Cryptocurrency. It’s the notoriously volatile “investment” that dominates the financial headlines for both good and bad reasons.
But despite the fear, uncertainty and doubt about this emerging technology, the truth is that “internet money” has evolved into an almost $3 trillion dollar industry and made a lot of people very rich.
There are pitfalls, however, and if you’re not savvy, you can stand to lose a good chunk of your investment. But with a little knowledge and the right guidance, you could be holding with the best of them.
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While the concept of digital money has been around since the 90’s, the true pioneer of the industry goes to Bitcoin. It was first created in 2008 by an anonymous coder that went by the pseudonym Satoshi Nakamoto. He theorized a digital, peer-to-peer payment system – free from the oversight of banks, governments and regulatory control.
He would do this through a type of computer code called a blockchain. Without going into heavy detail, this blockchain contained a ledger or record of all transactions that have occurred on the network. Every time someone wants to send some Bitcoin, the details of that transaction are processed and verified by a randomly selected “miner” and written on the ledger as a new block.
Now miners are just computers that are working to solve complex mathematical equations. These problems require massive amounts of computation and even greater amounts of power to solve. Once solved, that miner goes in the running to validate incoming transactions. As a reward for doing that work, a pre-determined amount of Bitcoin is given to the miner from a pool of “unmined” Bitcoin as well as a transaction fee collected from the sender.
This is how new Bitcoin are created, that is until all 21 million of the coins have been mined and are in circulation.
So, if we understand the basic mechanics of how a blockchain, and specifically Bitcoin operates, how does it go from being a secure and anonymous, peer-to-peer payment system to a globally recognized currency that gains value over time?
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This is ultimately the $3 trillion dollar question. Sending and receiving instant digital tokens is one thing, but how can these cryptocurrencies be worth anything in the real world?
To understand this, we have to take a short lesson in history and macroeconomics.
For thousands of years, human societies have been using the currency in one form or another. Whether it was precious metals like gold or silver, minted coins or the paper money of today, we’ve always assigned specific value to commodities and represented their value in an agreed type of payment.
Currencies of an economy worked because of six attributes, and these will become really important later in the context of cryptocurrency. They displayed;
For a long time, our printed and minted currencies were backed by physical gold. Governments could only print the equivalent amount of cash that they had in physical gold reserves – a type of monetary policy known as “the gold standard”.
This standard was the practice in many countries, with the US stockpiling federal gold reserves from 1879. Half a century later and the US was struggling through the Great Depression.
Faced with mounting unemployment and spiraling deflation, the US government was concerned that people would rush to their banks, withdraw their savings and deplete the gold supply. So, in 1933, President Franklin D. Roosevelt cut the dollar’s ties with gold, allowing the government to pump money into the economy and lower interest rates.
From this point forwards, the US dollar, now known as “fiat” currency, was backed by nothing more than trust. Trust that the government, banks, stores and services would accept and honor your money. Despite how powerful you feel with a stack of bills, that wad of cash only has value because everyone agreed that it does.
Over time, the vast majority of countries converted to a fiat currency as it was less volatile than other commodities and made trade a lot easier.
Now, when we consider the attributes required from a currency, the first one is scarcity. Bitcoin was created as a “digital gold”, designed to virtually mimic the properties of the precious metal we have to dig out of the ground. Just like there is a fixed amount of gold on the planet, a hard cap of 21 million Bitcoin can ever be in circulation.
This creates an asset that is deflationary, one that will increase in value over time when compared to fiat currencies. Deflationary assets, like gold are what investors like to call an “inflationary wedge”, designed to curb the losses incurred from inflationary pressures.
The second attribute is divisibility. All cryptocurrencies are infinitely divisible into smaller denominations. Just like one dollar is made up of 100 cents, 1 Bitcoin is equivalent to 1,000 millibitcoins (mBTC), 1,000,000 microbitcoins (μBTC), or 100,000,000 Satoshis.
When it comes to utility, Bitcoin lags behind traditional finance and fiat solutions. While it has made great strides over the past few years, especially with El Salvador and Panama now recognizing the cryptocurrency as legal tender, its still hard to find vendors that accept Bitcoin as payment.
