What is the Craze around Cryptocurrency all about?
You’ve probably heard of Bitcoin and how it has gone up a ton in value over the last few years and made some young geeks into multi-millionaires. You may have also heard of other cryptocurrencies like Dogecoin or Ethereum. You may be wondering whether you should invest in some yourself and what the best way is to do that. I did some research on the topic and here is what I learned:
- What is a cryptocurrency?
Cryptocurrency is built on the blockchain technology that has been around for almost two decades. Think of it like a Google Doc. There is a starting document or piece of information, call it a block, that is shared with many others over a network and everyone who has access to that block can add information to it. The information in the starting block is summarized into a hash ID and encrypted. Any change to that block would change the hash ID and show that it has been tampered with. If someone adds information or a transaction to that starting block, it is another block with another hash that is linked to that other one. Hence the “blockchain” name. If you’ve used a Google Doc, you will note that it tells you who has made changes to it and you can go back and look at each version over time and even restore a previous version if someone added bad data or messed up the file. Blockchain gives the same sort of audit trail because it is possible to view every block of information that has been added to the chain. Blockchain goes a step further than a Google Doc, however, because the encrypted hash information is kept by servers all over the internet and any time anyone wants to add a block to the blockchain, they first must prove they have all the data from the rest of the blocks and that they have permission to add to it by verifying the data with all the other servers. For someone to alter a blockchain, they must tamper with the data held by all the different servers at the same time. That’s pretty much impossible.
A cryptocurrency like Bitcoin starts with that hashed block of information that then has blocks added to it as transactions happen. In the case of Bitcoin, there are 21 million possible coins and creating a coin means solving a very complex set of mathematical functions. Think calculus on steroids. “Miners” use super computers to solve the mathematical functions to create possible blocks and are rewarded with Bitcoins for their efforts. So far, about 18 million of the 21 possible Bitcoins have been solved and created. Other computers and servers work as nodes that verify the information in the blocks and process transactions using Bitcoin and are also rewarded with some Bitcoin. The whole thing is completely decentralized and works because it rewards those who participate in enabling the network and disincentivizes those who would try to hack it because it would take far more computing power to reverse engineer the hashed info than it would take to just solve the mathematical functions and create another Bitcoin.
Not all cryptocurrencies are created equal. Bitcoin is one of the first and most secure in terms of being unable to decode. There are now over 4000 cryptocurrencies in existence and most of them are garbage. Some of them were created for fun and there is at least one out now that is a bit of a game where you can have your smartphone “mine” the coins in the background while you go about your day. Are those coins going to be worth anything? Probably not.
A cryptocurrency has no asset backing, unlike the currency of a country which is backed by the economic strength of the country. The value of a cryptocurrency is in its ability to be bought and sold easily on exchanges, its ability to be transferred worldwide to anyone with a receiving address for hardly any transaction cost, and the security of the blockchain underlying it. It is still mostly a perceived value and speculation that drives the cost up.
2. How do you transact with a cryptocurrency?
Cryptocurrencies have sender and receiver addresses that differ based on the coin. You can’t send Ethereum to a Bitcoin address, for instance. You hold your cryptocurrencies in a “wallet” which can be either a software program on your computer or smartphone or a hardware wallet that looks like a USB drive. The hardware wallet is the most secure since it is only accessible to the internet when you actually plug it in and use it, but otherwise it is sitting offline. Most hacks regarding cryptocurrencies happen with the user at the end point, not with the blockchain itself. If someone gets a hold of your private keys or password to your wallet, they control your cryptocurrency. Some of the more common software wallets include Jaxx and Bitcoin Core and hardware wallets can be purchased from Trezor, Ledger, or Keepkey.
Cryptocurrency can be bought or sold on an exchange much like a stock exchange. Most exchanges like Coinbase and Kraken are centralized and allow you to exchange country money like USD$ into any common cryptocurrency. You will need to set up an account and most of those exchanges will allow you to leave your currency in your account, much like PayPal allows you to keep a balance. However, exchanges have been hacked in the past, so it is not best practice to leave your currency there. Move it into your software or hardware wallet instead.
Whatever you do, don’t lose your password to get in to your wallet! Some guy in Ontario put a few thousand into Bitcoin years ago to try it, forgot about it and forgot his password, then realized he had millions of dollars worth of Bitcoin, but couldn’t access it. Since Bitcoin is decentralized, there was no central authority to help him recover his access. Tough luck.
3. What is the future of cryptocurrency?
Good question. There seems to be a move by certain governments, particularly China, to shut down the decentralized cryptocurrency like Bitcoin and introduce their own. They express concern with how much electricity super computers are using to mine Bitcoin and other cryptocurrencies and the environmental impact, but it is likely more of an excuse to try and control this craze. You may have read that Tesla was accepting Bitcoin for a while, but then Elon Musk changed his mind and cited environmental concerns as a reason. The real reason is probably the volatility of Bitcoin and the difficulty in setting a value on it for ongoing financial reporting to shareholders.
You should also be aware that any gains made on trading cryptocurrency needs to be reported on your taxes. You might think the government can’t track your trades, but remember that you have an address that is yours alone that you can send and receive trades from. An auditor can go to blockchain.com and look up your address to see all the transactions that have been done with that address. That is because that transaction history is embedded in the blocks that make up the coin itself and that is being verified through all the different servers. It is public knowledge.
In conclusion, I think cryptocurrency is quite revolutionary, but I also think government is going to try to take over that space to better control and tax it. This will mean that more businesses will be willing to accept cryptocurrency once government validates it, but it might be new cryptocurrencies that government introduces, not Bitcoin and other decentralized ones. If you are going to invest in cryptocurrency, only invest what you are willing to lose.