How does cryptocurrency work?

Cryptocurrencies are digital or virtual tokens that use cryptography to secure transactions on a decentralized network called a blockchain. They are gaining popularity as more and more people learn about them and see the potential for using them in their everyday lives. Cryptocurrencies offer many benefits over traditional payment methods, including security, speed, and ease of use.

The way cryptocurrencies operate in the digital environment is still a mystery to many users. In this article, we showcase best cryptocurrency practices and inform readers on how to maximize their cryptocurrency usage.

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what-is-cryptocurrency-home-dappgambl

What is a cryptocurrency?

Cryptocurrency is a digital currency that uses cryptographic proof instead of trust to ensure transactions are completed digitally. In 2009 Bitcoin developed as the first cryptocurrency created based on a trustless and secure peer-to-peer transaction system enabling users to make financial exchanges without restrictions.

Cryptocurrencies use blockchain or distributed ledger technology and ensure a trustless system. They’ve become the preferred online digital currency because it does not require a third party, such as a bank, to mediate and approve transactions. 

Cryptocurrencies are based on blockchain technology which ensures all transactions are occurring in a decentralized environment, and they provide what financial institutions have failed to deliver, specifically: privacy and security.

How does cryptocurrency work?

Cryptocurrencies are a new digital trend that uses blockchain technology to conduct and approve transactions. Users can send tokens between one another without interacting with any third party for approval. This type of censorless transaction is what makes cryptocurrency valuable.

The process of using cryptocurrencies is twofold. First, users rely on the blockchain network to approve and add transactions to the blockchains. Each blockchain uses a consensus mechanism where network validators (miners) approve a set of transaction blocks and add them to the blockchain string.

Every transaction on the blockchain is public and permanent, meaning nobody can alter or delete transaction data. Cryptocurrencies have gained popularity due to their ability to prevent double-spending, which helps secure the network and prevent fraudulent actors from taking advantage.

The second stage is token minting, a form of rewards miners receive for validating transactions. Miners are tasked with adding transactions to the blockchain, and in return, they are rewarded with new tokens. Again, the consensus mechanism can vary from PoW to PoS; however, the validation idea is similar across every network protocol.

How are cryptocurrencies used?

Cryptocurrencies are multipurpose, meaning they can serve various functions within the decentralized ecosystem.

Unit of Exchange

Cryptocurrencies like Bitcoin were developed to facilitate peer-to-peer transactions. Since then, every cryptocurrency can accommodate that specific function, and users must send tokens within the same ecosystem.

Smart Contracts

Ethereum is the first cryptocurrency to bring smart contract functionality to digital assets. Ethereum then becomes a utility token within their ecosystem which helps users access new blockchain features. Smart contracts are automated decentralized agreements between two parties and have provided cryptocurrencies with new use cases.

NFTs

NFTs are also a type of cryptocurrency that, unlike Bitcoin, are non-fungible. NFTs can provide ownership of digital or physical assets and allow users that hold the NFT to use blockchain data to prove digital ownership.

DeFi

DeFi crypto are also utility tokens that provide users access to decentralized applications. DeFi are decentralized protocols that use smart contracts to perform financial transactions within their ecosystem. DeFi token holders can stake their tokens to provide value and liquidity to the DeFi protocol.

How to buy cryptocurrencies?

Cryptocurrencies can be purchased from exchanges or received from other users. To own a cryptocurrency, you have to have a wallet that supports every crypto. Thus, cryptocurrency is accessible to individuals on major crypto exchanges, or they can use crypto through other banking platforms.

Users can keep their crypto on the exchange wallet or send it to their wallet using their unique wallet address.

Cryptocurrencies are not fully interoperable, meaning that sending an ERC-20 standard token to a Binance wallet will lead to a loss of funds. However, ERC-20 tokens are part of the Ethereum network, and every cryptocurrency built on Ethereum can be sent to an Ethereum wallet. 

Similarly, BEP-20 tokens, native to Binance Smart Chain, can be sent to the BSC network. Users can also buy crypto directly or use DeFi applications to swap their to other tokens on the same protocol.

Users must create an account on a platform that transacts cryptocurrencies. Then, each user must pass a KYC process to ensure they are the true beneficiaries of the account. Once the account is set up, users can fund their account using credit cards, payment processors or send cryptocurrencies to their account.

