Cryptocurrency: What’s It All About? Part 1: Understanding Cryptocurrency

Bitcoin - What's All The Hype?

It’s hard to scan the financial headlines these days and not feel some level of FOMO with Bitcoin. Stories of great wealth gained, whether in the news or from our neighbour’s mouths, prompts the same internal question: Why not me? So, before you start loading up on bitcoin or any other form of cryptocurrency, let’s take a closer look at what you may be getting yourself into, in three parts:

  1. Understanding cryptocurrency
  2. Spending cryptocurrency
  3. Trading in cryptocurrency

Our quick take? Cryptocurrency is an interesting development with a number of promising possibilities. But like any relatively new, highly volatile opportunity, it entails considerable risk.

If you’d like to try earning and spending cryptocurrency, be sure you’re familiar with the nature of the beast. If you’re thinking of trading in it for fun or profit, we advise against putting in any more than you could afford to lose entirely. In our estimation, cryptocurrency remains more of a speculative venture than a disciplined investment.

With that, let’s proceed!

Beginning with Bitcoin

Cryptocurrency was introduced in 2009 by Satoshi Nakamoto (pseudonym perhaps?). Nakamoto described a new kind of money, or currency, which was meant to exist in a secure, stable, and limited supply strengthened by electronic security, or encryption. Pair “Encryption” and “currency,” and, voila, “cryptocurrency”.

Bitcoin became the first cryptocurrency, and is still the most familiar kind.[1] According to CoinMarketCap, Bitcoin had a market cap of nearly $600 billion as of January 22, 2021, with its closest competitor Ethereum at $140 billion. Market caps drop considerably after that, but there are plenty of others. As of September 30, 2020, a CFA Institute Cryptoassets Guide reported: “More than 6,000 different cryptoassets exist, and many new ones are created each month.”

Unlike a dollar bill, cryptocurrency only exists as computer code. You can’t touch it or feel it. But increasingly, holders are spending cryptocurrency in ways only formerly done in traditional methods (i.e. exchanging regular money). There’s also growing interest in trying to build or at least preserve wealth by trading in cryptocurrency, which some describe as being like “digital gold.”

Cryptocurrency vs. “Regular” Money

In comparing cryptocurrency to regulated fiat currency – or most countries’ legal tender – there are at least two components to consider: limiting supply and maintaining spending power.

  • Limiting Supply: Obviously, if a currency “grew on trees” it would cease to have any value to anyone. That’s why central banks like the U.S. Federal Reserve, Bank of Canada, and Bank of England are tasked with limiting their currency’s supply, without strangling its demand. For Bitcoin, supply is limited to a maximum of 21 million coins. While cryptocurrency proponents offer explanations for how supply and demand will be managed, some systems will undoubtedly be more effective than others at sustaining this delicate balance, especially when exuberance- or panic-driven runs might outpace reason.
  • Maintaining Spending Power: Neither fiat currency nor cryptocurrency are still directly connected to the value of an underlying commodity like gold or silver. Thus, both must have another way to maintain their value, or spending power, relative to inflation. In most countries, the nation’s central bank is in charge of keeping its fiat currency’s spending power relatively stable; only the government can add or subtract from its “money” supply. For cryptocurrency, there is no central bank, or any other centralized regulator. Stability is instead backed by its underlying blockchain.

What’s a Blockchain?

Using bitcoin to illustrate, a block is essentially a bitcoin transaction waiting to be settled. Think of it as being like a written, but uncashed cheque; it’s not real money until the transaction is verified and added to a permanent ledger.

Except there is no bank to complete the transaction. Instead, bitcoin “miners” compete against one another for the role. Each block is secured with a complex mathematical equation. The first miner to solve the equation gets to add the new block to a blockchain. The winning miner is then rewarded handsomely for their effort. They are paid with bitcoin, which, at current, is valued at tens of thousands of dollars for settling a single block. [Source]

Blockchains create a strong, yet globally decentralized check-and-balance system. The competition among thousands of miners keeps everyone relatively honest. According to the CFA Institute’s Cryptoassets Guide, at current, approx. 40,000 computers are independently verifying every single bitcoin transaction.

Next Up: Spending Cryptocurrency

We’ve now provided a general introduction to cryptocurrency. In our next piece, we’ll cover some of the ways people are using it, along with some of the challenges involved in doing so. In the meantime, don’t hesitate to be in touch if we can answer additional questions.

[1] You may notice, we sometimes capitalize Bitcoin as a proper noun, and we sometimes leave it as lower case. General practice is to capitalize the entity, “Bitcoin,” but to use lower case for the coins themselves. Think of it like the difference between “the U.S. Dollar,” vs. “a dollar bill.”

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