Are you wondering where the money goes when you buy crypto? Are you investing directly in the virtual currency or is it stored somewhere specific? Do your US dollars, pesos, euros, and nairas get stored directly on a blockchain? In this post, I will walk you through the different scenarios of how people spend money to buy crypto and where the money goes. I will provide you with a step-by-step breakdown of what happens when a buyer initiates a crypto purchase, from the moment they click ‘buy’ to the completion of the transaction. Next, I will help you understand the role of cryptocurrency exchanges in facilitating transactions and how the exchange process works. Finally, I will also help you comprehend the role of digital wallets and private keys in securing and managing their crypto holdings.
By the end of this post, you will have an intuitive sense of the journey your money makes after you make a cryptocurrency investment.
Where the money goes when you buy crypto?
When you buy crypto with fiat currency such as dollars, euros, yuan, etc your money ends up in the bank account of the entity selling you the crypto. The entity could be a person to whom you hand over cash, it could be an online platform such as a crypto exchange or it could be a service provider who helps convert fiat currencies to crypto.
Let’s take a look at some of the first crypto transactions to see where it all started
First crypto transactions
- The first time Bitcoin was ever sold for fiat was when Finnish developer Martti Malmi sold 5,050 BTC for $5.02. Martti sent the bitcoin to the buyer’s bitcoin address and the buyer sent him the cash via Paypal.
- This wasn’t the first Bitcoin transaction though. The first Bitcoin transaction was when Satoshi Nakamoto, the creator of Bitcoin, sent Hal Finney 10 BTC after Finney gave Satoshi some positive feedback on Satoshi’s invention.
- The first time Bitcoin was used as a payment method was on the 22nd of May, 2010 when Laszlo Hanyecz a Bitcoin enthusiast and developer bought two supreme pizzas from Papa John’s for 10,000 BTC,
Does my cash go to the blockchain when I buy crypto?
No, your cash is not compatible with blockchains.
Even though nowadays most of us use digital cash when we buy stuff with our credit cards or debit cards our digital cash can’t speak to or be stored on a blockchain.
The cash has to be sent to the bank account of the person you are buying crypto from.
In turn, the seller will send the crypto to your wallet address.
To understand why it works this way let’s first understand what blockchain technology does:
What is a blockchain?
A blockchain is a file with information saying things like: “Sarah has 0.1 BTC, Kim has 3 BTC, Musa has 500 BTC and Rahul has 2 BTC”.
Except it does not use names.
Instead, it uses a string of characters like this:
So the Bitcoin blockchain looks something like this:
The BTC on the blockchain is just digital imaginary money just like how the dollars in your bank account are digital imaginary money.
“What?” You say. “My dollars are not imaginary!!”
“Oh yeah? Says who?”
“Says the bank”
Yeah so in the case of Bitcoin, there is no bank.
However, the file with all the information on who owns what is distributed across many computers.
Each of those computers, called a node, has a copy of the blockchain.
And together they form a network.
The network uses magic called cryptography to verify and agree on who owns what.
I am not going to get into the weeds here but instead of relying on a bank to tell you who owns what, with a blockchain, you have the network to validate that information.
This means you don’t have to rely on central banks and financial institutions to agree. The blockchain is decentralized so to speak.
Can you send money to a blockchain?
What this means for your money is that you can’t send it to a blockchain. The bank’s database is not compatible with the blockchain database.
In fact, blockchains themselves are incompatible with each other.
For example, the Ethereum blockchain does not speak to the Bitcoin blockchain.
You can’t store ETH on the Bitcoin network and you can’t store BTC on the Ethereum network
ok, now so say you send someone cash to their bank account.
What next? How do you get your hands on the crypto?
What happens to crypto once you buy it?
- First of all unlike cash crypto does not have a physical form. You can’t go to an ATM and withdraw crypto bills.
- Second, crypto cannot be transferred anywhere. It can’t move to a separate database such as your digital bank account
- The only thing that you can do is to update the blockchain to reflect the new state of affairs. If before Johny had 3 BTC and you had 0, Johny can send 1 BTC to your address so that when the blockchain updates it shows you have 1 BTC and Johny has 2.
