What is cryptocurrency?

What is cryptocurrency?

Once spoken about mainly in shady corners of the internet or by that annoying guy at your office, cryptocurrency has now gone truly mainstream. 

The global crypto market is regularly valued in the trillions, Tesla (NASDAQ: TSLA) chief Elon Musk tweets about Dogecoin (CRYPTO: DOGE), and El Salvador has even adopted Bitcoin (CRYPTO: BTC) as legal tender (and plans to mine it using computing power generated by a volcano!).  

Despite these developments, the average investor still finds cryptocurrency difficult to understand. That’s where we can help.

In this article, we’ll break it down so that you can better understand what cryptocurrency is, the technology behind it, and whether it would make a good investment for your portfolio.

So, what is cryptocurrency?

Cryptocurrency – or crypto, for short – is a type of digital asset. This means that in contrast to traditional forms of currency, such as the Australian dollar or English pound, the various cryptocurrencies in circulation today do not exist as physical coins or notes. Instead, they are virtual currencies stored on computer software in a digital format.

While their digital nature separates them from traditional currencies, there are similarities between them. For example, cryptos are designed to facilitate financial transactions. Just like your Aussie dollar, cryptocurrency tokens can be loaned, borrowed, or used to pay for goods and services.

However, where fiat currencies are issued and backed by governments, cryptocurrencies are created via decentralised computer networks called blockchains.

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What is a blockchain?

If it wasn’t for blockchains, cryptos wouldn’t exist. So let’s have a closer look at blockchain technology and how it differs from our traditional financial system.

In the typical system, intermediaries such as banks help to facilitate financial transactions. Customers deposit their savings into the bank, and the bank then uses that money to issue loans. From an accounting perspective, the bank then carries both a liability (the deposit) and an asset (the loan) on its balance sheet. But each customer only sees their side of the transaction: the customer who makes the deposit has an asset, and the customer who takes out a loan has a liability.   

A blockchain, on the other hand, removes the financial intermediary entirely from the equation. Instead of the 2 sides of a financial transaction being linked only on the intermediary’s balance sheet, blockchain technology relies on a ‘distributed ledger’ to store and validate transactions.

In a blockchain, the balance sheet (or ledger) is distributed among a peer-to-peer network of computers that together assume the role of the financial intermediary. For a financial transaction to take place, all computers in the network must reach a consensus about what the ledger will look like once it goes through. If they can’t agree, the transaction won’t be processed.

Each transaction is considered to be a block which is added to an existing, immutable ‘chain’ of transactions. These blocks are linked together by a secure cryptographic code (called a ‘hash’, in techno-speak). 

The idea behind blockchain technology is that it creates a decentralised record of transactions. It doesn’t rely on any central authority to validate transactions, and because the history of prior transactions is immutable (that is to say, previous records on the blockchain can never be altered) it maintains its fidelity over time.

The drawback is that a blockchain requires a sufficiently large network of computers to maintain the distributed ledger and to create the cryptographic code that links the whole thing together. So, in order to incentivise people to lend their computing power to the blockchain, each network participant is compensated with a form of cryptocurrency. 

Once a computer on the network creates a new hash, it is awarded a certain amount of crypto. You may have heard this referred to as crypto ‘mining’, particularly when it relates to the creation of new bitcoins. However, the amount and type of crypto awarded will vary depending on the particular blockchain.

Once crypto tokens have been created, they can be traded just like any other asset, or exchanged for a limited range of goods and services. A good way to think of an investment in crypto is having  a stake in the underlying blockchain – if the blockchain is successful and becomes widely adopted, the value of the related crypto will most likely increase.

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Why cryptocurrency could be good for your portfolio

Although investing in crypto carries a lot of risk (more on that later), it can still provide many benefits for your overall portfolio. There are a number of reasons why crypto is a particularly compelling investment right now, and we will explore a few of them below.

 

Quantitative easing

To try to combat the adverse economic impacts of the COVID-19 pandemic, governments across the globe have launched large-scale quantitative easing (QE) programs. QE is when a country’s central bank purchases long-term securities – generally government bonds – in the open market, thereby injecting more cash into the economy. By increasing the money supply, the central bank hopes to keep interest rates low and encourage borrowing, in an effort to drive economic growth.

However, all this excess liquidity needs to flow somewhere – and with returns on most fixed income investments kept low by QE – many investors have been seeking higher-returning, alternative asset classes like shares, commodities and even cryptos. This is why many share markets have delivered such strong returns since the pandemic crash, despite sluggish economic growth. It also explains a lot of the interest in relatively new asset classes like non-fungible tokens or NFTs and cryptocurrencies.

This trend is compounded by the fact that the QE programs, particularly of the scale and magnitude implemented over the past 2 years, can easily lead to inflation. In order to hedge against this risk, investors typically seek out ‘safe haven’ assets – stable stores of long-term value – like real estate or gold. Some investors now see cryptocurrency, and Bitcoin in particular, as a new potential safe haven asset – so much so that some even refer to Bitcoin as ‘digital gold’.

 

Diversification

Diversifying your portfolio is vital for generating stable, long-term growth. This is due to the fact that, if you spread your investment dollars across a broad range of asset classes, it can reduce the overall volatility of your returns.

For example, if you are invested in both shares and real estate, and property prices are booming while the share market is down, your overall sense of wealth remains unaffected – or may even increase, if house prices are high enough. The diversification benefits are strongest when the prices of 2 assets are negatively correlated with one another – meaning that when the price of 1 asset decreases, the other tends to increase, offsetting the loss on 1 side with a gain on the other.

