Cryptocurrency is all the rage at the moment.
Thanks to the commercial success of bitcoin and the Covid-19 pandemic driving investors away from the volatility of stock markets towards more innovative techno-finance products, cryptocurrencies have surged in popularity in recent years, and are even being touted as the next stage in the evolution of the global economy.
Despite being such a hot topic in the finance world, it can be difficult to find out what exactly cryptocurrencies are and how they work. For example, what is bitcoin? What is the difference between coins and tokens? What is a digital wallet? What are public and private keys?
A February 2021 survey by Bloomberg found that 61% of people that had heard of cryptocurrencies have "little or no understanding" of how they work.
If cryptocurrency is new to you or you just want to brush up on your knowledge, this article helps to break it down into manageable chunks and explain the technical jargon associated with cryptocurrencies.
What is a cryptocurrency?
A cryptocurrency is a digital currency that can be used to buy or sell products and services online. It is designed to be secure, and usually, anonymous.
As most cryptocurrencies are decentralised it means that they have no single overarching authority controlling them, as opposed to the centralised banking systems by which most traditional currencies (such as USD or GBP) are controlled. This enables many cryptocurrencies to exist independently from the influence of governments and financial institutions which is a key part of their attraction.
Cryptocurrency transactions and balances are verified and recorded using a virtual global ledger, known as a blockchain. Each type of cryptocurrency has its own blockchain. So bitcoin uses the bitcoin blockchain. Each block in a blockchain contains details of balances and transactions to certify the legitimacy of sales and purchases. Once a transaction is added to the ledger it can not be reversed. The blockchain is corroborated across a vast number of computers around the world, making it exceptionally hard to manipulate or hack.
Blocks are added to the blockchain by 'miners' which are high-powered computers on the network. When a miner manages to add a block to the blockchain, by solving an incredibly complex mathematical problem, they receive a reward in coins. So on the bitcoin blockchain that reward is currently 6.25 new bitcoins. On top of that, miners are paid a small fee (worth fractions of a bitcoin for example) for including transactions on the newly created block. These transactions fees vary based upon demand because the blockchain has a limited capacity at any one point. The fees are used to help maintain the integrity of the network.
That is why blockchain-based cryptocurrencies are especially appealing due to their enhanced security. Also as no one person or entity owns the database it prevents it from being manipulated for personal gain.
Cryptocurrency prices are not usually pinned to a physical asset (like gold, for example) so they have no intrinsic value. Their value is determined by supply and demand, making the price of most cryptocurrencies particularly temperamental, unpredictable, and largely at the mercy of public perception.
What are the different types of cryptocurrency?
There are three main "types" of cryptocurrency. Although cryptocurrency does not start and end with bitcoin, it does make up a large proportion of the cryptocurrency market, so we will start by explaining what a bitcoin is before we delve into the other two.
It would be quite hard not to have heard about bitcoin by now. Bitcoin was the world's first cryptocurrency and is the most popular type of cryptocurrency, and despite initial apprehension, the world of finance is increasingly starting to view it as a legitimate alternative to traditional money.
Founded in 2009 under the name Satoshi Nakamoto (later revealed to be a pseudonym for an unknown individual or group), bitcoin has surged to the forefront of a technological revolution. Initially used as the primary payment service on the dark web, bitcoin has hit the mainstream in recent years, and increased demand has sent its value skyrocketing.
As of June 2021, a single bitcoin is worth almost $32,000. Impressive as that is, this comes after a 45% fall in its value in a matter of weeks, demonstrating how volatile its price is.
Altcoins are essentially all the other cryptocurrencies that are not bitcoin. Once bitcoin was launched in 2009, it paved the way for thousands of alternatives, most of which operate in a similar way to bitcoin itself. There are close to a thousand altcoins in existence today.
