Are you curious about cryptocurrencies?
There has been an enormous amount of hype about how cryptocurrencies are the “next big thing” in the digital revolution and how they have the potential to transform not only traditional financial services, but other industries as well.
Several high-profile celebrities have endorsed both cryptocurrencies and cryptocurrency companies. There are also interesting stories that most of us may have heard, like the one about the crypto millionaire who made a fortune overnight and then lost it just as quickly. Even the president of El Salvador had his crypto moment in the spotlight when he declared that Bitcoin would be legal tender in his country.
But as many new crypto investors have learned, cryptocurrencies are extremely complex and difficult to understand, which can make them especially challenging for potential investors.
As with any investment, we recommend starting with the basics, so we’ve put together an overview of some of the essential crypto concepts to help you get started.
What are cryptocurrencies?
Bitcoin, the first cryptocurrency, was created by Satoshi Nakamoto, which is a pseudonym for the person or team who wrote about the technology in a 2008 white paper. The basic concept is relatively simple: Bitcoin is a form of digital cash that allows secure and seamless peer-to-peer transactions over the Internet.
Cryptocurrencies are not issued by a government and there is no central authority that oversees them. Instead, cryptocurrencies are managed by peer-to-peer computer networks, running on free, open source software.
While Bitcoin is the oldest, largest, and most established cryptocurrency, there are now thousands of others. Some are similar in design and purpose to Bitcoin, while others are based on different technologies or were created with other features in mind. For example, Ethereum is a cryptocurrency that can be used to run applications and create contracts.
The Blockchain Ledger
The blockchain is an essential feature of many cryptocurrencies. It is similar to a bank’s balance sheet or ledger in that it keeps a record of every transaction on the chain. However, unlike a bank ledger, the blockchain is distributed throughout the computer network.
The mining process
Most cryptocurrencies are mined through a decentralized network of computers. With Bitcoin and many other cryptocurrencies, miners work collectively to verify and record new transactions and create new units of cryptocurrency by solving complex mathematical equations using specialized computers known as mining rigs.
Determine consensus and secure the blockchain
Because cryptocurrencies operate without a central authority to process transactions, they must ensure that the same unit of cryptocurrency cannot be spent twice. They do this with a system called a consensus mechanism, which allows all the computers on the network to agree on which transactions to include in the blockchain.
Proof-of-work and proof-of-stake are the two main consensus mechanisms that cryptocurrencies use to verify new transactions, add them to the blockchain, and create new tokens.
Proof-of-work is the protocol used by Bitcoin and has been shown to maintain a secure and decentralized blockchain. With Proof of Work, miners compete to solve complex math puzzles. The winner can update the blockchain and is rewarded with cryptocurrencies. However, proof of work requires a significant amount of power and can be difficult to scale.
proof of stake
Proof-of-stake is typically based on a network of validators who contribute or stake their own cryptocurrency in exchange for the opportunity to validate new transactions and earn a reward in a process similar to proof-of-work. However, because proof-of-stake blockchains do not require miners to perform duplicate, energy-intensive processes (competing to solve the same puzzle), the networks require substantially less energy to operate.
Where do cryptocurrencies get their value?
The economic value of cryptocurrency is based on supply and demand. Supply refers to the quantity available. In the case of Bitcoin, there is a finite supply: there will never be more than 21 million Bitcoin available. Rather, demand is about how much people want cryptocurrency and how much they are willing to pay for it. The value of a cryptocurrency is determined by a balance of these two factors.
There are many risks associated with cryptocurrencies, especially for investors. Historically, cryptocurrency prices have been volatile, and wild price fluctuations can lead to significant losses and stress.
Cryptocurrency transactions cannot be reversed, unlike bank transactions. This means that if you make a mistake and enter the wrong amount or address, you could risk losing your cryptocurrency and you may not be able to get it back again.
It is also important to note that cryptocurrencies are relatively new and there are many nuances that are not yet widely understood. Issuance and trading are not well regulated, which means more oversight and regulation is likely in the future.
Should you invest in cryptocurrencies?
Bitcoin and other cryptocurrencies are speculative investments and do not fit traditional asset allocation models. They are not a commodity (like gold), nor are they a traditional fiat currency, backed by a government. Additionally, cryptocurrencies are difficult to value as most traditional valuation metrics do not apply.
Although some traders have had success taking advantage of changes in the prices of Bitcoin or other cryptocurrencies, we believe that most investors should treat cryptocurrencies as a speculative asset class to trade outside of a traditional long-term portfolio.
CIBC Private Estate wealth your way The podcast series is an educational offering on a variety of topics designed with our customers and future generations in mind. You can listen to our conversation about cryptocurrencies with Dave Donabedian here.