What are cryptocurrencies?

Discover what cryptocurrencies are, where they come from and why they’re so popular.

What are cryptocurrencies?

Cryptocurrencies are digital currencies. They can be exchanged or speculated on just like any traditional – or ‘fiat’ – currency, but they exist outside the control of financial institutions and governments.

There’s a massive number of cryptocurrencies available, all with unique features and applications. But those with a substantial market capitalisation are – at least for now – in the minority, and they include bitcoin, bitcoin cash, ether, litecoin, ripple and dash.

Currency or commodity?

Cryptocurrencies may be known as an ‘alternative’ to traditional currencies, but they were nonetheless conceived as a wholly conventional payment solution. Already, a number of outlets accept cryptocurrency as a form of payment.

But while it’s true that its legitimacy as a form of payment is central to its value, cryptocurrencies often bear more resemblance to commodities like gold than they do forex. Like commodities:

• The value of a cryptocurrency isn’t tied exclusively to the performance of a particular economy

• Interest rate changes and increased monetary supplies only have an indirect bearing on their value

• Cryptocurrencies are only valuable because people agree they will retain their value when converted back to fiat currencies

This means, at least for now, cryptocurrencies are primarily treated as a commodity: an investment whose return comes from speculating on their rising and falling value.

What is cryptocurrency mining?

Mining is the process by which recent cryptocurrency transactions are verified and new units are released.

As a miner, your goal is to compile recent transactions into ‘blocks’ – that is, a cluster of verified transactions – and find a solution to a complex algorithm. Do this and you’ll earn yourself a ‘block reward’, or a set amount of cryptocurrency. This amount varies depending on which cryptocurrency you’re mining: bitcoin’s block reward, for example, is currently 12.5 bitcoins.

Solving these algorithms is a continuous process, and depends on the results of previous algorithms in order to make the next calculation. Similarly, the difficulty of the algorithm can be – and is – regularly adjusted, with the aim of keeping block discovery constant, even as computing power improves. This means it resembles the rate at which commodities like gold hit the market – hence the name ‘mining’.

The miner consolidates recent cryptocurrency transactions into a 'block'. 

The block is cryptographically secured and linked to the existing blockchain. 

The miner earns a block reward, which they can inject directly back into the market.

What is the blockchain?

The blockchain is a shared digital ledger which records all transactions of a particular cryptocurrency between two parties. These transactions form clusters known as ‘blocks’, which are in turn cryptographically secured and linked to one another.

The information recorded on the blockchain is hosted by millions of computers and open to everyone, rather than being stored in one single location. This makes it both transparent and impervious to modification, with no one weakpoint vulnerable to human or software error. Once the data has been verified, it cannot be retroactively edited without the computing power and will of the network majority.

Keep in mind that cryptocurrency is just one of a number of smart applications that uses blockchain technology. The blockchain is essentially a digital platform on which all sorts of programs – including identity management, security software and transaction processing – can be built.

Cryptocurrencies: benefits and risks

Benefits

Global

Cryptocurrencies are a global currency, and far less susceptible to the economy or policies of any single country. They are accessible to everyone, and can be transferred instantly to anyone around the world

Decentralised

Cryptocurrencies are decentralised – they don’t have an official exchange – meaning they can be traded 24 hours a day, seven days a week

Volatile

Cryptocurrencies tend to experience sudden and significant price movements. This makes them problematic as a currency, but highly attractive as a market opportunity

Transparent

All transactions are recorded in a shared ledger, and operate on a mechanism which ensures only the sender’s required information – not all their details – are delivered to the recipient

Risks

Volatile

Volatility can bring risk as well as opportunity: wild price fluctuations could see a cryptocurrency lose hundreds of dollars’ worth of value overnight

Loss

There’s no perfect way to protect against human error, technical glitches or fraud – and there’s no system in place to reimburse you for losses

Widespread adoption

Cryptocurrencies are only as valuable as they are perceived to be: despite their growing popularity, there are still question marks over their long-term future

Regulatory changes

Cryptocurrencies may be free from regulation now, but if new mechanisms are introduced, many of its advantages over fiat currency may be undone

Fiat currencies vs cryptocurrencies

Fiat currencies Cryptocurrencies
Physical.

Digital.

Aligned with a particular nation or group of nations.

Global.

Issued by governments.

Released through mining.

Supply is mediated by central banks.

Supply is mediated by miners and mining software.

Must be injected into the economy through bonds and other securities.

Injected directly into the cryptocurrency market.

Heavily influenced by inflation and interest rates.

Largely uninfluenced by monetary policy. 

 

FAQs

What is an ICO?

An ICO is an initial coin offering. It is a way for founders of a new cryptocurrency to raise capital (in the form of ether or bitcoin) for their project, in exchange for their currency’s tokens. The project may solely be devoted to their new cryptocurrency, or may span multiple blockchain applications.

ICOs are quickly becoming the preferred way to launch a new cryptocurrency onto the market. The hope is that, should your cryptocurrency turn into the next big thing, you’ll have got in at the ground floor. They are, however, a risky venture: unlike companies which float on the stock market, new cryptocurrencies are unproven in the marketplace, and don’t confer any rights of ownership. This makes your investment almost wholly speculative.

Likewise, ICOs are unregulated. To avoid getting tangled up in legal implications, they present themselves as ‘presale tokens’ – not unlike a Kickstarter campaign which offers benefits to early supporters.

What is a cryptocurrency fork?

A ‘fork’ is the process by which one blockchain – or transaction ledger – splits into two. It occurs when the software used among miners becomes misaligned. Cryptocurrency miners must then decide which version of the blockchain to accept as valid, and which to discard.

Can you short cryptocurrencies?

Yes. When you trade CFDs on cryptocurrencies, you can take a position as it falls in value, not just when it rises.

Could cryptocurrencies replace cash?

It’s not impossible, but it’s unlikely to happen any time soon. There are a number of reasons why it will take some time, including:

• Cryptocurrencies still lack widespread adoption, among both individuals and businesses

• They are too volatile: vendors would currently have to revise their prices every day to cater for swings in value

• A digital currency would mean a complete revision of existing economic infrastructure

• The transition would need to be worked out, to prevent the redundancy of fiat currencies and the loss of assets

 

Still, there are a number of benefits to the idea:

• They can’t be manipulated like fiat currencies, as a result of the public blockchain

• Without a middle-man, they cut the costs and reduce the obstacles of global transactions

• They lend themselves to a universal basic income

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