Cryptocurrencies are digital or virtual currencies that incorporate cryptography tools to enforce security and money supply. They first gained mainstream prominence in 2009 after the financial crisis of 2008.
Cryptocurrencies are carriers of value on the Internet as opposed to being a purely financial instrument. In some instances, this could be monetary value. For example, a globally-used cryptocurrency can be used to purchase goods and services anywhere. In others, it could be value pertaining to a service such as a file storage service using its own cryptocurrency as a payment mechanism for tasks within its network.
The most famous example of a cryptocurrency is Bitcoin, a decentralized payment network that uses peer-to-peer technology for transactions in its network. According to Coinmarketcap, a site that aggregates price information from various crypto exchanges, there are more than 1,300 cryptocurrencies in existence today.
As of this writing, governments and financial institutions around the world are actively exploring the use of cryptocurrencies in modern financial instruments or in implementing economic policy. Most jurisdictions around the world do not regulate cryptocurrencies.
Characteristics of Cryptocurrencies
All cryptocurrencies share certain characteristics. The first one is decentralization. Most, if not all cryptocurrencies aspire to become decentralized entities in which anyone should be able to validate transactions occurring within a network. Mining algorithms, which are the most common way to verify a transaction, use cryptography tools – such as hash functions and puzzle-friendly features – to verify transactions.
The use of blockchains is another shared feature among cryptocurrencies. Blockchains are data structures that resemble linked lists in which each element points to the previous one. Because the chain of blocks is linked together, it is resistant to security breaches. Blockchains are distributed ledgers that cryptocurrency technology relies upon in order to keep track of a currency’s transactions.
The third common characteristic of cryptocurrencies is the use of digital signatures and keys. Public keys are used to identify the coin owner’s address while private keys enable access to funds. Together, these keys enable transparency of transactions and anonymity for users.
Advantages and Disadvantages of Cryptocurrencies
Just like any other financial instrument, the use of cryptocurrencies offers advantages and disadvantages. Here are three of them:
The first advantage of cryptocurrencies is that they enable seamless transfer of digital money. This is unlike fiat currencies, which are heavily regulated by governments. Cryptocurrencies have largely remained outside government scrutiny, leading to fewer bureaucratic hassles and regulatory friction for operations that involve their use.
The second advantage of cryptocurrencies is that they are secure. From credit card companies to payment processors, hackers have targeted numerous financial services institutions in recent times. While there have been numerous reports of crypto hacks, the largest cryptocurrency by market capitalization, Bitcoin, has remained impervious to security breaches.
Decentralization is another advantage of cryptocurrencies because it distributes the task of verifying and validating a transaction to multiple parties instead of relying on a single authority to ensure genuine transactions. The reliance on a central authority can be hazardous.
As an example, consider the 2008 financial crisis which was a consequence of the centralization paradigm. Banks and financial services companies colluded among themselves and ran amok with user funds, leading to big losses on their balance sheet. Eventually, they had to be bailed out because they were considered too big to fail.
A trustless system of stakeholders distributed across the world minimizes the threat of collusion and minimizes the risk of a default from a single point-of-failure across multiple stakeholders. It is possible for anyone to fire up a node to manufacture their own coin and contribute to the network’s security.
The absence of regulation is a double-edged sword for cryptocurrencies. On the one hand, it minimizes regulatory hassles. But it also represents a massive risk for investors and users because they have no recourse to legal remedy or governing authority. One consequence of this is that government authorities can create or decimate crypto markets at will by instituting restrictions or banning them outright. An example of this occurred in China, where the government banned cryptocurrency exchanges, leading to their exodus from the country.
For some investors, the volatility of cryptocurrency prices may also be a significant risk and a disadvantage. Wild price swings for cryptocurrencies are not uncommon. For example, Bitcoin price spanned the distance between $10,000 to $20,000 in less than two weeks in 2017. That price jump held the tantalizing promise of profits for several. But it had slumped to less than $10,000 barely three weeks later. Such price swings can make or break investor fortunes within hours, days, or weeks.
