Understanding Cryptocurrency

In finance and economics, for something to be considered money, it must fulfill three essential functions:

• Be a means of storing wealth.
• Be a medium of exchange.
• Be a unit against which to value other goods.

Basically, money has value because of collective agreement. As many aspects of our world become digital (photo albums, magazines, friends), money is following suit, with cryptocurrency often viewed as the next evolutionary step.

What is Cryptocurrency?

A cryptocurrency is a digital medium of exchange, similar to government-issued currencies, but not issued by a government. Just as anyone can create a website, anyone can create their own cryptocurrency.

The term cryptocurrency itself refers to a digital currency in which encryption is used to regulate the generation of new units and verify the transfer of funds. The most well-known example is Bitcoin, which its anonymous inventor, Satoshi Nakamoto (who created it in 2009), called a "peer-to-peer electronic cash system."

How Does Cryptocurrency Work? The Role of Decentralization

Since no central bank or government issues or controls a cryptocurrency, transaction verification relies on a decentralized, peer-to-peer (P2P) network.

Traditional internet traffic often relies on a central server from which users download data. In a P2P protocol, users (often called "peers") transfer data directly between one another, like a swarm, eliminating the need for a central authority. A reward system incentivizes clients to contribute to and maintain the network.

The Blockchain Mechanism

To realize a digital currency, a payment network needs accounts, balances, and transactions. A major challenge for any payment network is preventing double-spending—where the same amount is spent twice. Usually, a trusted third party (like a bank) solves this by keeping a centralized record. In a decentralized network, every peer must participate in this verification.

A blockchain is the core mechanism that enables this. It is a public ledger of all transactions (blocks), and every peer in the network possesses a copy of this sequential ledger.

• A transaction (e.g., "Avermis gives 100 Bitcoin to Mario") is created, signed by the sender's private cryptographic key, and broadcast to the network.
• For a transaction to be successful, it must be verified and added to the sequential blockchain as a new block.

Proof of Work (Mining)

Bitcoin uses a Proof of Work (PoW) scheme, commonly known as mining. Miners are peers who compete to maintain the network and verify transactions. Principally, anyone with a computer and an internet connection can be a miner.

Miners perform the following tasks:

1. Collect new transaction data (which is known almost immediately by the whole network).
2. Verify collected transactions against the existing blockchain (the existing ledger).
3. Solve a complex cryptographic puzzle that allows them to add a block of recent transactions to the sequential blockchain.

For successfully performing this job, miners are rewarded with a token of the cryptocurrency (e.g., Bitcoins). Once a transaction is confirmed and added to the blockchain, it is permanent and cannot be reversed or forged.

Advantages of Cryptocurrencies

Cryptocurrencies offer several benefits over traditional financial systems:

• Permanent: All transactions are permanent after confirmation and cannot be reversed by any third party (bank, government, or miner).
• Anonymous: Neither transactions nor accounts are necessarily connected to real-world people or companies.
• Fast and Global: Transactions are executed within minutes, regardless of the geographical location of the parties, unlike international bank wires which can take days.
• Secure: Funds are protected by a public key cryptography system, making them highly resistant to theft.
• Permissible: Using cryptocurrency only requires software that everyone can download for free; no permission is needed.

Supply Control and Value

Most cryptocurrencies, including Bitcoin, have a limited supply. For example, Bitcoin's supply is capped at 21 million coins, a final number expected around 2140. This scarcity is controlled by a pre-written schedule in the code. Because the future supply is predictable, cryptocurrencies are often viewed as "hard money," similar to gold coins, rather than modern currencies that represent debt.

Cryptocurrency Investment and Trading

Today, there are close to 1,000 different types of cryptocurrencies. While Bitcoin remains the largest by market capitalization, alternatives like Litecoin and Ethereum may offer benefits such as faster confirmation times.

Investors seek returns in cryptocurrency markets in several ways:

• Investing in new currencies (high risk, high reward potential).
• Trading in mature cryptocurrencies like Bitcoin (more gradual, natural growth).

Ways to Invest

1. Mining:

   The original method of acquiring Bitcoin involved mining. Rewards decrease over time (halving approximately every four years). Due to the increasing computational difficulty, specialized knowledge and expensive hardware/electricity bills are now required, making it difficult for the average person to participate effectively.

2. Buying Through an Exchange:

   A cryptocurrency exchange operates like a stock exchange, allowing users to buy digital assets using a cryptocurrency wallet (which stores encrypted passwords representing the coins).

   Drawbacks of Exchange Trading:
   • Funds are held in the exchange's account, not individual accounts. While Bitcoin is secure, exchanges are frequent targets for hackers and malware.
   • If login details are lost or if a scam occurs, there is no third-party or regulatory body to appeal to.
   • The process is often considered difficult or cumbersome for first-time buyers.
3. Trading CFDs (Contracts for Difference) with a Regulated Broker:

   Trading CFDs simplifies the process and mitigates risks associated with exchanges:

   • No need for complicated cryptocurrency wallets.
   • Passwords can be reset.
   • Trades are conducted with a regulated broker.
   • Allows for leveraging (increases risk but benefits skilled traders).
   • Allows traders to take both "long" (betting on a rise) and "short" (betting on a fall) positions.
   • Allows purchasing fractions of a coin.
   • Generally faster and lower cost than physical trading on an exchange or mining.

Factors Affecting Cryptocurrency Price and Risk

Like any asset, cryptocurrency prices are determined by supply and demand. Bitcoin’s limited supply (21 million coins) coupled with increasing demand contributes to its price appreciation.

However, several factors create volatility and risk:

• Increased Supply: The creation of new cryptocurrencies indirectly increases the overall supply of alternatives, potentially drawing demand away from established coins like Bitcoin.
• Technological Obsolescence: New technology could potentially make existing cryptocurrencies obsolete.
• Regulatory Uncertainty: Government regulation is the biggest unknown. Actions such as Japan endorsing Bitcoin as legal tender (2017) push prices up, while restrictions, such as the 2017 China ban, push prices down.
• Illegal Activities: Cryptocurrencies are sometimes used for illicit purposes (e.g., black market transactions, money laundering), making compliance with Anti-Money Laundering (AML) and Counter-Terrorist Financing (CTF) regulations difficult for companies.