– WHAT IS A CRYPTOCURRENCY EXCHANGE?

WHAT IS CRYPTOCURRENCY?

Cryptocurrency is a type of currency that is based on cryptography and uses a distributed ledger system called the blockchain. By harnessing these technologies, developers have aimed to create currencies that are, for the most part, secure, private, traceable and decentralised.

WIDESPREAD INTEREST

Since bitcoin came into existence in 2009, cryptocurrencies have drawn widespread interest from investors. Bitcoin, created in 2009, was the first cryptocurrency to scale. In the years since, these currencies have drawn significant inflows from investors, resulting in their total market capitalisation (market cap) surpassing £75 billion in June 2017.¹⁾

This figure represented a more than 400% gain over the market cap of £13.6 billion these cryptocurrencies had at the start of the year 2017.²⁾

ROBUST GAINS

A perfect example of this robust investor interest is the price gains that bitcoin has experienced since inception. Several media outlets have announced that if an investor had purchased a small amount of bitcoin in 2010, when it was worth a fraction of a penny, that investment would have been grown astronomically in the seven years after.

It has been estimated that if an investor purchased US$5 (roughly £3.84) worth of the cryptocurrency in 2010, they would have US$4.4 million (£3.38 milion) at the time of report.³⁾At that time, bitcoin was trading close to $2,200 (£1,690).

The cryptocurrency has risen significantly since then, reaching almost US$3,000 (£2,300) in June 2017. If an investor purchased bitcoin for US$5 (£3.84) and held onto the cryptocurrency until it hit this notable high, it would have climbed close to 60,000%.

SPECULATIVE INVESTMENTS

Investors should keep in mind that cryptocurrencies are speculative investments, and the willingness of investors to wager on their future value is what has driven their significant price gains over the years.⁴⁾

Unlike the companies whose ownership rights are represented in stocks, cryptocurrencies do not produce revenue or free cash flow. They do not generate earnings which can in turn be distributed in the form of dividends.

While cryptocurrencies do not generate revenue and earnings like companies, many consider these innovative assets the way of the future. Tyler and Cameron Winklevoss, co-founders of cryptocurrency exchange Gemini, have taken this point of view, stating in a 2016 interview that the use of these assets will be fairly widespread in the years to come.⁵⁾ They predict that people will stop using services like PayPal and will instead leverage cryptocurrencies.

A paper released by PwC stated that cryptocurrencies—and the blockchain that underlies these assets—could potentially disrupt many different transactions.⁶⁾ Amid this potential impact, many investors are wagering on the “inherent value” of the underlying technology, including the decentralised network that makes these cryptocurrencies a possibility and the strength of the cryptography involved.

To get a better understanding the key variables that help determine this inherent value, it is helpful to get a better understanding of cryptography and the blockchain, the key technologies that underlie cryptocurrencies.

CRYPTOGRAPHY BASICS

Cryptography involves concealing information so that it can be sent between sender and recipient in a secure manner.⁷⁾ Cryptocurrencies like bitcoin use cryptographic protocols, which have specific rules, to enable this discreet transfer of data.⁸⁾

When it comes to cryptocurrencies, cryptography is used in a few different places. A perfect example is the protocols used to create blocks in the blockchains of these currencies.

PROOF OF WORK

Multiple cryptocurrencies, including bitcoin, use something called a proof-of-work (POW) protocol to create new blocks. To mine bitcoin specifically, computers use the cryptocurrency’s mining software to compute an encryption function in an effort to mine blocks and obtain a bitcoin reward.⁹⁾

Every time a block is created, it comes with a nonce, which is a string of random numbers.¹⁰⁾To confirm that the block was mined properly, the computers involved with mining need to find a nonce that meets certain criteria.

In a way, the computers involved in this mining are behind leaving a code that other verifiers can use to confirm these blocks were mined.

THE BLOCKCHAIN’S POTENTIAL

Investors can also benefit from knowing about the potential of the blockchain. This distributed ledger system could disrupt a wide range of industries, making existing processes more transparent and efficient in the process.¹¹⁾

A perfect example of the benefit that the blockchain could offer is the safeguards it can provide against fraud. The distributed ledger systems used by cryptocurrencies are often immutable, meaning that once transactions are recorded, they cannot be erased. Bitcoin’s blockchain, for example, was designed to be immutable.

If a blockchain is both decentralised and immutable, this combination helps protect it from those who would seek to defraud the system.

