How the Cryptocurrency Market Really Works
Written by
Hanna Horvath
Edited by
Cory Dudak
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Investing in cryptocurrency is a divisive topic — but it’s worth knowing about the emerging (and volatile) new asset class. Chances are you’ve heard of cryptocurrency, even if you’ve never invested (or fully know how it works). While these digital assets have been around for a while, they’ve gone mainstream in the past few years.
If you’re not exactly sure what cryptocurrency is or how the crypto market works, you’re not alone. In this guide, we’ll dive into the cryptocurrency market, highlighting its similarities and differences with traditional stocks and other investments.
What Is Cryptocurrency?
Cryptocurrency is a digital currency backed by a blockchain, which uses a network to record and verify transactions. It was first created in 2009, one year after the Great Recession began, explained Jeff Owens, co-founder of Layer1 blockchain Haven1.
“The financial crisis destroyed faith in the traditional financial system. At the time, Bitcoin was designed as a form of peer-to-peer payment that eliminated the need for intermediaries such as banks,” Owens said.
Unlike fiat currency (such as the U.S. dollar or the euro), cryptocurrency is decentralized, functioning completely independent of banks. This makes crypto a potential alternative to traditional currencies.
“Without the facilitation by banks or governments, crypto works by one person directly paying another person digitally via blockchain, a public ledger,” noted David Kemmerer, CEO of CoinLedger, a cryptocurrency tax software company.
Unlike bills and coins, cryptocurrency doesn’t physically exist. However, it derives value from its users through supply and demand. Most cryptocurrencies have stringent monetary policies, including having a fixed number of tokens that can be created, or restrictions on the number of new tokens that can be created. This helps maintain their value.
Since its inception, cryptocurrency has grown beyond just a decentralized payments network into a viable alternative investment option, said Owens.
How Does the Cryptocurrency Market Work?
Though cryptocurrency is a currency, it’s also considered a digital asset, allowing you to invest in it as you would with stocks or bonds. You can buy cryptocurrency anytime, hold it in your crypto wallet or cash it into fiat currency through an exchange. The global cryptocurrency market capitalization today is around $1.7 trillion.
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Elijah Jackson, a blockchain industry commentator at MyChargeBack, uses a video game analogy to describe how cryptocurrency works as a store of value — and as an investment.
“When you go to an arcade and play a videogame, you score points and receive tickets or tokens that you can trade in for real prizes when you leave,” he explained.
Like other investments, such as stocks, if the value of the cryptocurrency you’re invested in increases, you can then sell it for a higher price and make a profit.
Pros and Cons of Investing in Cryptocurrency
Its decentralized nature and the potential for high returns make cryptocurrency an attractive investment option. It has fixed monetary policies that limit and even reduce supply, which can drive demand and lead to lucrative profits.
“Volatility is the name of the game with cryptocurrency,” said Jackson. “If you are a high-risk, high-reward investor, it’s fantastic because there is a potential to make exponentially higher percentage yields than traditional investments.”
Plus, because cryptocurrencies operate on a decentralized network, no central government or authority controls them. That aspect may appeal to investors who want freedom from traditional financial systems.
Yet the potential for higher yields comes with much greater risk. Because there is little regulation in the industry, there’s increased potential for scams and fraud. It’s reported that users lost as much as $1.8 billion in various hacks and scams in 2023.
“You can lose everything in the blink of an eye. Prices go up and down. Plus, many crypto projects are either scams or legitimate platforms run by irresponsible [people],” Jackson noted. “There are [also] vulnerabilities that result in hacks, phishing attacks, airdrop scams, and rug pull scams. So basically, the positive is the potential for very high yields. The downside is everything else.”
Popular Cryptocurrencies
There are many different types of cryptocurrencies, each with its functions and appeal. Fiat cryptocurrency is the most common type of cryptocurrency used as a store of value.
Bitcoin was the first created and remains one of the most popular cryptocurrencies today. It holds close to 50% of the total cryptocurrency market capitalization.
“Bitcoin is hands-down the most popular and successful cryptocurrency. It’s the leader in the crypto market that no other crypto comes close to in terms of market cap,” Kemmerer stated. “The second most popular is Ethereum, which is also very successful and has a great outlook.”
