Learn what you need to know before you invest in a virtual currency
What Is Cryptocurrency?
A cryptocurrency is a digital or virtual currency secured by cryptography, making it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers.
- A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.
Understanding Cryptocurrencies
Cryptocurrencies are digital or virtual currencies underpinned by cryptographic systems. They enable secure online payments without the use of third-party intermediaries. “Crypto” refers to encryption algorithms and cryptographic techniques that safeguard these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions.
Cryptocurrencies can be mined or purchased from cryptocurrency exchanges. Not all e-commerce sites allow purchases using cryptocurrencies. Cryptocurrencies, even popular ones like Bitcoin, are hardly used for retail transactions. However, the skyrocketing value of cryptocurrencies has made them popular as trading instruments. To a limited extent, they are also used for cross-border transfers.
Blockchain
Blockchain technology is central to the appeal and functionality of Bitcoin and other cryptocurrencies. As its name indicates, a blockchain is essentially a set of connected blocks or an online ledger. Each block contains a set of transactions that each network member has independently verified.
Every new block generated must be verified by each node before being confirmed, making it almost impossible to forge transaction histories. The contents of the online ledger must be agreed upon by the entire network of an individual node or computer maintaining a copy of the ledger.
Experts say blockchain technology can serve multiple industries, such as supply chains, online voting, and crowdfunding. Financial institutions like JPMorgan Chase & Co. (JPM) are testing blockchain technology to lower transaction costs by streamlining payment processing.
Types of Cryptocurrency
Bitcoin is the most popular and valuable cryptocurrency. An anonymous person called Satoshi Nakamoto invented and introduced it to the world via a white paper in 2008. There are thousands of cryptocurrencies present in the market today.
Each cryptocurrency claims to have a different function and specification—for example, Ethereum’s ether markets itself as gas for the underlying innovative contract platform. Banks use Ripple’s XRP to facilitate transfers between different geographies.
Bitcoin, made available to the public in 2009, remains the most widely traded and covered cryptocurrency. As of May 2022, there were over 19 million bitcoins in circulation, with a total market cap of around $576 billion. Only 21 million bitcoins will ever exist.
In the wake of Bitcoin’s success, many other cryptocurrencies, known as “altcoins,” have been launched. Some are clones or forks of Bitcoin, while others are new currencies built from scratch. They include Solana, Litecoin, Ethereum, Cardano, and EOS. By November 2021, the aggregate value of all the cryptocurrencies had reached over $2.1 trillion—Bitcoin represented approximately 41% of that total value.
Are Cryptocurrencies Legal?
Fiat currencies derive their authority from the government or monetary authorities. For example, each dollar bill is backstopped by the Federal Reserve.
However, cryptocurrencies are not backed by any public or private entities. Therefore, making a case for their legal status in different financial jurisdictions worldwide has not been easy. It doesn’t help matters that cryptocurrencies have primarily functioned outside most existing economic infrastructure. The legal status of cryptocurrencies has implications for their use in daily transactions and trading. In June 2019, the Financial Action Task Force (FATF) recommended that wire transfers of cryptocurrencies should be subject to the requirements of its Travel Rule, which requires AML compliance.
As of May 2022, El Salvador and the Central African Republic were the only countries to accept Bitcoin as legal tender for monetary transactions. In the rest of the world, cryptocurrency regulation varies by jurisdiction.
Japan’s Payment Services Act defines Bitcoin as legal property. Cryptocurrency exchanges operating in the country are subject to collect information about the customer and details relating to the wire transfer. China has banned cryptocurrency exchanges and mining within its borders. India was reported to be formulating a framework for cryptocurrencies in December.
Cryptocurrencies are legal in the European Union. Derivatives and other products that use cryptocurrencies must qualify as “financial instruments.” In June 2021, the European Commission released the Markets in Crypto-Assets (MiCA) regulation that sets safeguards for regulation and establishes rules for companies or vendors providing financial services using cryptocurrencies.