Cryptocurrency does excel when it comes to transportability and durability. Being a digital currency stored on an online blockchain means that you can store vast amounts of Bitcoin on digital wallets. These can sit on your computer, on your mobile phone or on a physical hardware wallet. Imagine carrying around a thumb drive worth millions of dollars!
Even if you lose your wallet, like the case of James Howells, who accidentally threw away a hard drive containing a wallet with 7,500 Bitcoins on it – you can still restore your funds with a 24-word seed phrase.
The final attribute is resistance to counterfeit. Fiat currency has long dealt with the effects of rampant counterfeit money printing. In the crypto world, this is a near impossibility. Each digital asset has its own unique signature and is essentially being “watched” by every other asset on the network. Fraudulent transactions can only take place if over 51% of the network is controlled by the counterfeiter – a situation which is impossible with such widespread of Bitcoin ownership.
So, with Bitcoin exhibiting all the attributes of a currency, where does the real-world fiat value come from? Well, as we mentioned earlier, a fiat currency is built upon faith and if enough people agree that something has value it suddenly does.
When the Bitcoin network began chugging along in 2009 with a small pool of miners minting blocks and sending Bitcoin to each other to test the network, each Bitcoin was effectively worth nothing. A year later, as early adopters began trading in the digital currency, demand for the novelty currency rose to a fraction of a cent. It was this year, in 2010, that Florida man Laszlo Hanyecz paid for two Papa Johns pizzas using Bitcoin, the first every recorded commercial cryptocurrency transaction.
Laszlo paid the 10,000 Bitcoin sum, worth around $41 at the time and received his two pizzas delivered. Today, that haul would be worth well over $600 million dollars.
By 2011, the price of a single Bitcoin hit $1 for the first time but it wasn’t until 2013 that it started to get public interest. It turns out, Bitcoin is affected by the same market fundamentals that all assets are. Supply and Demand. As demand surged, so too did the speculative price. Bitcoin crossed the $1,000 mark in November 2013 and the $20,000 mark in 2017.
While volatility in the price can see crashes of up to 80% over the course of just a few weeks, Bitcoin has always rebounded to test record all-time highs.
In fact, in November 2021, the price of a single Bitcoin reached a mind-blowing $68,521. 2021 has seen absolute fever pitch when it comes to demanding for cryptocurrencies and this has reflected in thousand-percent gains within a matter of months.
So, when answering the question, “How do cryptocurrencies create and store value?”, the answer is the same as if you were asking about fiat currency. Trust, faith and demand of cryptocurrencies are driving real money into the industry.
But what advantages do cryptocurrencies have over fiat currency?
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While fiat currency made it easier for governments to control inflation, interest rates and stimulate the economy – it does come with some inherent disadvantages. Irresponsible monetary policy can cause runaway inflation, making the value of your money worthless. You only need to look at countries like Venezuela and Zimbabwe to see what excessive money printing can do to the exchange rate.
Fiat currency also has famously slow transfer times and excessively high transaction fees. We’re reliant on banks and government bodies to store, validate and move currencies across a multitude of legacy financial systems. Even today, sending money around the world can take several business days with fees anywhere up to 30% of the amount depending on the destination.
Cryptocurrencies aims to solve several of these problems. Transaction fees depend on network congestion, but they generally hover around the 3-5% mark. They’re also lightning fast in comparison to legacy systems. A single transaction takes around 10 minutes on average to complete, meaning international transactions can be done virtually in real-time.
Cryptocurrencies with a fixed supply are also deflationary, meaning that as inflation decreases, the value of your fiat currency, the value of your crypto will increase.
You’re also exposed to a wide variety of peer-to-peer financial applications and earning opportunities in cryptocurrency that traditional finance doesn’t offer. We cover some of those in our next blog, “Cryptocurrency, Altcoins and Passive Income Streams”.
Written by: George Founder of Cryptonomous Consulting @ cryptonomousconsulting.com
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