Another disadvantage of cryptocurrencies is that they encourage criminal activity. Cryptocurrencies use well-known tools of cryptography, such as hash functions and digital signatures, to secure their systems and hide user identity. This makes it difficult to trace cryptocurrency activity to a particular person or organization and has made them extremely popular with criminals. In fact, cryptocurrencies have failed to gain mainstream traction even as their use in crime has surged.
While it is difficult to trace the origins of blockchain transactions using just public keys, the task is not impossible. The FBI has repeatedly demonstrated in cases of crypto crime, it is not impossible to identify the names behind public addresses.
This leads us to the third disadvantage of cryptocurrencies namely, spying and monitoring of monetary transactions for an individual or organization. The promise of privacy for user identities in cryptocurrencies may not always be an iron-clad one; it is footnoted with the prospect of monitoring of public transactions.
A History of Cryptocurrencies
The history of cryptocurrencies is intertwined with research to develop digital money. Cryptocurrencies tackle two of the biggest problems for digital money: user privacy and double spending. The former ensures that user identity is not compromised in a system where monetary transactions are transparent. The latter problem prevents users of digital money from making copies of a single coin and spending it at two different locations simultaneously. Cypherpunk activists, who did most of the early work and research on cryptocurrencies, developed them to build an anonymous system beyond government control and instigate social and political change.
Researcher David Chaum ranks among the pioneers of cryptocurrency. He developed the idea for eCash in 1983. Subsequently, along with researcher colleagues at UC Berkeley, he devised a solution to the double-spending problem. It utilized the concept of “blind signature” from cryptography to enable a digital signature without divulging the coin’s actual details. Chaum developed the idea of eCash into a commercial venture called DigiCash that contained two cryptocurrencies – eCash and Cyberbucks – in 1989. But DigiCash failed to gain traction with mainstream banks and financial services institutions and folded not too later.
Further research advanced the scope and capabilities of cryptocurrencies. In 1992, Cynthia Dwork and Moni Naor had proposed the idea of a system consisting of puzzle-solving for access to an email system to deal with the problem of email spam. British cryptographer Adam Back refined the concept and wrote a paper suggesting that the idea be used to “mine” b-money. The idea for b-money was part of a proposal made by Wei Dai, a computer scientist at the University of Washington.
Blockchain, a public ledger that records transactions occurring between parties, was proposed in a 1991 paper by Stuart Haber and Scott Stornetta, both scientists at Bellcore – a telecom research company. Stornetta explained in a 2019 interview that they wanted to design a trustless system in which centralized third parties were not required to validate transactions. But the third party would need to “collude” in the transaction in order to not become a centralized decision-making authority. The numbers of such third parties expands for decision sets that involve an increasing bunch of transactions. Eventually, the idea for the system morphed into a blockchain. Another notable contributor to the cryptocurrency canon is Nick Szabo, who developed the idea for Bitgold in a series of blog posts.
Even as cryptocurrency technology was being upgraded, the frequency and numbers for financial crises and frauds multiplied during the 80s and 90s, when Wall Street became synonymous with power in the nation’s economy. The latter set of events accelerated the move to reinvent financial infrastructure. The 2008 financial crisis proved to be a tipping point for public discontent. It was also the perfect vantage point to introduce Bitcoin, arguably the first mainstream cryptocurrency, to the world.
Since Bitcoin’s launch in 2009, thousands of other cryptocurrencies have been introduced. For the most part, these cryptocurrencies are Bitcoin spawns in that they share codebase and organizing principles with it. It is quite likely that a majority of them will fail to gain traction and disappear with time. But their emergence marks a seminal evolution for cryptocurrencies from being an arcane topic of discussion and research at universities to being actually implemented in society.
Discuss It With the Pros
We hope this has been helpful in explaining the concept behind Cryptocurrencies. Got any more questions? Feel free to consult with a financial advisor in Santa Fe, NM or visit our financial advisor page if you live outside the area.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.