Cryptocurrency is becoming increasingly popular. By this point, most of us have heard of Bitcoin and its fluctuating value. But what exactly is a cryptocurrency, and what determines its worth?
We will go over the basics here:
What is Cryptocurrency?
According to the brilliant financial guidance website nerdwallet.com,
Like money, right? Well, like most things in life, it’s actually slightly more complicated than that.
Nerdwallet.com states that numerous “companies have issued their own currencies, often called tokens, and these can be traded specifically for the good or service the company provides.” They continue to draw an analogy between cryptocurrency tokens and arcade tokens or casino chips.
Much like the previously mentioned arcade tokens, real money, like the American dollar, is initially needed to exchange cryptocurrency for goods and services.
So, why are so many people interested in using a more high-tech version of arcade tokens? Part of that answer is blockchain.
Cryptocurrencies work using blockchain technology.
Blockchain is a type of database that grants cryptocurrencies, like Bitcoin, to create a ledger that allows transactions to be recorded but not edited. This creates a strong sense of security, which is a large part of the appeal of cryptocurrency.
According to Nerdwallet.com, the most popular reasons cryptocurrency appeals to many of its supporters are:
- “Supporters see cryptocurrencies, such as Bitcoin, as the currency of the future and are racing to buy them now, presumably before they become more valuable.
- Some supporters like the fact cryptocurrency remove central banks from managing the money supply since, over time, these banks tend to reduce the value of money via inflation.
- Other supporters like the technology behind cryptocurrencies, the blockchain, because it’s a decentralized processing and recording system and can be more secure than traditional payment systems.
- Some speculators like cryptocurrencies because they’re going up in value and have no interest in the currency’s “long-term acceptance as a way to move money.”
Are Cryptocurrencies Legal?
Cryptocurrencies are legal in the United States, Japan, the United Kingdom, and most developed countries. But the same is not true across the globe. Some countries have completely banned the use of cryptocurrencies.
China restricted the use of cryptocurrencies but hasn’t yet criminalized the holding of cryptocurrency. Since the legalities vary so widely across the world, it’s always best to check with individual counties and jurisdictions regarding their cryptocurrency laws.
Even in places like the United States, where it is legal, there are laws regarding cryptocurrency that its holders need to be aware of. For instance, most of the ordinances that pertain to assets also apply to cryptocurrency.
Nerdwallet.com also warns to be aware of the possibility of cryptocurrencies being used in fraudulent transactions. “Also, be sure to consider how to protect yourself from fraudsters who see cryptocurrencies as an opportunity to bilk investors.”
Invesopedia.com also mentions fraudulent activity linked to cryptocurrency is a widespread concern. “Investors who find themselves in the unfortunate position of being a victim of financial crime do not likely have the same legal options as traditional victims of fraud. …Investors have so far not been able to eliminate the legal risks associated with owning cryptocurrencies fully, and, likely, they never will.” In short, buyer beware.
What are the Advantages of Cryptocurrency?
As mentioned above, cryptocurrency removes central banks from managing the money supply, limiting the possibility of inflation. Additionally, due to its decentralized processing and recording system, the blockchain technology behind cryptocurrencies can be more secure than traditional payment methods.
Cryptocurrencies can also be a profitable investment. According to Investopedia.com, more advantages of cryptocurrency include:
1. User Autonomy
Without third-party involvement from banks or the government, users can experience more autonomy over their money and how they choose to spend it.
2. Discretion
Purchases made with digital currencies, like Bitcoin, are discreet. Much like cash-only transactions, cryptocurrency purchases are never associated with one’s personal identity unless the user voluntarily chooses to publish their transaction history.
Bitcoin goes as far as generating a new anonymous bitcoin address for user purchases with each transaction. Investopedia.com notes: “This is not to say that bitcoin transactions are truly anonymous or entirely untraceable, but they are much less readily linked to personal identity than some traditional forms of payment. However, more privacy-oriented coins exist, such as Dash, Monero, or ZCash, which are far more difficult to trace.”
