What are Cryptocurrencies?
Cryptocurrencies come in many shapes and sizes. Some of them are designed to be like a form of “digital gold”, like Bitcoin. Others, like Ethereum are designed to be programable money. There are many different use cases for these “digital assets”. In general, cryptocurrencies are a form of digital money that is secured by the highest level of cryptography. Cryptocurrencies are built using blockchain technology and often exist outside of the control of governments and institutions.
What is Blockchain Technology?
A Blockchain is a kind of database. It is a time-stamped public ledger that stores all transactions that take place on the network. Copies of this ledger are distributed across the internet to sometimes thousands of computers around the world. When someone wants to add an entry to the ledger, the other computers on the network check the validity of the transaction. If the computers all agree that the transaction is legitimate then it can get added to the ledger. This spreading of auditors across the internet to verify transactions is why blockchain is described as a decentralized technology, and is an element of what makes it incredibly difficult to hack or control.
This public ledger system also means that you do not need a middle man, like a bank or a government, in order to trust someone you do not know personally because the network itself can verify the transactions – theoretically making it immune to hacking or errors. In fact, the reason blockchain technology is seen as ground-breaking is because it is the first time in human history that we have been able to create huge, global, person-to-person networks of trust.
There are 4 main objectives of blockchain technology.
- Confidentiality – only those who own or who share the information are able to “read” it.
- Integrity – the information cannot be altered or edited without being detected.
- Non-repudiation – a sender/creator cannot revoke or deny access to someone he/she has transmitted their information to. Even if they change their minds later.
- Authentication – both the sender and receiver can confirm the origin and destination of information.
Brief History
After the financial crisis in 2008, central banks and governments around the world devalued their nations’ currencies as they dumped money into the economy to “rescue” institutions from bankruptcy, leaving individuals with money that was worth less and less. Bitcoin was a response to the risk that fiat currencies were no longer a safe store of value. Having a system that could exist outside of centralized controls was very attractive.
Bitcoin was the first cryptocurrency, and was proposed by the famous Satoshi Nakamoto white paper in 2009. Over the last decade, the technology has evolved so that in it’s now possible to use it as a means of exchange. Over the last few years many other cryptocurrencies have emerged responding to other needs in the market.
Cryptocurrencies like Bitcoin are censorship resistant, permission-less and a trusted way to move value across a network. The first layer of the internet allowed humanity to transfer “information” like music, images or emails. Now cryptocurrencies allow us to move “value” like money, deeds and intellectual property. This is still a very young industry and many say there is a dire need for regulation to protect individuals and institutions, as well as more innovation to make them more user-friendly.
Types of Cryptocurrencies
The word altcoin refers to any cryptocurrency other than Bitcoin. A stablecoin is a cryptocurrency whose value is pegged to the value of another asset, such as a country’s currency, precious metals, or even another cryptocurrency. Stablecoins are meant to provide cryptocurrency investors access to other investable assets, like US dollars, Euros, oil, gold, or other metals. One would typically invest in a Stablecoin if your own home currency is not trusted, but you also do not have easy access to invest in commodities directly.
Most Popular Cryptocurrencies
- Bitcoin was started in 2009 by an anonymous person or group with the alias Satoshi Nakamoto. Bitcoin started the cryptocurrency revolution and now represents over 60 percent of all the cryptocurrency in the world.
- Ether is the cryptocurrency of Ethereum, one of the most popular blockchains in the world. It is second in popularity and value to Bitcoin.
- XRP is the cryptocurrency of Ripple, a system used to perform financial transactions.
- Litecoin is much smaller than Bitcoin, but is very safe and allows for even faster transactions.
- Tether is possibly the most popular stablecoin, as it is tied to the value of the U.S. Dollar.
Common Criticisms
Many critics of cryptocurrencies focus on the amount of energy that is required to secure the network. The argument is that it is damaging the planet and is a waste of energy because most people who use these digital currencies are doing it for speculation, (gambling). Energy use is a valid criticism. Bitcoin uses the energy of a small country in order to secure it’s network.
Proponents of cryptos argue that the energy is worth spending. They think it an unfair argument that using electricity to power cars is fine but using electricity to power a more efficient financial system is not. Furthermore, they argue that the energy might be worth spending because crypto can offer financial services to approximately 6 billion people who live under authoritarian regimes with double to triple digit inflation. These individuals live without any secure means to store their money or other assets. It is common for these governments to confiscate their personal property, assets and whatever wealth they have.
