What is Cryptocurrency and How Does It Work?

Cryptocurrency, or crypto, is a form of digital currency that can be used for internet-based electronic payments or as a store of value. The idea of "digital cash" isn't new—credit cards, PayPal, Venmo, and other payment methods permitting easy, traceable electronic transactions came before. But there are important differences. 

A big one is that transactions using these earlier methods were settled using traditional "fiat" currencies. Fiat currencies—such as the U.S. dollar and euro—are those issued by governments and whose supply is managed by central banks. 

In contrast, cryptocurrencies are considered a "non-fiat" medium of exchange because they function independently of any government or central bank, using unique algorithms to record transactions and determine supply. 

Cryptocurrencies have no intrinsic value, unlike a fiat currency (whose value stems from the fact that it is legal tender authorized by a government) or earlier commodity-based currencies (such as those tied to gold or silver). 

Instead, a crypto currency's price is based on the quality of the underlying technology, as well as supply and demand dynamics determined in part by technology that limits the creation of additional units and investor sentiment. Like with any traded item—think baseball cards—scarcity can influence value: The fewer units available, the higher the price potential buyers are willing to pay.

"Crypto" refers to the cryptography—i.e., the unique software code underpinning a virtual currency.

Cryptocurrencies are rooted in blockchain technology. A blockchain is an open-source database—essentially a public ledger—that is distributed across a decentralized computer network (in this case, the internet) and forms a permanent record of transactions between parties. Each transaction represents a "block" of data about who owns what at a given time, along with the hash (unique identifier) of the previous block. Together these blocks form a "chain" that can't be altered or counterfeited. 

Having a public ledger obviates the need for a central authority to confirm the database's accuracy or to clear transactions, as each new transaction is recorded across the entire network. 

So, you could think of a cryptocurrency transaction as a series of electronic messages that record information about the parties involved, the timing, and the quantity of currency being traded. Note that ownership of bitcoin or other cryptocurrencies is not an investment in blockchain, the technology, or its current or future uses.

While cryptocurrencies are perhaps the most famous application of this technology, blockchains have many potential uses beyond payments. They include "smart" contracts, which are executed automatically once the agreed terms and conditions are fulfilled. They can also be used to manage supply chains and provide financial services.

Bitcoin is the first and the most well-known cryptocurrency. Its creation is credited to a founder who goes by the pseudonym Satoshi Nakamoto. Though it traces its roots to an individual, no person or agency currently regulates or manages bitcoin. As outlined above, bitcoin is instead governed by its cryptography and a decentralized network of computers that record and verify the blockchain transactions. 

Bitcoin isn't considered legal tender in most countries. Like physical gold, bitcoin's value stems from supply and demand dynamics, and the perception that it can be a store of value, an anonymous means of payment, or a hedge against inflation—though none of these characteristics have yet to establish a long-term track record.

To buy and sell cryptocurrencies, you'll need to visit a cryptocurrency exchange, where you can swap dollars (or other currencies) for crypto. Then you'll need to have a specialized "digital wallet" to store your crypto units. 

You can also buy investment products linked to crypto. On that score, early 2024 marked a milestone for bitcoin specifically. On January 10, 2024, the Securities and Exchange Commission (SEC) approved trading in exchange-traded products (ETPs) that hold spot bitcoin. (The spot market, also known as the cash market, refers to forums where securities and other assets can be immediately exchanged between buyers and sellers.) That marked the first time a cryptocurrency had been authorized for use as an underlying asset in such a widely held, actively traded investment product. 

To be clear: An investor who buys one of the new spot bitcoin ETPs isn't purchasing bitcoin. The new ETPs are securities designed to track the price of the underlying cryptocurrency.

The IRS treats cryptocurrencies as property, not as a currency, meaning any transactions that use crypto will be subject to the capital gains tax rules. Most people don't think of shopping as a taxable event, but it can be if you use virtual currencies. When you buy something with cryptocurrency, you're effectively selling a portion of your crypto holdings and using the proceeds to cover the cost of the purchase.

