How do cryptocurrencies work?

An introduction to cryptocurrencies as a potential investment solution

29 July 2018, at 9:22pm

Cryptocurrencies (cryptos), such as Bitcoin, have grabbed a fair few headlines in recent months, with more and more new “currencies” being created all the time: there are now over 1,500 available. However, it is the price increases that have attracted most of the attention, with many comparing the recent rises to historic asset bubbles. For example, during the dot-com bubble around the turn of the last century, prices of technology stocks eventually fell by 80 percent. Another good example is the tulip bubble of the early seventeenth century, where speculation helped drive the value of tulip bulbs in the Netherlands to previously unheard of prices. Newly imported from Turkey, tulips were apparently a great novelty at the time, and perhaps cryptos are no different. 

Bitcoin was the first crypto and was described as a purely peer-to-peer version of electronic cash that would allow online payments to be sent directly from one party to another without going through a financial institution. This description underscores one of the key ideas behind digital currency – that it bypasses the traditional banking systems. You may, however, also note that it is not a clear explanation of an investment – which fairly well sums up these assets in that they are complex instruments that are difficult for many investors to understand. 

Unlike traditional finance, cryptos have no central monetary authority. Instead, banks are replaced by a peer-topeer network made up of users’ computers, which timestamp transactions by hashing them into an ongoing chain of work. This forms a chain of transaction history of every bitcoin, called the blockchain. If it is done properly, blockchain does have the potential to speed up transactions, allow for international transfers, cut costs and improve transparency across several industries. 

It is important, though, to realise that cryptos are fundamentally different from traditional currencies like the Great British pound or the US dollar. Money, in the form of currencies (coins and banknotes) and electronic money (bank deposits), is commonly characterised by at least three functions: a medium of exchange (for buying), a unit of account (for pricing) and a store of value (for saving). This is quite clearly not the case for these cryptocurrencies. 

The number of articles in the financial press that have tried to make a standard investment case for Bitcoin has been amazing. Most investment professionals have deliberately avoided covering the phenomenon, because the fundamentals simply do not support the rates of appreciation we have seen. Essentially, the market dynamic isn’t that far removed from a pyramid scheme; if you buy in, you are wholly reliant on market churn. 

Finally, cryptocurrencies are still not very well regulated by the authorities, although this is changing gradually, and in most countries (with the notable exception of Japan) they are not accepted as legal tender. Until this changes, the case for investment is based on chance and speculation, neither of which, we would suggest, are the key drivers of a rational and suitable investment for most people.

Rob Tiffin, AwPETR DipFA, joined RT Financial Planners in 2010. Rob is qualified to diploma level and advises on specialist pension transfers. He works with businesses and individuals, in the main advising on pension and investment matters.

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