Cryptocurrency Investments
Welcome to the chapter on Cryptocurrency.
Here we look at this investment option and understand what it is and why it is one of the hottest and hotly debated investment options in recent times.
What is Cryptocurrency?
A cryptocurrency is a digital or virtual currency that works as a medium of exchange just like a regular currency like a rupee or a dollar. It uses a technique called cryptography to secure and verify each transaction. This technique is also used to control the creation of new units of a cryptocurrency.
The cryptographical functions use Blockchain technology to make the entire process decentralised, transparent, trustworthy and safe. Blockchain is a name used to denote a chain of blocks where each block contains details that allow it to pass information received from the previous block to the next one.
Blockchain allows you to send or receive money from another through a distributed network of ledgers that work together to keep all transactions, contracts and accounts public. There is no third-party mediation needed in the process and the only thing needed to make a payment is something called Proof of Work.
The value of a cryptocurrency is mentioned usually in dollar terms. There is no central bank or authority that monitors the transaction or decides disputes. The structure of the network has been made in such a way that every transaction that is recorded is irreversible.
The first cryptocurrency was Bitcoin introduced in 2009. Since then hundreds of these cryptocurrencies have come into existence. In addition to Bitcoin, some of the important ones are Ethereum, Bitcoin Cash, Tether, BNB Coin (fka Binance Coin), Monero, XRP, Cardano and Solana, among others.
How it Works
A transaction is sent between peers using software called cryptocurrency wallets. The transaction amounts are public, but details of who sent the transaction are encrypted. Each transaction leads back to a unique set of keys, called public and private keys.
The person creating the transaction uses the wallet software to transfer balances from one account, which is known as a Public Key or Address, to another. To complete the transaction, it needs to be signed off by the sender with their Private Key, which is associated with each account. Whoever owns a set of the Public and Private keys, owns the amount of cryptocurrency associated with those keys. This is similar to a bank account as whoever owns a bank account owns the money in it.
All transactions made between peers are encrypted and once initiated, each transaction is broadcast to the cryptocurrency’s network and queued up to be added to the public ledger. Once they are added, the transaction is considered complete and the recipient receives the cryptocurrency.
Transactions are recorded on the public ledger using a process called Mining. Though the ledger is public, it is quite huge but users can choose to access it by downloading and running a copy of the software called a Full Node Wallet. Users can also instead hold their coins in a third-party wallet, though storing it in a personal hard wallet is considered the safest option.
What is Mining?
Mining is the act of confirming transactions by solving a cryptographic puzzle. This puzzle needs to be solved so that the transaction can be recorded on a ledger.
The reason it is called mining is that once miners solve the cryptographic puzzle they get rewarded with new cryptocurrency units – in other words, new cryptocurrency units have been mined. They also get a transaction fee for confirming the transaction.
Miners are the only users who can take a transaction, mark it as legitimate and spread the information about it across the network.
Cryptocurrency in Relatable Terms
Let us look at transactions in existing digital wallets such as a PayTM, Google Pay, PhonePe, etc. to understand cryptocurrency.
In a digital wallet payment transaction, you pay an amount to another person using the wallet.
Now, imagine if the amount in the wallet is not in rupees but in a currency that is specific to the wallet. So each of the wallets has its own currency and own conversion rates to the rupee.
When you make a payment, the digital wallet company ensures that the other party receives the amount. When you request a payment, the other party receives your request. But you cannot make a payment from one wallet to another. Both you and the other person needs the same wallet.
Cryptocurrency works just like that. Just that there is no authority like a digital wallet company to mediate the transaction. In its absence, transactions are verified using a system of two keys, public and private, and recorded onto ledgers that can be viewed by all. The recording is done by users who solve cryptographic puzzles specific to each transaction and essential for it to be authenticated and recorded.
And here since you don’t have an oversight authority, you can make payments to or receive payments from around the world without any restrictions.
Investing in Cryptocurrency
Cryptocurrencies like Bitcoin are limited in number and widely accepted for purchase and sale transactions and money transfers. This creates a strong demand for them.
There has been quite a bit of uptrend and fluctuations in the prices of various cryptocurrencies. So investing in them at the wrong time can result in a significant loss. On the flip side, the more popular cryptocurrencies are now getting more widely accepted making their future more certain with the passage of time.
A good idea is to stick with the cryptocurrencies with the higher market capitalisation. One thing you must do before investing is to get as much information as possible on the cryptocurrency. Reading their whitepapers so you know why they were created and how they operate is a good idea.
All that being said, let us look at some challenges of investing in cryptocurrency.
Volatility
The value of cryptocurrencies goes through extreme ups and downs. For example, Bitcoin ranged between $900 and $20,000 in 2017. There are quite a few reasons for this from large investors inflating prices to other manipulations. Most of these reasons are not in favour of the newbie or small investor.
Not Proven as Reliable Investments
It is difficult to predict changes or calculate returns. There are no historical precedents to gauge how much return you are likely to earn. They have even been seen as gambling. This means you cannot trust this investment option to create a long-term investing plan.
Used for Fraudulent Activity
Cryptocurrencies have been used for illegal purposes. People who want to remain anonymous and avoid banking and statutory laws have used cryptocurrencies to make shady deals on online black markets. Another major concern is money laundering as there are no restrictions on money transfers, unlike regular channels.
Large Number of Unknowns
Various issues need to be addressed in cryptocurrencies. For example, very few people understand the system inside out and know how to operate it. Lack of freely available information or even rules to get information are other factors.
Summary
Most central banks including the RBI have worried about the existence of a parallel currency system without any government or central authority to make it adhere to guidelines. But this unregulated nature is what makes cryptocurrency so interesting and appreciated a concept.
You do not need to depend on government mandates and rules to make a transaction, you do not need to wait for banks or give them large transaction fees to make payments worldwide. In a way, they are an indicator of what the world should be – borderless.
But the very lack of borders is also the most important problem.
As an investment, the suspicion with which governments and central banks eye these cryptocurrencies means you may face problems if you invest in them. Selling them off may prove difficult and even if you are able to sell them off, getting the money in an acceptable world currency format may prove difficult.
On top of that, the challenges of investing in them make them a risky investment proposition.
But as and when you are able to invest in them, it may be a good idea to only an amount that you can afford to lose due to volatility and other factors.