Interest in cryptocurrencies is growing for a number of reasons. Some people feel the stock market isn’t right for them or doesn’t offer the potential returns they desire. Others are unsure of the risks or rewards but hear about people buying cryptocurrencies as an investment and don't want to miss out. So what are the facts and what’s the real opportunity here?
It helps to have a straightforward outline of what cryptocurrency is, its benefits and its risks. Let’s take a closer look at cryptocurrencies to help you determine if they’re a wise investment for you.
What is cryptocurrency?
Cryptocurrency is a type of digital currency that can be used to buy goods or services or to trade in a similar manner as stocks. What makes it different from traditional currencies, in addition to being completely digital, is that it’s secured by cryptography and a decentralized public ledger system that documents transactions, making it nearly impossible to counterfeit or double spend.
Because cryptocurrency is not issued, backed, maintained or regulated by a central bank or government authority, its value is determined by a combination of supply and demand, availability, and competing cryptocurrencies. This explains why cryptocurrency values can be so volatile.
From an investment standpoint, this means cryptocurrency is typically regarded as high risk and speculative since prices can fluctuate substantially within a short period of time. However, investors find it attractive for a variety of reasons beyond the general hype. Some see it as a way to tap into the growing demand for digital currency. Others like the fact that it’s resistant to manipulation by governments or financial institutions. And yet others see it as just another way to diversify their portfolios.
Cryptocurrencies use blockchain technology to create a decentralized network where transactions take place. Instead of storing transactions on a single computer, they are stored on a large collection of computers that maintains a digital public ledger of transactions. Each “block” in a blockchain represents a collection of cryptocurrency transactions. All of the computers maintaining the ledger, also called “nodes,” have access to the entire blockchain on the decentralized network.
Many organizations have issued their own form of cryptocurrency in denominations called tokens. Tokens can be used to pay for services or products the company offers, much like going to a casino and using chips to play at tables. Because cryptocurrency is digital, it can be used across the world as a highly secured way for organizations to conduct transactions.
Quite often, companies use cryptocurrencies as a way to raise money through an initial coin offering, or ICO, similar to an initial public offering. With an ICO, though, investors buy cryptocurrency to use rather than stock in a company.
Types of cryptocurrency
CoinMarketCap lists more than 10,000 global cryptocurrencies with a market cap of more than $1.3 trillion as of June 2021. However, the value of these cryptocurrencies can change rapidly. Let's look at some of the most commonly used and recognized cryptocurrencies.
Probably the most recognizable cryptocurrency, Bitcoin first appeared in a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” published online in 2008. It described a decentralized, digital currency not controlled by any one person or entity, where transactions are held on a public ledger that can be stored on any computer.
Bitcoin was later launched in January 2009 and is one of the most popular cryptocurrencies to date. Bitcoin is a network that runs on a blockchain, which is made up of groups or blocks of transaction information arranged chronologically. Since the origin of Bitcoin, all types of cryptocurrency have been generically referred to as bitcoin.
Officially launched in 2015, Ethereum is the second most popular cryptocurrency. Like Bitcoin, it’s based on cryptography and a distributed ledger system. Unlike Bitcoin, however, Ethereum isn’t strictly a digital currency. It’s a platform that can be used to run programs, called “smart contracts,” in a decentralized way on the Ethereum network. In other words, by using the same blockchain technology as Bitcoin, a user can also write code, or a smart contract, and ensure it runs exactly as written when executed on the Ethereum network.
Authors of smart contracts must pay to deploy their programs on the Ethereum network. This payment is made in “ether” and incentivizes miners across the Ethereum network to maintain the distributed ledger. Ether is a digital currency, similar to Bitcoin. So when people talk about the value of Ethereum, what they’re really talking about is ether.
Invented by Charlie Lee, a former engineer at Google and a graduate of Massachusetts Institute of Technology, Litecoin launched in 2011. Similar to Bitcoin, it uses blockchain technology and has no central authority. However, Litecoin was designed to prioritize transaction speed, which has contributed to its popularity. Since Litecoin transactions can be confirmed in significantly less time, it’s especially attractive for merchants.
Cardano was founded by Charles Hoskinson, one of the co-founders of Ethereum, with the intent of creating a more stable cryptocurrency ecosystem. Cardano is a blockchain platform similar to Ethereum that bills itself as “the first to be founded on peer-reviewed research and evidence-based methods.” According to Cardano, its technology is independently audited after development. And the nonprofit foundation that runs Cardano has partnered with a number of leading academics and experts to achieve this level of assurance.
