What is Cryptocurrency and How Does It Work?
Cryptocurrency has become a buzzword in the financial world; it always hits the headlines when it peaks – but many people still struggle to understand what it is and how it functions. This guide will demystify the concept of cryptocurrency and explain its inner workings, helping you grasp this revolutionary digital asset.
What is Cryptocurrency?
Cryptocurrency is a digital or virtual form of currency that uses cryptography for security. Unlike traditional currencies issued by central banks, cryptocurrencies operate on decentralised systems called blockchains. This means they are not controlled by any government or financial institution, making them potentially immune to interference or manipulation.
Some popular cryptocurrencies include:
- Bitcoin (BTC)
- Ethereum (ETH)
- Litecoin (LTC)
- Cardano (ADA)
As of April, 2024, there are more than 9,000 digital currencies listed on CoinMarketCap with a combined total market value of US$2.41 trillion.
How Does Cryptocurrency Work?
Cryptocurrencies function on a technology called blockchain, which is essentially a distributed public ledger. Here’s a breakdown of how it works:
- Transactions: When you send or receive cryptocurrency, the transaction is broadcast to a network of computers.
- Verification: These computers, or nodes, verify the transaction using complex algorithms.
- Blockchain: Once verified, the transaction is combined with other transactions to create a new block of data for the ledger.
- Mining: This process of creating new blocks is called mining. Miners use powerful computers to solve complex mathematical problems and are rewarded with new cryptocurrency tokens for their efforts.
Key Features of Cryptocurrency
- Decentralisation: No central authority controls cryptocurrencies, making them resistant to government interference or manipulation.
- Transparency: All transactions are recorded on a public ledger, visible to everyone.
- Security: Cryptocurrencies use advanced cryptographic techniques to secure transactions and control the creation of new units.
- Limited Supply: Many cryptocurrencies have a cap on the total number of units that can ever exist, which can potentially increase their value over time.
- Tax: Crypto gains, just like gains made through buying shares on the stock market or by selling a house, are taxed on any gains you made at the time of the sale. Trading between currencies, ie. selling bitcoin to buy etherium, is also considered selling, so you will need to pay tax on any gains even if not converting crypto back to dollars.
Pros and Cons of Cryptocurrency
Advantages
- Fast and cheap international transfers
- Increased financial privacy
- Potential for high returns on investment
- Accessible to anyone with an internet connection
Disadvantages
- High price volatility – price often goes wildly up and down
- Potential for use in illegal activities
- Lack of regulation in many jurisdictions
- Risk of losing access to funds if private keys are lost
Cryptocurrency and SMSFs
For Australian investors, it’s possible to invest in cryptocurrency through a Self-Managed Super Fund (SMSF). This approach allows for greater control over your superannuation investments and potentially higher returns.
How to Buy and Store Cryptocurrency
- Choose a Cryptocurrency Exchange: Popular options include Coinbase, Binance, and Kraken.
- Create an Account: You’ll need to provide personal information and verify your identity.
- Add Funds: Transfer money from your bank account to the exchange.
- Buy Cryptocurrency: Choose the cryptocurrency you want and make your purchase on the exchange.
- Store Safely: Transfer your cryptocurrency to a secure wallet. This can be a software wallet on your computer or smartphone or a hardware wallet for added security. You can also take your crypto off the exchange you bought it on and put it onto a drive or USB stick—anything not connected to the internet. This is called ‘cold storage’ and it makes it hackerproof.
The Future of Cryptocurrency
As cryptocurrency continues to evolve, we’re seeing increased adoption by both individuals and institutions. Some potential future developments include:
- Greater integration with traditional financial systems
- Improved scalability and transaction speeds
- More regulatory clarity around the world
- Increased use in everyday transactions
Getting Started with Cryptocurrency
If you’re interested in exploring the world of cryptocurrency, start small, diversify your investments, and never invest more than you can afford to lose.
Cryptocurrency represents a significant shift in how we think about and use money. While it offers exciting possibilities, it also comes with risks and challenges, so it’s important to do your research and understand the risks involved.
New Venture can help you navigate these waters. For those looking to set up an SMSF for cryptocurrency investment, don’t hesitate to start here. With the right knowledge and approach, cryptocurrency could potentially play a valuable role in your financial future, so learn more about our crypto SMSF options at New Venture Wealth.
