What Are Cryptocurrencies?
Cryptocurrency is a digital currency that exists as an encrypted set of transactions on a digital ledger known as a blockchain. If all of that sounds like computer jargon to you, you should consider that the internet had the same effect on us over 20 years ago, but now it’s a central part of our daily life, and it seems simple.
The most common platform is the Bitcoin network. However, there are thousands of cryptocurrencies available. All cryptocurrencies share some common characteristics.
- They are not cash in the sense that they are physical entities like coins or paper money. The currency exists only inside computers.
- They are peer-to-peer. A transaction only goes from one person to another online.
- They are global. There is no exchange rate for cryptocurrency being traded in the U.S., Germany or Japan. It is a currency, like gold and other precious metals, that trades freely across countries and borders.
- They are encrypted. Cryptocurrency owners are completely anonymous because each user has a public key (similar to a username) and a private key (similar to a password).
- They are decentralized. This means there are no banks. An owner’s private key allows them, and only them, access to their digital wallet. If the owner loses his private key there is no bank to back them up.
- They don’t require trust in an individual. All cryptocurrencies are built and verified on a blockchain by computers based on a series of algorithms.
One of the obstacles to cryptocurrency becoming adopted by the mainstream investment community was that it was not a viable medium of exchange. There were no online exchanges and it had limited utility in retail applications. Both of those scenarios have changed. Today there are many online exchanges, some that have a trading volume that exceeds leading European exchanges. And an increasing number of retailers are finding ways to allow payment via Bitcoin – for starters.
But just as the introduction of wireless technology took the internet from its dial-up infancy to its 5G present, cryptocurrency is continuing to evolve. This is because of the blockchain technology that is at the core of cryptocurrency transactions. Rather than being limited to financial transactions, companies are finding ways to create digital applications (or DApps) that allow individuals to establish smart contracts using cryptocurrency, eliminating the need for brokers and their related fees.
Does the word cryptocurrency excite you or confuse you? Do you understand it, or do you avoid thinking about it? Cryptocurrency is easy to explain but can be difficult to fully understand. It is a virtual currency and the technology that makes it possible – the blockchain – is extremely technical in nature and comes with its own terminology that is new to many investors.
In this article, we’ll provide a broad overview of cryptocurrency. In addition to providing a definition, we’ll review how viable it is as a currency, how it is different from a standard currency, what a cryptocurrency transaction looks like, and if there are any drawbacks to owning cryptocurrency.
What is cryptocurrency?
Cryptocurrency is a digital currency that exists as a series of coded transactions on a blockchain (or digital ledger). Rather than money moving from one party to another via a bank, it moves completely from peer to peer. When looked at that way, investors who are novices to the crypto market can think of this virtual currency as being similar to PayPal or Venmo. However, that is where the similarities end.
For any digital currency to work there has to be a payment network to record accounts, balances, and transactions. With standard currencies (also called fiat currencies), a bank or government entity issues the currency and maintains a ledger of transactions. Since PayPal or Venmo transactions are made using U.S. currency; money is sent, received and transferred in U.S. dollars. In the case of cryptocurrency, a computer algorithm performs both tasks. This highlights two defining features of cryptocurrency: the concept of blockchain and cryptography.
A blockchain is a digital ledger that records all cryptocurrency transactions. Each transaction represents a “block” of data which strung together form a chain that theoretically makes all cryptocurrency transactions available to all owners. The data for every transaction is encrypted using cryptography.
Is cryptocurrency viable?
Investors who are new to cryptocurrency may wonder if it is a viable currency. After all, as described above, it is not physical currency. To believe in the present, and future, of cryptocurrency, requires trust in a network of computers doing their job to ensure the security of your money. There is no central government insuring your deposits.
However, cryptocurrency has two monetary properties that make it very appealing to users. First, every cryptocurrency has a limited, controlled supply. For Bitcoin, the most popular of all cryptocurrencies, the supply is steadily decreasing and by 2140 it is suspected that there will be no more Bitcoin available to be mined. Because the schedule of how much Bitcoin is released is determined by the code, the monetary supply of Bitcoin at any point in the future can be calculated today.
Second, cryptocurrency is a hard asset like gold. The only thing cryptocurrency represents is itself. It is not based on an IOU system as is the case of fiat money.
