Domestic Affairs

Crypto: Explained

On Feb. 13, 2022, millions of SuperBowl LVI viewers watched for a solid minute as a bouncing QR code danced across the screen during a commercial break. When scanned, this QR took users to a website made by Coinbase, a cryptocurrency exchange platform, where they were promised $15 of free Bitcoin in exchange for making an account. The ad, although simple, was incredibly effective, resulting in so many new members that the website was temporarily taken offline

Coinbase was not the only crypto platform advertising during the Superbowl. and FTX also bought ad slots, a surprising deviation from recent years. These ads are indicative of the overall increase in the presence of cryptocurrencies in our lives. In 2015, only 48% of adults in the U.S. had heard of Bitcoin, and only 1% reported ever trading or investing in it, according to Pew Research. According to another Pew study, as of November 2021, 86% of Americans had heard about cryptocurrencies, and 16% reported trading or investing in it. This huge increase drives home a message that’s beginning to appear everywhere: crypto is here to stay. 

However, even though the majority of Americans have cryptocurrencies on their radar, not all of them have a solid understanding of what these intangible currencies are or how they work. In fact, in March 2021, a study conducted by Cardify found that about 33% of investors who bought cryptocurrencies knew little to nothing about them. Thus, an overview of cryptocurrencies, as well as an examination of them as an investment opportunity, seems more than appropriate. 

What is a cryptocurrency? 

While this may seem like a simple question, it’s often hard to get a straight answer out of people, much less one that’s easily digestible. For example, a common definition of cryptocurrency is “decentralized digital money that’s based on blockchain technology,” which, while true, is difficult to unpack. The easiest place to start is with what blockchain technology is. 

Essentially, a blockchain is a way to store information, similar to a regular database. For context, databases are used just about everywhere, including banks and retail stores, for storing customer information and preferences. The key difference between a regular database and blockchain is the way they store information. Traditional databases keep information in tables, and that information can be changed at a later date. For example, if you change your legal name and notify your bank, your customer account will be amended to reflect your new name. On the other hand, blockchain technology collects and stores data in groups, known as blocks, and once the data contained within the block is verified, it is sealed and effectively impossible to change. This process repeats itself, forming a chain of blocks and thus, a blockchain. 

The inability to alter data that have been verified and recorded makes blockchain technology perfectly compatible with cryptocurrencies. The blockchain acts as a giant ledger with records of every single transaction made using a given digital currency— often in the form of coins— that is “permanently recorded and viewable to anyone.” Another important aspect of blockchain technology, especially in regard to cryptocurrencies, is decentralization, which means that, unlike traditional databases, the data contained within the individual blocks is not stored in one location. Instead, the information is stored across hundreds or even thousands of “network nodes” in different locations, which implies that no one individual or organization has control over the stored data. 

Decentralization is desirable for many reasons, many of which pertain to data integrity and trust. For example, even if a node failed, the others would be able to cross-reference each other and preserve the integrity of the stored data. Additionally, decentralization allows for “trustless transactions.” Admittedly, the term “trustless” may appear intimidating, but all that it implies is that there is no need to entrust a third party, such as a bank or vendor, with being the intermediary for your transactions or holdings. In other words, instead of transferring money through a bank, which involves trusting the bank with both your money and with the responsibility of depositing the appropriate amount in another person’s account, blockchain technology allows you to eliminate the intermediary and executes the transfer with your digital currency by using coded commands. Consequently, there is no need to trust any institution or even any individual you may be conducting a transaction with, as you are instead “trusting the soundness of the code” and the fact that both you and the entire community have access to the same general ledger— almost like a giant receipt. 

However, “trustless transactions,” while useful, are also very inefficient. The process begins when a transaction occurs, causing the resultant data to be sent to the network of nodes. Then, each individual node must run various “consensus protocols” that evaluate the transaction, and if consensus is reached after the nodes cross-reference each others’ results, it goes through and is recorded in the general ledger, forming an immutable part of a block. 

Cryptocurrencies themselves are commonly created through a process called mining, which is a complicated computer process. Essentially, computers expend copious amounts of energy to solve extremely complex puzzles, and the owners of these computers are rewarded with coins, or individual units of the currency. Alternatively, an easier way for one to acquire a cryptocurrency is to buy it from either an exchange or another user. From there, owners of cryptocurrencies use their coins and blockchain technology to conduct regular marketplace interactions.

Where does Bitcoin fit into all of this? 

