What is a cryptocurrency and how does it work?

By now, you’ve probably heard of Bitcoin. But if you’re still trying to work out what a cryptocurrency actually is, read on.

A cryptocurrency is a digital or virtual currency. Rather than existing in a physical form, like as coins and notes, it exists as a digital token1.

How does cryptocurrency work?

When you buy or receive cryptocurrency, you are given a digital key to the address of that currency. You can use this key to access, validate and approve transactions, as unlike a currency – which is regulated or controlled by a bank or government – cryptocurrency transactions are verified online by the people using it2.

Users verify every transaction, and the transactions are recorded on a digital public ledger called the blockchain. This prevents the same unit of the digital currency (or coin) from being spent twice by the same person3.

Cryptocurrencies are kept in a digital wallet and can be used to pay for actual goods and services. But because they’re not legal tender, they aren’t accepted everywhere. They’re most commonly used for online payments but can sometimes be used in stores, with the payment made using a mobile device4.

  • AMP Capital chief economist Shane Oliver explains more in this short video.

How many cryptocurrencies are there?

The most well-known cryptocurrency is Bitcoin, but there are hundreds of different types. Some of the other well-known ones include Ethereum, Litecoin and Ripple.

How’s a cryptocurrency valued?

“The big debate around cryptocurrencies is how to value them. On the one hand, you could argue that it’s a revolution in the making and that this will be the way of all currencies in the future and, therefore, the sky’s the limit in terms of the price,” Shane says. “The counter argument is that it’s very hard to value an individual cryptocurrency like Bitcoin. It doesn’t spit out income or dividends, so it makes it very hard to value.”

Bitcoin reached a record high of almost $US 20,000 per coin in December 2017, but it’s value has since halved. Like other currencies, the value of a cryptocurrency is ultimately determined by supply and demand – or how much investors are willing to buy it and sell it for.  

What are the risks and benefits associated with cryptocurrency?

Benefits

Shane says that, on the plus side, cryptocurrencies are a good medium of exchange and way of transacting money around the world very cheaply, bypassing the banks and doing so with very low transaction fees.

Risks

Aside from the risks associated with the fluctuating value of cryptocurrencies, there are also risks associated with the online nature of cryptocurrencies, such as the online platforms where they are bought and sold, or your digital wallet, being hacked. And due to their anonymous nature and the inability of governments to freeze funds, cryptocurrencies are also popular among criminals5.

For more information

As with any financial decision, it’s worth doing your research and ensuring you fully understand the risks involved before investing in any financial products.

For more information on investments, speak to your financial adviser. If you don’t have an adviser but would like to seek some advice, you can call AMP on 131 267 or use our find an adviser tool.

1 ASIC Moneysmart, Cryptocurrencies.
2,3 Finder, What is cryptocurrency – and how can I use it?
4,5 ASIC Moneysmart, Cryptocurrencies.

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