A cryptocurrency, or crypto for short, is basically digital money with some additional potentially disruptive innovations, such as the fact that it is secured by cryptography. Perhaps the most defining feature of cryptos is that they are decentralized networks based on blockchain technology, which is an online ledger with complex cryptography behind it to secure online transactions.
There’s a lot of talk about what crypto is and what it could possibly become, which is made all the more confusing because all sorts of people value it for different reasons. There are crypto purists who are true believers in the technology and have been on board with it since day one, there are the blockchain nerds who are less interested in cryptocurrencies but more in the digital ledger, and then of course there are the speculators who are merely interested in cryptos to make a buck.
For the latter, trading cryptos is just like trading oil or silver. However, there’s clearly more to cryptos and those who have the most faith in this technology believe cryptocurrencies have the potential to completely revamp the financial sector.
The first blockchain-based cryptocurrency was Bitcoin, which to this day is the most popular and most valuable crypto out of more than 8,000. On January 12th, 2009, the person or persons who invented Bitcoin, known under the pseudonym Satoshi Nakamoto, sent 10 Bitcoin to Hal Finney, a cryptographer who has since passed away, marking the first ever cryptocurrency exchange.
Since then, Bitcoin has ballooned. In 2010, someone bought two pizzas for 10,000 Bitcoin. At this article’s publishing date, one Bitcoin is worth $53,000, so the 2010 exchange would have been worth $530,000,000. Now I hope those pizzas tasted good.
Bitcoin was essentially born from crisis, as a response to the 2008 banking sector crash. The original Satoshi Nakamoto white paper from 2008 mentioned that “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”
As the U.S. government and Federal Reserve were looking to tweak the system and strengthen financial regulations in the wake of the Lehman bankruptcy, others like the Satoshi gang were cooking up an entirely new financial system that would avoid dangerous banking dependencies by being completely decentralized. Bearing this in mind, it’s no wonder that the authoritarian communist regime of China banned the use of cryptocurrencies.
The reason why cryptocurrency markets are inherently decentralized is that they run on a network of computers. Unlike traditional currency, crypto tokens only exist as a shared digital record of ownership, stored on the blockchain.
Transactions with cryptocurrencies are performed using exchanges and digital wallets. When two parties exchange cryptocurrencies, the transaction isn’t considered final until it has been verified and added to the blockchain by solving complex mathematical equations — this is known as mining. This is also how new tokens are brought into circulation.
What’s a blockchain?
A blockchain is a growing list of records, known as ‘blocks’, that are linked using cryptography. It’s essentially a digital ledger of transactions that is duplicated and distributed across the entire network of computer systems participating in the blockchain. Each block in the chain can contain a certain number of transactions and each time a transaction is performed, a record of that transaction is added to the ledger. But since the ledger is duplicated across the entire network, so is the transaction’s record. A blockchain file is always stored on multiple computers across the network rather than in a single location. This way of recording information makes it virtually impossible to change, hack, or cheat this system.
This decentralization means that currencies based on the blockchain cannot be controlled by one person. What I mean by that is no one can, for instance, award themselves one million Bitcoin. Because nobody is in charge, Bitcoin is actually run by the network of computers participating in the blockchain.
New blocks are verified or added to the blockchain through mining. During verification, computers make sure that the sender involved in a transaction has sufficient funds to complete the payment. New blocks are created when a computer finds a solution to a complex algorithm. When a new block is linked to the previous blocks, the new version of the blockchain file is broadcasted across the entire network.
What exactly is the difference between cryptocurrency and fiat money?
Cryptocurrencies and conventional currencies, also known as fiat currencies, share two essential features: they both enable easy payments between two parties and act as a store of value.
However, cryptos also offer features which traditional money systems like the dollar or euro cannot emulate easily or are downright impossible for them to accomplish. The first and foremost differentiator is that cryptos can be sent, received, and traded by anyone, anywhere, at any time across the world without the need for a bank, government, or third party.
Another important difference between crypto tokens and fiat money is that cryptos are not insured by the government in the way a bank deposit is. If your crypto wallet is hacked and your tokens are transferred, the government may not be able to intervene in the same way they would with money stored in a bank.
What’s the value of Bitcoin?
Fiat money (meaning money backed by a government that isn’t pegged to gold) has value due to trust in the authority that serves as an intermediary that vouches for the currency’s worth, which in the case of the dollar is the Federal Reserve. Basically, fiat money has value because a government declares it legal tender. If it wasn’t for this trust, then a dollar bill wouldn’t be worth more than the paper it’s printed on.
A crypto asset’s value is also due to trust vested by the users of the crypto network, but rather than trusting a governmental authority, the trust is vested in the blockchain technology.
Due to this trust, cryptos and fiat currencies are seen as a store of value. But aside from this feature, a safe currency must also meet qualifications related to scarcity, divisibility, utility, transportability, durability, and counterfeiting.
