What is cryptocurrency and what are the risks?
Summary: In this post we cover the basics of cryptocurrency and blockchain: the technology that cryptocurrency operates on. We look at why cryptocurrency was born in 2009, the biggest developments in the space since then, and the key risks associated with using it.
- Cryptocurrency: All digital coins and tokens that have value
- Crypto: Refers to cryptocurrencies or the entire system (interchangeable)
- Coins: The native cryptocurrency of a blockchain like Bitcoin
- Token: Any cryptocurrency that is not the native currency of a blockchain
- Blockchain: The technology that cryptocurrencies operate on
- Miners: The people that run and manage blockchains on their computers
Note that cryptocurrency, crypto, coin and token are often used interchangeably
Since the debut of the world’s first cryptocurrency, Bitcoin, on January 3, 2009, the value of the entire crypto market has risen to $1.7 trillion, a figure on par with the GDP of Canada. Today, the world’s biggest companies and asset managers are now buying, selling and trading cryptocurrencies as well as accepting them as payment. So, then, what exactly is a cryptocurrency, and how much risk comes with using one?
The birth of Bitcoin and blockchain
As most will remember, 2009 witnessed one of the worst financial crises in history – one brought about by some of the world’s biggest banks that were also the beneficiaries of government bail-outs and a program of monetary easing (also known as money printing, or QE) that has fundamentally changed the financial systems of most developed markets.
Interestingly, quite a bit of this was foreseen by the creator of the world’s first cryptocurrency, Bitcoin (BTC), who in 2008 launched a white-paper outlining a new, revolutionary monetary system based on a new form of technology: blockchain.
Fundamentally, a blockchain is the conveyor belt on which cryptocurrency runs. A huge, digital ledger book, a blockchain manages and logs all the transactions that happen in the cryptocurrency that sits on it. Unlike a traditional ledger book, though, the blockchain is totally transparent and 100% tamper proof.
On a blockchain, anyone can check when a transaction has taken place. This transparent ledger is stored and updated constantly on thousands of computers, making the blockchain tamper-proof, since any illegitimate changes are instantaneously discovered via a massive chain of cross-references.
Miners and crypto make the chain go round
The security and immutability of blockchains make cryptocurrency possible. Because it is impossible to change values in a blockchain without everyone noticing, this makes counterfeiting or duplicating the cryptocurrency that sits on the blockchain impossible. And this makes blockchains ideal environments for minting money we can trust.
Bitcoin (BTC) and its crypto counterparts are digital forms of currency that, unlike “real world” or fiat cash, cannot be counterfeit. This makes cryptocurrency highly attractive to the people that make their respective blockchains and the entire ecosystem possible: blockchain miners.
Every blockchain exists with the help of a large number of miners, on whose computers the entire blockchain runs. In order to keep the blockchain running securely, earning cryptocurrency is the incentive for these miners to use their computing power and energy for verifying and updating the blockchain.
Enter Ethereum and infinite cryptocurrency
Bitcoin and the Bitcoin blockchain were invented hand in hand: the secure system produces the secure currency that motivates people to keep the system secure. It's a brilliant invention by any measure, and it was the first of its kind. However, the way Bitcoin was designed and coded limits how the Bitcoin blockchain can be used.
The Bitcoin blockchain is not programmable: it can only hold Bitcoin, a limitation that led to the creation of what is now the world’s second largest blockchain: Ethereum. Also known as the world’s computer, Ethereum is a fully programmable blockchain and its security and open source coding provides a platform for innovative projects to develop and then run on the chain.
Like Bitcoin, Ethereum mints its own cryptocurrency: Ether (ETH), which is used as the form of payment for all transactions that happen on the chain (also known as “gas” fees). In addition, the projects that run on Ethereum can also issue their own form of cryptocurrency, known as ERC-20 tokens, which can be minted independently by these projects and then traded throughout the Ethereum ecosystem.
The next generation of blockchains are proving to be more open, dynamic, and teeming with use cases. Creative and inspired minds are dreaming up innumerable possibilities for blockchain technology. New blockchains are constantly emerging, and many blockchains are now in operation, each with their own coins, programming designs, and possibilities.
What is cryptocurrency worth?
An entirely digital invention, it may be difficult for some to understand what gives Bitcoin (BTC), Ether (ETH) or any of the thousands of different cryptocurrencies any value. We can hold dollar or euro bills in our hands and we can exchange them for goods and services, but cryptocurrency is less tangible.
The answer lies in the fact that all money is conceptual, it’s value simply a product of what the market decides it is worth. That is the same for the US dollar as it is for shares in Microsoft. Various different actors including central banks and investors set parameters and then they buy and sell assets whose value is determined by that activity. The same goes for cryptocurrency.
Like any other asset, each cryptocurrency has its own drivers that affect its value. For Bitcoin it is scarcity: only 21 million Bitcoin can ever be minted, which means it is finite and therefore valuable, like gold. For Ether it is its position as the native currency of Ethereum – the engine room of the entire crypto world.
Ultimately, however, the value of any cryptocurrency will be determined by the number of people buying and selling it, which is often driven by fickle sentiment - just the same as stocks on a stock market. And, also just the same as stocks, this doesn’t always make sense.
Risks associated with crypto
There is often a lot of focus on the risks associated with cryptocurrency, and not without reason. As an unregulated area, the crypto world comes with no guarantees. If you put your money into a wallet or exchange on a blockchain, its safety is determined and overseen by the company and/or developers that created it. And, as a fledgling technology, blockchain and crypto has been vulnerable to attacks and scams.
These have included heists at some of crypto’s biggest early exchanges, most notably Mt. Gox which in 2014 saw $460 million go missing, never to be returned. The Initial Coin Offering (ICO) craze of 2018 also saw many investors fleeced by developers of new projects and tokens that turned out to be entirely bogus (and which led the US authorities to ban ICOs altogether).
In addition to this, cryptocurrency is notoriously volatile, with Bitcoin often subject to wild daily swings. While a crash of 20% is the technical measure of a full-blown recession in traditional finance, this is all-in-a-day’s work for Bitcoin and almost nothing for some of the newer, more exotic cryptocurrencies.
Traditional finance pitfalls
However, much of this is not too dissimilar from what goes on in the world of traditional finance, with the events leading to the global financial crisis case in point in terms of scams and losses. Moreover, depending on your jurisdiction, typically the only thing guaranteed in the “real” world is the cash in your bank account, and then often only up to a certain amount.
It is also important to consider the very different times we now live in. The solid and safe savings opportunities once offered by traditional banks are simply no longer available in most developed markets where money printing has led to rock-bottom interest rates that mean cash savers are actually losing money every year when you take inflation into account.
Indeed, for more than ten years now the only way to generate a real return on your capital has been to invest it in the stock market where risk can be just as great as in cryptocurrency, regulation or no regulation. Those not keen on traditional crypto volatility can also now look to stablecoins pegged to “real world” fiat currencies that can be invested with a cryptocurrency wealth management platform like YIELD App for annual percentage yield’s (APYs) of up to 18%.
For many people, cryptocurrency and blockchain technology are merely an extension of a global drive towards more and more digitalization, a world where everyday we are increasingly running our lives online. Indeed, seen in this light, it seems more likely that a currency based on an incorruptible, transparent digital chain will be much easier to understand than one based on the vagaries of disparate ledgers held at unconnected banks.