Part 1: Understanding Cryptocurrency
It’s hard to scan the financial headlines these days and not spot at least one call to action related to Bitcoin’s latest moves. Has all the attention given you cryptocurrency fever, or are you just wondering what it’s all about? 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:
- Understanding cryptocurrency
- Spending cryptocurrency
- Trading in cryptocurrency
Our quick take? Cryptocurrency is an interesting development with a number of promising possibilities. Human ingenuity is always a marvel to behold. But like any relatively new, highly volatile pursuit, it entails considerable risk.
If you would like to try earning and spending cryptocurrency, be sure you’re familiar with the nature of the beast. If you are 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 a pseudonymous Satoshi Nakamoto. 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” with “currency,” and you’ve got cryptocurrency.
Bitcoin became the first cryptocurrency, and is still the most familiar kind. 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. You can’t flip it, heads or tails. But increasingly, holders are spending cryptocurrency in ways that emulate “regular” money (although limitations remain) – and potentially even adding to its uses. There is 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, in the face of 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 supply of legal tender. For cryptocurrency, there is no central bank, or any other centralized repository or 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 check; 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 can currently be valued at tens of thousands of dollars for settling a single block. [Source]
The CFA Institute’s Cryptoassets Guide describes cryptocurrency security as follows:
“This is the real breakthrough of blockchains: creating timely, bad-actor-proof consensus across all copies of a decentralized and distributed database. … Today, more than 40,000 computers are independently verifying every single bitcoin transaction.”
In other words, blockchains create a strong, yet globally decentralized check-and-balance system. The competition among thousands of miners keeps everyone relatively honest, as any attempted “cheating” by cryptocurrency holders or miners should be promptly detected.
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.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.