Cryptocurrencies: A Primer

Cryptocurrencies have taken the world by storm. In the past few years, the cryptocurrency market has transformed into a mainstream financial market. Cryptocurrencies have come a long way from the time when they were used only by individuals who were digitally aware, valued their privacy, and were not comfortable with the central bank’s control over their monetary savings.

The rapid and unprecedented rise in the value of cryptocurrencies is a testament to this fact. For example, the value of Bitcoin has grown by a multiple of 2500 within a short span of 9 years!

The market capitalization of all the cryptocurrencies put together is close to $2 trillion. This means that if the cryptocurrency market would be considered to be a national economy, it would be ranked 8th in the world! If experts are to be believed, then this is just the beginning and within the next few years, we can expect cryptocurrencies to rapidly increase in value.

In this article, we will have a closer look at what cryptocurrencies are and the reasons that underpin their phenomenal growth in the international markets.

The Problem with Fiat Money

The rise of cryptocurrencies also marks the demise of fiat currencies. Hence, it can be said that the basic reason for the rise in the value of cryptocurrencies is that they do not suffer from the same problems as fiat currencies.

The biggest problem with fiat currencies is that their value is regulated by central banks. In most countries of the world, central banks are quasi-government entities. However, it still means that one single entity can inflate the value of the currency if they want to. This has been happening in most parts of the world.

It is estimated that over the past century, the value of the United States dollar has eroded more than 90%. Also, since most governments around the world have high amounts of debt, it is likely that the currency will be inflated even further to pay off the loans.

Investors prefer cryptocurrencies because, unlike fiat currencies, they are not under the direct control of any one agency. The cryptocurrency mechanism has been set up in such a way that no single entity can control its value. There is only a finite number of digital tokens that will ever be produced by the system. Once that full potential is reached, the creation of more units will cease. Hence, cryptocurrencies are much less prone to inflation.

What are Cryptocurrencies?

The world cryptocurrency is made up of two different words, “crypto” and “currency”. Hence, it can be said that cryptocurrencies are currencies that use the science of cryptography. This is because these currencies widely use encryption techniques. This means that encryption techniques are used for two main functions related to currencies viz. generating new currency as well as verifying the transfer of funds in a public ledger.

Hence, cryptocurrencies are not like traditional money in the sense that they are just digital tokens. Also, fiat money laws make it illegal for anyone to not accept money issued by the government. Hence, right now, cryptocurrencies cannot be directly used to make payments. Instead, they have to be converted to fiat money before they can be spent.

Many skeptics were not willing to invest in cryptocurrencies since they believed that since cryptocurrencies are a computer network, they would be prone to hacking. However, they have been proven wrong over the past decade. There are several forms of cryptocurrencies already in existence for over a decade. However., the system is so secure that it has never been hacked into until now.

How Can Cryptocurrencies be Obtained?

People can obtain cryptocurrencies in one of two ways.

1. The first way is fairly simple. In this way, people can exchange their fiat money and buy digital cryptocurrencies. An example of this would be exchanging Dollars, Euros, or Yen for Bitcoin. Conceptually the process is very similar to the process of buying stocks or bonds however in real life the process can be quite different since the regulations related to buying and selling cryptocurrency vary wildly across geographies.

2. The second way to obtain Bitcoin is by mining it. In order to understand this, we will have to once again consider the definition of cryptocurrencies. Please note that each and every cryptocurrency transaction needs to be stored in a public ledger. This public ledger is available to all the participants. Now, maintaining these records requires a lot of computational power.

   Since cryptocurrencies are “open source”, there is no single organization that maintains these records and provides the required computational infrastructure. Instead, the infrastructure is provided by all the participants. Hence, when people “mine” cryptocurrencies, they are essentially allowing the network to use the computing power of their personal equipment in order to maintain these records.

   Now, since the participants are performing a service, they need to be paid. This payment also happens in the form of cryptocurrencies. Therefore, mining is a mechanism to obtain more cryptocurrency by providing computing infrastructure to settle transactions between already existing cryptocurrencies.

The fact that hundreds of different types of cryptocurrencies have already proliferated the market is proof that this is not some fad. The technology being used behind cryptocurrencies is stable which makes it obvious that it will survive for a long time.

Over time more and more investors have started acknowledging the benefits of using cryptocurrencies which is why their valuation is shooting through the roof.