“Cryptocurrencies, Bitcoin, blockchains, Ethereum, HODL…” these are all words that now form part of a lot of people’s everyday vocabulary but there are some of us who are still left in the dark about what they all mean. Hopefully this article will give you a basic understanding of this new “financial craze”.
I would just like to make it clear from the beginning that this article is intended to educate and not to promote or demote investing in cryptocurrencies. By educating yourself and learning as much as you can about anything, you will be able to make an informed decision and lower the risks you take.
So, what is cryptocurrency:
To put it in very basic terms: it is a digital currency. Like most countries or regions have their own currency, cryptocurrencies are a universal currency that is stored digitally. The different cryptocurrencies increase and decrease according to supply and demand, just like normal foreign currencies and exchange rates fluctuate as a result of different factors like economic strength or political unrest.
There are only a fixed number of cryptocurrencies and in order to create new units, a strict set of rules and guidelines need to be adhered to. The limit on the supply is what gives the unit it’s value. Like most things in life – the rarer it is the more valuable it is, assuming there is a demand for it.
Some characteristics of cryptocurrencies:
- It is a set of encrypted digital data
- It has no physical form
- It is decentralized meaning that it is stored, created and processed outside of a central bank or government so no company, country or third party has control of it.
- It is both a currency (it can act as a medium of exchange or a way of transferring value from one person to another) and a virtual accounting system as the data is stored similarly to a cloud-based filing system.
How does it work:
Cryptocurrencies automatically store all records of transactions through the use of blockchain. Blockchains are basically digital records of transactions, certificates or contracts, similar to a ledger or balance sheet. Each currency has its own blockchain.
The platform being used archives both the buyer and seller’s information and records it as a string of numbers and letters that are generated by a complex mathematical function, called a “hash”. Each “hash” is linked to the one before it so any manual or unauthorized changes made to the data will be very apparent.
A certain number of hashes all linked together are converted into a “block”. Each “block” is then linked to other “blocks” on the server and these form a “blockchain”.
What are the risks:
- It does not physically exist. It is not a tangible asset like gold or other commodities, neither is it printed or minted like normal currencies. Unlike a bond or share, it doesn’t even represent a share in a company. Based on this, it only has its trading value and no fundamental value.
- It is decentralized. Cryptocurrencies are private and unregulated, which can raise concerns about tax liabilities on gains and losses.
- It is volatile. Since there is no regulation, the prices are determined solely by supply and demand which can change drastically based on someone’s perception. One influential person’s opinion can have a significant impact on the cryptocurrency market and can cause huge gains or losses.
What are the benefits:
- It is safe and secure. As a result of the use of blockchain technology, the data stored is constantly checked and verified by computers.
- Little personal information is needed to transact in cryptocurrencies which means your financial information is protected from being compromised or shared with third parties.
- It is universal. Cryptocurrencies are available to anyone anywhere in the world, which makes it extremely easy to transfer value (in the form of crypto’s) to someone who is in a different country. It can also be used in a lot of countries to pay for certain goods and services, so it makes travelling a little more convenient as there is no foreign exchange taking place.
This is just the tip of the iceberg when talking about cryptocurrencies. There is a lot more information and detail regarding all the aspects but I hope that this short article has provided you with a foundational understanding thereof.