- Cryptocurrency is a form of digital, “decentralized money” — not government-issued but managed via private encrypted databases, called blockchains.
- Bitcoin is the original, and still most popular, type of cryptocurrency. Tether, Ethereum, and Litecoin are other highly traded types.
- Mainstream investing apps now allow individuals to purchase cryptocurrency, but risks include high volatility and a lack of regulatory oversight.
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Your pocketbook may soon be going virtual.
That is, if the trend in cryptocurrency continues. This non-physical, digital form of money — issued not by governments but by private systems — keeps multiplying. Since 2009, when bitcoin — the first and best-known — debuted, thousands of cryptocurrencies have become available. Cryptocurrencies have been championed and developed by several corporations and financial institutions, including Air Asia, Mitsubishi UFJ Financial Group, and Facebook.
And the currencies have also attracted the attention of the financial world. The rapid ups and downs in the prices of bitcoin and the 12 other major types that can be traded are the stuff of daily headlines.
S&P Dow Jones Indices, which runs the S&P 500 Index, is going to start publishing the price moves of several cryptocurrencies in 2021, helping investors track the performance of different coins. This sort of index gives a major boost of transparency and legitimacy to “crypto” as an asset class.
For all its fame, though, “crypto” can still be confusing. Here’s a guide to the basics behind the electronic currency — how it works, and what to know before investing in it.
What is cryptocurrency?
Cryptocurrency is often referred to as “decentralized money,” meaning that it is stored, created, and processed outside of a central bank, or government.
Unlike traditional “hard” or paper money, cryptocurrency has no physical form. It’s really a set of data, secured by cryptography (the science of encoding and decoding information) — that’s why it’s called “cryptocurrency.”
When data is encoded, the information is converted from one form to another, less discernible form, and is then decoded — or reverted — back to its original form by the end-user. This complex process eliminates the possibilities of double spending and counterfeiting, thus reinforcing the security of using cryptocurrency to pay for things.
In a way, cryptocurrency works like a secure, cloud-based filing system, much like Dropbox or Google Drive.
By decentralizing, cryptocurrency avoids interactions with third-party servers and government agencies, which often engage in mass data collection and allow potential control of an individual’s access to funds. This lack of affiliation with a government or banking system allows transactions to be processed anonymously, which some users consider a notable benefit.
On the flipside, cryptocurrencies lack one of the main advantages of a physical or “hard” money system, since there is no government entity responsible for maintaining the central supply, or even a record of the money or its transactions.
How does cryptocurrency work?
Cryptocurrencies maintain their own record-keeping through the use of blockchain, an online ledger and transaction log.
Blockchains create digital records — of transactions, certificates, or contracts —that can only be added to, rather than changed or deleted. This independent transaction log, crypto-converts insist, is far more secure than paper records or institutional digital accounts, which could be hacked.
Essentially, the platform archives both the buyer’s and seller’s information and records it as a “hash,” or string of letters and numbers generated by a complex mathematical function. Each hash is directly linked to the hash before it, so unauthorized changes to the ledger will become apparent immediately after a hash is altered.
Once a certain number of hashes is reached, the group is converted into a “block” and linked to the other blocks on the server — hence the name “blockchain.” The blockchain is updated every ten minutes and stored on a multitude of servers worldwide.
Cryptocurrencies operate in a closed system, meaning that there is a fixed amount of them and new units can only be created following a strict set of guidelines. Some currencies, such as bitcoin, have a software-enforced cap on how many units can be created. This limited supply makes each unit more valuable—especially as the currency gains popularity among day traders.
Most popular cryptocurrencies
Several varieties of cryptocurrencies exist. The most popular and widely traded include:
- Bitcoin (BTC): Both the first and by far the most popular crypto, Bitcoin was created by the pseudonymous Satoshi Nakamoto, who described it as a “peer-to-peer electronic cash system.” The first use of bitcoin occurred in 2010 when a user traded 10,000 bitcoin for two pizzas — an amount that, at the currency’s current prices, would now be worth over $100 million. Since being established, Bitcoin has also splintered off into several Bitcoin-based products, including Bitcoin SV (BSV) and Bitcoin Cash (BCH).
