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Understanding Cryptocurrency – Part I

By Jane Young, CFP, EA

Cryptocurrency is a digital currency that can be used to buy goods and services or hold as an investment. It is a private, decentralized currency that is not issued, managed, or regulated by a government or banking institution.  It does not physically exist.   It is an entry on a digital ledger that is secured with strong cryptography, a system that encodes and decodes the data.

Cryptocurrencies work using a technology called blockchain.  Blockchain is a decentralized digital ledger that prevents central control and guards against cyber-attacks.  Information is recorded as a hash, a long string of numbers and letters, generated by a complex mathematical function.  Each hash is linked to the hash before it, this makes unauthorized changes immediately apparent.  A predetermined number of hashes creates a block and blocks are linked to other blocks creating a blockchain. The blockchain is updated every 10 minutes on servers throughout the world.

People were exploring the idea of a virtual currency for years, but it did not really gain traction until 2008 when Bitcoin was started.  One of the goals of Bitcoin was to create a system that did not depend on third-party intermediaries to process electronic payments and to create a currency where supply could not be controlled by a central bank.  Until now this has not been a major concern in the U.S. but is a significant concern in countries like Zimbabwe and Venezuela where they have experienced hyper-inflation due to the excessive printing of money.  

According to coinmarketcap.com, there are currently more than 6,700 different cryptocurrencies being traded publicly.  The total value of all cryptocurrencies is close to $650 billion dollars and the value of Bitcoin accounts for about $422 billion.  The most widely traded cryptocurrencies include Bitcoin, Ethereum, Litecoin and Tether.

The value of cryptocurrency is based on supply and demand.  Cryptocurrency does not generate cash flow and has no intrinsic fundamental value.  The value is not based on physical assets and it is not backed by the financial strength of a government.  The value is based on the confidence and trust the buyers place in the currency and what they are willing to pay.  When cryptocurrencies are launched a limited number of units can be created based on strict guidelines.  As the currency gains in popularity the value increases.  For example, only 21 million Bitcoins will ever exist and there are currently 18.6 million in circulation.  With the supply of new coins steadily decreasing, the value of Bitcoin is rising.

When cryptocurrencies were first introduced, they were commonly used for criminal activity, but they have recently become more widely accepted.  They are used for a variety of transactions including investing in start-ups, negotiating import and export deals and most recently to make purchases on PayPal.  However, most people use cryptocurrency as an investment or as a place to hold their money.