BENEFITS OF CRYPTOCURRENCY

Investors who are interested in cryptocurrencies may want to know about the various benefits these assets offer.

One major attraction of cryptocurrencies is that many of them are decentralised. Fiat currencies like the euro, British pound and U.S. dollar are issued by central banks, and some have voiced concern that they could be devalued rather easily.¹²⁾

A notable benefit of this decentralisation is that while certain countries have restricted the use of their native currency by imposing capital controls, the residents of these nations were able to use bitcoin to make transactions.

Some cryptocurrencies have an upper limit or cap on the number of units that can be created. Bitcoin, for example, is limited to roughly 21 million coins, a figure that is expected to be reached by 2140.¹³⁾ Litecoin, a cryptocurrency whose technology is similar to that of bitcoin, has a total cap of 84 million units.¹⁴⁾

This upward limit helps provide a check on unwanted inflation. In other words, it helps prevent these currencies from losing significant purchasing power. At the end of the day, the value of any asset is a function of supply and demand, so any cryptocurrency could have very little regardless of what its cap is.

Another benefit of cryptocurrencies is privacy. While bitcoin advocates have repeatedly touted the cryptocurrency as providing anonymous transactions, bitcoin transfers are not, in fact, anonymous.

Bitcoin transfers take place between bitcoin addresses, which are randomly generated strings of letters and numbers. Over time, a growing number of transactions can attach to a bitcoin address, offering insight into that user’s purchasing trends.

Other cryptocurrencies, notably monero and zcash, have done more to provide users with privacy. Monero, in particular, has enjoyed widespread demand, as several dark web marketplaces have opted to use the currency.¹⁵⁾

Another benefit of cryptocurrencies is the traceability of transactions. This means that any and all transactions are made public and can be tracked as such.

SUMMARY

Cryptocurrencies, which are currencies that harness cryptography and the blockchain, have drawn widespread interest in the last several years. These digital assets have attracted significant funds from investors, causing them to gain significantly in value.

However, investors should keep in mind that cryptocurrencies are speculative investments. Nobody knows for certain what the future holds for global asset markets. While cryptocurrencies are considered by some to be the way of the future, they could also be a fad.

As a result, investors might benefit from speaking with a qualified financial professional, such as a financial advisor, before deciding to purchase any cryptocurrency.

– Welcome to the future

WHAT IS BITCOIN?

Bitcoin is a form of digital currency, created and held electronically. No one controls it. Bitcoins aren’t printed, like dollars or euros – they’re produced by people, and increasingly businesses, running computers all around the world, using software that solves mathematical problems.

It’s the first example of a growing category of money known as cryptocurrency.

What makes it different from normal currencies?

Bitcoin can be used to buy things electronically. In that sense, it’s like conventional dollars, euros, or yen, which are also traded digitally.

However, bitcoin’s most important characteristic, and the thing that makes it different to conventional money, is that it is decentralized. No single institution controls the bitcoin network. This puts some people at ease, because it means that a large bank can’t control their money.

Who created it?

A software developer called Satoshi Nakamoto proposed bitcoin, which was an electronic payment system based on mathematical proof. The idea was to produce a currency independent of any central authority, transferable electronically, more or less instantly, with very low transaction fees.

Who prints it?

No one. This currency isn’t physically printed in the shadows by a central bank, unaccountable to the population, and making its own rules. Those banks can simply produce more money to cover the national debt, thus devaluing their currency.

Instead, bitcoin is created digitally, by a community of people that anyone can join. Bitcoins are ‘mined’, using computing power in a distributed network.

This network also processes transactions made with the virtual currency, effectively making bitcoin its own payment network.

So you can’t churn out unlimited bitcoins?

That’s right. The bitcoin protocol – the rules that make bitcoin work – say that only 21 million bitcoins can ever be created by miners. However, these coins can be divided into smaller parts (the smallest divisible amount is one hundred millionth of a bitcoin and is called a ‘Satoshi’, after the founder of bitcoin).

What is bitcoin based on?

Conventional currency has been based on gold or silver. Theoretically, you knew that if you handed over a dollar at the bank, you could get some gold back (although this didn’t actually work in practice). But bitcoin isn’t based on gold; it’s based on mathematics.

Around the world, people are using software programs that follow a mathematical formula to produce bitcoins. The mathematical formula is freely available, so that anyone can check it.

