What is Cryptocurrency? An easy-to-understand guide

Blockchain or fintech continue to make news with headlines ranging from people becoming millionaires overnight to opinion pieces about how industries view financial transactions.¹ Often viewed as a volatile market for investment, it is still attracting a high volume of interest with Coinbase reporting that 70,000 to 100,000 new crypto trading accounts are being opened daily on their platform.² However, in spite of so much press, due to the technical nature of the topic, there is often a fair amount of uncertainty around cryptocurrency. As US Senator Thomas Carper said, “Virtual currencies, perhaps most notably Bitcoin, have captured the imagination of some, struck fear among others, and confused the heck out of the rest of us.”³

What is cryptocurrency?

Cryptocurrency is the joining of two words: cryptography and currency:⁴

• Currency
  This channel of exchange allows people to convert their work into something of value that can be exchanged for goods or other services.
• Cryptography
  This is the process of converting understandable text into unintelligible text and vice-versa for confidentiality, integrity, and authentication purposes. 
• Cryptocurrency
  Put the two together, and you get word that means a medium of exchange that is digital and uses encryption to make the transactions secure.

Useful cryptocurrency terms to know:⁵

• Block
  Each record or series of records on the blockchain.
• Block reward
  When a person who adds a new block to the blockchain is paid in bitcoin.
• Blockchain
  A digital public ledger on which every transaction in the network is recorded.
• Proof of stake
  A consensus algorithm that allows miners ‘put up a stake’ of their currency to verify a block of transactions.
• Proof of work
  A hash – an algorithm that turns a large amount of data into a large number that is of a fixed length, typically written as a hexadecimal – that is so difficult, it could only have been solved through significant work or power.

Cryptocurrencies are quantified entries in a database or ledger that no one can change or exchange unless specific conditions are met.⁶ Cryptocurrencies are like virtual accounting systems and allow you to transact like you would typically with cash, credit cards, or cheques in order to make purchases, invest, or accept payment. The transactions are recorded within digital blocks, and then cryptographically signed (hence “crypto”currency) making them entirely secure.⁷

When Satoshi Nakamoto – a pseudonym for the person or group – introduced Bitcoin in 2009, it was described as a ‘peer-to-peer electronic cash system’, a completely decentralised system, with no servers or central controlling entity involved.⁸

Double-spending solved

The reason why this was so revolutionary, is that blockchain – the technology that underpins cryptocurrency – solved one of the most critical challenges digital payments faced; that of ‘double spending’, which is a fraudulent technique of spending the same amount twice.⁹ Blockchain released digital platforms from having to depend on trusted third parties to prevent double spending, as the decentralised network uses a universal public ledger that visibly displays every transaction within the network. If someone tries to spend the same cryptocurrency more than once by making two separate transactions with the same input in the same block, then the two transactions cancel each other out.

The key is key

When you buy or receive cryptocurrency, such as bitcoin, you’re given a secret digital key, or password, that proves to anyone on the network that a certain amount of bitcoin is yours to spend or use as you wish. When you spend that bitcoin, the entire network will know that you have transferred ownership of it, and your key is proof that you have authority to do so. The history of every transaction made is a permanent record of who owns what. That record is called “blockchain”.¹⁰

Use wallets for assets

It’s important to keep your key or password safe, as anyone who discovers your key can gain total, irreversible control over your cryptocurrency. Cryptocurrency wallets allow you to keep your cryptocurrency safe. There are a variety of online and offline cryptocurrency wallets to choose from, where you can ‘download’ your cryptocurrency to, such as desktop wallets, mobile, paper, and hardware wallets.¹¹

How to buy cryptocurrency

The disclaimer that is often attached to cryptocurrency investments serves as a stark reminder that this is an unstable investment environment, “Investing in cryptocoins or tokens is highly speculative and the market is largely unregulated. Anyone considering it should be prepared to lose their entire investment.”¹²

Here are some tips for when investing in cryptocurrency:

