With all the buzz about Bitcoin, here’s a primer on what cryptocurrencies are and how they work.
Picture a landfill in the United Kingdom. Now imagine that somewhere among the rusted cars and garbage sits several million dollars. The strange reality is, you don’t have to imagine anything. There really is a few million dollars lost in a landfill in Wales.
In 2013, James Howell, an IT worker living in the United Kingdom, threw away a computer hard drive while cleaning. On that hard drive were roughly 7,500 bitcoins he had mined years prior. He had hoped to hold on to the coins in case they increased in value, but accidentally threw them away with his hard drive.
As of 2018, those coins would be worth more than $50 million.
What is Bitcoin?
Bitcoin is the first cryptocurrency. It was created in 2009 by an anonymous individual or group using the pseudonym Satoshi Nakamoto. (Their true identity remains a mystery.) Bitcoin was developed as a peer-to-peer payment system. Initially, people like James Howell “mined” bitcoins on the internet by completing puzzles. While this is still possible (more on that later), most people prefer to buy or trade Bitcoin on secondary markets.
In 2010, someone traded 10,000 bitcoins for two pizzas, giving the coins their first valuation.
In 2011, alternatives to Bitcoin began to appear. Litecoin and Namecoin were the next cryptocurrencies to make an appearance onto the cryptocurrency scene. These alternative, or “alt,” coins were created from Bitcoin’s original open-source code, but they were edited to offer advantages such as faster and more secure transactions, coins tailored to niche audiences, and other differentiations from bitcoin.
What are Cryptocurrencies?
The main thing that differentiates cryptocurrencies from typical currencies is that they are created and traded without any oversight from a government or central bank. Control of these digital currencies is completely decentralized.
In 2017, Securities and Exchange Commission chairman Jay Clayton compared cryptocurrencies to cash or gold. This analogy can be helpful to understanding them; like cash, you can use cryptocurrencies to buy or sell goods. But unlike cash, their value isn’t assessed relative to other currencies. Instead, cryptocurrency prices are determined by supply and demand, similar to gold.
How Cryptocurrencies Work
Now that you understand how these currencies were started and generally how they function, let’s take a closer look at how they work, starting with Bitcoin. The technology developed by Satoshi Nakamoto and the original Bitcoin enthusiasts is known as blockchain. Blockchain technology tracks and verifies the mining of bitcoins as well as transactions related to the coins.
All the information stored on the blockchain is publicly shared, constantly updated with transactions, and is validated by users. This makes it very difficult to hack.
It’s important to remember that blockchain is a type of technology, rather than an asset or company. A number of companies are trying to use blockchains for different applications. For instance, Ethereum is trying to leverage blockchain technology into smart contracts, which would eliminate the middleman and make the exchange of money, shares or property completely automated.
As these currencies gain in popularity and value, more attention is being paid to how they are mined. Remember, early users didn’t buy or sell bitcoins. Instead, they mined them. Simply put, cryptocurrency mining is the verification of transactions on the blockchain ledger.
As transactions occur, “miners” verify each and every one to ensure they are accurate. These transactions happen constantly, and as they occur, they’re added to a block. Each block is made up of a definite number of transactions and a link to the previous block. Once a specific number of transactions is added to a block, that block is then added to the blockchain. But before it can be added to the blockchain, the miners solve complex math puzzles (with the help of powerful computers) to verify all the transactions and the order they occurred in, and then add the block to the blockchain.
As a reward, the miners receive their fee in that block’s coin, thus increasing the number of coins of that specific cryptocurrency in the world. Note that some coins, like Bitcoin, have a cap on the number of coins that can be issued.
Initial Coin Offerings
In 2016, a number of companies (mostly startups), began using cryptocurrencies as a way to fundraise. Most commonly, a company would create a coin or a token and when people buy or invest in the coin, the company raises money.
Many startups prefer this method of fundraising because they aren’t required to give away any equity in exchange for the funds. Investors, in turn, hope the newly created digital coins increase in value.
Clayton says, “I believe that initial coin offerings — whether they represent offerings of securities or not — can be effective ways for entrepreneurs and others to raise funding, including for innovative projects.”
However, in the same statement, Clayton warns that because the issuers do not think of these coins as securities, these ICOs may be regulated by the SEC. This places more responsibility on the purchasers to ask questions and fully understand what they’re buying.
How to Buy and Trade Cryptocurrencies
You can trade cryptocurrencies via an exchange, such as Coinbase, Bitbuy.ca, and Coinsquare. These websites allow you to buy, sell or exchange cryptocurrencies for conventional currency (like dollars) or other digital currencies.
For example, Coinbase allows you to buy and sell Bitcoin, Bitcoin cash, Ethereum, Ethereum classic, and Litecoin, plus it gives users a digital wallet to store the coins. Once you have an account, you can buy and trade coins similarly to how you might trade stocks. Like with any security transaction, it’s important to evaluate any commissions or fees charged by the exchange.
It’s important to note these exchanges are not regulated in the same way as other security exchanges, and some authorities, including the New York State’s Attorney, have raised questions about the risk posed to consumers who use them.
It’s also important to keep in mind that the number of vendors that accept bitcoins as payment is still limited. While some major websites do accept cryptocurrencies, as of 2018 a number of major retailers did not.
Perhaps because of this, a number of investors prefer to speculate on the price of Bitcoin without actually owning it. They do this via the futures market. Since the Commodities Futures Trading Commission said in late 2017 that it would allow traders to begin buying and selling Bitcoin futures, the cryptocurrency has become one of the most popular trades on the Chicago Board Options Exchange.
Volatility and Price Fluctuations
Bitcoin has experienced large price fluctuations in the past few years. For instance, on Dec. 17, 2016, one bitcoin was worth about $789. Exactly one year later, one bitcoin was worth more than $19,000 — near its peak. Six months later, on May 17, 2018, one bitcoin was worth about $8,059.
As more users and investors became excited about the possibilities inherent in a governmentless currency, supply surged. But since its peak in late 2017, Bitcoin’s value has been declining. Ultimately, no one can predict future values for any cryptocurrency, but understanding how Bitcoin works and its potential uses can help you asses its value. Cryptocurrencies are complex and can be highly volatile, so they may not be the best direct investment. Before making any investments or decisions about cryptocurrency, talk to your financial advisor.
To learn more about investing, risks and all your options, talk to your financial advisor.