Like bitcoin, all altcoins are able to operate independently from banks and financial institutions on their own networks. Litecoin, for example, is a peer-to-peer currency and global payment system similar to bitcoin, while ethereum boasts the world’s first programmable blockchain and enables developers to build and deploy decentralised apps and smart contracts. In short, this means that the ethereum blockchain, unlike other blockchains, can be used as a ledger for other assets, not just ethereum coins (ether). This opens up the exciting opportunities of tokens, as explained in the next section. Other cryptocurrencies include dogecoin.
The value of an altcoin can vary vastly, however. A single ethereum coin (ether) is worth just under £1,427 as of June 2021, but litecoin is worth barely over £97.
A token can be used as a form of payment like bitcoin but the main use of a token is to represent tradable assets or utilities within the wider ecosystem of its parent blockchain. To explain that in simple terms, firstly you must bear in mind that each cryptocurrency operates on its own blockchain (i.e. has its own online ledger of transactions). That means bitcoin operates on the bitcoin blockchain, litecoin operates on the litecoin blockchain. ether operates on the ethereum blockchain and so on and so on.
The ethereum blockchain is what is known as a smart contract blockchain that enables other assets (and not just ether) to be tracked and traded on it. This is where tokens come in. Tokens don't have their own blockchain, they have to operate on an already existing smart contract blockchain like ethereum. Tokens can be created to represent all sorts of things and have a value of their own.
For example, the cryptocurrency exchange platform Binance has a token that allows users to trade cryptocurrency on their system with a 50% reduced fee. But more interestingly tokens can be used as a digital representation of a real-world asset such as a share certificate or a property or a piece of art.
This opens up the possibility of creating a token (which is relatively easy to do) on something like the ethereum blockchain to represent a physical asset that you own. In the future ownership and sales/purchases of property could use tokens to speed up the house buying process. You will probably have heard about NFTs (non-fungible tokens) and all they are are tokens that usually represent unique assets, like a property or piece of art.
By contrast, a fungible token will represent an asset that is not unique, such as a share certificate. One share certificate for a stake in Apple is exactly the same as another Apple share certificate and therefore interchangeable. In this instance, someone who has 100 (fungible) tokens each representing an Apple share will own 100 Apple shares.
When tokens are created or traded a fee has to be paid to the miners of the blockchain to record the transaction, just as when you trade a cryptocurrency. As this blockchain will usually be the ethereum blockchain (the bitcoin blockchain won't work for anything other than bitcoin transactions) this fee will be paid in ether.
It follows that a token could be used to represent a currency such as the US dollar. These types of token already exist and are called stablecoins. Examples include tether and USDC. The value of one of these stablecoins always equals $1 which makes them a stable "cryptocurrency" and more useful when making transactions. The biggest drawback of most true coins like bitcoin is that their volatile value makes them less likely to become a mainstream way of paying for things in the wider economy.
What is a cryptocurrency wallet?
To use cryptocurrencies you need a digital wallet, think of it as a bank account.
Every wallet has two keys, a public key and a private key. The public key is used to provide a unique address for the wallet, which works in a similar way to a bank account number and sort code on a traditional bank account. With that information, people can pay coins into the wallet. Essentially the blockchain is just a list of transactions between different wallets. It doesn't record who owns each wallet. If you want to spend the money in a wallet you have to prove you own it. Think of it as entering the pin number when making a transaction from a traditional bank account.
How you do that is with the unique private key (which is just a very long string of seemingly random letters and numbers) that is associated with the public key for the wallet. Again, it is a similar concept (albeit more secure) to having to enter the correct pin number for your credit card when you go shopping. If you enter a number not associated to that credit card it won't work. Similarly, there is usually only one private key associated with each public key.
That's why it's important to know what your private key is. Unlike bank accounts where someone can unlock your card if you forget the pin, cryptocurrencies are decentralised so the only way of proving ownership is with the private key. If you eventually forget that private key or lose it then the coins in the wallet are worthless as they can't be spent.
Now, to be technically correct, coins don't actually live in a digital wallet. They are technically stored on the blockchain. Your wallet is your means of interacting with the blockchain. The blockchain contains the information to determine the number of bitcoins associated with a wallet address and your private key is your mechanism for proving ownership and then using those coins.
