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Someone in your life is talking about cryptocurrency – maybe your partner or your best friend. Or maybe you saw it in the news or on social media. Either way, you want to understand this new technology that people are telling you to invest in.
Below, Select dives into what constitutes a cryptocurrency and what to look for before investing.
In its most basic form, a cryptocurrency is a digital asset that uses computer code and blockchain technology to somehow operate on its own, without the need for a central part – which it whether a person, a company, a central bank or a government – to manage the system.
A blockchain is a ledger that keeps track of cryptocurrency transactions. This ledger of transactions is kept on computers connected by a distributed network. Transactions in cryptocurrency protocols are combined into blocks, and those blocks are then linked together into a historical record of everything that happened on that blockchain.
Bitcoin, the first cryptocurrency created, was initially developed to act as a native payment mechanism of the online world. Faster, cheaper, censorship-resistant, and not subject to the whims of any government or central bank.
Today, there are thousands of cryptocurrencies. These still act as payment mechanisms, but have also been developed for other use cases, such as lending and borrowing or digital storage. And one of the broadest use cases for this technology is speculation, buying in the hope that the price will rise and holders can make a profit.
The vision behind cryptocurrency is that of a peer-to-peer electronic money system that is not controlled by a central authority and, therefore, is fast, cheap and invulnerable to censorship (e.g., PayPal blocks arms sales) and other forms of corruption or control.
Although the definition is fluid, several features generally constitute a crypto asset:
- Cryptography: This is where the term “crypto” comes from. A cryptocurrency (or crypto for short) uses cryptography, which are techniques for securing information or communications. Cryptocurrencies use what is called public key cryptography. In systems using public-key cryptography, there is a public key, which can be shared with others; in cryptocurrency, it’s the key you share with people so they can send you crypto. There is also a private key, which you do not share with others. Think of the private key as a password. It secures your crypto holdings and is used to sign transactions you initiate to others.
- Transparency: The philosophy of cryptography is one of transparency. Much of the code on which these protocols are built is open source, made freely available for redistribution and modification. Additionally, each crypto transaction is timestamped on the blockchain, creating a public provenance or timeline of asset ownership or custody.
- Incentives: Cryptocurrency protocols are designed with game theory components in an effort to ensure that all users of the system act in ways that keep the system running. For example, Bitcoin miners must use computer power to verify blocks of transactions. To compensate for the work of miners, newly minted coins are automatically distributed to miners when they verify a block of transactions. This way, miners are incentivized to continue putting power on verifying transactions.
Coins, tokens and crypto assets
In the crypto space, many terms are used interchangeably, which of course makes the conversation confusing for newcomers. But broadly, there are three categories of crypto:
- Crypto Assets/Digital Assets: It is the catch-all term for all the unique assets that were born out of the blockchain revolution and use cryptography. Cryptocurrencies and crypto tokens fall under this category.
- Cryptocurrency: These crypto assets are also called crypto coins and are native to blockchains. So, for example, bitcoin (BTC) is the native cryptocurrency of the Bitcoin blockchain and ether (ETH) is the native cryptocurrency of the Ethereum blockchain. These coins are used to pay transaction fees and also compensate miners or users who verify transactions.
- Crypto Tokens: These are crypto assets that do not have their own blockchain. Crypto tokens run on top of an existing blockchain. Ethereum is the most popular blockchain to create tokens on, but there are other blockchains that can support it. For example, the Beeple’s NFT art, which sold for a whopping $69 million, was built on top of the Ethereum blockchain. Decentralized Finance (DeFi) tokens also fall into this category.
Since its inception in 2009, the ecosystem surrounding cryptocurrency and blockchain technology has evolved into a billion dollar industrywhile cryptocurrencies have a total market capitalization greater than $1 trillion.
Technology has driven serious innovation, both internally and externally, pushing financial service providers and other industries to update their processes to better reflect people’s expectations for online transactions and communication. For example, the speed and low cost of cross-border crypto transactions has led many people to start re-evaluating the remittance industry and other payment networks, namely Western Union.
Being an open system, one of the objectives of cryptocurrency is to expand access to financial services tools to many people who are not allowed to enter the traditional banking system. And the industry encourages self-sovereignty, the ability of individuals to maintain control over their data, whether it is identity information or their money.
Still, there are risks of getting involved in cryptocurrency and financial systems that aren’t regulated by the government, including hacks and lost wallet passwords, where people are completely locked out of their accounts and/or lose their money. Remember: these accounts are not FDIC insured.
Because cryptocurrency is beyond government control, it allows individuals and organizations to circumvent laws, restrictions, and regulatory watch. Early in bitcoin’s history, it was used to send donations to WikiLeaks, after the US government pressured card networks Visa and Mastercard to halt transactions with the organization. More recently, some Venezuelans have turned bolivars into bitcoins in order to store value, as the bolivars have been inflated to the point of no longer having any value by the Venezuelan government. However, cryptocurrencies have also facilitated illicit activities such as money laundering.
There are many ways to analyze crypto assets and projects, although there is no single silver bullet to finding the next big thing. Here are some things to consider when researching cryptocurrencies:
- Data: Because it relies on transparency, the industry generates a huge amount of data. Market capitalization, or the total value of all coins or tokens that have been minted, is a serious indicator in the space. You can compare cryptocurrency data on sites such as CoinGecko and CoinMarketCap.
- Use case : It is useful to understand the number of active users on a network and what those users are doing on the network. Is the project tackling a real problem? How much adoption might a protocol see, both from individual users and enterprises?
- Developer activity: Separately, protocols with a large developer ecosystem are generally considered better projects because it means lots of people maintaining the code base and working to improve it.
- The team: Investigating the team behind a cryptocurrency project can be helpful, but it’s also challenging. Since there is a philosophy of privacy in the crypto ecosystem, many users, developers, and even the C-suite like to remain anonymous, using only a pseudonym. And that doesn’t always mean the projects aren’t trustworthy.
Remember that cryptocurrencies and crypto tokens are a new category of investment, only a little over a decade old. These digital assets are built with experimental new technology, and regulatory oversight of the industry is thin and ever-changing. As such, crypto assets are considered a riskier bet than more traditional assets, like stocks and bonds.
Editorial note: Any opinions, analyses, criticisms or recommendations expressed in this article are those of Select’s editorial staff only and have not been reviewed, endorsed or otherwise endorsed by any third party.