Cryptocurrency 101

What’s Cryptocurrency and What’s all the Hype?

By now, you have likely heard the terms cryptocurrency, bitcoin mining, and blockchain.  As I recently dug in to learn more about the topic, I discovered there is a lot of information out there.  While this blog post just barely scratches the surface, I hope this introduction ignites your curiosity to learn more about cryptocurrency specifically and about the financial markets and investing in general.   

What is cryptocurrency?

Cryptocurrency is digital currency used to buy goods and services.  Because cryptocurrency is virtual, there are no physical coins or notes to carry.  Rather than being produced by a central bank or government, cryptocurrency units enter circulation through a technological process that involves the participation of volunteers from all over the world using their computers.  Without a central bank or government, there is no government intervention or manipulation.

Cryptocurrency is secured through cryptography – the system of encrypting and decrypting information, which is used to secure all the transactions.  Cryptography makes it difficult to counterfeit the transactions and enables users to transfer cryptocurrency without an intermediary, like a bank, to keep track of each person’s balance. 

Cryptocurrencies use a blockchain – a decentralized technology spread across many computers (called nodes) to manage and record transactions.  Each transaction is recorded in “blocks” that are linked together on a “chain” of previous transactions.  Software logs and timestamps each new transaction as it happens and each copy of the blockchain updates simultaneously with the new information.  All records are identical and accurate and the historical record is unalterable.     

How are cryptocurrency transactions validated?

Node operators are incentivized to validate the transactions.  Validators who participate actively and honestly in the validation process earn rewards in the form of newly created cryptocurrencies.  These incentive infrastructures are called consensus protocols.  Two of the most common are:

Proof-of-work (“PoW”): Validators, known as miners, compete using expensive equipment to generate a winning code that grants them the right to add a new block of transactions to the blockchain. When the new blocks are added, miners receive newly minted cryptocurrencies as incentives, as well as any fees attached to the transactions. 

Proof-of-state (“PoS”): Less intensive than PoW, this protocol requires node operators to deposit a particular amount of coins in the blockchain to show their commitment to the well-being of the network.  Randomly selected miners are assigned specific tasks, and will receive newly minted cryptocurrency tokens for their efforts.

A few examples of cryptocurrency

According to CoinMarketCap.com, there were nearly 15,000 publicly traded cryptocurrencies, valued at over $2.5 trillion, on November 29, 2021.  The first, and arguably the most popular, is Bitcoin. With more than $1 trillion in market value, Bitcoin makes up nearly half of the cryptocurrency market. 

The second largest cryptocurrency is Ethereum.  Investors can us Ethereum in other non-traditional ways, such as in the non-fungible tokens (NFT) space.  Launched in 2015, ether is the digital currency of the Ethereum network. 

Litecoin is based on Bitcoin’s open-source code, but with some changes, like speeding up the time it takes to mine new coins.

In 2013, using technology derived from Litecoin, Dogecoin creators started the cryptocurrency as “a parody of all the ‘serious’ clone coins that were trying so hard to differentiate themselves, but all seemed the same.”  Using the image of a Shiba Inu dog, it has a low price and unlimited supply.

Is cryptocurrency a good investment?

Originally designed as an alternative to fiat currency because it is portable and easily and inexpensively transferred across borders, cryptocurrency has received mixed reviews.  This year, El Salvador and Cuba classified Bitcoin as legal tender.  However, China and Turkey declared all cryptocurrency transactions illegal. 

Most cryptocurrency holders consider its investment potential.  The value of cryptocurrency depends on the utility of its underlying blockchain.  Those perceived to have a wide range of utilities are usually more valuable.  But, even the more versatile cryptocurrencies are speculative investments.  Cryptocurrencies generate no cash flow.  For you to profit, someone has to pay more for the currency than you did.  This is in contrast to a well-managed business that increases in value over time by growing profitability and cash flow.

The value of cryptocurrency is also driven by scarcity.  For example, under the Bitcoin protocol only 21 million BTCs can be mined.  As Bitcoin’s scarcity increases, the price will increase.  However, prices could plummet if accounts with large amounts of cryptocurrency decide to sell.   

Some risks to cryptocurrency

Theft:  Beyond the volatility of cryptocurrency, having cryptocurrency exposes you to the risk of theft.  Hackers will try to invade the computer networks that maintain your assets.  In 2014, Mt. Gox, a high profile exchange, declared bankruptcy after hackers stole hundreds of millions of dollars in bitcoin.

Scams:  Scammers use social media platforms to dupe consumers into making investments.  One exchange – QuadrigaCX – turned out to be a Ponzi scheme. 

Loss of access to funds:  Cryptocurrency is stored in a digital wallet.  If you lose access to your wallet you lose access to your digital coins.

Violations of regulatory oversight:  Because cryptocurrency operates outside the control of government, individuals and organizations can skirt laws and regulatory oversight. 

Cryptocurrency and U.S. Regulation

U.S. Securities and Exchange Commission (“SEC”) chair, Gary Gensler, described cryptocurrency investments as “rife with fraud, scams, and abuse.”  The Federal Trade Commission reported that consumers lost more than $80 million on cryptocurrency-investment scams between October 2020 and March 2021, more than 10 times the amount lost during the same period in the prior year. 

To date, the SEC has failed to answer the industry’s biggest question – do cryptocurrencies qualify as securities?  If they do, they would be subject to securities laws and regulations.  Some believe cryptocurrency should be regulated by the Commodity Futures Trading Commission.  Regardless of which agency regulates cryptocurrency, one fear is that any regulation will quash innovation. As long as cryptocurrency exists, there will be much to debate.

The bottom line: Investors must continue their due diligence and stay informed of the ever-changing landscape and regulations relating to cryptocurrencies. This due diligence will also serve to protect them from scammers and con artists who may be trying to deceive unwitting investors and steal their hard-earned money. 

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