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What are cryptocurrencies and should you invest in them?

01 Aug 2022

Cryptocurrencies have gained popularity even as their prices remain volatile. We explain what the hype in digital assets such as Bitcoin and Ethereum is about.

What you need to know about cryptocurrencies

What you'll learn

  • What are cryptocurrencies?
  • How did cryptocurrencies come about?
  • How do cryptocurrencies work?
  • What are the uses of cryptocurrencies? 
  • Should you invest in cryptocurrencies? 

TL;DR

  • Cryptocurrency refers to any digital currency based on blockchain technology
  • Compared to other investments, cryptocurrencies are highly speculative
  • If you’re thinking of investing in cryptocurrency, be prepared for extreme volatility

“It seems to me that Bitcoin has succeeded in crossing the line from being a highly speculative idea that could well not be around in short order to probably being around and probably having some value in the future.” – Ray Dalio, January 2021

What are cryptocurrencies?

The word cryptocurrency can be broken down into “crypto” and “currency”. As the name suggests, cryptocurrency is essentially a virtual currency. Think of it as money that exists in the virtual world except it’s encrypted by a code.

This encryption comes in the form of cryptography. Cryptography simply refers to a type of data transmission that protects information security. There are many existing applications in online communication, internet banking, and email services that rely on cryptographic techniques for security purposes.

Bitcoin, for example, can be described as both a digital currency and computer software. It operates independently of any bank or central authority. No single corporation, government, or entity can control it since every change made to the software is open and transparent. As a digital form of money, Bitcoin does not have any physical componentBitcoin as a currency

How did cryptocurrencies come about?

The idea for Bitcoin originated in the aftermath of the 2008 global financial crisis when analysts saw the need for a decentralised form of currency. Simply put, the financial crisis exposed the shortcomings of our reliance on the centralised banking system.

The founder of Bitcoin, a person going by the alias ‘Satoshi Nakamoto’, aimed to decouple our financial transactions from the banks by creating a peer-to-peer payment system. This meant that people could make transfers to one another without the need for a bank to be involved as a third party.

There are also alternative cryptocurrencies, or ‘altcoins’, such as Ethereum, Solana, and Luna amongst others. Ethereum, the most popular altcoin, was launched in 2015 and has other uses within the cryptocurrency space. For example, Ethereum coins are used to purchase Non-Fungible Tokens (NFTs) which are part of the Ethereum ecosystem.

How do cryptocurrencies work?

Instead of a central network processing all the transactions, Bitcoin uses blockchain technology to confirm the ongoing transactions. Think of the blockchain as a data source that verifies and keeps records of all transactions, while securing each payment.

A simple analogy for understanding how this works is a Google Doc. When you type out information on a document and share it with a group of people, everyone can see the changes being made to the document. Ideally, blockchain technology would allow cryptocurrencies to be secure, transparent, and trustless.

Analogy

See also: What you need to know about crypto tokenomics

What are the uses of cryptocurrency?

It has been argued that cryptocurrencies such as Bitcoin serve as a medium of exchange. In other words, it can be used as money. 

Of course, this doesn’t mean you can pay for your groceries with Bitcoin. But there is an increasing number of companies that have begun accepting Bitcoin as payment. These include the likes of Mastercard, Microsoft, Starbucks, and Tesla.

Others have contended that cryptocurrencies can serve as a store of wealth

This means that cryptocurrencies can maintain their value over time. In fact, Bitcoin has been dubbed as “digital gold” for its rarity and championed as a means to counter rising inflation.

Should you invest in cryptocurrency?

Cryptocurrencies have been regarded by some as a revolutionary invention, and blockchain technology is already changing the world and the financial industry. 

Yet, many remain sceptical about the use of cryptocurrencies.

Is it a good investment? As the leading cryptocurrency, it has been argued that Bitcoin will eventually receive mainstream adoption. 

For this to happen, there needs to be long-term demand for Bitcoin and it has to be widely accepted by governments and financial institutions.

If you are thinking of investing in cryptocurrency, you should be prepared for extreme volatility. 

But just how volatile can cryptocurrency be? In 2017, the price of Bitcoin surged by over 2,000%, hitting its all-time high of US$19,886. Then it quickly crashed in the early part of 2018, dropping as low as US$3,282.

The absence of a central regulatory authority, as well as limited liquidity, also means that aggressive price moves are to be expected.

It is generally agreed that assets such as stocks have intrinsic value, and their fair value can typically be calculated using several valuation methods. Cryptocurrency, on the other hand, is valued differently.

Billionaire investor Warren Buffet has even gone as far as to decry it as a speculative asset.

Overall, it pays well to be cautious in approaching your investment journey. 

Volatility chart

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