Wallets can be held in software (either online or on your computer or in an app) that is connected to the internet and known as 'hot' wallets. Alternatively, you can have a wallet on a physical device not connected to the internet (such as a piece of hardware like a USB stick) or in paper format (essentially the private key is not stored on a device but written down). These last two are known as cold wallets because they are offline and are less vulnerable to compromise than hot wallets.
Given the importance of securely knowing your private key some digital wallets provide a backup means of recovering your private key using something called a seed phrase. This is a list of up to 24 random words (which you need to note elsewhere) that can be used to recover your private key.
Some people simply use a wallet provided by the cryptocurrency exchange (more on those later) in order to trade/use bitcoin and other cryptocurrencies. But do beware when using any online option such as this as concerns have been raised about some not providing users with the details of their private key, instead just storing this information on the platform which can't be viewed by the user. That could potentially prove problematic as the private key is your only means of proof of ownership. If the exchange is hacked and the key compromised then theoretically your coins can be stolen.
So while the bitcoin infrastructure is secure, the software and exchanges that you may use to interact with it will always be a potential weak point. It is, for this reason, it is usually advisable to have a wallet that is separate from the cryptocurrency exchange that you use.
For more details on what cryptocurrency wallets are, and which type would be best for you, visit our article "What is a cryptocurrency wallet?".
How do you use a cryptocurrency?
You have three options when it comes to how you can spend your cryptocurrency.
1. Crypto-friendly debit cards
One way in which you can use cryptocurrency is to connect it to an existing debit card and spend it like cash in stores. A number of crypto-friendly debit cards are offered by the largest debit card providers, including Visa and MasterCard, so you are be able to spend your cryptocurrency wherever your debit card is accepted.
Different types of cryptocurrency are supported by different debit cards. There tend to be more options if your chosen cryptocurrency is bitcoin because it is widely seen as the most legitimate on the cryptocurrency market, but various altcoins are growing in popularity and are expected to catch up to bitcoin soon. Note that most of these cards charge a small fee either monthly or with each transaction.
Below is a list of some bitcoin-friendly debit cards:
|Debit cards you can use with bitcoin:||Features|
|Shift Card||This Visa debit card lets you connect to your Coinbase (a popular American cryptocurrency exchange platform) account to spend cryptocurrency online and offline.|
|CoinsBank||This cryptocurrency exchange offers four different cards, each with different features and fees. The cards automatically convert bitcoin into several different currencies, including USD and GBP.|
|Xapo||This card connects an existing Xapo account to a card that lets you pay in stores or online or even to retrieve cash. It also comes with an app to help you keep track of your spending and current bitcoin value.|
|Cryptopay.me||This is a prepaid card with low commission fees which comes with both a plastic and a virtual version, so you can choose whichever suits you best. This card works with GBP, USD, and EUR.|
|SpectroCoin||This prepaid card lets you cash in bitcoins at any ATM worldwide. You can also use it like a debit card. Cards can be used in USD, EUR, or GBP.|
|Bitpay||This Visa-branded card lets you load your bitcoins from your virtual wallet. You can then withdraw cash or use the card at retailer stores.|
Or, if you are using altcoins, here are some debit cards which may work for you:
|Debit cards you can use with altcoins:||Features|
|Uquid||This card, which also supports bitcoin, works with 89 altcoins, including: ethereum, ETC, augur, emercoin, and more.|
|TenX||TenX already currently supports bitcoin, but is currently beta-testing support for ethereum and its token called ERC20.|
|Polybius||This is a relatively new project that will take bitcoin, as well as a number of altcoins.|
2. Retailers which accept cryptocurrency as payment
If you want to avoid the fees that come with many using crypto-friendly debit cards, you can opt to spend your cryptocurrency directly with a retailer which accepts cryptocurrency as a form of payment.
Most of these rely on third-party processors such as Bitpay or Cryptopay to facilitate cryptocurrency transactions. These platforms cut out the middle man and allow you to simply opt to pay with cryptocurrency using your digital wallet at checkout.