Perhaps the biggest difference between Cardano and other cryptocurrencies like Bitcoin or Ethereum, however, is that it uses “proof of stake” rather than “proof of work” as its consensus mechanism to verify new transactions.
So why is this important? Without a central authority in place, these consensus mechanisms enable all of the distributed nodes in a network to agree on the legitimacy of a transaction. But the network takes a huge amount of processing power to maintain. That’s because, according to Coinbase, “Proof-of-work blockchains are secured and verified by virtual “miners” around the world racing to be the first to solve a math puzzle. The winner gets to update the blockchain with the latest verified transactions and is rewarded by the network with a predetermined amount of crypto.”
Because blockchains like Ethereum have to process more than just incoming and outgoing transactions, proof of work is quickly becoming unsustainable as these networks grow in popularity. That’s where the proof-of-stake system comes in. Instead of dedicating processing power to solve puzzles, validators instead “stake” their own cryptocurrency for the opportunity to be chosen to validate a new transaction.
While the process can vary by network, validators are generally chosen based on a combination of how much cryptocurrency they’ve staked and how long it’s been staked. So the more invested validators are, the more likely they are to be selected. Validators are also selected to participate by attesting to the accuracy of new transactions entered by other validators. Similar to the proof-of-work system, all validators then receive cryptocurrency rewards proportionate to their stakes.
Being a validator isn’t without risks. If there’s a problem with a node or if a bad block is accepted, a validator may be penalized a portion of their stake — or their entire stake. There’s often a fairly high barrier to entry as well. The minimum stake required to become a validator can be substantial. However, the proof-of-stake system doesn’t require the enormous amount of processing power that the proof-of-work system does.
Bitcoin Cash was one of the first splits from the original Bitcoin. It originated in what’s referred to as a “hard fork” in August 2017. Hard forks are often the result of disagreements between miners and developers. When there’s a need to change something, such as a token's underlying code, those decisions must be made through consensus.
There are times when some may not agree, and that can lead to a digital currency splitting, with the original blockchain remaining in place using the original code. A secondary chain starts a new life, and new changes to the code are implemented.
Part of the disagreement that led to the creation of Bitcoin Cash was the issue of scalability, specifically the size of blocks. Bitcoin Cash has a maximum block size of 32MB to hold more transactions and increase transaction speed, while Bitcoin blocks are a maximum of 1MB.
It should be noted, however, that larger block sizes have raised questions about security. Furthermore, the average block size of Bitcoin Cash has rarely been more than 1MB as of June 2021, meaning the value proposition of faster transaction speeds has yet to be tested. Another concern with this cryptocurrency is that it has already experienced its own hard fork due to further disagreements between miners and developers.
Chainlink leverages blockchain “oracles,” which are like smart contracts that can communicate with data outside of the blockchain — in a way extending the Ethereum model. In doing so, it can facilitate contract execution based on data it otherwise would not be connected to.
Chainlink oracles have several potential use cases, such as enabling local governments to monitor corporate water consumption by connecting data from water table sensors to smart contracts that automatically issue fines when illegal syphoning is detected. The same oracle could be used to send warnings to people living nearby when flooding conditions are detected. There are a number of implications for Chainlink technology spanning everything from decentralized finance, to gaming to insurance, utility usage, supply chains and more.
Tether is a “stablecoin,” a type of cryptocurrency that ties its value to another currency or an outside reference point to stay stable and avoid wide price fluctuations. In the case of Tether, its price is linked to the U.S. dollar. It was created in 2014 to reduce volatility to some degree in an effort to attract investors who otherwise might not be willing to take on radical shifts in value.
It can be cheaper and faster to trade cryptocurrency for Tether tokens instead of U.S. dollars, so it is often used as a way for investors to keep their money in the cryptocurrency market while avoiding the volatility of Bitcoin, for example.
As with any cryptocurrency investment, however, it’s important to do your homework, and Tether is no exception. There have been a number of concerns raised about the transparency of Tether’s use of funds and allegations that its reserves were misrepresented in 2018 and 2019.
