Cryptocurrency: Meaning, Types, How It Works and How To Invest

Cryptocurrencies have emerged as an exciting new asset class for investors in India. With the potential for high returns, cryptocurrencies are attracting investor interest, especially among millennials. India now has over 100 million cryptocurrency investors, more than the total number of investors in the stock markets. While returns have been attractive, cryptocurrencies also come with significant risks due to their volatility and unregulated nature. This article provides a detailed guide on investing in cryptocurrencies in India, including their work, top cryptocurrencies to consider, where to buy them, strategies, and risks involved.

What are Cryptocurrencies? 

Cryptocurrencies are digital or virtual currencies that use cryptography to authenticate and confirm transactions. They are based on a decentralised peer-to-peer network not governed by any central authority. In the case of cryptocurrencies such as Bitcoin, there is no physical currency as they exist only on the decentralised ledger called the blockchain. Similarly, you can make digital payments with rupees and use cryptocurrencies to pay for goods and services if the recipient is willing to accept them. Still, cryptocurrencies do not allow you to withdraw physical notes or coins.

Cryptocurrencies allow payments to be made directly from the transacting parties without the need for mediators such as banks. They make use of public and private keys for security and identification. Transactions are recorded on a public ledger known as the blockchain, which promotes transparency and accountability. More than 5,000 cryptocurrencies exist, with Bitcoin being the first and most well-known.

How Cryptocurrencies Work?

Cryptocurrencies are based on blockchain technology, a decentralised and distributed digital ledger. It serves as a public record of all transactions made using that cryptocurrency. Transactions are added to the blockchain chronologically in bundles called blocks linked cryptographically to the previous block. This creates a chain of blocks - hence the name blockchain. 

When a transaction is initiated, it is broadcast to a peer-to-peer network of computers known as nodes. Nodes validate the transaction using algorithms, and once a consensus is reached, the transaction is added as a new block to the blockchain. Validation of transactions is done by cryptocurrency miners who use computing power to solve complex cryptographic puzzles and earn rewards in the process. 

Once validated and recorded on the blockchain, transactions cannot be altered or deleted, enhancing security and transparency. As there is no central authority, blockchain networks are governed in a decentralised manner.

What is Bitcoin?

The first and most popular cryptocurrency, Bitcoin (BTC), was launched in 2009 by the pseudonymous Satoshi Nakamoto. It was at the forefront of using blockchain technology for P2P transactions, avoiding banks and financial institutions. Bitcoin is limited to a supply of 21 million coins, of which approximately 19 million have already been mined.

Network nodes confirm Bitcoin transactions and store them in the public distributed ledger blockchain. If they do so, goods and services can be bought using Bitcoin. Different Bitcoin addresses are employed to safeguard the anonymity of the transacting parties. In general, Bitcoin aims to offer a decentralised payment system that is an alternative to the traditional banking system.

How to Invest in Cryptocurrencies in India?

Here are the typical steps to start investing in cryptocurrencies in India:

1. Open an account on a crypto exchange platform: Sign up on any major Indian crypto exchange by completing KYC verification. 
2. Create a crypto wallet: Every exchange provides a digital wallet to store purchased cryptocurrencies.
3. Fund your wallet: Transfer money from your bank account to your exchange wallet to buy cryptocurrencies. 
4. Place buy orders: Use the exchange interface to buy your preferred cryptocurrency with INR and store them in your wallet.
5. Manage and safeguard: Carefully store wallet keys and passwords. You can sell and book profits similarly.

Popular Indian exchanges like WazirX and CoinSwitch Kuber make it easy to invest in top cryptocurrencies like Bitcoin, Ethereum, and others in a few clicks.

Types of Cryptocurrency Wallets

Cryptocurrency wallets can be broadly categorised into software (hot) wallets and hardware (cold) wallets.

Software wallets: These applications can be installed on devices like desktops, mobiles, etc., to store private and public keys and interact with the blockchain to send/receive cryptocurrencies. Examples - MetaMask, Exodus, Jaxx.

Hardware wallets: These are physical devices, like USB drives, used to store cryptocurrency offline for security. Private keys remain isolated from internet connectivity, reducing hacking risks. Examples - Ledger, Trezor.

While software wallets are convenient, hardware wallets are more secure for long-term holdings.

Cryptocurrency Investment Strategies

Given the high volatility of cryptocurrencies, here are some suggested strategies for investing:

1. Long-term holding: Set aside a small part of an investment portfolio for cryptocurrency, long-term holding from 3 to 5 years or more. Historical data indicates substantial growth over the long term despite intermediate volatility.
2. Timing the markets: Study the price chart of Bitcoin and detect possible highs and lows. Buy on dips when the sentiment is bearish and sell when the sentiment is bullish. Requires depth of analysis.
3. Diversification: Diversify your investment in Bitcoin with other uncorrelated cryptocurrencies like Ethereum, Litecoin, etc., to scatter risk.
4. Dollar-cost averaging: Automatic investment of fixed smaller amounts regularly to cost averaging. Reduces the impact of volatility.
5. Take partial profits: Take profit systematically when the Bitcoin price rusts out of the part to keep some profit and hold the core position.

Unrelated to the strategy, invest only according to the risk appetite and practice prudence when investing in this highly speculative asset class.

Cons of Investing in Cryptocurrencies

While cryptocurrencies hold great potential, they also carry considerable risks: 

1. Extreme volatility: The prices of cryptocurrencies are highly speculative and can fluctuate within a few minutes.
2. Unregulated market: Unregulated nature leaves investors open to manipulation and scams.
3. Cybersecurity threats: Loss arising from hacking of exchanges and wallets. Carefully safeguard keys.
4. Technology risks: The bugs in the protocol code or the problems related to the network scalability could also destroy the value.
5. Wallet risks: Not backing up wallets can lead to a complete loss of cryptocurrency assets.
6. Taxation: Absence of clear rules on tax treatment of cryptocurrency income as well as capital gains in India.

Consider allocating only a small percentage of investible funds into the cryptocurrencies after evaluating the risk appetite. Dollar-cost averaging is a tool to manage risks. Be informed about the taxation regulations.

Conclusion

Cryptocurrencies provide an original decentralised substitute for the usual currencies and payment systems. Although still in infancy, they have been gaining more of an adoption in the mainstream and interest from investors. By choosing top cryptocurrencies, using safe and compliant platforms, and prudent risk management, Indian investors can seek to capture the opportunity of this new asset class. But, it is important to conduct a lot of education and tread carefully while investing in this highly speculative market.