Bitcoin is the original cryptocurrency and was invented after 2008, likely to address doubts about the trustworthiness of big banks and financial institutions following the recession, which is also the reason that blockchain technology was invented. Interestingly, when the first Bitcoin transaction occurred in 2009, it had almost no economic value. Over the next several years, it began to appreciate in value as more people began using the platform, and it quickly became the most widely-used cryptocurrency. As of March 2022, it remains the world’s most popular cryptocurrency with a market cap of over $845 billion, which is more than double that of the second-most popular cryptocurrency, Ethereum. 

In fact, usage of Bitcoin has become so popular that some countries have elected to use Bitcoin as a national currency. El Salvador became the first country to do so in September 2021, citing reasons including a desire for faster, easier transactions and hopes of encouraging foreign investment. Making Bitcoin a national currency has the potential to benefit many citizens who might not have bank accounts but can access Bitcoin via their phone or the internet. Still, responses were mixed, as some citizens and international financial organizations expressed concern over the volatility of cryptocurrencies and the risk El Salvador would be taking on. 

There is also a dark side to Bitcoin. The anonymity provided by this technology means that it is often used for illicit activities. For example, criminals have been caught using cryptocurrencies as a way to launder money. In 2020, Bitcoin-based money laundering activities were linked to Mexican drug gangs, as well as human trafficking. Cryptocurrencies also have been proven to have the potential to assist in funding terrorist organizations, as transactions have been traced back to individual terrorist activity as early as 2014. This alarming issue, which extends across all cryptocurrency platforms, is difficult to address due to the decentralized nature of blockchain technology. Some solutions, including increased regulations, have been implemented to varying degrees, but comprehensive protection against crime is still a long way away.

Overall, Bitcoin has revolutionized the way we think about financial transactions and networks. It was also the impetus for blockchain, one of the most ingenious technological creations of our time. The legacy this currency will have on the future of financial services is unknown, but assuredly vast. 

Should I invest in a cryptocurrency? 

At the end of the day, this remains a personal question, as there has been no general consensus on the future of existing cryptocurrencies like Bitcoin.

The two biggest risks to consider before investing in a cryptocurrency are volatility and security. Cryptocurrencies are notoriously volatile, experiencing dramatic highs and lows in seemingly no discernible pattern. For example, Bitcoin once dropped 30% in value in a single day. On other days, it has experienced single-day gains of over 40%. This presents a large risk for investors, as there is no reliable way to tell when a cryptocurrency is going to depreciate in value. Additionally, this is unlike traditional investing in which one tries to outsmart the market and picks securities they believe are over or undervalued. Rather, two people can both invest in the same cryptocurrency, and one may emerge rich and the other worse for wear. The difference between the two seems to depend mostly on timing, underscoring the volatility of the crypto market and the need for investors with high risk tolerance.

Another aspect that makes cryptocurrencies volatile is that most are not backed by any government or currency. This implies that any losses or transactions that go wrong are not insured or protected by any centralized authority. In other words, if something goes wrong with your digital wallet or with a transaction, your money’s gone for good. However, there are some cryptocurrencies that are stablecoins, such as Tether, which is backed by fiat currencies and “hypothetically keeps a value equal to” denominations such as the U.S. dollar or the euro.

Security breaches in the form of cryptocurrency scams are also an important factor to consider before investing. Just last year, these scams cost investors $14 billion, which was nearly double from the year before. These scams can take many forms, but some of the common ones include demands for crypto-only payments, crypto investment schemes, phishing, and romantic schemes. Regarding demands for crypto-only payment, if a seemingly legitimate retailer or vendor claims that they cannot accept any payment method other than crypto, it is likely a scam, as cryptocurrencies are still relatively new. Crypto investment schemes refer to fraudulent ICOs, or initial coin offerings. New cryptocurrencies launch frequently, and investors can buy into the new currency in a way very similar to an IPO. However, sometimes scammers will convince investors to invest their funds before eventually leaving them high and dry. Finally, romance and phishing scams are somewhat familiar concepts. Romance scams refer to scammers engaging people on dating apps or digital relationships and convincing them to send cryptocurrencies, and phishing, of course, involves sending random, poorly written emails with links that try to trick the user into giving up their crypto wallet credentials. 

Ultimately, while specifics about the future of cryptocurrencies are uncertain, it seems likely that they are here to stay. Whether you are indifferent to the world of crypto or willing to take on the risk of investing, it is always important to build your own knowledge and understanding of the crypto market and the specific currency you want to invest in before buying. Moreover, it is important to think about what kind of investor you are— are you risk-averse or risk-neutral? Asking these kinds of questions alongside building your base crypto knowledge will help you build that portfolio that is best for you. In the meantime, hopefully, the crypto industry will keep churning out entertaining halftime ads.

1 reply »

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s