Here is a list of some cryptocurrency-friendly retailers and details on what you can purchase from them:
|Retailers which accept cryptocurrency as payment:||Features|
|Overstock||This retailer processes payments through Coinbase, allowing you to spend from your virtual bitcoin wallet at the point of purchase.|
|Microsoft||You can stock your Microsoft account with bitcoin, but you can only use these funds in the Windows and Xbox online stores. They cannot actually be used to purchase items from the Microsoft online store.|
|Virgin Galactic||In keeping with its futuristic theme, this famous up-and-coming space tourism company accepts purchases with bitcoin.|
|Save the Children||For an alternative way to donate money to those in need, you can use Bitpay to directly donate bitcoin to children's charity Save the Children.|
|Expedia||This popular travel booking company allows you to pay for hotels with bitcoin via an integrated version of Coinbase.|
|Wikimedia||You can donate to the company which funds Wikipedia with bitcoin, bitcoin cash or ether.|
3. Trading cryptocurrencies
Lastly, you can choose to treat cryptocurrency similarly to shares on the conventional stock market by buying and selling it on a cryptocurrency exchange platform.
This comes with plenty of risk due to the extreme volatility of cryptocurrency value, but there is also the potential to make a profit if you get your timings right. For example, if you bought bitcoin while its value was low and sold it once it recovered, you would be able to make money off of trading the currency itself. But equally, if you bought bitcoin during a peak, you could end up making a substantial loss if its value dropped. Accurately timing the market is impossible to do on a consistent basis so it is difficult to predict which side you will end up on.
Nevertheless, if you are looking to invest in cryptocurrency, head to our article on "How to buy bitcoin".
Where can I buy cryptocurrency?
Just like when you buy and sell shares to funds you need an investment platform like Hargreaves Lansdown, when you want to trade/buy a cryptocurrency you need to use a cryptocurrency trading platform. There are a number of companies that you can use to buy cryptocurrency, but each platform has its own unique attributes which affect your trading experience.
Below is a list of some of the most popular cryptocurrency trading platforms, the typical fees associated with transactions, and a round-up of their key features:
|Coinbase||Between $0.99 and $2.99 depending on the dollar value of the purchase.||Offers bitcoin as well as a variety of altcoins, easy user interface, provides a cryptocurrency wallet to store your assets.|
|Cash App||Charges a service fee for each transaction, and an additional fee determined by price volatility. Both of these are subject to the cryptocurrency market's activity.||Can only be used to purchase bitcoin, offers a crypto-friendly debit card, allows users to invest in stock market shares.|
|Binance||0.1% for the taker and 0.1% for the maker. This can be scaled down depending on trade volume to 0.02% for both parties. Using Binance’s own cryptocurrency, BNB, lowers fees by 25%.||Wide variety of altcoins, lower fees than most alternatives, in-depth userface suitable for advanced investors.|
|Kraken||Maker fees start at 0.16% of your total order value and can go as low as 0%. Taker fees begin at 0.26% of your total order value and can go as low as 0.10%.||Easy to use interface, 24/7 live customer service chat, offers more than 50 different cryptocurrencies.|
|Gemini||0.5% - 3.99% depending on the payment method and platform you use.||Offers insurance of digital assets against cybercrime, more than 30 different cryptocurrencies, higher fees compared to alternatives.|
For an explanation of how maker and taker fees work and how they are calculated, head to our article on "What are maker and taker fees?",
What are the advantages of cryptocurrency?
By now, most of us have heard horror stories about people that have lost everything to cryptocurrency. Bitcoin, for example, regularly attracts attention from mainstream media for its volatility, and often comes attached to "rags to riches" or "I lost it all" fables warning people of the risks involved.
The governor of the Bank of England himself has even weighed in, warning that investors should beware of losing everything, as the cryptocurrency market is still in its infancy and public understanding is generally poor.
Nevertheless, cryptocurrencies continue to defy analysts' expectations. They have even been touted as a burgeoning technological revolution that could transform the world of finance as we know it.