Diversifying your portfolio by investing in crypto could be a good way of ensuring an alternative source of returns when other markets are down. However, because cryptos are still considered a highly speculative, risky asset class, it’s wise to only have a small portion of your overall portfolio invested in them at any one time.

 

Big opportunity

Cryptos and the blockchain technology associated with them are entirely new, and could completely shake up the financial system. Blockchain technology could democratise lending and cause us to seriously rethink the ways in which we do business and process transactions. And investing in cryptos allows you to buy a small stake in that technology.

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What are the types of cryptocurrency?

There are currently more than 8,000 different cryptocurrencies out there, though many have little to no real value. Some of the major cryptos are:

 

Bitcoin

The oldest and mostly widely known crypto, Bitcoin was apparently created by a mysterious Japanese coder named Satoshi Nakamoto – whose true identity remains unknown. Nakamoto first proposed the blockchain technology that all cryptos are now based on in a paper published in 2008 titled Bitcoin: A Peer-to-Peer Electronic Cash System. In January 2009, the Bitcoin network was launched. The first Bitcoin transaction took place soon after, when Nakamoto transferred 10 bitcoins to software developer Hal Finney. The first commercial purchase using Bitcoin took place in 2010, when computer programmer Laszlo Hanyecz traded 10,000 bitcoins for 2 pizzas. Just for context, that 10,000 in bitcoin would be worth well over US$600 million in January 2022.

 

Ethereum

Ether (CRYPTO: ETH) is the native cryptocurrency of the Ethereum blockchain, and it is currently the second most valuable crypto after Bitcoin. The Ethereum network was launched in 2015. Ethereum expands the use of blockchain technology to include immutable applications that can sit on top of the network, increasing the range and complexity of transactions that can be performed on the blockchain.

For example, we have the Ethereum network to thank for the creation of NFTs. These are essentially like certificates of authenticity issued for digital property, like images, videos and audio files. Although the digital files themselves can be reproduced, if you own the NFT, it proves that you own the original version. Ethereum’s increased functionality allows these new forms of digital property to be created, verified, and exchanged.

 

Dogecoin

Originally developed as a joke by 2 software engineers to highlight the highly speculative nature of the crypto market, Dogecoin has become a legitimate investment for many crypto traders. Although most people still consider Dogecoin to be a ‘meme coin’ – essentially a passing fad that has been jokingly spruiked by figures like Elon Musk – its supporters praise the efficiency of its blockchain’s transaction processing ability, and compare it favourably against the bitcoin network.

 

Binance Coin

As of January 2022, Binance Coin is the third largest cryptocurrency by market capitalisation. It is the native crypto of the Binance network, the largest cryptocurrency exchange in the world. It is primarily used to pay transaction fees when trading cryptocurrencies on the Binance exchange.

What are the risks of investing in cryptocurrency?

Despite its upsides, there are still plenty of risks associated with investing in cryptocurrencies. Cryptos are a relatively new asset class and should be considered a highly speculative investment. 


Some of the key risks of crypto investing are detailed below.

 

No intrinsic value

When you buy shares in a company, you are really buying a stake in that company’s future success. If the company makes a profit, you get paid a cut of it in the form of dividends. Using real-world inputs, financial analysts can create sophisticated models to try and determine the intrinsic value of a share in the company, based on its underlying business performance. This enables investors to get a sense of whether a company’s shares are under- or over-valued based on their current market price.

This is much harder to do in the case of cryptocurrencies, as they aren’t really backed by anything, leading some analysts to contend that they have no real intrinsic value at all. In a worst-case scenario, this could mean the whole crypto market could very easily collapse, leaving all the currencies worthless.

Others might argue that a given crypto is backed by its blockchain. If a particular blockchain becomes widely adopted as an alternative to traditional financial systems, then its native crypto would be used more frequently as a medium of exchange, thereby shoring up its value. However, with thousands of blockchains out there, only a tiny fraction of them could ever hope to survive and become mainstream, meaning plenty will lose out.

 

Highly volatile prices

Because of how difficult cryptos are to value – if it’s even possible to value them at all – their prices tend to be incredibly volatile. Through the 12 months of 2021, the price of Bitcoin has dropped as low as US$28,722.76, and has reached as high as US$68,789.62. Those are some incredibly large swings in price to have to endure as an investor – and most other cryptocurrency prices are even more volatile.

So, if you choose to invest in cryptos, you have to be prepared for a rollercoaster ride of quickly changing prices. The real risk is if you happen to need cash quickly to cover an unexpected expense, right when the prices of cryptos are tumbling. This could force you to have to realise a loss on your investment, which is never a good feeling. Therefore, never invest any money in cryptos that you can’t afford to lose – and definitely don’t use your crypto portfolio as your emergency fund.

 

Security risks

It’s important to remember that cryptocurrency markets are largely unregulated. After all, the whole blockchain ethos is that it evades institutional or government control. And while this might excite the Robespierre in you, the downside is that if you fall victim to theft or fraud, you’re largely on your own.

In 2014, Mt. Gox – once the world’s largest Bitcoin exchanges – was hacked, and subsequently declared bankruptcy. An estimated US$615 million in Bitcoin was stolen from Mt. Gox customers’ digital wallets, and most are still yet to receive any compensation.

If you choose to invest in crypto, first read up on the security of the exchange you’re planning to use. Also consider whether storing your crypto in a private cryptocurrency wallet might provide added security. A private wallet is software that allows you to store your crypto on your own computer’s hard drive, and off the exchange, so that only you can access it.

 

This article last updated on 12 January 2022. Motley Fool contributor Rhys Brock has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and has recommended Bitcoin and Ethereum. The Motley Fool Australia owns shares of and has recommended Bitcoin and Ethereum. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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