Dec 1, 2021
A Primer on Cryptocurrency: Understanding Bitcoin, Dogecoin, and other virtual currencies
Bitcoin, Dogecoin and other cryptocurrencies have taken off in recent months. We explain what they are and how they work.
Bitcoin, Dogecoin, Ethereum, Litecoin, and Ripple. You may have heard these names, but wonder what they are.
These are virtual currencies, sometimes referred to as cryptocurrencies, and they’ve become a hot market with consumers and investors in recent years.
In November, 2021, the price of a single bitcoin, the cryptocurrency invented by a mysterious software programmer named Satoshi Nakamoto in 2009, soared to a record high of more than $68,000. And investors have poured approximately $2.6 trillion into more than 5,000 types of cryptocurrency over the past few years, according to recent reports.
And while cryptocurrency is considered a highly speculative investment prone to volatility, it has moved from margins of the internet to the mainstream of the business world. Recently, the Bank of New York (BNY) Mellon Corporation, the oldest bank in the nation, announced that it will start holding, transferring, and issuing cryptocurrencies, including bitcoin. Mastercard also announced in February, 2021 that it will start supporting certain cryptocurrencies for payments.
And in early 2021, electric car manufacturer Tesla said it had invested $1.5 billion of its assets in bitcoin as a hedge against inflation and announced it would let customers use the cryptocurrency to pay for its electric cars. (The currency’s movement was further complicated by a series of tweets from Elon Musk, Tesla’s chief executive officer, in June of the same year, suggesting that Tesla might sell its holdings.)
But what is a cryptocurrency and why have they become so valuable?
How does it work?
Cryptocurrency is a purely digital currency, which means it’s a form of money that exists exclusively online. As its name suggests, it also relies on a technology called encryption, which encodes information about how the currency is used in transactions, to keep it secure. And just like cash, cryptocurrency can be used for payment, or as an investment.
Here’s where it gets complicated. Cryptocurrencies are created using something called blockchain, or distributed ledger, software. That means the code produces an encrypted record of the value of each virtual coin and the transactions it’s involved in, distributing that record across numerous networks on the Internet. Distributed ledger is different from the way your bank keeps track of your dollars, in a centralized database that only it controls, cryptocurrency experts say.
Theoretically, “anyone on the Internet can access records of cryptocurrencies and transactions, which are recorded on a public ledger,” says Andrew Lokenauth, director of finance and accounting at insurance tech company Cover Genius, based in Tampa, Florida.
The distributed aspect of cryptocurrency potentially makes it more secure against hackers than the cash in your bank account. Hackers would have to break into millions of computers to steal a particular cryptocurrency, rather than one centralized network.
Cryptocurrency, particularly Ethereum, has paved the way for something called decentralized finance (DeFi). DeFi is a financial environment that exists entirely online, through blockchain. Businesses in the DeFi industry, often called DeFi apps or dapps, operate by taking out the middleman: traditional banks. Rather than requiring the many steps banks use, DeFi uses the technology behind cryptocurrency to securely and automatically carry out financial transitions.
Dangers and risks of cryptocurrency
Initially, a lack of oversight and regulation led to a number of scandals centered around transactions made with cryptocurrency and the exchanges where cryptocurrency is bought and sold. For example, bitcoin was the currency used in many of the transactions on the now shut down Silk Road, a marketplace for drugs and other illegal items on the “dark web.”
Good to know: In the U.S., cryptocurrency is not considered an official currency, and regulators have taken a hands-off approach to regulating it, providing oversight while allowing it to be bought and sold on specialized exchanges, used in financial transactions, and offered to the public through something called an initial coin offering, or ICO. Some of the regulators include the Securities and Exchange Commission, the U.S. Department of the Treasury, and the Commodity Futures Trading Commission. Unlike bank deposits, cryptocurrency deposits are not insured by the U.S. Federal Deposit Insurance Corporation (FDIC).
Until recently, big banks have been wary of cryptocurrencies due to the potential risks and regulatory concerns that could accompany them. Keep in mind that cryptocurrencies can be volatile, meaning their prices are subject to big swings up and down.
Where do you find it?
Coinbase recently had an initial public offering and became the first digital currency exchange to go public. The offering could lend more credibility to the fledgling cryptocurrency market, while possibly encouraging more IPOs in the industry, according to experts.
The other way to obtain it is through a process called mining. This is a complex and labor-intensive procedure that involves using computers that have large amounts of processing power, to create new units of a cryptocurrency using algorithms, or complicated mathematical formulas.
Miners essentially help track and update the networks containing distributed ledgers. You can think of it as receiving cryptocurrency payment in kind for taking care of the network.
Here’s something else to keep in mind: most cryptocurrency networks limit the number of units of cryptocurrency that can be in circulation. For example, the bitcoin network will stop producing bitcoin once there are 21 million in circulation. The limits help to ensure that the virtual currency has value, experts say.
How do you use cryptocurrency?
Unfortunately, you can’t store cryptocurrency in a standard bank account yet–although some banks appear to be working on it. Once you have your digital currency, you usually need to set up a digital wallet, and numerous versions of these are available for desktop or as a phone app.
A wallet will allow you to store the currency, and use it in transactions.
While the list of merchants who take bitcoin for payment is still small, it’s ever-growing and includes big names like Dell, Microsoft, and Expedia who accept it through various bitcoin trading partners.
What are the risks?
Cryptocurrencies have experienced a huge run-up in value over the past few months. Some of those increases have been driven by venture capital and private equity investment money flooding into the virtual currency market, said Joshua Rosenblatt, a partner at law firm Frost Brown Todd, in Nashville, Tennessee, and an expert in digital payments.
“Investors have been seeking these outsized returns,” Rosenblatt says.
While cryptocurrency has been fertile territory for experienced hedge fund and venture capital investors, the average investor needs to exercise caution and do their homework, financial experts say. “Most people would not invest in stocks, bonds, or properties without a reasonable understanding of what the asset does, and any applicable pitfalls,” says Jeremy Britton, a Sydney, Australia-based financial advisor for cryptocurrency fund Boston Trading Company.
Cryptocurrencies can be extremely volatile, which means their values can be subject to big swings up and down. In late 2014, for example, bitcoin traded at close to $1,000 a coin. Just five months later, in the spring of 2015, its value had fallen by nearly half.
One reason for the wild fluctuations is that it’s still early days, and the number of people using cryptocurrency is still relatively small. “Cryptocurrency as an investment class, and individually, are highly volatile with large price swings…As an investor, if you can’t tolerate downswings of several points in the course of a day then crypto is not of you as this is the norm,” says Shane Hackett, a partner at private equity firm Legion Capital, based in New York, New York.
For more information on the risks associated with cryptocurrencies, the Securities and Exchange Commission (SEC), which sets regulations pertaining to market investments, has published some general guidelines about digital currency and initial coin offerings, which you can find here.
The SEC is just beginning to consider how to regulate cryptocurrency more comprehensively. Cryptocurrencies are currently considered commodities, which means they’re regulated by the U.S. Commodity Futures Trading Commission (CFTC). In contrast, stocks, bonds, and ETFs are considered securities, and are regulated by the SEC. Securities are typically more heavily regulated than commodities are. Regulators are weighing whether or not the SEC should oversee cryptocurrencies.
Key Takeaways: A cryptocurrency is a highly encrypted virtual currency that can be used to buy and sell goods and services, or as an investment vehicle. Banks won’t let you store it, so you have to set up a special digital wallet if you want to own it. Cryptocurrency is highly volatile, and can be subject to big swings in value. It’s still early days for cryptocurrency, but there is an interest in it, from big and small investors alike.
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