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Demystifying Cryptocurrency: The Fundamentals

Understand the basics of cryptocurrency.

This article will explain the basics behind cryptocurrency and will introduce some of the most popular ones that are prevalent today.

Cryptocurrencies. They’ve taken the world by storm over the last year, yet their origins lie just over a decade ago in 2009, when the pseudonymous developer Satoshi Nakamoto introduced Bitcoin. For many, cryptocurrencies seem puzzling, dangerous, and the term is synonymous with ‘get rich quick’ schemes. However, it should be argued that there is more to them than that. Indeed, cryptocurrencies are gaining traction – and for good reason. They offer a high level of security through their cryptographic nature, easier access to credit and other financial products, and either eliminate or charge significantly lower transaction fees than conventional banking practices. 

But what really are they, and how do they work? Cryptocurrencies share many of the characteristics of traditional fiat currencies like the dollar or euro: they are a medium of exchange, their value is governed by economic laws (such as supply-demand), and they permit the transfer and storage of value. Importantly, there are also differences: cryptocurrencies are not issued or backed by a central government, they are purely digital, and they rely on an encrypted and decentralised ledger. This ledger acts as a type of checking book – similar to the type used in restaurants and hotels – which tracks and stores all historical information related to transactions and ownership of a specific cryptocurrency in what is known as a blockchain. Blockchains are complicated, but the basic concept is simple. Essentially, a blockchain is a peer-to-peer network where groups of transactions are added in blocks to a longer blockchain by volunteers who contribute their computing power to solve complex algorithmic mathematical problems – this is the cryptographic aspect of cryptocurrencies. 

In return for their maintenance service, these ‘crypto miners’ are rewarded with the cryptocurrency itself as part of a proof-of-work system. You can picture the blockchain as a giant worldwide game of monopoly in which all of the players (some of whom might cheat), keep a copy of all transactions. This means that fraud is very difficult; no central authority holds all of the records, so they cannot be manipulated. This protection against criminality, in addition to the possibility to conduct transactions anonymously or pseudonymously (under a fake name), makes investing in cryptocurrencies attractive to certain investors. Importantly, while the use of blockchains is a common feature of most cryptocurrencies, there are also many differences between coins. Indeed, in recent years, there has been an explosion of new cryptocurrencies entering the market with some sites reporting that there are in excess of 10,000 different cryptocurrencies in circulation today. This far exceeds the number of normal fiat currencies in foreign exchange markets, so which ones are important and good to know?

The main cryptocurrency that kickstarted this whole financial movement is Bitcoin. Many have heard of Bitcoin (BTC), and many may even hold some in their own financial portfolios. Bitcoin is by far the largest cryptocurrency in the world, with a total market capitalisation of just over $670 billion dollars – more than twice that of Ethereum’s $290 billion. It has seen significant peaks and troughs in its lifetime (see below), but this volatility hasn’t discouraged investors or businesses. Until recently, automotive manufacturer Tesla accepted Bitcoin as payment for their cars before environmental concerns spurred the company’s CEO, Elon Musk, to withdraw this payment option. As one would expect, the popularity of Bitcoin has resulted in a great deal of mining which has created problems. Indeed, the more Bitcoins that are mined, the more complex the mathematical problems become, requiring more computing power, and Bitcoin is reaching its maximum supply. Almost 19 million out of 21 million have been produced, yet some doubt that this limit will ever be reached due to the exponentially increase in costs associated with creating more. 

Source: www.tradingview.com

While Bitcoin remains the most popular cryptocurrency, there have been others that have tried to overcome its limitations. Litecoin (LTC), created by MIT graduate Charlie Lee, was launched in 2011 and it is also based on a similar decentralised network to ensure the cryptocurrency’s security. Although similar to Bitcoin in a variety of ways, Litecoin transactions are both faster and cheaper – as opposed to relatively long and expensive transaction times quite commonly associated with Bitcoin – which has made it more attractive to some investors. Despite this, Litecoin, as of the time of this writing, is only the 14th largest cryptocurrency with a relatively small market capitalisation of just over $4 billion dollars.

Another more recent cryptocurrency is Binance Coin (BNB), launched in June 2017 by the company Binance – the largest cryptocurrency exchange that provides a platform for trading many other coins as well. Binance allows its users to pay fees on its exchange with Binance Coin – one reason why the asset has become so popular in recent times. Unique to this cryptocurrency, however, is that every quarter, Binance uses one-fifth of its profits to repurchase and permanently destroy coins held in its treasury – an interesting strategy to control its supply. This can be thought of as very similar to a share buyback whereby a company decides to buy back its own shares to reduce supply and increase the market price. At the time of writing, Binance Coin is the fourth largest cryptocurrency, with a market capitalisation of just over $50 billion dollars that is quickly rising.

Finally, another incredibly important asset in the cryptocurrency scene is Ethereum – a strong rival to Bitcoin. Ethereum is unique in the sense that, while it uses a decentralised network as other common cryptocurrencies do, more than just currency can be built upon its infrastructure. Ethereum enables smart contracts and applications to be created, leading to an infinite number of possibilities surrounding decentralised financial instruments. Smart contracts, for example, allow individuals to exchange property, shares, or anything of value without the need for a middleman (which would usually be a bank). The goal of the developers is to provide a range of financial products that anyone can access freely and regardless of their location or nationality, and reduce the inefficiency and bureaucracy associated with banking. For those without sufficient state infrastructure, this access to bank accounts, mortgages, insurance or many other financial products is an incredibly attractive prospect.

In addition, Ethereum maintains its own decentralised currency, Ether (ETH), which at the time of writing is the second largest cryptocurrency. Ether can also be mined, and interestingly has an infinite potential supply – as opposed to Bitcoin’s finite potential supply. There are plans from the developers to upgrade the cryptocurrency within the next year, which would implement a variety of improvements. One proposed change is the transformation of the currency from a proof-of-work to a proof-of-stake system. This latter system was created as an alternative to the former, whereby individuals can verify block transactions according to how much of the currency they own, rather than according to how much they have mined. One key benefit of a proof-of-stake system is that it does not require the significant amounts of energy needed by a proof-of-work system in order to mine the currency. There have been many environmental concerns surrounding cryptocurrency and so a transition like this within Ethereum may make it more viable within socially responsible investing (SRI) portfolios.

There are a multitude of other cryptocurrencies out there, such as Tether, Cardano and Ripple. Some, such as Dogecoin, started off as a internet-based joke and have rapidly gained traction in recent months. But one thing is clear: cryptocurrency is becoming mainstream and moving away from the obscure, unorthodox reputation that had characterised it for many years. Retail trading, which refers to non-institutional market participants, has risen exponentially as a result of the COVID-19 pandemic; having driven recent market frenzies such as the GameStop short-squeeze. It is also a driving factor behind the rise of cryptocurrency: many ordinary people are increasingly gaining access to technology, such as Binance and Coinbase, which enables them to interact with various financial markets such as cryptocurrency exchanges. This is vastly different to the time where a savings account at your local bank was your only viable option. Interestingly, the frightening volatility has often been a selling point, rather than a deterrent for those looking to make a quick profit, and the advanced cryptography behind many of these coins is proving to be a safer investment than many fiat currencies. The large-scale investment into cryptocurrencies from institutions and banks has still eluded the financial world due to strong fears about volatility, but the way things are going, it would be foolish to ignore the momentum.

Oliver Wainwright – 01/06/21

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