- Ethereum (ETH): The second-largest cryptocurrency, Ethereum is a digital coin and computing platform that automatically executes each transaction. The Ethereum blockchain is the most commonly used worldwide, and the platform is currently working on Version 2.0, which will contain some new ways to manage transactional data.
- Litecoin (LTC): Often referred to as the “silver to Bitcoin’s gold,” Litecoin was created just after Bitcoin and currently stands as the sixth most popular cryptocurrency in the world. One of the token’s primary benefits is its speedy transactional time.
- Tether (USDT): Unlike Bitcoin, Ethereum, or Litecoin, which exist solely in the virtual world, Tether is backed by local currencies in an effort to avoid the tumultuous fluctuations of the crypto market.
What is cryptocurrency used for?
In its early days, crypto seemed a tad shady, associated with criminals and money launderers. A black market operation, the Silk Road, used bitcoin as its currency of choice until the FBI shut it down in 2013.
Since then, cryptocurrency has slowly gained prominence in the public eye — and respectability. Today, it can be used for a variety of transactions, including investing in startups, negotiating import-export contracts, and even paying utility bills.
In 2020, Paypal announced that it would allow users to hold multiple types of cryptocurrencies on their accounts, and is even looking to allow crypto to be used as a payment option on their many partner websites like eBay.
But while its uses are growing, cryptocurrencies mainly seem to flourish as an investment asset, trading in specialized currency markets.
How to invest in cryptocurrency
Cryptocurrency can form part of a well-balanced portfolio. Unlike traditional stocks, bonds, and mutual funds, crypto offers the security of anonymity and the potential for rapid future growth. In addition, because it operates outside of a traditional government setting, the assets are typically not subject to a freeze or seizure by authorities.
Common investing apps like Robinhood, Coinbase, and Kraken all offer the ability to purchase crypto with ease. There are also entire online trading platforms and exchanges (like Gemini, BlockFi, eToro, and Bitcoin IRA) dedicated exclusively to crypto products.
Additionally, publicly traded Bitcoin trusts and funds allow individuals to invest in professionally managed portfolios that trade the currencies — offering the diversification and economical prices that regular mutual funds and ETFs do.
What are the risks of investing in cryptocurrency?
Cryptocurrency poses three major risks:
- It operates entirely without government oversight. The fact that crypto and its marketplaces are private and unregulated has raised questions as to what types of taxes are paid on gains or losses of the asset, as well as its potential for abuse. For example, in 2014, Tokyo-based Bitcoin exchange platform Mt. Gox was hacked, resulting in the loss of over 700,000 BTC.
- It doesn’t physically exist. Some compare crypto to blinker light fluid — it’s not a real thing. It’s not a tangible asset, like gold or other commodities. It doesn’t represent a piece of a company, like a stock or bond. Crypto is not printed or minted like other currencies. So it has no fundamental value — only its trading value, which makes it highly speculative.
- It is volatile. Crypto prices swing dramatically, sometimes plunging or climbing by hundreds of dollars in hours. In 2013, bitcoin plunged from $1,000 to $300 per unit; in November 2020 bitcoin crashed $3,000, then climbed to a new all-time high of $23,770.85 on Dec. 17. Other currencies trade in the mere hundreds, but their moves can be just as extreme.
Innovations are already being established to manage the market fluctuation of the system and control its valuation. For example, the crypto coin Tether quite literally “tethers” itself to local currencies, thus sidestepping the characteristic volatility of other unsecured tokens.
The financial takeaway
Cryptocurrency is an emerging asset that is sure to continue evolving in the coming years. Whether the future will be one where all tokens are backed by local currency or whether they’ll remain intangible, crypto can certainly form a portion of a prudent investor’s portfolio.
Its decentralized nature has protected cryptocurrency from the influence of third-party servers and government agencies, which has created an anonymous processing system that appeals to many users. Its blockchain technology maintains a complex and highly-secure transaction log.
However, the system is not risk-free by any means. The current lack of government and international regulations may hinder the product’s desirability for some. For others, the volatility of different coin prices may seem just too dangerous — especially for an asset that has no intrinsic, fundamental value.
Much like the asset’s price, public perception of cryptocurrency has fluctuated dramatically over time. But it’s safe to say that this new type of currency is not yet spent.