come From?

Ready for some interesting history about cryptocurrency’s beginning, and it’s contribution to electronic currency transfers?! Cryptocurrency existed as an idea way before any of the technology existed to build it. Crypto’s technical start dates back to the 1980’s. An American cryptographer named David Chaum invented an algorithm that web-based encryption uses today. The “blinding” algorithm provided secure, unalterable information to exchange between users. This paved the beginning of electronic currency transfers! Pretty cool, huh?

As the years progressed and electronic payment transfers evolved, a 2008 white paper published by Satoshi Nakamoto described the first modern cryptocurrency – bitcoin. In early 2009, Nakamoto released Bitcoin to the public. By 2010, other cryptocurrencies started appearing, as well as the first public trading of bitcoin.

The field of cryptocurrencies is expanding. In early 2021, more than 4,000 cryptocurrencies exist. Many different types of cryptocurrencies exist for different types of investors, as well as business and trading needs. For example, some cryptos may offer a faster transaction confirmation time, or provide solutions for blockchains to work together easier.

As cryptocurrency continues to evolve into mainstream, a technology and financial services firm called NYDIG is creating a way for customers to buy and sell cryptocurrency through their existing bank accounts. Essentially, NYDIG would handle Bitcoin custody and trade execution, and the cryptocurrency is not FDIC-insured. Like with any new emerging technology or idea, it is still figuring out the details. As your financial partner, it’s our duty to keep you informed on emerging financial news, and how it might impact you one day.

Sources:

  1. Bitcoin is coming to hundreds of U.S. banks this year, says crypto custody firm NYDIG, CNBC
  2. Blockchain Explained, Investopedia
  3. Cryptocurrency, Investopedia
  4. Is Bitcoin Legal?, Investopedia
  5. Virtual Currencies, IRS.gov
  6. What Is Cryptocurrency?, Forbes
  7. What Is Cryptocurrency? Here’s What You Should Know, NerdWallet
  8. What Is Cryptocurrency – How It Works, History & Bitcoin Alternatives, Money Crashers
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