Golden bitcoin coin with bull trading stock chart.

Cryptocurrency 101: The basics

Merriam-Webster recently added ‘cryptocurrency’ to its dictionary, a sign of how widespread the word has become. But what are cryptocurrencies, and how do they work?

What is a cryptocurrency?

A cryptocurrency is a kind of “digital money.” In other words, it’s not tangible like cash but exists electronically. The most well-known cryptocurrency is Bitcoin, which was invented in 2009. Other popular cryptocurrencies include Ethereum, Ripple, and Litecoin.

What can cryptocurrencies be used for?

One obvious use of cryptocurrencies is they can be converted to cash (such as Canadian or U.S. dollars). This can be done on an exchange where cryptocurrencies are traded. Some merchants do accept cryptocurrencies as payment for goods or services. That said, there has not been widespread acceptance of them as of yet.

How cryptocurrencies are created

Cryptocurrencies are known as decentralized currency systems. Unlike government-run currencies, where a central bank can alter the money supply, cryptocurrencies do not have a central body regulating the total number of units in circulation. Rather, they are created through a process known as “mining,” which theoretically can be done by anyone (Although increasingly, it requires substantial computing power and infrastructure).

Mining involves solving complex mathematical equations to verify past transactions. As an incentive for doing this work, the first person to solve an equation gets rewarded with new digital currency known as “coins”.

Limits on supply

One of the features of cryptocurrencies is that the underlying technology specifies that only a certain number of units may be in circulation. In the case of Bitcoin, that number is 21 million. This is seen as giving it an underlying value given that it cannot be created out of thin air like government-run money.

The Blockchain

You may have heard the term blockchain with regards to cryptocurrencies. The word refers to the chain of verified transactions (i.e. blocks) which is constantly evolving. Blockchain is a technology, often referred to as a distributed ledger that allows anyone to verify transactions in a cryptocurrency such as Bitcoin. While Bitcoin and blockchain are often used in the same sentence, it’s important to note that Bitcoin is merely one application of blockchain technology. Many sectors are now exploring the use of a blockchain in verifying and recording transactions.

Problems with cryptocurrencies

There are some issues that have cropped up with cryptocurrencies. Two well-publicized problems have been the risk of theft and the incredible use of energy required to mine new cryptocurrencies. With regards to the latter issue, it’s been observed that the Bitcoin network used more power in one month than the entire Republic of Ireland.

Cryptocurrency as investments

In recent years, the value of various cryptocurrencies skyrocketed. Amazingly, even now that prices are sliding, the total value of all cryptocurrencies is still over US$300 billion.  Naturally, soaring prices led to greater interest in these coins by the public.

Cryptocurrencies are a very speculative endeavour and generally should not be considered for investment except by highly sophisticated investors who can afford to lose their entire investment. Many experts believe these currencies have all the hallmarks of classic market bubbles, driven by unsustainable hype and exponential price increases. Indeed, compared to other well-known bubbles, such as the internet stock bubble of the late 1990s, the surging value of Bitcoin was even more remarkable.

Another consideration for would-be investors is the sheer volatility of cryptocurrencies. One of the functions of currencies is supposed to be as a store of value. Yet cryptocurrencies can rise or fall by double digit percentage points on any given day.






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Andrew Hepburn is a freelance writer based in Toronto who specializes in financial issues. He's written for Maclean's, Canadian Business, MoneySense, Morningstar and T.E. Wealth, among others.