These two properties are what make cryptocurrency revolutionary, and very appealing. One of the keys to the monetary policy of a nation is the ability of a central bank to increase or decrease the money supply. With cryptocurrency, the supply is secure and free from political influence. Which means that cryptocurrency is certain to increase in value over time as supply becomes scarce.
And although cryptocurrency is not a physical currency (i.e. there is no such thing as an actual “bitcoin”), it can be exchanged for fiat currency. It is also making significant inroads at becoming an expected payment method for buying goods and services through online and even brick-and-mortar retailers. This ability to find new payment processors has helped to overcome a common objection to owning cryptocurrency.
But what makes cryptocurrency particularly viable is its use by speculators and investors via a series of online exchanges. There are currently a number of exchanges like Coinbank, Okcoin, Poloniex, and Shapeshift that have a total trading volume that exceeds the volume of some major European stock exchanges.
How is cryptocurrency different from standard currency?
The biggest difference between cryptocurrency and what would be considered standard (fiat) currency is that cryptocurrency is completely decentralized. There is no central bank that serves as a third party to monitor or regulate transactions. Every transaction is cleared via a network of data miners who verify every transaction to prevent the possibility of “double selling” (i.e. a user trying to make multiple transactions using the same cryptocurrency).
Cryptocurrencies are categorized as coins (also called Alternative Cryptocurrency or Altcoins) and tokens. Altcoins in cryptocurrency means an alternative to Bitcoin. All altcoins have their own independent blockchain. These can be derived from Bitcoin’s open-source protocol as is the case with Namecoin, Peercoin, Litecoin, Dogecoin, and Auroracoin. They can also create their own blockchain and protocol for their native currency. Examples of this approach are Ethereum, Ripple, Omni, Bitshares, NEO, Waves and Counterparty.
Tokens operate on top of an existing blockchain and allow the creation of more decentralized applications (called DApps), which is the future of cryptocurrency. Tokens are created using smart contracts – which are programmable computer codes that are completely self-executing. Tokens can represent any tradable asset. DApps can be thought of as similar to an interface that allows smart contracts to interact with the blockchain. Ethereum is the most popular digital application. Some are calling Ethereum the next Bitcoin.
What is required to own or exchange cryptocurrency?
Because it is a decentralized currency, the standard monetary tools (such as debit cards, credit cards, bank accounts, etc.) are not needed to buy and sell cryptocurrency. Instead, buyers and sellers must have some unique tools such as:
Digital Wallet (Cryptocurrency wallet) – This is where a user’s cryptocurrency is stored. The digital wallet is software that makes it possible for the blockchain to recognize the owner.
Public Key– this is similar to a Username that allows balances to be transferred from one account to another.
Private Key– this is a password that allows the user to confirm the transaction.
What does a cryptocurrency transaction look like?
Step One: Tom makes a request to send cryptocurrency to Steve. Since Tom is initiating the transaction, he must sign for using his private key.
Step Two: Tom’s request is broadcast to a peer-to-peer (P2P) network of computers (called nodes).
Step Three: The network (known as miners) uses known algorithms to validate the transaction and user status.
Step Four: The verified transaction is recorded as a block of information for the digital ledger.
Step Five: The new data block is added to the blockchain that exists for that currency.
Step Six: The transaction is confirmed to Tom and Steve.
There are several common properties of every cryptocurrency transaction.
- They are irreversible– Once a transaction has been verified, it cannot be reversed. Period. This means that buyers and sellers have to be very careful to secure their digital wallet to prevent scammers or hackers from accessing their bitcoin.
- They are linked to pseudonyms– Every transaction is not linked to a real-world identity. Instead, cryptocurrency is received on an “address” that are chains with 30 seemingly random characters.
- They are fast and global– unlike other digital transactions that may take hours or days to confirm, cryptocurrency transactions are sent out immediately on the network and typically confirmed in just a few minutes. And the speed at which the transaction takes place is independent of the physical location of the sender or receiver.
- They are highly secure– Because of the cryptography system that uses public and private keys, a cryptocurrency transaction is more secure than having gold stored at a physical location.
- They do not require permission– Cryptocurrency is really software that users can download for free. Once you have the software installed you can send and receive Bitcoin.
