What is cryptocurrency?

  • By James Royal,
  • Bankrate.com
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Cryptocurrency is a kind of digital currency that is intended to act as a medium of exchange. Cryptocurrency has become popular in the last decade, in particular, with Bitcoin becoming the most widely tracked alternative currency. Typically, cryptocurrency is electronic-only and does not have a physical form – that graphic at the top of the page is just an artist’s vision of digital currency.

Cryptocurrency appeals to many people because of its ability to be managed without a central bank and therefore concerns around secrecy and subterfuge. It appeals because of its ability to hold value and not be inflated away by central banks that want to print money. It’s also very difficult to counterfeit due to the blockchain ledger system that manages the currency.

Here’s what cryptocurrency is, how it works and the significant drawbacks to its use.

How cryptocurrency works

Cryptocurrencies are produced, tracked and managed through what’s called a distributed ledger such as blockchain. In a distributed ledger, the currency’s movement is processed by computers in a decentralized network, to ensure the integrity of the financial data and ownership of the cryptocurrency. Think of it like a giant never-ending receipt of all the system’s transactions that is being constantly verified by everyone who can see the receipt.

This decentralized system is typical of many cryptocurrencies, which eschew a central authority. That’s part of the appeal of cryptocurrencies such as Bitcoin – it keeps governments and central banks out of the currency system, reducing their interference and political maneuvering.

To this end, in some cryptocurrencies, the number of units of currency is limited. In the case of Bitcoin, the system is organized so that no more than 21 million bitcoins can be issued.

But how exactly does cryptocurrency come to exist? The key way is through what’s called mining, to use a metaphor related to the old monetary system based on gold or silver. Powerful computers, often known as miners, perform calculations and process transactions on the ledger. By doing so, they earn a unit of the currency, or at least a part of a unit. It requires a lot of expensive processing power and often a lot of electricity to perform these calculations.

Owners of the currency may store it in a cryptocurrency wallet, a computer app that allows them to spend or receive the currency. To make a transaction, users need a “key,” which allows them to write in the public ledger, noting the transfer of the money. This key may be tied to a specific person, but that person’s name is not immediately tied to the transaction.

So part of the appeal of cryptocurrency for many is that it can be used somewhat anonymously.

There’s literally no limit to the number of cryptocurrencies that could be created. The range of them is astonishing, and literally thousands of currencies popped up in the last few years, especially as Bitcoin soared into mainstream popularity in 2017. Some of the most popular cryptos include Bitcoin, Litecoin, Ethereum, Ripple and Tether. Even Facebook has been trying to get in on the cryptocurrency game by establishing a consortium of industry partners.

The drawbacks of cryptocurrency

While proponents have a good story to tell about digital currencies such as Bitcoin, these currencies are not without serious drawbacks, at least as currently configured. That doesn’t mean you can’t make money on it by selling it to someone else at a higher price than you paid. However, these drawbacks do make it virtually useless as a currency, a means of exchange.

Bitcoin and other cryptos have real detractors, including some of the world’s top investors, such as multi-billionaire Warren Buffett. Buffett has called Bitcoin “probably rat poison squared,” while his longtime business partner Charlie Munger has said cryptocurrency trading is “just dementia.”

Mining the currency is expensive and polluting

One of the most significant negatives to cryptocurrency is that it is “mined” by computers. Mining isn’t free, of course, and requires substantial amounts of energy to create a coin. While miners consume and pay for energy to run their rigs, it also creates significant pollution and waste.

One 2019 study in technology journal Joule concluded that Bitcoin mining produced enough carbon emissions in 2018 to rank it between the countries of Jordan and Sri Lanka. Researchers from MIT and the Technical University of Munich concluded that Bitcoin mining alone accounted for 0.2 percent of global electricity consumption. Add in the effects from other cryptos and electricity usage more than doubled.

The number of coins is fixed

Proponents of Bitcoin tout the currency’s fixed number of coins as a positive, saying that it will ensure that the currency cannot be devalued, for example, by central banks. However, by limiting the total amount of currency, cryptocurrency would act like a gold standard, exposing an economy to potentially destructive deflationary spirals, if implemented on a widespread basis.

When money flows freely in an economy during a boom, no problems may arise. But when times get tough, consumers and businesses often hoard money, to provide them a buffer against instability and job loss. By hoarding, they slow the movement of money through the economy, potentially leading to a destructive deflationary spiral. At its worst form, consumers end up not spending, because goods will be cheaper tomorrow, plunging the economy into crisis.

This problem is exactly why modern countries have moved away from the gold standard and to fiat currency. Free from the gold standard, central banks can increase money flowing through the economy in tough times, even if consumers and businesses hoard it, preventing the economy from seizing up.

A volatile currency is unusable

The limited number of coins, speculative mania and a good story have combined to make the price of Bitcoin volatile. That may be fine if you’re looking to trade it, but it makes Bitcoin useless as a currency. Currency is valuable only if consumers can rely on it to retain purchasing power.

Imagine going to a restaurant where your meal costs $10 one day but $20 the next. You might be tempted to spend only on the days when your meal is cheap, but economies as a whole can’t function like that. Instead, they need a medium of exchange that is stable, so participants can trade one thing for another and can understand the value of what they’re trading.

So to the extent that Bitcoin is great for traders — that is, it’s volatile — it’s terrible as a currency.

Other drawbacks

Cryptocurrencies have other drawbacks as well, including the lack of security in digital wallets for holding currencies, its use in crimes, and its slowness in processing transactions, compared to near-instantaneous processing from traditional networks such as Visa and Mastercard.

In addition, because the IRS has labeled Bitcoin an asset and not a currency, every transaction with Bitcoin has the potential to create a taxable capital gain, meaning you must report it on your tax return. If you spend bitcoins at a price higher than you purchased them, you’ll owe tax.

Bottom line

While cryptocurrency certainly has some potential benefits, it also has serious drawbacks that so far make it unusable as a currency. Investors are probably best advised to take Buffett’s advice and stay away from the cryptocurrency market. But if you have to test it out to see what it’s all about, keep your position size small and don’t put in more than you can afford to lose.

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