The popularity of cryptocurrency is based on a number of advantages that make it more attractive than traditional money:
- Low fees - One of the reasons why cryptocurrency has proven so popular around the world is that there are very few, and generally low, fees associated with using it. However, fees do fluctuate depending on demand.
- Independence - Cryptocurrencies are not subject to an overarching authority such as a government or financial institution. In theory, this means that cryptocurrency can remain stable even in the face of political turmoil which might affect the value of traditional money. In reality, they tend to reflect investor risk sentiment in traditional assets such as equities.
- Ease - As awareness increases, there are increasingly more avenues for you to use and spend cryptocurrency, most of which are linked to a mobile device so you can access, spend or trade your cryptocurrency wherever you are in the world.
- Security - Traditional money is increasingly at risk from cybercrime, but cryptocurrency's strong encryption methods often make it safer than usual payment by protecting your personal information. The caveat to that is that exchanges have been hacked in the past and investors have their bitcoin stolen.
What are the disadvantages of cryptocurrency?
Cryptocurrency, for all its revolutionary appeal, has attracted plenty of well-deserved criticism. Famous investor Warren Buffet, for example, has referred to cryptocurrency as a "bubble" with no set indication of when it could burst.
It may not come as a surprise that established investors generally tend to warn against cryptocurrency, however, because the stakes involved in cryptocurrency are much higher than with traditional money simply due to their extreme unpredictability.
While cryptocurrencies have many unique advantages over conventional forms of payment, they also come with a number of disadvantages that need to be considered carefully if you want to use cryptocurrency as safely and sensibly as possible:
- High volatility - As noted with bitcoin, most cryptocurrencies are extremely unpredictable and there is a significant risk of making a loss. The value of traditional money such as USD or GBP often changes slightly day by day, but rarely enough to dramatically impact its utility as a payment option. Cryptocurrency value can plummet at very short notice and could leave you stranded with much less to your name than you had just a few days, or even hours, earlier.
- Potentially endless supply - Although most cryptocurrencies currently boast a limited supply of coins, which helps to keep their value as stable as possible, there is nothing to stop the launch of more new cryptocurrencies which could tilt the supply-demand scales and cause the value of existing cryptocurrencies to fall due to the sheer volume of cryptocurrency to choose from. This was perhaps less of a concern a few years ago, but as cryptocurrency grows in popularity, investors should consider that the sky-high crypto values making headlines may be a temporary phenomenon.
- Limited acceptance - While there are increasingly more ways for you to store, spend or sell cryptocurrency, there are still far fewer options than with traditional money, and until it catches up you could find yourself struggling to use your cryptocurrency as a form of payment in day-to-day life.
- Unregulated - Some see cryptocurrency's independence from banks to be a significant advantage, but equally this leaves your digital assets vulnerable to exploitation without the regulation or monitoring provided by traditional financial institutions such as the Financial Conduct Authority (FCA). The anonymity that cryptocurrency offers also means that it is increasingly used for illegal transactions.
- No financial protection - As buying and selling cryptocurrency is unregulated, investors do not receive any financial protection from the Financial Services Compensation Scheme (FSCS).
- Storage security - Cryptocurrency cannot be physically carried around in your wallet and accessed simply by opening it like traditional money. Digital wallets require the use of a password to use, and should you forget what that is, the strong encryption used in cryptocurrency storage means it would be impossible to recover a forgotten password (if the wallet has no backup option) and would lock you out of your digital assets until you remember it. This would effectively leave your cryptocurrency worthless as you would not be able to use it.
Cryptocurrencies are here to stay. They have many advantages and disadvantages and it is advisable to research and read around the topic before engaging with them. As a means of payment their utility is still questionable and remains in its infancy. As an investment opportunity, they represent a high-risk asset with no financial protection from the Financial Services Compensation Scheme, which makes them unsuitable for most investors. Even if you are accepting of the risks then the likes of bitcoin should account for a very small proportion of your wealth, if you mitigate the risks.