There’s been an explosion of new cryptocurrencies in the past few years, with thousands now available for trading. This includes memecoins or cryptocurrencies named after characters, individuals or animals, such as dog-themed tokens Dogecoin and Shiba Inu, said Owens.
While some of these memecoins experience significant price increases over a short period of time, they’re often more volatile than other cryptocurrencies and are more susceptible to scams.
Investment Strategies: Cryptocurrency vs. Stocks
Stocks represent ownership in a company. When you buy a share of stock, you purchase a fraction of that company. When the company generates profits, its stocks generally increase in value. When a company doesn’t perform well, a stock’s value may drop. Stocks are traditionally more volatile than conservative investments like bonds.
To earn a profit from stocks, you can sell a stock that’s gained value or receive profits back in the form of dividends. Stocks are bought and sold on exchanges, like the New York Stock Exchange.
As you can see, cryptocurrency and stock investing operate similarly — but there are some key differences.
Performance
Stocks and stock exchanges have existed for centuries, much longer than cryptocurrency. Additionally, stocks tend to generate much more stable returns than cryptocurrencies, though they do experience some fluctuation. For example, the S&P 500, a market index tracking the stock performance of the largest companies in the U.S., has averaged a return of about 10% since its creation in 1957.
Since stocks are tied to a company’s performance, they’re bolstered by that company. Cryptocurrency isn’t backed by a physical asset, which can make it much more susceptible to intense price swings.
Yet cryptocurrency’s volatility can work in your favor — sometimes experiencing much higher returns than you’ll find with any other asset. For example, Bitcoin has had an almost 50% annual return in the past 10 years.
Regulation
Stocks are much more heavily regulated than cryptocurrency. All stock markets have government oversight — for example, the U.S. market is regulated by the Securities and Exchange Commission (SEC).
The SEC can investigate, fine, or punish companies that commit fraud or other crimes. Cryptocurrency is a much less regulated industry, making it more susceptible to scams. There’s also a lot of recent regulatory uncertainty with cryptocurrency, and legality and regulations can change rapidly, impacting the market.
Diversification
Lastly, diversification is the foundation of any smart investing strategy — and stocks make it much easier to achieve a balanced portfolio. It’s much easier to spread your investments across countries, industries, companies, and more via stocks.
While there are many different types of cryptocurrency, it’s much harder to achieve diversification. For example, there aren’t any mutual funds or index funds that offer large exposure to the entire cryptocurrency industry.
That said, there may be a place in your investment portfolio for cryptocurrencies and stocks. Cryptocurrencies can significantly hedge against inflation and other more significant economic trends often affecting stocks. Cryptocurrency also often represents the growing technology and innovation sector, helping you get ahead of certain trends and potentially capitalizing on gains in the space.
But it’s important to research and find investment options that work for you and your situation.
Investing in Cryptocurrency
There are a few strategies you can employ to maximize your cryptocurrency investments. Like with other types of investing, ensuring your cryptocurrency picks align with your risk tolerance, time horizon and general financial goals is vital.
Novice cryptocurrency investors should consider a buy-and-hold strategy, which involves buying crypto and holding onto it for an extended period of time while the value goes through ups and downs.
More experienced traders may employ a combination of strategies, resorting to more complex investment options such as derivatives to maximize returns and hedge some of the risks, said Owens.
Reducing Risk While Investing in Cryptocurrency
As with any asset, it’s important to do your research before investing. Make sure you understand the risks involved with a particular cryptocurrency.
Cryptocurrency’s volatile and unregulated nature makes it even more vital to ensure you’re investing in a reputable digital asset.
Taking the time to learn the background and future outlook of cryptocurrency can help reduce some of the risks, says Owens. There are many online resources that list a cryptocurrency’s total market capitalization, circulating supply, price history and other details. The crypto should also be listed on well-known exchanges and have easy options to cash out in case you want to sell.
“A lack of information, low liquidity and no social media presence are red flags,” said Owens. “So is a rapid increase in the price of a cryptocurrency straight after launch with little previous price history.”
It’s also important to research the exchange you’re using, especially after the bankruptcy and subsequent fraud case of FTX, a once-popular exchange. Look into how reputable a platform is, what protections investors have, and what other investors have to say.
Bottom Line
Investing in the cryptocurrency market can be lucrative as long as you understand what you’re getting into. Now that you know what cryptocurrency is and how it works, you can invest more confidently.
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