The words cryptocurrency, bitcoin, and ethereum may sound familiar, but what do they mean?

Cryptocurrency is a type of digital currency. In simple terms (on a very complex subject), it is limited entries in a database that no one can change without fulfilling specific conditions. It is designed to be secure and, in many cases, anonymous.

Cryptocurrency is sometimes considered digital gold. It is a form of money that is not issued by a government, with a fast and easy means of payment within a worldwide scope. But buyer beware, it is also a means for speculation in a fast-growing and volatile market.

According to Investing.com, there are about 2,000 types of cryptocurrency. Bitcoin, ethereum and ripple are a few of the largest cryptocurrencies based on their current market capitalization. The total market share of cryptocurrencies is currently more than $200 billion.

The practice of using cryptocurrency to buy goods and services has been established by some retailers including Overstock.com, Expedia, CheapAir, and Dish. These retailers and others are making it easy for customers to spend their digital currency by accepting it for payment.

Bitcoin is the dominant player in the market. The price of a bitcoin (in dollar terms) rose from about 6 cents for most of 2010 to more than $19,500 in mid-December. Recently, the currency has fallen back to around $6,500. Due to some shortcomings, such as limited scalability, high transaction fees, and relatively long transactions times, bitcoin’s dominance may eventually be surpassed by other cryptocurrencies.

In late 2008, Satoshi Nakamoto — the name given to an unknown inventor or group of inventors — announced the creation of bitcoin, an electronic peer-to-peer network, to prevent double spending. This digital cash system was completely decentralized with no server or central authority. Since the 1990s, others have tried to create digital currency but all have failed. Satoshi Nakamoto was the first to succeed.

An underlying principle of all cryptocurrencies is blockchain. In a very basic explanation, the blockchain is a network of peers, in which transactions are continually reconciled. Every time a transaction happens, a “block” is added to the “chain” of encryptions. Every peer has a record of the complete history of all transactions and, thus, the balance in every account. Once the transaction is confirmed, it cannot be reversed. It then becomes a part of a permanent record of historical transactions of the so-called blockchain.

The data are not stored in a single location but hosted by millions of computers simultaneously and accessible to anyone on the internet. The data cannot be controlled by any single entity and has no single point of failure.

In cryptocurrency networks, only miners can confirm transactions. The miner’s job is to take the transactions, stamp them as legitimate, and spread them in the network. Once the transaction is confirmed in the database, it becomes part of the blockchain. Miners are also responsible for finding the new bitcoins. According to the Satoshi Nakamoto theory, there are a limited number of them. In fact, there is a total of 21 million bitcoins that can be mined.

Unique transactional properties of cryptocurrency:

Irreversible: Once you send cryptocurrency to someone, it is sent. After you receive a confirmation, the transaction cannot be reversed.

Pseudonymous: Neither transactions nor accounts are connected to real-world identities.

Fast and global: Transactions are processed in a global network of computers, propagated nearly instantly in the network and confirmed in a few minutes.

Virtual wallet: Owners receive a “private key” to access the contents of their virtual wallets. For example, access to bitcoin is only available with the private key; if the key is lost or stolen, so is the property.

Secure: The complexity of this system makes it difficult, if not impossible, to break.

No gatekeeper: You don’t need to ask for permission to use cryptocurrency. Once you download the software, you can receive and send bitcoins or other cryptocurrencies. No bank is involved.

Before you purchase any cryptocurrency, do your research to fully understand the risks associated with the purchase. And remember, when you sell your cryptocurrency, the transactions are reportable on your income tax returns. You will realize either losses or gains, and you may owe capital gains tax.

Next week columnist, Marcia Campbell CPA, will discuss the tax ramifications of using cryptocurrency.

Teri Parker CFP® is a vice president for CAPTRUST Financial Advisors. She has practiced in the field of financial planning and investment management since 2000. Reach her via email at Teri.parker@captrustadvisors.com.