The only way for you to verify you have received the crypto is to check your digital wallet address. If before you had 0 and now you have 1BTC you know that Johny has fulfilled his promise.
But how do you make sure transactions like these happen at scale?
How can I trust Johny to send me 1 BTC after I deposit cash into his bank account?
This is where intermediaries such as crypto exchanges and payment platforms come into play.
Step-by-step breakdown of what happens when you initiate a crypto transaction
- When you join an exchange the first thing you will do after you verify your personal information is to hook up to your bank account, debit card, or other payment method to deposit cash in your account. Here are some payment methods that exchanges commonly accept:
- Credit card
- Debit card
- Wire transfer
- ACH bank transfer
- Google Pay
- Apple pay
- E-wallets such as skrill and epay
- When you deposit cash on an exchange the cash ends up in a bank account that belongs to the exchange.
- Next, say you want to buy some crypto. Let’s assume you want to buy $100 worth of Solana. So you click on the exchange’s trading tab enter the amount of SOL you want to buy and click buy
- Now people are waiting to sell their SOL on the other side of the trade. This SOL belongs to the seller but the exchange keeps it on one of its addresses on the Solana blockchain on behalf of the seller.
- The exchange acts as an intermediary. It will take your cash and send an equal amount of it to the seller. It will then take the seller’s SOL and send to a cryptocurrency wallet address that they own on your behalf. Should you ask for it to be transferred to your own wallet address the exchange will then initiate the transaction for you.
How come there was a seller available at the exact same time I wanted to sell?
There might not always be one.
It depends on how liquid the exchange is which in turn depends on the number of buyers and sellers on the exchange and which digital currencies are being traded.
But one of the reasons that exchanges exist is that they manage order books.
How order books work
As a trader on an exchange, you can set a limit order.
This indicates what price point you are willing to buy or sell an asset.
For example, if you look at the order book for ETH right now you will see some people are willing to sell at $1,915, some at $1,917, some at $5,300, etc.
These people have placed what’s called a limit order with the exchange and are waiting for someone to come and offer them that price.
Now imagine you come along and you want to buy some ETH.
The best price you can get is $1,915.
So you if set a buy order you will immediately buy ETH at the lowest limit order available which is $1,915.
Other buyers have set limit orders to buy at a lower price.
Some at $1914, some at $1,900, some at $1,440, and so on.
But all these limit orders have tied up cash with the exchange making it able to fulfill orders across multiple price points quickly just like a stock market.
Wait how does the whole address thingie work?
When you own crypto you don’t actually own it.
You only have access to a code that allows you to make transfers from a public address.
This code is called a private key.
Every public key has a corresponding private key. You can derive the public address from the private key but you can’t derive the private key from the public address.
Whoever has access to the private key is the owner of the address to which the digital assets are assigned. This is why you should never share your private keys with anyone and why you should not store them online. If you lose your private keys you lose your crypto assets
To send crypto to someone you need to know their public address.
They can share the address with you by copy-pasting the long string of characters that they see in their exchange account or wallet.
Or to make it a little simpler they can share the QR code with you.
Most wallets have a QR code reader next to the send field. Using QR codes reduces the likelihood of a manual error when copy-pasting.
You can find out more about what a crypto address is here
What are crypto wallets? Is that where my money goes?
A crypto wallet is a digital software that encrypts your private keys.
If you have crypto on an exchange then you are storing your crypto on the exchange’s wallet.
The exchange keeps track of what it owes you but it’s not going to share any private keys with you.
The exchange’s wallet is custodial meaning it has custody of your crypto and holds them on your behalf.
If they end up going bankrupt or being a scam you won’t be able to get your crypto back.
This is not hypothetical.
It happens all the time.
Just look up Mt. Gox, Qaudriga, or FTX to find out how others have lost their money.
For this reason, many experienced crypto investors advocate that you store your crypto in a non-custodial wallet where only you have access to your private keys which you have written down offline somewhere.