How cryptocurrency differs from stock
Now that you have a better understanding of the various types of cryptocurrencies, you may be wondering how cryptocurrency is different from stock. Although 55% of Americans own stock, only 14% own cryptocurrency.1
For starters, stocks have been around in some form for hundreds of years. By comparison, cryptocurrency is a much newer type of investment, originating in 2009. When you purchase stock, it’s an investment in a company. You’re placing a bet that the company will grow and prosper and that its value on the stock market will increase. Cryptocurrency, on the other hand, is a digital currency that can be used as a form of payment for goods or services where that cryptocurrency is accepted. When you buy cryptocurrency as an investment, it’s often in the hope that it might increase in value at some point in the future.
Another key difference between stocks and cryptocurrencies is how they are bought and sold. Stocks are purchased through highly regulated and managed stock exchanges in numerous locations around the world. Cryptocurrencies are purchased through cryptocurrency exchanges; then, the tokens are stored in a digital wallet. Because of the volatility of cryptocurrencies, they can be more difficult to buy and sell than stocks — and the regulations surrounding them are much less clear.
It can be hard to predict if and when a cryptocurrency’s value will rise or fall. That could be said about stocks too, but investors have more ways to mitigate potential losses. For example, investors can gather information about a company and consider factors such as economic and political conditions to draw conclusions about how its stock price might change.
Risks of cryptocurrency
Cryptocurrency is volatile. Even though the rewards sound great, here are some things to think about before buying cryptocurrency:
- Wide market fluctuations of cryptocurrency prices
- Possibility of cybertheft
- Scam trades and exchanges
- Lack of governmental regulation
- Heavy reliance on technology
- Sparse use as actual currency
As with any new investment in your financial portfolio, it's important to evaluate your personal risk threshold. For some investors, the possibility of a massive payout is worth the risks associated with cryptocurrency. For others, cryptocurrency is too risky.
Ecological impact of cryptocurrency
It may seem odd to think that a digital form of currency could have an impact on the environment, but most cryptocurrencies actually require a significant amount of energy. You may be wondering why that’s the case. It all goes back to the proof-of-work system.
In this system, in order for miners to compete for the opportunity to “mine” the next block on the blockchain, they have to use incredibly powerful computers that consume large amounts of electricity. According to the Digiconomist Bitcoin Energy Consumption Index, Bitcoin alone results in more than 62 metric tons of carbon dioxide emissions and over 8 kilotons of hazardous electronic-waste generation annually. Part of the reason for Bitcoin’s massive carbon footprint is that a large percentage of its network is located in China and other regions where the majority of energy is derived from coal.
Another problem is that, as an inflation control, the value of mining Bitcoin is designed to decrease over time, meaning it will take more and more processing power, and therefore more energy and more advanced computers, for miners to reap the same rewards in the future. This has already ignited an arms race for the best and latest computer hardware, contributing massive amounts of electronic waste.
Recognizing how unsustainable this system is, some cryptocurrencies are shifting to a proof-of-stake system instead. Cardano is an example of a digital currency that already uses proof of stake. Ethereum will introduce a number of upgrades to its blockchain when it releases Ethereum 2.0, one of which will be the move to proof of stake.
How criminals exploit cryptocurrency
Because of its virtual nature, cryptocurrency has universal appeal. The ability to make money from anywhere, trade money from anywhere and pay for items without physical currency is attractive. Unfortunately, all of these benefits of cryptocurrency are also attractive to criminals.
Often, transactions made using cryptocurrency are difficult to trace back to individuals because they aren’t connected to an individual’s personal identifying information. This can give individuals a degree of anonymity when transacting that makes it difficult for law enforcement to identify criminals.
While law enforcement has gotten better at tracking the flow of illicit funds, things like privacy wallets, which anonymize cryptocurrency transactions, can bring an investigation to a dead stop. According to a cryptocurrency crime report by CipherTrace, U.S. cryptocurrency exchanges sent $41.2 million in bitcoin directly to criminals in 2020.
Cryptocurrency has been used to conceal crimes related to sex trafficking, money laundering, hacking and cryptocurrency theft, illegal drug trafficking, and more. However, it should be noted that the vast majority of cryptocurrency transactions are legitimate.
Should you buy cryptocurrency?
Although cryptocurrency offers an attractive opportunity with potential for reward, there’s no real way to predict if cryptocurrency will become a mainstream form of currency. It’s important to learn as much as you can about investments before jumping on the proverbial bandwagon. Buying cryptocurrency as an investment is not without risk — so do your homework before deciding if cryptocurrency is right for you.