Cryptocurrency: Here’s what you should know
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What is cryptocurrency?
Cryptocurrency is a decentralized digital currency that uses blockchain technology to verify transactions. These transactions are considered extra secure due to the nature of the blockchain database and how it stores data. When you make a payment using cryptocurrency, transactions are verified by miners, which act as crypto-auditors to confirm the legitimacy of these transactions and help to prevent fraud. Miners are compensated for their work with cryptocurrency.
Once the transaction has been verified by the involved parties, the balance is stored within a cryptocurrency network.
Bitcoin, probably the most well-known cryptocurrency, was the first to employ blockchain mining as a means of digital transaction security. It was created as “a peer-to-peer electronic cash system,” and once it took off in 2009, it paved the way for the thousands of cryptocurrencies in use today. As with many other cryptocurrencies, though, only a limited supply of bitcoins were created — currently, about 18.5 million out of Bitcoin’s supply of 21 million have been unlocked by miners, leaving less than three million to be brought into circulation.
It’s possible that Bitcoin may enact changes once the supply is exhausted, but the idea behind Bitcoin makes it difficult to simply just increase its supply. As a result, many refer to it as “digital gold.”
Just like cash, cryptocurrency must be stored in a wallet to be managed and maintained securely. Many cryptocurrency wallets exist, and there are different types based on their classification and level of security.
Also similar to cash, cryptocurrencies can be used as a form of payment in a business transaction, such as buying something at a store. However, not all businesses accept cryptocurrency as a form of payment. Even within the United States, each state has a different history with regards to its legislation on cryptocurrency.
Perhaps one of the most significant innovations resulting from crypto and blockchain technology are smart contracts. Smart contracts are essentially encrypted, standardized contracts that can be made legally-binding. Coindesk explains the difference between the term “smart contract” being used to refer to the identity or the application of a specific blockchain technology. The latter use of the word is more appropriately used to describe smart legal contracts, which is what we discuss below.
A typical legally-binding contract is put into effect when two or more parties agree on the conditional or actionable circumstances outlined in the contract. What makes a smart contract different from a traditional contract is how it’s enforced. Rather than being subject to the interpretation of a court, a smart contract is enforced and verified by blockchain technology. This, in turn, minimizes the transaction costs associated with asset transfers and business transactions involving cryptocurrency because human intermediaries are no longer needed to be involved and, therefore, compensated for any execution and litigation of the contract.
“It’ll be very difficult for a human-run company to compete with the longevity, the low cost, the efficiency of a smart contract….[businesses] can take care of workers and stakeholders, not just shareholders. We would make the rules to say that.” — Phil Ratcliff
Investing with Crypto
The most critical point to note is that the market values of cryptocurrencies are highly volatile. This is due to many factors related to its lack of regulation and intrinsic value in addition to media influences and the constantly-developing technology behind it. Different geographic regions within and outside of the United States have differing laws and regulations about cryptocurrency that also lead to it being a high-risk investment.
Despite super-security measures protecting crypto transactions, it is not impossible for one of these exchanges to get hacked. Additionally, because of the largely deregulated nature of crypto exchanges, there has been increasing pressure from the US government to create laws against the use of cryptocurrencies due to the risk of money laundering and market manipulation, among others. With the absence of regulation in this market, institutional investors are discouraged from entering and therefore providing additional stability.
As a market that is mostly driven by speculation, the media plays a significant role in its performance. Even significant public figures and business executives have differing opinions on the true value of cryptocurrencies, such as Bitcoin and Dogecoin. Investors are quick to follow their behaviors once they hit the media which can and typically does, in turn, result in undesired effects in the long-term due to basic laws of supply and demand.
Asset bubbles result when the price of an asset, such as gold or stocks, significantly rises in price against its true value. These price spikes may be caused by a number of factors; low-interest rates, demand-pull inflation, and asset shortages are among the top drivers, according to The Balance. The bursting of a bubble is commonly an implication for an economic depression.
Knowing how to protect yourself from an asset bubble is closely tied to understanding the risks associated with cryptocurrency investments, but the two are not directly correlated. Risky crypto investments made by many investors at once may be only one of the causes of an asset bubble, but it can be significant.
It is always suggested that you do your own research, especially on topics that are financial in nature. The sources provided in this article may not be sufficient for your needs or interest in the topic of cryptocurrency, but there are plenty of sources out there. rebel Financial’s YouTube channel is an additional resource that features discussions from our Certified Financial Planners on financial subjects such as cryptocurrency and asset bubbles.