At the height of the cryptocurrency wave in 2021, investors couldn’t get enough of the trendy investment and the adjacent blockchain technologies, with many jumping in before they could even answer the question “What is cryptocurrency?”.
The leader was – and still is – Bitcoin, the world’s largest cryptocurrency. It hit an all-time high near $68,000 in November 2021. Over the next year, it shed 75% of its value as investors lost confidence in high-risk assets due to the Federal Reserve’s use of rising interest rates to slow inflation.
All cryptocurrencies, including Bitcoin, were hit especially hard by the changing investment climate.
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Nearly a year later, some sanity has returned to the digital currency market, which makes it an excellent time for Kiplinger to provide a primer for investors unfamiliar with cryptocurrency and the industry behind it.
What is cryptocurrency and how does it work?
Vanguard is one of the most prominent asset managers in the world. Its website’s “How to Invest” section provides a good definition of cryptocurrency.
“A cryptocurrency is a digital asset stored on blockchain technology that serves as a type of currency or store of value. Unlike traditional currencies, cryptocurrencies aren’t backed by major governments or developed economies,” states the Vanguard website.
There’s that word “blockchain” again. What does blockchain technology have to do with cryptocurrencies?
Blockchain technology enables cryptocurrencies like Bitcoin to view and verify transactions between two parties through a decentralized network of users known as nodes. These nodes validate and record these transactions rather than through a single authority or middleman.
The Bitcoin blockchain, for example, contains every Bitcoin transaction that’s ever taken place, divided into blocks. When stacked on each other, these blocks create a chain of blocks, or a blockchain.
“Finding and publishing new blocks is what Bitcoin miners do to earn bitcoins,” states a Coinbase help page explaining the Bitcoin blockchain. “Whenever a new block is broadcast, approximately every 10 minutes, a quantity of bitcoins is received by the miner who solved that block. Bitcoin miners keep the network secure, and this is how they are rewarded. This system ensures that all transactions are valid, and keeps the bitcoin network secure from fraud.”
Why own cryptocurrency?
Investors have been asking themselves “Why own cryptocurrency?” ever since Bitcoin was created in 2009.
Proponents of the digital asset argue that decentralized finance takes the power of money creation away from central banks and bankers, democratizing the global financial system.
Cryptocurrencies are especially effective for transferring funds across borders quickly and efficiently to people living in countries with volatile currencies or significant cross-border restrictions, etc.
The other reason to own cryptocurrencies such as Bitcoin is as an investment. There is a school of thought that cryptos provide a hedge against inflation.
To be such a beast, they must provide a store of value into the future, meaning they are worth the same or more with time. Further, they must be exchangeable for things like gold, U.S. dollars, etc. Lastly, they must have limited supply increases over time.
Bitcoin, for example, has a capped limit of 21 million. There are currently around 20 million Bitcoins. Every 10 minutes, approximately 6.25 bitcoins are mined and put into circulation. The limit is not expected to be reached until 2140.
This scarcity may make Bitcoin more expensive as the limit draws closer, but that’s purely hypothetical.
Advantages of cryptocurrency
Three of the most significant advantages of cryptocurrency are accessibility, faster transactions and transparency.
Cryptocurrency markets operate 24 hours a day, seven days a week. Whether you’re in your living room at three in the morning in the U.S. or traveling overseas, you can buy and sell digital assets without any concern your crypto exchange will be closed. It’s always open.
The benefits of this accessibility to crypto beginners are debatable. However, cryptocurrencies have always been about democratizing finance. Anyone, anywhere, at any time can make a trade. That’s what makes it appealing to investors.
Market participants have always been interested in faster and, where humanly possible, cheaper transactions. In the case of cryptocurrencies, faster transaction speeds are critical because they influence the overall adoption of cryptocurrencies.
“For example, if it takes 10 minutes for a Bitcoin transaction to be confirmed, it may not be practical for buying a cup of coffee,” wrote The Baltic Times in an April 2023 article about cryptocurrency scalability and transaction speeds.
Transparency is a critical benefit of cryptocurrencies too. Their open-source code provides real-time, accurate results for auditors. That’s essential for regulators seizing cryptocurrency used in criminal activities.
“According to the Financial Action Task Force (FATF), seizure rates of illicit funds within the traditional financial system are around 0.1% – meaning regulators have recaptured about one-thousandth of the funds known to have been used for criminal activity. The seizure rate for crypto: 27%, according to [Uniswap Legal Chief Salman] Banaei,” Consensus magazine deputy managing director Daniel Kuhn wrote in April 2023.
Disadvantages of cryptocurrency
As a result of this move to decentralize finance, countries such as the U.S. have looked to regulate cryptocurrencies further. In early June 2023, the U.S. Securities and Exchange Commission (SEC) sued Binance and Coinbase Global (COIN), the world’s two largest cryptocurrency exchanges.
The SEC’s lawsuit against Binance accused the company of knowingly operating an unregistered exchange, as well as offering and selling unregistered securities. The complaint against Binance included 12 cryptocurrencies, such as Solana and Polygon.
The separate SEC lawsuit against Coinbase claims that it, too, operated an unregistered exchange, offering and selling unregistered securities.
“We allege that Coinbase, despite being subject to the securities laws, commingled and unlawfully offered exchange, broker-dealer, and clearinghouse functions,” the SEC said in a statement.
If you are new to cryptocurrency, it is crucial to understand that the industry remains in transition. There remain many regulatory challenges from agencies such as the SEC.
This makes any investment – including in diversified crypto ETFs – potentially volatile and possessing above-average risk.