1. Start slowly. Risk and investment go hand in hand, and it’s wise to bear in mind that digital currency is still in the early stages of development when compared to investments such as stocks or bonds. Tim Enneking, managing director of Crypto Asset Management, suggests being patient and allowing the Bitcoin price to come to you, and once the price is right, investing a little at a time in varying stages.¹³
2. Diversify investments. Diversifying investments means that, when one component declines, another will improve. Consider an investment portfolio of an equal amount of Bitcoin, Ether, Litecoin, Ripple, and Bitcoin Cash, plus traditional stocks and bonds, in order to mitigate fluctuations.¹⁴
3. Use your wallet. Exchanges are a good place to buy digital currencies, but assets should be stored in online and offline crypto wallets in order to prevent being hacked.¹⁵
4. Buy and hold. The strategy of invest-then-wait is used successfully for all investments, not just cryptocurrency, and is advocated by legendary investor Warren Buffett.¹⁶ Gavin Yeung, founder and CEO of digital asset management firm Cryptomover, offered a similar point of view. “We at Cryptomover believes that a passive investment style will outperform active strategies in the long term,” he stated. “Not only is passive investing inexpensive and simple, it also lowers trading fees leading to much lower operating expenses.”¹⁷

Being street-smart as a crypto-newcomer

Although digital-ledger technology, or blockchain, has never been hacked, cryptocurrencies are vulnerable to theft and hacking. The most infamous theft occurred in 2014, when someone assumed another person’s identity and 850,000 bitcoin was taken from the Mt. Gox exchange.¹⁸ More recently, in January 2018, $530 million was stolen from a Tokyo-based cryptocurrency exchange in a single hack.¹⁹

But losing your investment could be simpler than someone hacking your account. The U.S. Commodity Futures Trading Commission (CFTC) warns of “pump and dump” schemes that target inexperienced crypto investors. This is where large groups of people coordinate to push the price of a certain coin up by buying into it at the same time, and making it look more attractive to new, naive buyers.²⁰ When the price is high these scammers sell their coins at the same time, dropping the value of the coin drastically, and making the newcomer lose significant investment value.

There’s also the threat of the ‘51%’ attack.²¹ This hasn’t happened yet, but threatens to happen from time to time. This is where a group of miners controls over 50% of a network’s computing power and can deny verification of transactions and refuse to pay users.

Success stories of cryptocurrency adoption

While the prices of individual cryptocoins have a tendency to fluctuate freely, blockchain-based currency is here to stay, and there are some investors and fintechs who have made huge successes of their investments. Here are the top five people listed on Forbes’ list of cryptocurrency millionaires:²²

• Chris Larsen, well-known for co-founding a host of fintech apps, saw his net worth reach nearly $20 billion in early 2018, thanks to his ownership of 5.2 billion XRP, the tokens of Ripple, the company he founded. XRP has since crashed dramatically but Larsen still tops the Forbes list.
• Changpeng Zhao, the Chinese-Canadian coder who runs Binance, a cryptocurrency exchange that can process a lightning 1.4 million transactions per second, has a personal fortune worth as much as $2 billion.
• Joseph Lubin, the founder of the 600-employee business ConsenSys, home to the Ethereum ecosystem, began his career working in robotics, machine vision, neural nets and software engineering, is now estimated to be worth $1 billion – $5 billion.
• Tyler and Cameron Winklevoss, the twins famous for suing Mark Zuckerberg for $65 million for stealing their social media platform idea, bought cryptocurrency in 2012, during its infantile stages. They also started a successful New York-based cryptocurrency exchange, Gemini, where investors can buy and sell digital currencies. The twins are estimated to be worth $900 million-$1.1 billion each.

Investing in cryptocurrency can be extremely lucrative, but it’s reward is given to those who approach it with a long-term view of financial return. Assessing these factors reasonably and sensibly will reveal the correct strategic approach on where and how to invest in cryptocurrency in order to allow investors to start seeing a return in the long run.

Enhance your knowledge of cryptocurrency and the way it operates within the economic environment in the Cryptocurrency short course from MIT Media Lab.