Just about everyone has heard of cryptocurrency by now, but most people still don't really understand what it is. More than just a form of digital cash, cryptocurrency and the technology underlying it have the potential to transform the financial sector and many other industries as well. Therefore, it's worth taking your time to learn a bit about cryptocurrency.

What is cryptocurrency?

Cryptocurrency is a digital currency that doesn't rely on central banks or trusted third parties to verify transactions and create new currency units. Instead, it uses cryptography to confirm transactions on a publicly distributed ledger called the blockchain, which enables direct peer-to-peer payments.

That definition might seem downright cryptographic right now, but, by the end of this overview, you won't need a decryption key to understand crypto.

There are hundreds of different cryptocurrencies in circulation, each with varying value. The first cryptocurrency, Bitcoin, was developed in 2009 by a programmer using the pseudonym Satoshi Nakamoto.

In a 2008 white paper entitled, "A Peer-to-Peer Electronic Cash System," Nakamoto provides the first description of blockchain. Blockchain is the technology that enables cryptocurrency to work like government-issued (fiat) currencies without the involvement of any central bank or trusted third party.

Specifically, blockchain solves the "double-spending problem" associated with digital cash. Since digital information is easily copied, digital money requires a mechanism that reliably prevents a currency unit from being "duplicated" or otherwise spent more than once.

The global financial system, as a collective entity, has historically been responsible for establishing and ensuring the legitimacy of monetary transactions. The validity of cryptocurrency is established and maintained without any involvement by the world's central banks; instead, ledgers of cryptocurrency transactions are publicly maintained. But, unlike most publicly kept records, which are vulnerable to hacking and modifications, transactions verified by blockchain technology are immutable -- meaning they cannot be changed.

A rendering of a coin with a lock on it.

Image Source: Getty Images.

How cryptocurrency works

To make a cryptocurrency transaction, you need a wallet for that digital currency. A cryptocurrency wallet doesn't actually hold any currency; it merely provides an address for your funds on the blockchain. A cryptocurrency wallet also includes private and public keys that enable you to complete secure transactions.

You can buy or sell cryptocurrency in exchange for a fiat currency, such as the U.S. dollar, using a cryptocurrency exchange. Exchanges, which can hold deposits in both fiat and cryptocurrencies, credit and debit the appropriate balances of buyers and sellers in order to complete cryptocurrency transactions. You can also use cryptocurrency to buy something, like a product or service.

Every time you buy cryptocurrency or use it to complete a purchase, you authorize the movement of a specified amount of the cryptocurrency from your wallet address to the wallet address of the seller. The cryptocurrency transaction is encrypted with your private key and pushed to the blockchain. The cryptocurrency network's miners access your public key to confirm that your private key was used to encrypt the transaction. Once the block that includes your transaction is confirmed, the ledger is updated to show the new cryptocurrency balances for both your address and the seller's address. This entire process is conducted by software.

Cryptocurrency works because blockchain works. Blockchain technology gives everyone a copy of every transaction and uses the blockchain to ensure that everyone's copy is, and remains, the same. That transparency makes cryptocurrency transactions work.

Why is it called a blockchain?

A block is a collection of transaction data on a cryptocurrency network. It basically states that Person A sent this amount of the cryptocurrency to Person B, Person X received this much cryptocurrency from Person Y, and so on.

A block includes a reference to the block that immediately precedes it. The blocks create a chain, linking one to another through references to prior blocks. Cryptographic hash functions create the references to the preceding blocks by mapping sets of data to strings of letters and numbers called hash digests. Changing the data automatically changes the hash digest. To change a block in the ledger, a hacker would have to reproduce the entire chain of blocks following it since not doing so would create a chain of invalid hash values that would not be accepted by the cryptocurrency network.

Artist rendering of blockchain.

Image source: Getty Images.

Blocks include additional information that further enables the cryptocurrency network to verify the validity of the block. The proof-of-work method of establishing distributed consensus relies on cryptocurrency miners using high computing power to add blocks to the blockchain. The computing power solves complex puzzles, like math problems, for which solutions are easily verified as being correct. The miners are typically rewarded with cryptocurrency and transaction fees.

