With Bitcoin, Ethereum, and other cryptocurrencies, we’re breaking new ground in investing, banking, and using money. This beginner’s guide tells you more.
The terms cryptocurrency or cryptocurrency refer to digital assets that also function as a medium of exchange. Individual asset attributions are thereby recorded in a distributed database, usually a so-called blockchain. This public financial transaction database uses strong encryption technology to confirm and secure transactions, ownership, and, if necessary, the creation of additional coins or even the destruction of coins.
The terms “cryptocurrency” and “cryptocurrency” include all crypto projects with tradable shares. As of June 2021, there were over 10,000 different cryptos, few of which were designed as currencies. What they have in common is that the coins of these projects, some of which offer a purpose themselves, are tradable. Various crypto exchanges, as well as dexes (decentralized exchanges), offer trading or direct purchase for different coins and tokens in each case. These can be transferred to private wallet addresses, where they are protected from third-party access and can only be accessed by a key.
As a typical object of speculation, cryptocurrencies have not yet been recognized by states as an official form of money, with the exception of El Salvador, but as of June 2021 they were used by over 220 million people worldwide. Especially in developing and emerging countries with underdeveloped financial systems and high inflation, a rapid adaptation is observed, while many states are working on the digitalization of their currencies at the same time.
- With cryptocurrencies, assets can be transferred online without relying on an intermediary such as a bank or payment system. This allows assets to be transferred globally, virtually in real time, around the clock, and at low fees.
- Cryptocurrencies are generally not issued or controlled by governments or other central authorities. They are managed by peer-to-peer computer networks using free open-source software. Basically, anyone who wants to participate can do so.
- Who or what guarantees the security of cryptocurrencies if there are no banks or government agencies behind them? Cryptocurrencies are secure because all transactions are verified using a technology called blockchain.
- The blockchain of a cryptocurrency is comparable to a bank’s balance sheet or account ledger. Each currency has its own blockchain. It is an ongoing, constantly re-verified register that records every single transaction that has been made with that currency.
- Unlike a bank’s account ledger, the blockchain of cryptocurrencies is distributed across all participants in the digital currency network
- No company, country or third party has control over this network and anyone can become part of it. A blockchain is a breakthrough technology that has only recently become available and is the result of decades of innovation in computer science and mathematics.
Cryptos are not currencies in the strict sense and do not exist in physical form (such as paper money and coins). With the exception of El Salvador, they are not legal tender in any state and are not usually issued by a central authority or controlling body. Instead, behind many cryptos is capitalist private-sector interest, as well as a desire for speculation and decentralized control: anyone can become the owner of the means of production used to produce and issue the coins and participate in managing them, as well as share in the value created. Nevertheless, there are also crypto projects where, for example, a single issuer issues all the coins. However, by distributing the coins or tokens appropriately, there is also the possibility here, if desired, to convert them into decentralized projects.
Cryptocurrencies enable digital payment transactions without central instances such as banks. This is done with the help of decentralized data storage and cryptographically encrypted transmission protocols. Ownership of credit is represented by possession of a cryptological key. The credit, which is also cryptographically signed, is mapped in a collaborative ledger in the form of distributed ledger technology, usually a blockchain. Cryptocurrencies do not exist in physical form (like paper money) and, unlike fiat money or central bank digital currencies as originally conceived, are not issued by a central authority. However, even though with many cryptocurrencies, unlike everyday common money, a single party is not able to single-handedly accelerate, interfere with, or in any way materially abuse the production of currency units, many other cryptocurrencies are absolutely produced centrally by owner-operated, privately held, for-profit companies. For example, Ripple Labs held up to 80 percent of new issues of the cryptocurrency Ripple and distributes them at its discretion.
The summed market capitalization of all cryptocurrencies has been determined since 2013. In 2017, a combined market capitalization of USD 100 billion was reached for the first time, which climbed to its temporary peak in January 2018 at USD 800 billion. Subsequently, this fell to below 500 billion within a few weeks. This limit was not exceeded again until November 2020. Since then, the prices literally exploded and reached a preliminary peak on May 12, 2021, when the total market capitalization exceeded 2.5 trillion US dollars. The prices of cryptocurrencies, with the exception of the so-called stablecoins, can therefore be classified as extremely volatile. The trading prices of all cryptocurrencies are also directly related to the valuation of bitcoin and – to generalize – decrease when the price of bitcoin decreases, and vice versa. All coins and tokens that are not Bitcoin are subsumed under the term altcoins (from: alternative coins).
Bitcoin, which was first released as open source software in 2009, is the first decentralized cryptocurrency. Bitcoin was conceived purely as a currency and a means of payment. Since 2020, the narrative of Bitcoin as a store of money has been increasingly embraced. Some other early cryptocurrencies, such as Litecoin or Digibyte, were also conceived purely as a means of payment in competition with Bitcoin and claim to offer, for example, faster or cheaper transactions than Bitcoin. Nevertheless, in terms of market capitalization, Bitcoin is so far the largest and most widely used of all cryptocurrencies.
