What Is Cryptocurrency?

Cryptocurrency is a type of currency that is based on cryptography and uses a distributed ledger system called the blockchain. By harnessing these technologies, developers have aimed to create currencies that are, for the most part, secure, private, traceable and decentralised.

Widespread Interest

Since bitcoin came into existence in 2009, cryptocurrencies have drawn widespread interest from investors. Bitcoin, created in 2009, was the first cryptocurrency to scale. In the years since, these currencies have drawn significant inflows from investors, resulting in their total market capitalisation (market cap) surpassing £75 billion in June 2017.^[1]

This figure represented a more than 400% gain over the market cap of £13.6 billion these cryptocurrencies had at the start of the year 2017.^[1]

Robust Gains

A perfect example of this robust investor interest is the price gains that bitcoin has experienced since inception. Several media outlets have announced that if an investor had purchased a small amount of bitcoin in 2010, when it was worth a fraction of a penny, that investment would have been grown astronomically in the seven years after.

It has been estimated that if an investor purchased US$5 (roughly £3.84) worth of the cryptocurrency in 2010, they would have US$4.4 million (£3.38 million) at the time of report.^[2] At that time, bitcoin was trading close to US$2,200 (£1,690).

The cryptocurrency has risen significantly since then, reaching almost US$3,000 (£2,300) in June 2017. If an investor purchased bitcoin for US$5 (£3.84) and held onto the cryptocurrency until it hit this notable high, it would have climbed close to 60,000%.

Speculative Investments

Investors should keep in mind that cryptocurrencies are speculative investments, and the willingness of investors to wager on their future value is what has driven their significant price gains over the years.^[3]

Unlike the companies whose ownership rights are represented in stocks, cryptocurrencies do not produce revenue or free cash flow. They do not generate earnings which can in turn be distributed in the form of dividends.

While cryptocurrencies do not generate revenue and earnings like companies, many consider these innovative assets the way of the future. Tyler and Cameron Winklevoss, co-founders of cryptocurrency exchange Gemini, have taken this point of view, stating in a 2016 interview that the use of these assets will be fairly widespread in the years to come.^[4] They predict that people will stop using services like PayPal and will instead leverage cryptocurrencies.

A paper released by PwC stated that cryptocurrencies—and the blockchain that underlies these assets—could potentially disrupt many different transactions.^[3] Amid this potential impact, many investors are wagering on the "inherent value" of the underlying technology, including the decentralised network that makes these cryptocurrencies a possibility and the strength of the cryptography involved.

To get a better understanding the key variables that help determine this inherent value, it is helpful to get a better understanding of cryptography and the blockchain, the key technologies that underlie cryptocurrencies.

Cryptography Basics

Cryptography involves concealing information so that it can be sent between sender and recipient in a secure manner. Cryptocurrencies like bitcoin use cryptographic protocols, which have specific rules, to enable this discreet transfer of data.

When it comes to cryptocurrencies, cryptography is used in a few different places. A perfect example is the protocols used to create blocks in the blockchains of these currencies.

Proof Of Work

Multiple cryptocurrencies, including bitcoin, use something called a proof-of-work (POW) protocol to create new blocks. To mine bitcoin specifically, computers use the cryptocurrency's mining software to compute an encryption function in an effort to mine blocks and obtain a bitcoin reward.

Every time a block is created, it comes with a nonce, which is a string of random numbers. To confirm that the block was mined properly, the computers involved with mining need to find a nonce that meets certain criteria.

In a way, the computers involved in this mining are behind leaving a code that other verifiers can use to confirm these blocks were mined.

The Blockchain's Potential

Investors can also benefit from knowing about the potential of the blockchain. This distributed ledger system could disrupt a wide range of industries, making existing processes more transparent and efficient in the process.

A perfect example of the benefit that the blockchain could offer is the safeguards it can provide against fraud. The distributed ledger systems used by cryptocurrencies are often immutable, meaning that once transactions are recorded, they cannot be erased. Bitcoin's blockchain, for example, was designed to be immutable.

If a blockchain is both decentralised and immutable, this combination helps protect it from those who would seek to defraud the system.

Benefits Of Cryptocurrency

Investors who are interested in cryptocurrencies may want to know about the various benefits these assets offer.

One major attraction of cryptocurrencies is that many of them are decentralised. Fiat currencies like the euro, British pound and U.S. dollar are issued by central banks, and some have voiced concern that they could be devalued rather easily.

A notable benefit of this decentralisation is that while certain countries have restricted the use of their native currency by imposing capital controls, the residents of these nations were able to use bitcoin to make transactions.

Some cryptocurrencies have an upper limit or cap on the number of units that can be created. Bitcoin, for example, is limited to roughly 21 million coins, a figure that is expected to be reached by 2140. Litecoin, a cryptocurrency whose technology is similar to that of bitcoin, has a total cap of 84 million units.

This upward limit helps provide a check on unwanted inflation. In other words, it helps prevent these currencies from losing significant purchasing power. At the end of the day, the value of any asset is a function of supply and demand, so any cryptocurrency could have very little regardless of what its cap is.

Another benefit of cryptocurrencies is privacy. While bitcoin advocates have repeatedly touted the cryptocurrency as providing anonymous transactions, bitcoin transfers are not, in fact, anonymous.

Bitcoin transfers take place between bitcoin addresses, which are randomly generated strings of letters and numbers. Over time, a growing number of transactions can attach to a bitcoin address, offering insight into that user's purchasing trends.

Other cryptocurrencies, notably monero and zcash, have done more to provide users with privacy. Monero, in particular, has enjoyed widespread demand, as several dark web marketplaces have opted to use the currency.

Another benefit of cryptocurrencies is the traceability of transactions. This means that any and all transactions are made public and can be tracked as such.

Summary

Cryptocurrencies, which are currencies that harness cryptography and the blockchain, have drawn widespread interest in the last several years. These digital assets have attracted significant funds from investors, causing them to gain significantly in value.

However, investors should keep in mind that cryptocurrencies are speculative investments. Nobody knows for certain what the future holds for global asset markets. While cryptocurrencies are considered by some to be the way of the future, they could also be a fad.

As a result, investors might benefit from speaking with a qualified financial professional, such as a financial advisor, before deciding to purchase any cryptocurrency.