The software is also open source, meaning that anyone can look at it to make sure that it does what it is supposed to.

What are its characteristics?

Bitcoin has several important features that set it apart from government-backed currencies.

1. It’s decentralized

The bitcoin network isn’t controlled by one central authority. Every machine that mines bitcoin and processes transactions makes up a part of the network, and the machines work together. That means that, in theory, one central authority can’t tinker with monetary policy and cause a meltdown – or simply decide to take people’s bitcoins away from them, as the Central European Bank decided to doin Cyprus in early 2013. And if some part of the network goes offline for some reason, the money keeps on flowing.

2. It’s easy to set up

Conventional banks make you jump through hoops simply to open a bank account. Setting up merchant accounts for payment is another Kafkaesque task, beset by bureaucracy. However, you can set up a bitcoin address in seconds, no questions asked, and with no fees payable.

3. It’s anonymous

Well, kind of. Users can hold multiple bitcoin addresses, and they aren’t linked to names, addresses, or other personally identifying information. However…

4. It’s completely transparent

…bitcoin stores details of every single transaction that ever happened in the network in a huge version of a general ledger, called the blockchain. The blockchain tells all.

If you have a publicly used bitcoin address, anyone can tell how many bitcoins are stored at that address. They just don’t know that it’s yours.

There are measures that people can take to make their activities more opaque on the bitcoin network, though, such as not using the same bitcoin addresses consistently, and not transferring lots of bitcoin to a single address.

5. Transaction fees are miniscule

Your bank may charge you a £10 fee for international transfers. Bitcoin doesn’t.

6. It’s fast

You can send money anywhere and it will arrive minutes later, as soon as the bitcoin network processes the payment.

7. It’s non-repudiable

When your bitcoins are sent, there’s no getting them back, unless the recipient returns them to you. They’re gone forever.

So, bitcoin has a lot going for it, in theory. But how does it work, in practice? Read more to find out how bitcoins are mined, what happens when a bitcoin transaction occurs, and how the network keeps track of everything.

WHAT IS A CRYPTOCURRENCY EXCHANGE?

Cryptocurrency exchanges are websites where you can buy, sell or exchange cryptocurrencies for other digital currency or traditional currency like US dollars or Euro. For those that want to trade professionally and have access to fancy trading tools, you will likely need to use an exchange that requires you to verify your ID and open an account. If you just want to make the occasional, straightforward trade, there are also platforms that you can use that do not require an account.

Types of exchanges

Trading Platforms – These are websites that connect buyers and sellers and take a fee from each transaction.

Direct Trading – These platforms offer direct person to person trading where individuals from different countries can exchange currency. Direct trading exchanges don’t have a fixed market price, instead, each seller sets their own exchange rate.

Brokers – These are websites that anyone can visit to buy cryptocurrencies at a price set by the broker. Cryptocurrency brokers are similar to foreign exchange dealers.

What to look out for before joining an exchange

It’s important to do a little homework before you start trading. Here are a few things you should check before making your first trade.

Reputation – The best way to find out about an exchange is to search through reviews from individual users and well-known industry websites. You can ask any questions you might have on forums like BitcoinTalk or Reddit.

Fees – Most exchanges should have fee-related information on their websites. Before joining, make sure you understand deposit, transaction and withdrawal fees. Fees can differ substantially depending on the exchange you use.

Payment Methods – What payment methods are available on the exchange? Credit & debit card? wire transfer? PayPal? If an exchange has limited payment options then it may not be convenient for you to use it. Remember that purchasing cryptocurrencies with a credit card will always require identity verification and come with a premium price as there is a higher risk of fraud and higher transaction and processing fees. Purchasing cryptocurrency via wire transfer will take significantly longer as it takes time for banks to process.

Verification Requirements – The vast majority of the Bitcoin trading platforms both in the US and the UK require some sort of ID verification in order to make deposits & withdrawals. Some exchanges will allow you to remain anonymous. Although verification, which can take up to a few days, might seem like a pain, it protects the exchange against all kinds of scams and money laundering.

Geographical Restrictions – Some specific user functions offered by exchanges are only accessible from certain countries. Make sure the exchange you want to join allows full access to all platform tools and functions in the country you currently live in.

Exchange Rate – Different exchanges have different rates. You will be surprised how much you can save if you shop around. It’s not uncommon for rates to fluctuate up to 10% and even higher in some instances.