Scarcity is key to preserving a currency’s value. If the Federal Reserve were to crank the money printer every day, the dollar wouldn’t be worth anything. This is why bankers often walk a tightrope with their monetary policies, carefully balancing the money supply and debt in order to keep inflation under control.
Unlike fiat currency, Bitcoin has a fixed supply since it launched in 2009. The supply of Bitcoin tokens was capped at 21 million, and currently, there are around 18 million Bitcoin in supply. In order for more Bitcoin to enter circulation, tokens have to be ‘mined’ by completing “blocks” of verified transactions that are added to the blockchain. The rate at which Bitcoin is released decreases by half roughly every four years and the last bitcoin is not scheduled to be mined until around the year 2140.
Bitcoin is divisible up to 8 decimal points. While the U.S. dollar can be divided into cents, or 0.01 USD. The smallest unit for Bitcoin, equal to 0.00000001 Bitcoin, is called a “Satoshi”.
Thanks to crypto exchanges and wallets, Bitcoin and other cryptocurrencies are easily transferable between parties, regardless of the size of the transaction with very low costs.
In terms of durability, cryptocurrencies may be more durable than fiat currencies, whose physical form is vulnerable to deterioration that can render them unusable. Bitcoin cannot be destroyed in the same way a dollar bill can be torn or burned. As long as the network is alive, so too will every Bitcoin be valid.
Counterfeiting Bitcoin is virtually impossible since doing so would entail confusing all participants in the blockchain network. The only way a counterfeit Bitcoin could be introduced in circulation is through double spend, which refers to the situation where a user transfers the same Bitcoin in two or more separate settings, effectively duplicating the record. This has yet to happen in the Bitcoin network for doing so would require a concentrated attack by a group that controls more than half of all the network’s mining power. Because such an effort involves a ridiculous amount of resources (money and computing power), counterfeiting Bitcoin is extremely unlikely.
Utility is where cryptocurrencies are the most lacking. You can easily exchange fiat money like USD for goods and services. Because fiat money can also be digital, such transactions can occur effortlessly and almost instantly. Meanwhile, Bitcoin is barely accepted as payment, nevermind other less established currencies.
Tesla made headlines in February after it announced it bought $1.5-billion-worth of Bitcoin from its corporate reserves and that it would also accept Bitcoin as payment for its products. However, this kind of adoption is still in its early stages. Very few businesses accept Bitcoin and even fewer people own a cryptocurrency.
Bitcoin is also extremely volatile, which makes it challenging to adopt it for practical day-to-day use. The price of Bitcoin since the May 2020 halving has seen an increase of nearly 500%. Instead, what this volatility invites is a lot of speculation.
Of course, Bitcoin isn’t the only cryptocurrency out there. In fact, there are over 8,000, but most of them operate under similar principles. And, by far, Bitcoin is the most important crypto token in the world.
Data updated on Feb. 18, 2021.
What are cryptos good for?
Cryptocurrencies are exchanged securely and provide a high degree of anonymity. Transactions cannot be faked or reversed, which is both a good thing and bad thing — depending on who you ask. For some consumers, not being able to reverse a payment, like you can with a credit or debit card, might make them more vulnerable to scams.
Although Bitcoin is more than 10 years old, adoption is still lagging and there are only a few stores that accept cryptocurrencies as payment.
While Nakamoto referred to Bitcoin as electronic cash, the slow rate of adoption suggests we’re still a long way from that goal. Instead, many see Bitcoin as a form of “digital gold”, which is a long-term store of value.
Today, perhaps the most common use of cryptocurrency is as a speculative investment. Buyers purchase and hold Bitcoins because they believe their value will increase in time, so they will be able to sell them later at a higher price. However, these speculative interests can drive prices up and cause the market to exhibit characteristics of a bubble. As such, investing in Bitcoin or any other crypto is extremely risky as the bubble may burst at any time. This has happened before in late 2017 when Bitcoin came crashing down and didn’t recover from its all-time low until late 2020.
The huge trading volumes and hyper increases in price for Bitcoin in the past year have attracted a spate of both amateur and professional investors. Some say we’re in a new bubble that’s about to burst, others claim that Bitcoin could reach $100,000 or perhaps even $200,000 by the end of the year.
Before you jump the bandwagon, be aware that Bitcoin’s greatest strength can also be its biggest weaknesses. Since they’re completely decentralized, cryptocurrencies are also entirely unregulated, which makes them liable to fraud. Speculators who buy digital tokens should also be aware that they are at risk of losing all their money. The market is so volatile that even a tweet from Elon Musk is enough to move Bitcoin by double digits. Other smaller coins are even more volatile.
And while their anonymous nature makes cryptocurrencies great for privacy, it’s also one of the reasons why they’re the preferred mode of payment for illegal digital transactions such as the purchasing of drugs or firearms on the dark web.
Cryptocurrencies are definitely promising and blockchain technology may be a fantastic tool beyond cryptocoins, such as securing medical records and preventing election fraud. However, the crypto space is very much a Wild West, so tread lightly.