Bitcoin, Ethereum, Ripple, Litecoin, Zcash, Dash… Suddenly the investing world is full of the new ‘cryptocurrencies’. But what are they really, how do they work, and are they an investment – or just a gamble?
What is cryptocurrency? An intro for beginners
Cryptocurrencies are units of money produced by software and encrypted through a technology known as blockchain (of which more in a mo). Like any traditional asset, the values of cryptocurrencies are based on supply and demand, but are also influenced by other factors, such as a practice known as ‘mining’ . Typically there is little regulation of cryptocurrencies when compared to traditional currencies, although this could be changing soon.
Normal money, the kind in your bank account, is created by governments and banks out of thin air (it’s known as ‘fiat’ money because that’s the Latin for ‘let there be’, and also because it lets you buy small cars). By contrast, Bitcoin and the like are created by electricity – or more specifically, by number-crunching computers.
What is blockchain and how does it work?
So how does this money actually work? That’s down to the blockchain (you’ve probably heard that word a lot in recent years. Nothing to do with plumbing.) Blockchain is a way for a large number of people to know who owns what. It’s the electronic equivalent of making an announcement to a football stadium crowd, for instance, ‘Steve just bought a steak pie.’ Now everyone in the stands knows that Steve bought a pie. If the announcer does that for everyone (and if you’re taking notes) you’ll soon know what every single member of the crowd is eating at half time.
Once you’ve made such an announcement, it can’t be retracted – so everyone in the stadium has a complete and accurate record of who bought what. This means that blockchain can effectively replicate the functions of a currency without the need for a bank to act as middle-man. It’s interesting technology, and is likely to become very widely used for this reason.
How risky is cryptocurrency?
In a word: very. In two words, very very. In investment terms, we say an asset is ‘volatile’ if it is prone to sharp decreases or increases in value over a short period of time. Ordinary cash is (usually) not volatile: interest increases its value only very slowly, inflation erodes it only gradually, and often the two cancel each other out. By contrast, a highly volatile asset will result in a performance graph that looks like the Big Dipper at Blackpool. Most cryptocurrency falls into that class, although some of the better-known crypto has been hitting calmer waters recently. According to some experts, volatility is currently at its lowest ever, and Bitcoin’s has been comparable to the equity markets (which, it’s worth pointing out, are still generally considered higher risk).
That said, cryptocurrency has historically been amazingly turbulent – to the extent that people could wake up a millionaire and go to bed bankrupt, or vice versa. The reason for this is a combination of factors, one of the main being powerful emotions: greed on the one hand, fear on the other, and squeezed in between them FOMO – the fear of missing out. Added to that explosive mixture are the ‘whales’ – big-hitting investors who can influence the markets by the sheer size of their punts. In summary, this stuff is incredibly high maintenance and needs to be watched like a hawk. Ideally 24/7.
At-a-glance: Know your cryptocurrency
- The first cryptocurrency
- The largest market share – market capitalization of Bitcoin is 54 per cent of the entire cryptocurrency market
- Computers ‘mine’ Bitcoin by solving computational puzzles
- Other cryptocurrencies are predominantly bought using Bitcoin
Ethereum, Litecoin & Ripple
- These are some of the newer well-known cryptocurrencies
- Their advantages include better technology, with faster, cheaper transactions than Bitcoin
- These have experienced sharp growth in the last couple of years, but can also be more volatile
- There are many other Bitcoin competitors out there
- Volatility is currently at its lowest ever, with Bitcoin comparable to the equity markets at present
- Some lower market cap coins can have extreme volatility – it’s common for some to rise by more than 100% of its original price within a few hours or less (or fall by a similar amount)
- Volatility is also exacerbated by investors being more emotional and less experienced than traditional investors
- An incorruptible digital ‘ledger’ of economic transactions
- Can be programmed to record virtually anything of value – not just financial transactions
- Information held on the blockchain is like a shared database that is continually updated