Whether the transaction results in a gain or a loss is calculated by taking the difference between the fair market value of the goods or services you purchased and your adjusted cost basis for the crypto used in the transaction—generally the amount you paid for your cryptocurrency, plus any fees.

If you make money on a cryptocurrency transaction and don't report the capital gains or income, you could be in hot water.

As you might expect with a highly speculative investment, cryptocurrencies carry notable risks, including:

• Volatility: Cryptocurrency prices historically have been highly volatile, and fluctuations could result in significant financial losse
• Fraud and scams: According to the Federal Trade Commission, "Many people have reported being lured to websites that look like opportunities for investing in or mining cryptocurrencies, but are bogus."
• Lack of recoverability: You need login credentials to access a cryptocurrency exchange, but these can be stolen or lost. With conventional financial accounts, there's normally a recovery process if you forget or misplace your login credentials. If you lose your cryptocurrency "key," however, you cannot retrieve your cryptocurrency. Similarly, if you lose access to the place where you store your key, you will effectively lose possession of your cryptocurrency. Lastly, if you store your cryptocurrency in a cold 
  (offline) wallet, it could be damaged or lost.

While Bitcoin is the best known and most widely held cryptocurrency, there are thousands of types of cryptocurrencies. Here are the most popular cryptocurrencies (based on market cap) that are available today:

• Bitcoin (BTC)
• Ethereum (ETH)
• Tether (USDT)
• XRP (Ripple)
• BNB (Binance Coin)
• Solana (SOL)
• Dogecoin (DOGE)
• USD Coin (USDC)
• Cardano (ADA)
• TRON (TRX)

Here are some common cryptocurrency terms and definitions that you might find helpful to know. 

Address: Sort of like an e-mail address, you can share your coin-specific address so somebody can send coins to you. People can have many different addresses and it's typically recommended that you generate a unique one for every transaction. 

Altcoin: Short for alternative coin, the term may be used to refer to any cryptocurrency other than bitcoin. 

Blockchain: A cryptographically protected distributed ledger made up of blocks that contain transaction history. As the blockchain grows longer and longer, it becomes increasingly difficult to alter older transactions. 

Cryptocurrency exchange: A crypto exchange is a digital marketplace where users can buy, sell, and trade cryptocurrencies.

Digital assets: Electronically stored valuables, such as cryptocurrency, that rely on algorithms and computing power for secure transfer and ownership verification, without need for a brokerage or bank account.

Digital wallet: To use cryptocurrency, you'll need a digital wallet. A digital wallet stores private and public keys, which are necessary to send and receive coins. There are hardware, software, and paper wallets. Hardware and paper wallets (also known as "cold wallets" since they are not connected to the internet) are typically considered more secure than software wallets, although there are pros and cons associated with each. If you lose your private key and can't access your digital wallet through back-up methods, you will never be able to recover your coins and they are effectively removed from circulation.

Initial Coin Offering (ICO): An ICO, also known as a token sale, is a means of crowdfunding where a company offers a new coin in exchange for fiat currency (U.S. dollars for example) or a digital currency (Bitcoin, Ether, Litecoin, etc.). Typically, the funds they receive are used to develop the new concept, and the token they issue will be used to transact on their network once it is launched. 

Smart Contract: An agreement that is written in computer code and automatically executes when certain conditions are met. Some networks, most notably Ethereum, support smart contracts while others do not.

Schwab continues to monitor cryptocurrencies as regulations and technology evolve. We suggest investors continue to treat them as a speculative instrument primarily for trading with money outside a traditional long-term portfolio.

Cryptocurrency-related products carry a substantial level of risk and are not suitable for all investors. Cryptocurrency investments are relatively new, highly speculative, and may be subject to extreme price volatility, illiquidity, and increased risk of loss, including your entire investment in the fund.