Within the United States, the biggest and most sophisticated financial market in the world, crypto derivatives such as Bitcoin futures are available on the Chicago Mercantile Exchange. In the past, the Securities and Exchange Commission (SEC) took the stance that Bitcoin and Ethereum were not securities; however, in September 2022, SEC Chair Gary Gensler stated he believes cryptocurrencies are securities. This stance implies that cryptocurrency’s legal status may become subject to regulation.
Important:
- Although cryptocurrencies are considered money, the Internal Revenue Service (IRS) treats them as financial assets or property. And, as with most other investments, if you reap capital gains in selling or trading cryptocurrencies, the government wants a piece of the profits. On May 20, 2021, the U.S. Department of the Treasury proposed requiring taxpayers to report any cryptocurrency transaction of and above $10,000 to the IRS. How exactly the IRS would tax proceeds—as capital gains or ordinary income—depends on how long the taxpayer held the cryptocurrency.
Are Cryptocurrencies Safe Investments?
Cryptocurrencies have attracted a reputation as unstable investments due to high investor losses due to scams, hacks, and bugs. Although the underlying cryptography is generally secure, the technical complexity of using and storing crypto assets can be a significant hazard to new users.
In addition to the market risks associated with speculative assets, cryptocurrency investors should be aware of the following risks:
- User risk: Unlike traditional finance, there is no way to reverse or cancel a cryptocurrency transaction after it has already been sent. By some estimates, about a fifth of all bitcoins is now inaccessible due to lost passwords or incorrect sending addresses.
- Regulatory risks: The regulatory status of some cryptocurrencies is still unclear, with many governments seeking to regulate them as securities, currencies, or both. A sudden regulatory crackdown could make it challenging to sell cryptocurrencies or cause a market-wide price drop.
- Counterparty risks: Many investors and merchants rely on exchanges or other custodians to store their cryptocurrency. Theft or loss by one of these third parties could result in losing one’s entire investment.
- Management risks: Due to the lack of coherent regulations, there are few protections against deceptive or unethical management practices. Many investors have lost large sums to management teams that failed to deliver a product.
- Programming risks: Many investment and lending platforms use automated smart contracts to control the movement of user deposits. An investor using one of these platforms assumes the chance that a bug or exploit in these programs could cause them to lose their investment.
- Market Manipulation: Market manipulation remains a substantial problem in cryptocurrency, and some exchanges have been accused of manipulating prices or trading against their customers.
Despite these risks, cryptocurrencies have seen a significant price leap, with the total market capitalization rising to over $1 trillion. Despite the asset’s speculative nature, some have created substantial fortunes by taking on the risk of investing in early-stage cryptocurrencies.
Advantages and Disadvantages of Cryptocurrency
Cryptocurrencies were introduced with the intent to revolutionize financial infrastructure. As with every revolution, however, there are tradeoffs involved. At the current stage of development for cryptocurrencies, there are many differences between the theoretical ideal of a decentralized system with cryptocurrencies and its practical implementation.
Some advantages and disadvantages of cryptocurrencies are as follows.
Advantages
- Cryptocurrencies represent a new, decentralized paradigm for money. In this system, centralized intermediaries, such as banks and monetary institutions, are not necessary to enforce trust and police transactions between two parties. Thus, a system with cryptocurrencies eliminates the possibility of a single point of failure, such as a large bank, setting off a cascade of global crises, such as the one triggered in 2008 by the negligence of institutions in the United States.
- Cryptocurrencies promise to make transferring funds directly between two parties easier without needing a trusted third party like a bank or a credit card company. The use of public keys and private keys and different forms of incentive systems, such as proof of work or proof of stake, secures such decentralized transfers.
- Because they do not use third-party intermediaries, cryptocurrency transfers between two transacting parties are faster than standard money transfers. Flash loans in decentralized finance are an excellent example of such decentralized transfers. These loans, processed without backing collateral, can be executed within seconds and used in trading.
- Cryptocurrency investments can generate profits. Cryptocurrency markets have skyrocketed in value over the past decade, reaching almost $2 trillion. As of May 2022, Bitcoin was valued at over $550 billion in crypto markets.