3. Peer-to-Peer Focus
Cryptocurrency payment systems are exclusively peer-to-peer. Investopedia.com explains this means “users can send and receive payments to or from anyone on the network around the world without requiring approval from any external source or authority.”
4. Elimination of Banking Fees
According to Investopedia.com, it is considered standard among cryptocurrency exchanges to charge so-called “maker” and “taker” fees, as well as occasional deposit and withdrawal fees; however, cryptocurrency users are not susceptible to the enumeration of traditional banking fees associated with traditional currencies.
5. Very Low Transaction Fees for International Payments
Investopedia.com points out steep fees and exchange costs are typically involved in standard wire transfers and foreign purchases. Since cryptocurrency transactions have no third-party involvement, like intermediary institutions or the government with traditional currencies, the costs of transacting are kept very low.
This is a major advantage for travelers using cryptocurrency. Additionally, the inconveniences of typical authorization and wait periods are eliminated with any cryptocurrency transfer, as they happen very quickly.
6. Mobile Payments
Cryptocurrency users can pay for tokens anywhere they can find Internet access. Thus, purchasers never have to worry about traveling to a bank or even a store to make a purchase.
7. Accessibility
Investopedia.com illustrates how far-reaching cryptocurrency can be. “Because users can send and receive cryptocurrencies with only a smartphone or computer, cryptocurrency is theoretically available to populations of users without access to traditional banking systems, credit cards and other methods of payment.”
What are the Disadvantages of Cryptocurrency?
Like there is a multitude of advantages, there are just as many disadvantages of using cryptocurrency. Some of the most troublesome disadvantages include:
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Criminal Activity
The anonymity that accompanies cryptocurrency transactions can make them convenient for criminals to utilize in illegal activities, such as money laundering and tax evasion. However, not all cryptocurrency transactions are truly untraceable.
Investopedia.com explains not all cryptocurrencies are ideal for criminal use. “Bitcoin, for instance, is a relatively poor choice for conducting illegal business online, since the forensic analysis of the Bitcoin blockchain has helped authorities arrest and prosecute criminals.”
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Fluctuation in Value
Cryptocurrencies do not have value rooted in material goods. Instead, the value is based solely on supply and demand. Since the design of many cryptocurrencies guarantees a high degree of scarcity, the exchange rate of a cryptocurrency for another form of currency can fluctuate considerably.
“Bitcoin has experienced some rapid surges and collapses in value, climbing as high as $19,000 per Bitcoin in Dec. of 2017 before dropping to around $7,000 in the following months. Some economists thus consider cryptocurrencies to be a short-lived fad or speculative bubble,” as explained on investopedia.com.
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Cryptocurrencies Are Not Widely Accepted
As mentioned previously, cryptocurrencies are not legal in every country. Legalities concerning cryptocurrencies vary greatly. Additionally, even where it is legal, not all merchants accept cryptocurrencies, making it a less reliable payment method.
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“Wallets” can be Lost
Cryptocurrencies rely on “wallet” files to store an accumulation of tokens. If a user experiences a hard drive crash, downloads a data-corrupting virus, or their wallet file is compromised in any way, tokens can be lost.
These tokens will permanently be orphaned in the system. A wealthy cryptocurrency user can be bankrupt within a matter of seconds if they experience losing a “wallet” and with no hope of “finding” it again, like with a physical wallet.
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No Buyer Protection
As previously mentioned, users need to protect themselves from becoming the victim of financial crime. Once the crime is committed, the victim does not have the same legal options that a traditional victim of fraud would have.
For example, when goods are bought using cryptocurrency, and the seller doesn’t send the promised goods, nothing can be done to reverse the transaction. Or, if another individual hacks a user’s wallet, there is no way to recover stolen tokens – or even to prove they were used without the user’s permission in the first place, making the anonymity cryptocurrencies provide a double-edged sword.
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Built-in Deflation
It has already been said that cryptocurrencies are designed to have a high degree of scarcity, which causes vast fluctuations in value and makes deflation inevitable. For example, the total number of bitcoins is capped at 21 million.
