What on Earth is Cryptocurrency?

In its simplest form, cryptocurrency is digital money. Like any other currency, it’s a medium of exchange used between parties to complete a transaction.

Traditional currency comes in the form of a banknote and coins and is circulated between people, businesses, or governments. This is the type of currency that we’ve all come to understand.

What do we do with traditional currency?

A currency makes commerce easier by functioning as a substitute for some other valuable good. For example, let’s assume that we lived in a society where no currencies existed and that we only bartered for goods. In this society, your neighbor builds computers and you build toasters. One day, you decide that you need exactly one computer. In order to obtain the computer, you’ll need to give your neighbor something of value in exchange. But there’s a problem: your neighbor’s computers are far more valuable than your toasters. It would take 25 toasters to equate to the value of one single computer.

Enter currency. It converts your single toaster into something more readily exchangeable.

What determines currency value?

There are many forms of currency with different values in use around the world. Conceptually, there are two types of currencies that exist:

  • Commodity money - is money backed by physical metal reserves, and its value is derived from the value of those underlying commodities.

  • Fiat money - is “fake” money. In other words, money whose value is derived through policies by an issuing government and the health of that government’s economy.

How are cryptocurrencies different from others?

Cryptocurrencies aren’t much different than other fiat currencies. They’re just not represented in a physical form like paper money or coins. They’re digital.

Some argue that a cryptocurrency’s value is harder to determine because it isn’t backed by the assets and good faith of a government. The U.S. Dollar, for example, is backed by a government. Others argue that the decentralized nature of the cryptocurrencies allows for wider spread use and wider-scale consensus building over the underlying value of the currency.

What are the benefits of cryptocurrencies?

Some of the benefits of cryptocurrencies include:

1.      Fraud Protection – the security infrastructures underlying cryptocurrencies are robust, utilizing ledger systems that track currency activity anonymously.

2.      Faster Processing – without complicated regulatory systems that require various checks and balances (especially for money transferred international), cryptocurrencies allow for faster processing of money transfers.

3.      Technological Advancement – the technology underlying cryptocurrencies (blockchain) has the potential to help organizations of any kind improve logistics and accounting functions. The technology provides detailed ledgers and precise, real-time data. (Even companies like Chase and Walmart are investing in this technology).

What are the disadvantages of cryptocurrencies?

Some of the downsides of cryptocurrencies include:

1.      Ancillary Security Risks – we’ve heard countless stories about people who lose passwords (and lose fortunes in the process), suffer from technical disruptions (and lose fortunes in the process), or fall prey to incompetent or fraudulent service providers in whom customers provide their trust.

2.      Market Volatility – the prices of cryptocurrencies swing wildly. Partly a biproduct of their new and novel nature (think tech stocks in the early 2000’s). We don’t yet fully understand their place in the world, and this results in less price stability.

3.      Scale – cryptocurrencies have a long way to go before their respective infrastructures can rival other payment merchants like Visa and Mastercard, and there’s even some doubt they’ll ever reach that point.

What does this mean for us?

The benefits are important, not only as a standalone currency, but for the technology that has sprouted from the currency’s inception. It has piqued the interest of some very large organizations, and some of them are investing a lot of capital in projects surrounding the currencies and blockchain.

Does it mean we should start using it now? Maybe. Options are currently limited (at least for those of us law-abiding citizens). Should we start investing in Bitcoin or Ripple? Your financial advisor would likely squash this idea, but that doesn’t mean you can’t invest a small percentage of your disposal income in something appealing to you. If your risk appetite allows it and the investment isn’t reckless, where’s the harm?

The bottom line is that this industry has arrived swiftly, and the benefits are just as exciting as the downsides are troubling. The technology, however, is appealing in and of itself. And it’s safe to say that it’s an industry that will evolve in interesting and likely useful ways in the near future.