- The remittance economy is testing one of cryptocurrency’s most prominent use cases. Cryptocurrencies such as Bitcoin are intermediate currencies that streamline money transfers across borders. Thus, a fiat currency is converted to Bitcoin (or another cryptocurrency), transferred across borders, and subsequently converted to the destination fiat currency. This method streamlines the money transfer process and makes it cheaper.
Disadvantages
- Though they claim to be an anonymous form of transaction, cryptocurrencies are pseudonymous. They leave a digital trail that agencies like the Federal Bureau of Investigation (FBI) can decipher. This opens up possibilities for governments or federal authorities to track the financial transactions of ordinary citizens.
- Cryptocurrencies have become a popular tool with criminals for nefarious activities such as money laundering and illicit purchases. The case of Dread Pirate Roberts, who ran a marketplace to sell drugs on the dark web, is already well known. Cryptocurrencies have also become a favorite of hackers using them for ransomware.
- In theory, cryptocurrencies are meant to be decentralized, their wealth distributed between many parties on a blockchain. In reality, ownership is highly concentrated. For example, an MIT study found that just 11,000 investors held roughly 45% of Bitcoin’s surging value.
- One of the conceits of cryptocurrencies is that anyone can mine them using a computer with an Internet connection. However, mining popular cryptocurrencies require considerable energy, sometimes as much energy as entire countries consume. The expensive energy costs and the unpredictability of mining have concentrated mining among large firms whose revenues run into billions of dollars. According to an MIT study, 10% of miners account for 90% of their mining capacity.
- Though cryptocurrency blockchains are highly secure, other crypto repositories, such as exchanges and wallets, can be hacked. Many cryptocurrency exchanges and wallets have been hacked over the years, sometimes resulting in millions of dollars worth of “coins” stolen.
- Cryptocurrencies traded in public markets suffer from price volatility. Bitcoin has experienced rapid surges and crashes in value, climbing to as high as $17,738 in December 2017 before dropping to $7,575 in the following months.3 Some economists thus consider cryptocurrencies to be a short-lived fad or speculative bubble.
How Do You Buy Cryptocurrencies?
Any investor can purchase cryptocurrency from popular crypto exchanges such as Coinbase, apps such as Cash App, or through brokers. Another popular way to invest in cryptocurrencies is through financial derivatives, such as CME’s Bitcoin futures, or other instruments, such as Bitcoin trusts and ETFs.
What Is the Point of Cryptocurrency?
Cryptocurrencies are a new paradigm for money. They promise to streamline existing financial architecture to make it faster and cheaper. Their technology and architecture decentralize existing monetary systems and make it possible for transacting parties to exchange value and money independently of intermediary institutions such as banks.
Can You Generate Cryptocurrency?
Cryptocurrencies are generated by mining. For example, Bitcoin is generated using Bitcoin mining. The process involves downloading software containing a partial or complete history of transactions in its network. Though anyone with a computer and an Internet connection can mine cryptocurrency, the energy- and resource-intensive nature of mining means that large firms dominate the industry.
What Are the Most Popular Cryptocurrencies?
Bitcoin is the most popular cryptocurrency, followed by other cryptocurrencies such as Ethereum, Binance Coin, Solana, and Cardano.
Are Cryptocurrencies Securities?
In the past, the SEC has said that Bitcoin and Ethereum, the top two cryptocurrencies by market cap, were not securities. In September 2022, SEC Chair Gary Gensler stated he believes cryptocurrencies are securities and has asked SEC staff to begin working with crypto developers to register their crypto. However, he also clarified that he did not speak on behalf of the SEC; he was only speaking for himself. He encouraged those in the crypto space to register their crypto in the spirit of getting ahead because “It’s far less costly to do so from the outset.”
The Bottom Line
Cryptocurrencies are digital assets that are secured by cryptography. As a relatively new technology, they are highly speculative, and it is essential to understand the risks involved before investing.
Investing in cryptocurrencies and other initial coin offerings (“ICOs”) is highly risky and speculative. This article is not a recommendation by ZPEnterprises or the writer to invest in cryptocurrencies or other ICOs. Because of each individual’s unique situation, a qualified professional should always be consulted before making financial decisions. ZPEnterprises makes no representations or warranties regarding the information’s accuracy or timeliness.