A majority of the now more than 10,000 cryptocurrencies were not conceived as pure payment systems. Instead, most of the coins or tokens called cryptocurrencies are indeed exchangeable and tradable assets, according to the above six conditions of the definition, but with additional functionality to the pure means of payment. These additional added values or functions are highly diverse. For example, there are cryptocurrencies that provide voting rights for a wide variety of decisions within a network (or even external factors), cryptocurrencies that represent a current equivalent value to fiat currencies, cryptocurrencies that are used solely as transaction fees for a network, or cryptocurrencies that allow a warehouse to communicate with the appropriate supplier, and many more.
Some cryptocurrencies pay out some sort of interest or even participation in approximately transaction costs in various ways when they are “staked” or otherwise invested.
All cryptocurrencies besides Bitcoin are called altcoins. The long-standing second largest of all cryptocurrencies is called Ether and is the internal payment method for the blockchain system Ethereum.
Central Bank Digital Currency
Central Bank Digital Currency (CBDC), or central bank digital money in German, refers to projects that involve a digital currency issued by a central bank. The value of a CBDC is said to be 1:1 the value of the regular (country) currency it represents.
A Bank for International Settlements report states that while the term “central bank digital currency” is not precisely defined, “it is viewed by most as a new form of central bank money […] distinct from balances in traditional reserve or settlement accounts.”
A CBDC also differs from virtual currencies and cryptocurrencies, in that the latter are not issued by a government and do not have legal tender status declared by a government.
In general, CBDCs are at a very early stage of development. According to a 2021 survey, about 80% of central banks worldwide are investigating CBDCs, with 40% already conducting proof-of-concept tests.
Privacy coins are cryptocurrencies that enable digital anonymous payments (digital cash). Bitcoin was still considered a privacy coin at the beginning of its introduction, and it found its application as a means of payment on numerous darknet marketplaces. However, due to the increasing integration of cryptocurrencies into existing government payment systems, regulatory requirements, e.g. KYC or AMLA, have led to a softening of anonymity in the Bitcoin ecosystem Transactions with Bitcoin are therefore not anonymous, but merely pseudonymous. Therefore, efforts are being made to extend the pseudonymization that exists in the cryptocurrency ecosystem to as complete an anonymization as possible.
A Non-Fungible Token (NFT), or non-exchangeable token, is a non-replaceable token that represents something in the blockchain. Such an NFT is used, for example, for digital works of art, cosmetic items in computer games or trading cards.
Why are cryptocurrencies the future of finance?
Cryptocurrencies are the first alternative to traditional banking, and they have tremendous advantages over previous payment methods and traditional asset classes. Think of cryptocurrencies as a kind of money 2.0 – a new kind of money born on the internet, giving it the potential to become the fastest, easiest, cheapest, safest, and most universal method ever to exchange assets.
- Cryptocurrencies can be used to purchase goods and services or held as part of an investment strategy. However, they cannot be manipulated by a central authority, as there simply is no such authority. Your cryptocurrency is and remains safe – no matter what happens at the government level.
- Digital currencies allow for equal opportunity, regardless of where you were born or where you live. As long as you own a smartphone or other internet-connected device, you have the same access to cryptocurrencies as everyone else.
- Cryptocurrencies create unique opportunities for expanding the economic freedom of people around the world. The fact that digital currencies have essentially no borders promotes free trade, even in countries that rigorously control the finances of their citizens. In places where the main problem is inflation, cryptocurrencies can provide an alternative to failed fiat currencies for savings and payments.
- As part of a broader investment strategy, there are a wide variety of ways to add cryptocurrencies. One approach is to buy and hold a cryptocurrency such as Bitcoin, which was virtually worthless in 2008 and is worth thousands of dollars per coin today. Another option would be a more active strategy, i.e. buying and selling cryptocurrencies that go through volatile periods.
- One option for investors who are interested in cryptocurrencies but do not want to take too much risk is the USD Coin currency, which is pegged 1:1 to the value of the US dollar. It combines the advantages of cryptocurrencies, including the ability to make international transfers in a fast and cheap way, with the stability of a traditional currency. Coinbase customers who hold USDC receive rewards, which makes the currency an attractive alternative to a traditional savings account.
In 2020 and 2021, cryptocurrencies have seen unprecedented institutional adoption, especially Bitcoin, which also greatly boosted the prices of virtually all cryptocurrencies. Square, MicroStrategy, and Tesla are just three of the many companies now invested in Bitcoin.
As of June 2021, the Grayscale Bitcoin Trust managed $25.7 billion. A survey of 100 chief financial officers of hedge funds worldwide, conducted by fund manager Intertrust, found that these executives expect to hold an average of 7.2 percent of their assets in cryptocurrencies in five years. Intertrust estimates that if that translates to the entire sector, it could equate to a total of about $312 billion in assets in cryptocurrencies for the hedge fund industry as a whole.
In Canada, three Ethereum ETFs were approved on April 20, 2021, following the approval of a Bitcoin ETF in February. In 2022, both bitcoin and ethereum ETFs are expected to be approved in the United States. ProFunds, an asset manager that manages $60 billion globally, successfully registered a mutual fund based on bitcoin futures with the U.S. Securities and Exchange Commission (SEC) on July 27.
The April 2021 IPO of crypto exchange Coinbase, one of the largest and longest-serving companies in the fledgling industry, also caused a stir. The IPO was the largest since that of Facebook in 2012 and the first by a company whose business model is exclusively trading and staking cryptocurrencies.