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Introduction to Cryptocurrency

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By now many people are at least vaguely familiar with cryptocurrencies like bitcoin. A conceptual token, exchanged only over the internet, which supposedly holds real value. Bitcoin alone has risen from a value less than a tenth of a penny twelve years ago to a high of over $50,000 in 2021, and there are many other cryptocurrencies out there with similar astronomical rises. Now the world is starting to notice.

I get a ton of questions around cryptocurrency. Most are along the lines of, “How does it work?”, “Is it safe to invest in?”, and more recently, “Is it here to stay?”. I want to give a brief introduction to cryptocurrency including where it stands today and where we think the blockchain technology is going.

How does cryptocurrency work?

Imagine if every trade and purchase in a community had to be etched with a chisel into a large stone in the middle of the town square. Once they are etched in, it never goes away, and when one stone is filled they set another one down. There is also a team of people that work around the clock make sure and chisel the transaction in once they happen.

Bitcoin and other cryptocurrencies run on a technology algorithm called blockchain. The important thing to remember about blockchain is that it’s a long, public ledger that can’t be altered. When a transaction is made, i.e. a cryptocurrency like bitcoin is sent from one user to another, the details are stored in a block, the blocks are then added to the chain along with other transactions, and each transaction is validated by computers in the network. 

The people responsible for chiseling the numbers into the stone? Those are called crypto miners. People with serious computing setups can join online networks and lend computing power to the blockchain’s algorithm to participate in validating these transactions. As a reward for the computing power (and significant energy bill), miners are awarded small amounts of the cryptocurrency they “mine”, which go directly to their digital wallets.

The root of cryptocurrency: blockchain

Miners are who pave the way for a token like bitcoin to be transferred from one party to another, all online and without the need of any bank. But the real game-changer here is the blockchain technology itself.

This concept of a ledger system that maintains perfect accuracy and is not owned by any single entity has become one of the most important innovations of the century. Companies are using blockchain for everything from tracking farm shipments to securing IoT applications, and the technology has sparked an entire new wave of “decentralized” finance that cryptocurrencies are based upon.

This decentralized model is what makes cryptocurrency special in today’s world.

How crypto is different than the dollar

Cryptocurrencies like bitcoin and ethereum are called decentralized currencies, meaning there’s no central bank like the federal reserve that governs the supply, and no financial institution required to transfer it. Let’s take a brief lookback to think about that. Fiat currencies like the US Dollar are completely decoupled from having its value pegged to a commodity like gold, and the supply/value can be manipulated simply by printing more.

However, cryptocurrencies have a fixed supply. There are only 21 million bitcoin in existence, and there’s no monetary policy that can inject more into an economy. The only other commodity in the world that acts as a true decentralized currency, i.e. a currency that’s a store of value, medium of exchange and completely free from control of a central bank, is gold.

In the grand scheme of things, fiat currencies like the dollar and other major currencies we know today are still fairly new. China adopted paper notes around AD 1000, but the rest of the world didn’t jump on the fiat train until the 19th century. Now these government-backed fiat currencies are being placed in the ring with new mediums of exchange like bitcoin, and we are only seeing the very beginning of what is likely to unfold.

The application for cryptocurrency matters

When you think about a currency, especially a fiat, paper currency, what is its value derived from? Since it’s not backed by a commodity, the value is simply derived from demand for the currency and maybe a bit of government taxation.

Many cryptocurrencies and tokens are backed by the specific application it’s built for. To give a completely fictitious example, logisticsCoin could be a cryptocurrency based around a supply chain blockchain platform that helps businesses track and validate freight shipments. Transactions are conducted on the logisticsCoin blockchain using that coin, giving it some inherent value in the use by other businesses.

The use for these coins and the number of different coins we see is starting to teeter on the edge of being countless, which certainly leads to the question of what can be trusted.

Is it safe to invest?

The cryptocurrency landscape can seem like the wild west, and rightfully so. Prices of bitcoin and ethereum are swinging dramatically, with swings sometimes of up to 30% per day. Hundreds of new crypto coins are minted daily, some with little to no background available. The dramatic price swings and volatility often makes the news, which adds gasoline to the fire as more people jump on board.

From a technology standpoint, there are still risks with investing if you lose access to your digital wallet or private key. However, companies are starting to catch up with secure digital wallets that are better integrated with other financial tools and applications.

As for the blockchain itself, the common blockchain networks are regarded as extremely efficient and secure. Each cryptocurrency blockchain is slightly different, with subtle nuances that even computer scientists don’t always understand. But to this point there’s never been a fault attributed directly to a blockchain’s algorithm.

Is cryptocurrency here to stay?

Blockchain has already proven its’ usefulness across a wide array of applications, and there will be more and more services built on top of it. The US federal reserve just announced in May that it’s investigating an option for a digital dollar hosted on a blockchain, and other countries are already further along in the process.

This leads to the question: are bitcoin and other cryptocurrencies here to stay?

Will cryptocurrencies like bitcoin stay at the current prices? No one knows. Will the technology stick around? Definitely. The adoption of blockchain is becoming increasingly prevalent, and we’ll likely see cryptocurrencies, smart contracts, and tokens more and more over the next 25 years.

If you have any more questions on cryptocurrencies or the blockchain technology, feel free to reach out at austin.proctor@jatowealth.com. We also will have more at our Resources page.

This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon for purposes of transacting in securities or other investment vehicles.

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