Another way to acquire cryptocurrencies is to use Decentralized Financial platforms like Uniswap or Pancakeswap. For that, users have to connect their crypto wallet to the platform and have the native token they want to swap ready in their account. Then to purchase crypto, they must swap tokens on the DEX. Each trade takes place on the protocol itself, and every user must pay a network fee to finalize the transaction.

One of the main reasons users purchase cryptocurrency is that they become an investment instrument for traders. Thus the objective of each trader is to identify the top cryptocurrencies to invest in early and buy or sell them at the appropriate time to generate a profit.

Where to store cryptocurrency?

Cryptocurrencies are stored on digital wallets connected to a blockchain protocol. Each wallet has a uniquely generated address that can be used to receive or send cryptocurrencies. There are two types of crypto wallets: hot wallets and cold wallets, each with specific characteristics.

Hot wallets are always connected to the internet, making them ideal for quicker transactions. For example, each exchange has a hot wallet for every token available to facilitate the selling and direct purchasing of cryptocurrencies. Additionally, hot wallets can be digitally kept on a computer or a smartphone. However, the drawback of hot wallets is that they are more susceptible to security issues and can potentially be hacked in numerous ways.

Cold wallets, on the other hand, are more secure. This is because funds are stored on an offline platform that is not always connected to the internet. As a result, cold wallets like Trezor are more secure, given they don’t facilitate unauthorized access to the user’s funds when they are offline.

What are the risks of cryptocurrency?

Using cryptocurrencies is safe as most battle-proven protocols have developed enough network hashrate to impede a 51% attack on the network. However, cryptocurrencies are not without risks, but these risks can be managed if each user practices an increased level of awareness.

Blockchain protocols are fail-proof, and the only reason cryptocurrencies could fail is due to human errors, such as poorly written code, security breaches, malware, or low network hashrate. However, there have been a number of high-profile hacks on cryptocurrency exchanges or DeFi platforms where hackers have stolen millions of dollars worth of digital tokens. The largest blockchain hack involved Poly Network which lost over $600 million in users assets.

As with every developing technology, cryptocurrencies are no different, and hackers are always drawn to find loopholes to steal users’ funds. The only way users can lose cryptocurrencies is if they store their crypto on platforms where they don’t own the secret keys or use blockchain protocols that can be compromised.

Cryptocurrencies can be hacked if crypto holders don’t adhere to security measures and click on fraudulent links. Therefore, users should implement multiple security layers to their wallets – a two-factor authenticator, and only use trusted websites to prevent sharing their security key with bad actors.

Ways to avoid cryptocurrency scams

Not everyone understands cryptocurrencies. It’s extremely easy for users to be drawn to the mirage of quick returns and fall for industry scams. Below are the most common cryptocurrency types of scams to avoid.

Crypto influencers

Crypto influencers are problematic because they promote tokens they own and then dump them on their followers. This is an issue because the industry is not regulated, making it easy for influential people to take advantage of their public perception.

Ponzi cryptocurrencies

Bitcoinnect is one of the most famous Ponzi schemes, which was eventually closed by the Texas state regulators. The owners of such platforms use pyramid schemes to attract new investors with a high APY and offer them tokens which ultimately prove invaluable in exchange for their Bitcoin or other established assets.

Fake Websites

A report by the Verge has shown that hackers have used Google Ads to funnel users to popular cryptocurrency wallets and get access to their security phrase. In addition, websites that mirror already successful platforms can be misleading, causing users to lose their token value by making bad investments or revealing their secret keys to bad actors.

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Vlad Hategan
Written by Vlad Hategan verified symbol NFT Gaming Specialist
75 Articles

Vlad is a cryptocurrency expert and social media specialist. With a focus on cryptocurrency culture and how network variables affect cryptocurrency interactions, Vlad has learned the industry's complexities. He is committed to sharing his knowledge in various crypto sectors with anyone interested and is always looking for the next big narrative! Vlad is always interested and keen to be on top of every new blockchain development.

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Reviewed and Fact Checked by Eugene Abungana , Investment Analyst, Financial Analyst, and Institutional Trader