New blocks cannot be added to the blockchain without a miner computing a valid solution to the block's puzzle. With every transaction, the blockchain grows longer and the amount of computing power required to add a new block increases. The blockchain by design becomes increasingly tamper-proof; a hacker today would need computing power equivalent to the majority of the computing power on the cryptocurrency network to successfully alter transactions.

Another method of establishing distributed consensus to add to a blockchain is known as proof of stake. Instead of requiring vast amounts of computing power, the proof-of-stake method enables the cryptocurrency holders with the most wealth or the oldest stakes to create blocks by verifying transactions. Stakeholders are selected semi-randomly and with additional mechanisms in place to prevent the wealthiest individuals from creating fake transactions or otherwise exerting too much power over the blockchain.

Biggest cryptocurrencies

These are the five largest cryptocurrencies:

Rank

Coin Name

1

Bitcoin (CRYPTO:BTC)

2

Ethereum (CRYPTO:ETH)

3

Binance Coin (CRYPTO:BNB)

4

Tether (CRYPTO:USDT)

5

Cardano (CRYPTO:ADA)

Data source: Coinmarketcap.com; ranking current as of 3/26/2021.

The list of the most valuable cryptocurrencies is always changing, just like the list of the most valuable publicly traded companies. But, since cryptocurrencies tend to be more volatile than blue chip stocks, how cryptocurrencies rank in value can change quickly. There are a few consistencies at the top of the list, though.

Bitcoin is, by far, the most valuable cryptocurrency. As the original cryptocurrency, it has the strongest adoption rate and a large network of miners. Those factors ensure it remains at the top of this list.

Ethereum's Ether is the second-largest cryptocurrency and consistently so. Ethereum serves as a platform for other cryptocurrencies besides Ether, and offering decentralized applications to other token creators ensures that Ether consistently retains greater value than those other tokens. Most cryptocurrencies rely on the decentralized applications provided by Ethereum.

Graphic of a price chart with Bitcoin coin in the background.

Image source: Getty Images.

Best cryptocurrencies

Determining a "best" cryptocurrency is practically impossible. People use different cryptocurrencies for different purposes. Some use it for transacting, while others hold it as an investment asset. Some consider investing in cryptocurrency as an alternative to buying gold. Companies can require you to buy their cryptocurrencies in order to use their services.

Buying Bitcoin is an obvious choice for anyone interested in cryptocurrency. It's widely supported as a form of payment -- at least more so than other cryptocurrencies -- and a well-established ecosystem of software is available to facilitate transactions. The sizable network of miners makes transactions very secure, provided that you don't reveal your private key.

Ether is another attractive option because of the value that Ethereum provides to the broader cryptocurrency sector. Tether is the most popular stablecoin available. Stablecoins are pegged to assets with low volatility, such as the U.S. dollar or gold, and Tether is backed by a 1:1 reserve of fiat currency. Litecoin is popular among those interested in spending cryptocurrency on everyday purchases. Mining a block of Litecoin takes only 2.5 minutes versus 10 minutes for a block of Bitcoin. These faster transactions also have extremely low transaction fees, making Litecoin suitable for small payments.

Are cryptocurrencies a good investment?

Cryptocurrencies are not simply "good" or "bad" as investments. Cryptocurrencies may fit well in a diversified portfolio of assets, but putting most or all of your money in an asset class as volatile as cryptocurrency is unlikely to serve your portfolio well.

The newness of cryptocurrencies makes their risks not well understood, which translates into poor understanding of how cryptocurrency values correlate with the values of other assets. Not enough historical data exists to confidently predict how the prices of cryptocurrencies fluctuate when the prices of other assets change. This lack of visibility creates an obstacle to establishing a balanced portfolio that maximizes returns without exceeding your desired level of risk.

Lack of historical data notwithstanding, many investors -- including institutional investors, banks, and company CEOs -- assert that cryptocurrency should be part of everyone's portfolio. Understanding what cryptocurrency is, how it works, and what value it can provide over fiat currency is an important first step before investing money in cryptocurrency.