Verification is the key to cryptocurrency
Understanding cryptocurrency means understanding how transactions are validated which is where cryptocurrency miners come in. Once a transaction is verified, it becomes part of a final record of historical transactions on the blockchain. Only miners can verify transactions and once a transaction is verified, it has to be added to every node in the network. In theory, because cryptocurrency has no central authority to “hire” miners, anybody can be a miner. However, there has to be some way to ensure no single person or entity could abuse the system. Plus, the ability to validate cryptocurrency transactions quickly requires sufficient computing power that usually comes in the face of mining farms that make agreements on how to distribute any earned Bitcoin.
This is where the concept of proof of work comes in. The founder of Bitcoin, Satoshi Nakamoto, made a rule that requires miners to find a hash – a product of a cryptographic function – that connects a new block on the blockchain to its predecessor. This involves answering a specific math problem or cryptologic puzzle. Once they solve the puzzle, the miner owns the right to build a block and add it to the blockchain. The miner then has the right to add a Coinbase (a cryptocurrency exchange) transaction for a specific number of, in this case, Bitcoin. This is the only way that valid Bitcoins are created.
Since each hash is connected to another by math, not by trust, it becomes virtually impossible for a transaction to be forged.
How many cryptocurrencies exist?
There are thousands of cryptocurrencies that are available for exchange. In theory, since they do not exist in a physical form, there can be a nearly infinite number of cryptocurrencies. The original and most well-known cryptocurrency is Bitcoin. Some additional cryptocurrencies include Ripple, Litecoin, Namecoin, Peercoin, Ethereum, Ethereum Classic, EOS, and Cardano. In early 2019, the aggregate market value of all cryptocurrency was $120 billion with Bitcoin accounting for over 50% of that value.
Does cryptocurrency have any drawbacks?
One of the potential drawbacks to cryptocurrency is that it is a very volatile form of currency. Even casual investors can remember the “Bitcoin bubble” of late 2017 where the price rose to nearly $20,000. It quickly plummeted and currently sits at around $3,800. Although no form of investing is completely without risk, cryptocurrency does carry above-average risk and is still subject to the laws of supply and demand.
Another potential drawback to cryptocurrency is its usefulness as a medium for common financial transactions. Although the number of merchants (both online and brick-and-mortar stores) that accept bitcoin as a payment method is beginning to increase, you still can’t go to the grocery store and pay with Bitcoin. Some analysts suggest that cryptocurrency will never rise above its “fad” stage unless it becomes a widely accepted medium of exchange. Plus, many investors question the wisdom of using bitcoin to make retail transactions when it is far more valuable as a long-term investment.
A third potential drawback for cryptocurrency is the limited supply. In fact, Bitcoin founder Satoshi Nakamoto has said that the total amount of Bitcoin available for mining will be capped at 21 million. Once that number is reached, no more Bitcoin will be available for circulation. This is leading to concerns about how the miners will be compensated for clearing transactions. Currently, they are rewarded with Bitcoin. When that incentive goes away, will there have to be higher transaction fees? Or will there be fewer miners which some critics say could lead to cryptocurrencies instituting some form of central authority which may further harm the unconventional appeal of the currency.
Finally, the same privacy and security benefits of cryptocurrencies raise concerns that it can be used on the black market and for people who are looking to engage in illegal activities. The dark web platform known as the Silk Road, which ironically helped to facilitate the growth of Bitcoin and blockchain technology, was the most infamous example of the possibility of cryptocurrency to be a medium for people looking to hide anonymous, illegal activities.
The final word on cryptocurrency
Cryptocurrency is a virtual currency that is encrypted using cryptography and exists only as a series of transactions on a blockchain. Cryptocurrency has the following characteristics:
- It has no intrinsic value – it is not redeemable for another commodity such as precious metals.
- It is not a physical currency – it exists only as a series of transactions on a digital ledger.
- Supply is limited – there is no central bank that can create new supply.
Cryptocurrency is a decentralized currency. Meaning there is no central authority to serve as a middleman for transactions. All transactions are secure, private and peer-to-peer. Every transaction is verified by a computer network (known as miners) and assigned a unique hash before being added as a block to the existing blockchain. This makes it virtually impossible for fraudulent transactions to take place.
When cryptocurrency first came on the scene it was shrouded in mystery and seen as a fad that would end badly for investors who were rushing to get in on the ground floor. Today, cryptocurrency is available for trading on many online exchanges and is becoming a viable medium of exchange in many retail applications. However, many investors find that cryptocurrency is a better buy-and-hold investment. This is because the supply of the currency is finite – like gold. Therefore the currency represents only itself and its value both now, and in the future, can be determined.