A beginners guide to cryptocurrency
The Los Angeles Lakers’ home game on Christmas Day against the Brooklyn Nets will be a coming-out party for Crypto.com Arena, the new name for the facility formerly known as Staples Center. The point of the renaming deal — which will reportedly cost the Singapore-based company more than $700 million — is to promote Crypto.com as the best way to buy and sell cryptocurrencies and related digital goods.
Today, however, only a fraction of the TV-watching world could explain the difference between a bitcoin and an Amazon gift card, or between a non-fungible token and a Chuck E. Cheese token. The hype surrounding cryptocurrencies may be inescapable, but that doesn’t mean people understand how they work or why some of their values have gyrated so wildly.
Here are some of the basics to help bring you up to speed. Do not interpret any of this as an endorsement of cryptocurrencies, which are not particularly useful today as currencies nor reliable as investments.
What is cryptocurrency?
To understand cryptocurrency, it helps to consider that bitcoin rose from the ashes of the global financial crisis of 2007–08.
Created by an individual or group using the pseudonym Satoshi Nakamoto, bitcoin — the first cryptocurrency to gain a global foothold — was billed as a digital version of money that didn’t depend on banks and was impervious to governmental interference. Anyone could exchange bitcoins with anyone else at any time for any reason.
But cryptocurrency is just the first use of a technology, called “blockchain,” that is slowly spreading into (and potentially shaking up) other pursuits, such as real estate, music and gaming. Bitcoin’s blockchain exists solely to keep track of bitcoins, but ethereum and later initiatives use blockchains to run “smart contracts” — applications that could be triggered on demand. As a result, blockchains offer an alternative not just to banks and government record-keepers, but to computer servers.
Blockchains rely on a far-flung network of computers to store and update a permanent digital record of every transaction, eliminating the need for a centralized ledger or record-keeper. They use cryptography — mathematical techniques that turn information into essentially unbreakable code — to make sure the people exchanging bitcoins are who they claim to be and to enable computers on the network to keep identical, immutable records. That prevents bitcoins or any other asset tracked by a blockchain from being duplicated or spent more than once, although they can still be lost or stolen (more on that later).
The records on a public blockchain such as bitcoin are open for all to see; anyone can inspect the list of transactions (even as they are happening, although that’s like trying to read the labels on boxes speeding down a conveyor belt) or track the activity of any individual account holder. But account holders’ identities are encrypted, so you can’t tell who is behind the accounts making those transactions.
But what is it worth?
Cryptocurrencies are worth whatever the market says they’re worth. Investors have poured more than $2 trillion into bitcoin and other cryptocurrencies, all presumably on the expectation that future investors will be willing to pay more for them.
You could argue that this is all prestidigitation, the conjuring of money from nothing. Technically, each bitcoin started as the payment some person awarded him or herself for doing the computer-intensive cryptographic work required to record transactions into the blockchain (an activity called “mining”). But their value depends on what people are willing to pay for them, which in turn depends on where people expect the price to go over time.
Bulls note that the supply of bitcoin is capped at at a level that ensures scarcity; there will never be more than 21 million bitcoins, while the global population is 7.9 billion and growing. In their view, the more widely bitcoin is used, the more demand for it will drive price growth.
Bears argue that the wild price swings — bitcoin has seen two boom-and-bust swings just in 2021 — will deter most people from jumping on the cryptocurrency bandwagon. So too might crypto’s vulnerability to price manipulation and to the whims of momentum-driven investors.
In a paper summing up economic research on bitcoin, Parthajit Kayal and Purnima Rohilla of the Madras School of Economics in India warned that the price of bitcoin could fall to zero if the benefits bitcoin offers “are taken away by the government or the coins are hampered by fraudulent activities or if a better alternative emerges in the market.” There’s certainly no shortage of alternatives; there are more than 7,500 cryptocurrencies in circulation now, according to Statista.com.
Is it actually currency?
As a medium of exchange, cryptocurrency leaves much to be desired. For starters, few businesses accept these coins as payment today.
The list of places where you can spend bitcoins includes a handful of tech companies, a couple of sports franchises, and a smattering of retailers and restaurants around the world. There are workarounds such as Purse, which lets you trade bitcoins for Amazon gift cards, but the need for such services underlines how poor a substitute cryptocurrency currently is for dollar bills.
One place you won’t be able to spend cryptocurrency today is Crypto.com Arena. Steven Kalifowitz, Crypto.com’s chief marketing officer, said the company is working on how it will integrate its cryptocurrency-powered payment app and other products into the venue and its other partnerships.