Again technically speaking there is not crypto on your wallet.
There are only the encrypted private keys to your public address which allow you to move funds.
Types of wallets
There are two main categories of cryptocurrency wallets to encrypt your keys with
- Digital wallets. These are desktop and mobile apps that encrypt your keys locally on your device. You might also come across the term hot wallet or software wallet for these types of wallets.
- Hardware wallets: these are devices that look similar to a USB and encrypt your keys on the device. The benefit of using a hardware wallet is that it is not connected to the internet which is why it’s also called a cold wallet. Offline wallets are much safer as they are harder to hack.
Non-custodial wallets do not require you to register. You do not need to provide an email address or any form of identification. The only thing you need is a seed phrase which is a mnemonic set of 12-25 keywords that you need to write down.
Your seed phrase is used to derive your private keys.
Copying down a seed phrase is harder to mess up than copying down as long alphanumeric string.
How do you get paid in crypto?
When you get paid in crypto you need to share your wallet address with the person sending you the crypto. The crypto lives on the blockchain and is not reflected in your bank account.
If you want to spend it you can either search for marketplaces that accept crypto as payment or you can sell it for fiat money using either an exchange or a payment provider such as MoonPay or Simplex.
Both will take a fee for providing this service and in both cases, you will need to KYC.
If you want to avoid cashing out to a bank account you can use a prepaid card.
Service providers such as Binance and crypto.com issue cards which allow you to spend your crypto directly from your prepaid card.
The service providers take care of the conversion from crypto to fiat in the background but this way your cash does not appear in your bank.
Please keep in mind that in many countries such as the United States capital gains are taxed.
So when you convert from a digital currency to fiat and have made a profit from price appreciation you may be liable to report those gains and pay tax on them.
Also keep in mind that long-term capital gains may be treated differently. More on capital gains here.
How does buying crypto make Money
Buying crypto does not guarantee that you will make money.
If the price of the digital asset increases and you sell you can make a profit. But prices can go down just as easily.
The other way to make money in crypto is to invest your crypto by staking it, lending it, or placing it in a liquidity pool.
Here are some resources to better understand these options.
- How does crypto lending work.
- Passive crypto mining
- What Is Coinbase Staking?
- What Does It Mean to Stake Ethereum?
Does crypto turn into cash?
Yes, you can convert crypto to cash on an online exchange by selling it to the exchange and then transferring that cash to your bank account.
What happens when you buy a cryptocurrency?
When you buy a cryptocurrency on an exchange you deposit money in the exchange’s bank account and they place the cryptocurrency in a wallet address that they control on your behalf.
To take ownership of your crypto you need to move it off the exchange and onto a crypto wallet that you own the access codes, known as private keys, to.
Buying crypto on an exchange entails transaction fees that are paid to the blockchain network and the exchange for their service.
Can you lose real money with crypto?
Yes, when you buy crypto you use real money to do that. If the price of the cryptocurrency you bought drops and you sell it then you will have less money than you started with.
What is the safest cryptocurrency?
The most stable cryptocurrencies over the past 7 years are USDC and USDT.
These cryptocurrencies are known as stablecoins because they peg their value to the USD dollar so that 1 USDT or 1 USDC is redeemable for 1 USD at any point in time. Some people consider these stablecoins to be the safest form of cryptocurrency. This does not mean they are risk-free. If the peg does not hold you could lose you money. Check what is pegging in crypto for more on this subject
Is being paid in Bitcoin safe?
The price of Bitcoin is volatile which means its market value will shift almost as soon as you get paid. To reduce volatility consider converting it to cash or a stablecoin such as USDT. The other risk to consider is that of your Bitcoin being stolen. The safest place to store large amounts of Bitcoin is in a hardware wallet or the cold storage vault of a crypto exchange (see my explanation on Coinbase Vaults). Alternatively, for a smaller amount, you could choose to use a hot wallet such as a mobile or desktop app. Desktop apps are considered slightly safer than mobile wallets.