In 2009, the world of finance was transformed by the introduction of Bitcoin and its blockchain technology. Investors and market speculators are rallying behind the new age of cryptocurrency that bypasses traditional governments and banks. According to CoinMarketCap.com, there is close to a thousand different cryptocurrencies in the world. Notable ones include Ethereum, Litecoin, Ripple, Dogecoin and Monero. However, before we delve into the world of cryptocurrency, we need to take a look at Bitcoin, the currency that started it all.
- Bitcoin is only one among hundreds of other cryptocurrencies
- Cryptocurrencies employ blockchain technology that is highly secure
- Bitcoin and other cryptocurrency prices are very volatile
- Cryptocurrency is still a nascent market that has yet to stabilise
What is Bitcoin?
Bitcoin is the first successful decentralised digital currency. Created by the mysterious Satoshi Nakamoto, who some speculate may even be a group of individuals, Bitcoin does not take on any physical form. Despite being a completely intangible asset, Bitcoin has gained widespread popularity. As of 13 July 2017, 1 Bitcoin equates to approximately US$ 2,371.50.
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Besides its rapid increase in value, more merchants are accepting Bitcoin in exchange for goods and services. Online retailers, gaming platforms, and even food vendors like Subway and Whole Foods accept Bitcoin as payment.
Since financial institutions play no part in the movement of Bitcoin, transactions are recorded on a public ledger on the cloud – visible to anyone at any time. In order to add a new line to the public ledger, your transaction must be time-stamped and put through a series of algorithms. Multiple transactions are then encrypted, verified by a third-party who solves a complex mathematical problem, and eventually adding a ‘block’ of transactions to the ledger. This ‘block’ serves as a record of the movement of Bitcoin, and is chained to the previous block of transactions. This brings us to the technology that powers the use of Bitcoin – blockchain.
What is Blockchain?
Blockchain is a powerful technology that encrypts Bitcoin transactions algorithmically, and is regulated by all users, globally. The technology allows buyers to transact directly with sellers without the need for a financial institution to verify the transaction. You can read about the implications of blockchain technology in the finance industry and the possible challenges here.
The algorithms used to encrypt the transactions differ from currency to currency. Bitcoin introduced one of the first hashing functions in their encryption algorithms, SHA-256. Subsequently, a newer cryptocurrency, Litecoin, introduced ‘scrypt’, which is fast becoming the preferred hashing function.
How is the Price Determined?
Like all assets, the price of Bitcoin and other cryptocurrencies are subject to market demand and supply. So, what exactly is the current supply of Bitcoin? According to the parameters set up by the founder, Satoshi Nakamoto, there will be a cap of 21 million bitcoins. From an initial batch of 50 Bitcoins released on 3 January 2009, there are approximately 16.4 million Bitcoins in circulation as of 12 July 2017.
New Bitcoins are created every time a new block is added to the blockchain. As mentioned earlier, ‘blocks’ are heavily encrypted and need to be ‘solved’ before they can be added to the ledger. People who ‘solve’ these blocks are called miners, and they are rewarded with newly generated Bitcoins. The first miners received 50 Bitcoins for every block solved. After every 210,000 blocks, or approximately 4 years, the reward gets halved. The current reward now stands at 12.5 Bitcoins per block.
Bitcoin and other cryptocurrencies are notoriously volatile. The volatility can be pinned to the varying levels of demand for cryptocurrencies. The fluctuations can be caused by a wide number of factors.
Any form of bad press can greatly reduce the value price of a cryptocurrency. Most recently, the founder of the cryptocurrency network, Ethereum, was falsely reported to have passed away. In 2013, the FBI uncovered the rampant use of Bitcoin for drug trade over the darkweb marketplace, Silk Road, which was subsequently shut down. These negative headlines adversely affected the prices of the cryptocurrencies involved.
Other factors that can greatly affect the price of a cryptocurrency include:
- People holding large amounts of the currency who decide to liquidate it
- The large variance in the perceived value of the currency, coupled with low transaction volumes
- The exchange of cryptocurrency with fiat currencies that are experiencing high inflation rates (Argentinian Pesos for example)
- New government regulations in regard to a cryptocurrency
What are the Risks?
Based on the high volatility, the clear and evident risk of investing in cryptocurrency is the unpredictability of the markets. A disastrous headline about the cryptocurrency that you’re holding could result in a huge crash in its value. Your government could impose a nationwide ban on the use of Bitcoin, which would render your Bitcoin wallet completely useless. Theoretically, all cryptocurrencies could be virtually worthless if investors suddenly decide to lose all interest in it.
Besides the volatility, security is also another issue for cryptocurrencies. While blockchain technology protects users against fraud, it does not protect them against theft. Bitcoins and other cryptocurrencies do not belong to any specific user. Instead, they belong to whoever holds the currency’s encryption key. If someone should gain access to your encryption key, they can transfer your digital money to their own account easily. Also, once the transfer is made, it cannot be recovered thanks to the irreversible nature of blockchain.
Like any other form of alternative investment, make sure that you have a diversified portfolio. Don’t put all your money into one single currency, and keep the majority of your funds invested in tangible investments. Cryptocurrency is still in its early stages, and while you can make huge gains, you are open to making huge losses as well.