It is interesting to note that the countries with the highest rate of adoption for cryptocurrencies are those with the most unstable financial systems.
The other main criticism of cryptocurrencies is that they’re used by criminals for illegal activity. Ransomware attacks are often paid in bitcoin. Cash is much more difficult to trace but is also much more difficult to move around. Governments are investing in blockchain analysis technology to help them trace movements of cryptocurrencies.
Regulation
Regulation of cryptocurrency is important to protect investors and institutions. This is an ongoing process and cryptocurrencies have been classified in the US as both a security and a commodity. It depends on which cryptocurrency you’re referring to and which regulatory body classified it. There is a lot of debate over how to regulate these digital assets because of this ambiguity, and due to their decentralized nature. Governments and regulating bodies like the SEC, (Securities and Exchange Commission) are not in agreement on how they should be treated. Let alone traded!
Investing In Cryptocurrencies
Cryptocurrencies were originally envisioned to act as money – a medium of exchange and store of value. Bitcoin in particular was theorized to be an alternative for dollars or euros for different types of transactions.
Investment vs Currency
However, there is an important caveat in how cryptocurrencies are “mined”. It takes time and energy to mine a coin – and that amount increases over time. Bitcoin, for example, has a finite number of total coins that can be “mined” in a year, and that amount decreases every year. That means there is a finite total number of bitcoins that exist – or ever will exist. This is unlike dollars or euros, which are created through debt – so the total number of dollars or euros in circulation at any one time depends on the strength of the economy. We call this “inflationary currency” – meaning it usually will be coupled with inflation (where the value of a dollar decreases over time, and prices of goods and services goes up). Since a dollar a year from now buys less than a dollar today (due to inflation), it encourages spending – unless you can invest in a savings account or stocks to get a return on your investment.
Bitcoin, and most other non-stablecoin cryptocurrencies, are instead deflationary. Because bitcoins will become more rare in the future (even as more people want to use them), it means each bitcoin becomes more valuable over time – the “value” of a Bitcoin goes up over time, meaning prices of goods and services instead goes down.
Think of it this way: one of the first transactions with Bitcoin was to buy a pizza – 10,000 bitcoins for two pizzas (or 5,000 Bitcoins per pizza). At that time, a pizza was worth about $15 – so an exchange rate of about $0.003 per Bitcoin. Today, a single Bitcoin costs about $100,000, meaning a $15 pizza would instead cost 0.00015 BTC. Since you can buy more things with a Bitcoin tomorrow than you can today, it heavily encourages saving instead of spending – you get a “return” just by owning the Bitcoin (not needing any other return on investment).
Pricing Cryptocurrencies
Because of their deflationary nature, most people look at cryptocurrencies not as “currencies” to be used for everyday transactions, but as investments in and of themselves. However, how to actually price these assets is difficult. Investing in bonds has a published interest rate, telling you exactly how much you will earn on that investment. Investing in stocks is based both on the underlying value of the company that you can find in their financial statements (known as Fundamental Analysis), and market sentiment (known as Technical Analysis).
Crytocurrencies have no real underlying “value”, they are based only on market sentiment of how many other people want that cryptocurrency today, and how much they are willing to pay for it. This means that pricing cryptocurrencies can be very difficult, and prone to wide fluctuations in price. New cryptocurrencies can be created every day (with literally millions of coins having an ICO, or Initial Coin Offering, as of 2024).
Because there is no true underlying value (like a bond or stock), investing in cryptocurrencies is inherently risky. Beginning investors are also often taken in by cryptocurrency scams, notably the “pump and dump” type of scams (where influencers or promoters try to garner a lot of interest and support in a new cryptocurrency to get investors to buy it up at a high price, then sell their entire holdings for a profit).
Novice investors should treat cryptocurrencies with caution – but that does not mean well-established cryptocurrencies have no place in a well-balanced portfolio.
Summary
As a financial instrument, cryptocurrencies are still very volatile and lack the regulation to make them attractive to most investors. Time will only tell how much humanity truly needs decentralized networks that exist outside the whims of governments and their short-term goals.