Just as important, bitcoin hasn’t held its value over the short term, a key attribute for any currency. The value of the U.S. dollar creeps up and down relative to other countries’ currencies, and its buying power shrinks over time because of inflation. But it doesn’t jump up 33% in a week, as bitcoin did the first week of October, or lose almost a quarter of its value in a week, as bitcoin did in mid-May. A 2017 study found bitcoin prices to be 30 times more volatile than the dollar, the euro or the yuan.
On top of that, you have to pay fees to get your cryptocurrency payments or other transactions added to the blockchain. Those fees tend to be a small percentage of the transaction’s value, less than what merchants pay to credit-card processors. But if you want your transaction processed quickly, you may have to pony up a bigger fee. Otherwise, the wait could be hours or even days.
Given the dramatic price swings and other drawbacks, why would anyone use bitcoin or similar technologies as a medium of exchange? Possibly because crypto coins can be spent anonymously, like cash, but at a distance. That may explain why digital coins are the payment of choice in ransomware schemes and dark web contraband purchases.
For those who really want to use their cyber coins as currency, there is a class of tokens called stablecoins whose value is tied to the value of the dollar or some other non-cryptographic asset. The most popular of these is called Tether; its creators pledge that each Tether token is backed by $1 in cash and other reserves (although the value of those reserves has been disputed), and its price has remained at or close to $1 for much of its history.
Then what is it?
For most people who buy cryptocurrency, it’s an investment. But as the roller coaster nature of the crypto markets indicates, it’s not a conventional one.
Cryptocurrencies are not like shares of corporate stock, whose value is at least nominally tied to something concrete (namely, the company’s prospects for growth and profitability). Nor are they like commodities whose supply and demand can be forecast.
Instead, they’re more like a collectible item, such as stamps, whose value is driven in large part by their scarcity. There are no analyses or quarterly reports, production forecasts or fundamental measures such as earnings per share to guide investors. Instead, they have to rely more on any evidence they can find about which cryptocurrencies have momentum in the market.
According to Kayal and Rohilla’s paper, researchers have noted a number of factors that appear to be correlated with bitcoin values. One is geopolitical risks around the globe; bitcoin prices become more volatile as an index of those risks goes up. Interest rates after inflation and tax burdens, meanwhile, are “significant in determining Bitcoin prices,” they wrote. Researchers also found that bitcoin prices went up as trading volume of stocks increased but went down as stock prices rose, Kayal and Rohilla reported.
One last factor that suggests cryptocurrency trading is an insider’s game: Studies show substantial evidence of price manipulation in bitcoin values. For example, one 2018 study of doomed Japanese bitcoin trading site Mt. Gox found that “Bitcoin prices rose on approximately 80% of the days on which suspicious trading activity was recorded, while it rose on a comparatively lesser number of days, 55%, in which no such suspicious activity was observed,” Kayal and Rohilla wrote.
How do you get started?
Most cryptocurrency is available for anyone to buy. All you need is a way to present your order to the blockchain for the currency in question.
The simplest way to do that is to use an exchange, such as the ones operated by Binance and Coinbase. These are the cryptocurrency equivalent of a shopping mall, offering access to many cryptocurrencies. Typically, these sites will provide a digital wallet that acts a lot like a checking account, except that it’s secured by a personal cryptographic key instead of a PIN. You deposit cash or cryptocurrency into the wallet, and it funds your purchases, keeps track of your holdings and stores the digital receipts that track what you’ve bought and sold.
That’s called a “custodial” wallet, which means it’s stored in the cloud and maintained by a third party that can help you recover your password. One downside is that it relies on centralized servers that can be attacked by hackers, as the BitMart exchange was this month, resulting in $150 million or more in cryptocurrency losses. Such losses may be covered by insurance, as appears to be the case for BitMart. But sometimes they’re not.
If you’re worried about that kind of threat, you can do one more transaction on your exchange to transfer your holdings to a “non-custodial” wallet that’s in your possession. It could be a software application on your computer or phone, such as the one from metaMask, or a specialized, high-security USB drive (called a “hardware wallet”). Either way, it’s maintained by you alone — and if you lose your password, you’ve lost your cryptocurrency.
If you jump into the crypto pond, beware of the sharks. According to Chainanalysis, cryptocurrency users lost more than $7.7 billion to scams and other crypto-based crimes in 2021 alone.
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