“Each bitcoin will be worth more and more as the total number of Bitcoins maxes out. This system is designed to reward early adopters.”
Since each bitcoin will be valued higher with each passing day, the question of when to spend becomes important. This might cause spending surges which will cause the Bitcoin economy to fluctuate very rapidly and unpredictably,” according to Stanford University.
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Risk of Unknown Technical Flaws
While blockchain technology is typically very secure, other aspects of the cryptocurrency system are not. For example, “wallets” are not immune to the threat of hacking.
Investopedia.com notes in “Bitcoin’s 10-year history, several online exchanges were the subject of hacking and theft, sometimes with millions of dollars worth of tokens stolen.”
If cryptocurrencies were widely adopted, and a previously undiscovered glitch was found, or if a hacker successfully exploited the system, it could give tremendous wealth to the exploiter at the expense of destroying the digital economy.
How do you Buy Cryptocurrency?
The first step in purchasing cryptocurrency is to create a “wallet,” an online app that can hold your currency. Any investor can purchase cryptocurrency through crypto exchanges.
Coinbase is one of the most popular cryptocurrency exchanges. Coinbase provides a platform to create a “wallet” and buy and sell cryptocurrencies, such as the ever-popular Bitcoin or Ethereum.
Nerdwallet.com also suggests online brokers, such as eToro, Tradestation, Sofi Active Investing, and Robinhood. Specifically, Robinhood, which is available in most- but not all states in the U.S., offers free cryptocurrency trades.
Bitcoin, like most cryptocurrencies, can be purchased with U.S. dollars. But other types of cryptocurrencies require the use of bitcoins or another cryptocurrency to be purchased.
The second step is to decide if you want to store your currency in a hot wallet or a cold wallet. A hot wallet stores your cryptocurrency in the cloud and can be accessed through an app or computer browser on the internet.
Hot wallets are offered through providers like Coinbase. Cold wallets are encrypted portable devices that provide the ability to download and store cryptocurrency. Cold wallets are understood to be much more secure than hot wallets.
The third step, which is the last and easiest, is to decide how much to buy of your preferred cryptocurrency. Nerdwallet.com explains, “bitcoin made news in January by cresting past $40,000 for the first time, bitcoin (trading symbol BTC or XBT) can be bought and sold for fractional shares, so your initial investment could be as low as, say, $25.”
Here’s more information on how to purchase and invest in Bitcoin.
Are Cryptocurrencies actually Valuable?
Countless people are looking to cryptocurrencies as investments. With the fluctuating value of cryptocurrencies, are they actually wise investments? Nerdwallet writers perfectly answer this question:
Cryptocurrencies may go up in value, but many investors see them as mere speculations, not real investments. The reason?
That’s what’s called ‘the greater fool theory of investment. Contrast that to a well-managed business, which increases its value over time by growing the profitability and cash flow of the operation.
As NerdWallet writers have noted, cryptocurrencies such as Bitcoin may not be that safe. Some notable voices in the investment community have advised would-be investors to steer clear of them. Of particular note, legendary investor Warren Buffett compared bitcoin to paper checks: ‘It’s a very effective way of transmitting money, and you can do it anonymously and all that.
A check is a way of transmitting money too. Are checks worth a whole lot of money? Just because they can transmit money?’
For those who see cryptocurrencies such as Bitcoin as the future currency, it should be noted a currency needs stability so that merchants and consumers can determine what a fair price is for goods. Bitcoin and other cryptocurrencies have been anything but stable through much of their history.
For example, while Bitcoin traded at close to $20,000 in December 2017, its value dropped to as low as about $3,200 a year later. By December 2020, it was trading at record levels again.
This price volatility creates a conundrum. If bitcoins might be worth a lot more in the future, people are less likely to spend and circulate them today, making them less viable as a currency. Why spend a bitcoin when it could be worth three times the value next year?”
For more in-depth information about cryptocurrency, click here.
