Cryptocurrencies have the potential to reshape the financial world as we know it and call traditional financial infrastructure into question. But what are the pros and cons of cryptocurrency Investing? How do you decide which to invest in, if any?
Don’t worry if you’re perplexed by cryptocurrencies. We’re here to explain the benefits and drawbacks of cryptocurrency so you can learn everything you need to know.
What Exactly Is Cryptocurrency?
A cryptocurrency is a digital or virtual currency that is protected by cryptography, making counterfeiting or double-spending nearly impossible. Many cryptocurrencies are decentralized networks built on blockchain technology, which is a distributed ledger enforced by a network of computers.
The fact that cryptocurrencies are generally not issued by any central authority makes them theoretically immune to government interference or manipulation.
Key Lessons
- A cryptocurrency is a type of digital asset that is based on a network that is distributed across many computers. Because of their decentralized structure, they can exist independently of governments and central authorities.
- Blockchain and related technology, according to some experts, will disrupt many industries, including finance and law.
- The benefits of cryptocurrencies include cheaper and faster money transfers, as well as decentralized systems that do not fail at a single point.
- Cryptocurrency disadvantages include price volatility, high energy consumption for mining activities, and use in criminal activities.
Understanding Cryptocurrencies
Cryptocurrencies are digital or virtual currencies that rely on cryptographic systems to function. They make it possible to make secure online payments without the use of third-party intermediaries. The term “crypto” refers to the encryption algorithms and cryptographic techniques used to protect these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions.
Cryptocurrencies can be mined or bought on cryptocurrency exchanges. Unfortunately, not all e-commerce sites accept cryptocurrency payments. In fact, even popular cryptocurrencies like Bitcoin are rarely used for retail transactions. However, the cryptocurrencies’ skyrocketing value has made them popular as trading instruments. They are also used for cross-border transfers to a limited extent.
Blockchain
Blockchain technology is central to the appeal and functionality of Bitcoin and other cryptocurrencies. Blockchain, as the name implies, is essentially a collection of linked blocks or an online ledger. Each block contains a collection of transactions that have been independently verified by each network member.
Every new block generated must be verified by each node before being confirmed, making forging transaction histories nearly impossible.
The contents of the online ledger must be agreed upon by the entire network of a single node or computer that keeps a copy of the ledger.
According to experts, blockchain technology can benefit various industries, including supply chains and processes such as online voting and crowdfunding. JPMorgan Chase & Co. (JPM) is testing the use of blockchain technology to reduce transaction costs by streamlining payment processing.
Cryptocurrency Types
The most popular and valuable cryptocurrency is Bitcoin. Satoshi Nakamoto, an anonymous person, invented it and published it in a white paper in 2008. Thousands of cryptocurrencies are available on the market today.
Each cryptocurrency claims a unique function and specification. Ethereum’s ether, for example, is marketed as gas for the underlying smart contract platform. Banks use Ripple’s XRP to facilitate transfers between different geographies.
Bitcoin, which went public in 2009, is still the most widely traded and covered cryptocurrency. There were over 19 million bitcoins in circulation as of May 2022, with a total market cap of around $576 billion. There will only ever be 21 million bitcoins.
Many other cryptocurrencies, known as “altcoins,” have been launched after Bitcoin’s success. Some are Bitcoin clones or forks, while others are completely new currencies. Solana, Litecoin, Ethereum, Cardano, and EOS are among them. By November 2021, the total value of all cryptocurrencies had surpassed $2.1 trillion, with Bitcoin accounting for approximately 41% of that total value.
Are Digital Currencies Legal
Fiat currencies are backed by the government or monetary authorities. The Federal Reserve, for example, backstops each dollar bill.
However, cryptocurrencies are not backed by any government or private entity. As a result, making a case for their legal status in various financial jurisdictions around the world has been difficult. It doesn’t help that cryptocurrencies mainly operate outside most existing economic infrastructure.
The legal status of cryptocurrencies affects their use in everyday transactions and trading. The Financial Action Task Force (FATF) recommended in June 2019 that cryptocurrency wire transfers be subject to the requirements of its Travel Rule, which requires AML compliance.
El Salvador was the only country in the world to accept Bitcoin as legal tender for monetary transactions as of December 2021. Cryptocurrency regulation in the rest of the world varies by jurisdiction.
The Payment Services Act of Japan declares Bitcoin to be legal property.
Cryptocurrency exchanges operating in the country are required to collect customer information as well as wire transfer details. Within its borders, China has prohibited cryptocurrency exchanges and mining. However, in December, India was reportedly developing a cryptocurrency framework.
In the European Union, cryptocurrencies are legal. Derivatives and other products based on cryptocurrencies must be classified as “financial instruments.” The European Commission issued the Markets in Crypto-Assets (MiCA) regulation in June 2021, establishing regulatory safeguards and rules for companies or vendors providing financial services using cryptocurrencies.
Crypto derivatives such as Bitcoin futures are available on the Chicago Mercantile Exchange in the United States, the world’s largest and most sophisticated financial market. Previously, the Securities and Exchange Commission (SEC) held that Bitcoin and Ethereum were not securities; however, SEC Chair Gary Gensler stated in September 2022 that cryptocurrencies are securities. This stance implies that the legal status of cryptocurrency may be subject to regulation.
Important Notice: Although cryptocurrencies are classified as money, the Internal Revenue Service (IRS) classifies them as financial assets or property. And, as with most other investments, the government wants a cut if you profit from selling or trading cryptocurrencies. The United States Department of the Treasury announced a proposal on May 20, 2021, that would require taxpayers to report any cryptocurrency transaction valued at $10,000 or more to the IRS.
The IRS would tax the proceeds differently depending on whether they were capital gains or ordinary income.
Are Cryptocurrency Investments Risky?
Due to high investor losses as a result of scams, hacks, and bugs, cryptocurrencies have earned a reputation as risky investments. While the underlying cryptography is generally secure, the technical complexity of using and storing crypto assets can pose a significant risk to new users.
Cryptocurrency investors should be aware of the following risks, in addition to the market risks associated with speculative assets:
In contrast to traditional finance, there is no way to reverse or cancel a cryptocurrency transaction once it has been sent. According to some estimates, roughly one-fifth of all bitcoins are now inaccessible due to forgotten passwords or incorrect sending addresses.
- Regulatory risks: The legal status of some cryptocurrencies is still unknown, with many governments attempting to classify them as securities, currencies, or both. A sudden regulatory crackdown could make selling cryptocurrencies difficult or result in a market-wide price drop.
- Counterparty risks: Many investors and merchants store their cryptocurrency with exchanges or other custodians. One of these third parties’ theft or loss could result in the loss of one’s entire investment.
- Management risks: There are few safeguards against deceptive or unethical management practices due to a lack of consistent regulations. Many investors have lost significant sums due to management teams that failed to deliver a product.
- Programming risks: To control the movement of user deposits, many investment and lending platforms use automated smart contracts. An investor who uses one of these platforms accepts the risk that a bug or exploit in these programs will lose their investment.
- Market Manipulation: Market manipulation continues to be a significant issue in the cryptocurrency space, with some exchanges accused of manipulating prices or trading against their customers.
Despite these risks, cryptocurrency prices have skyrocketed, with the total market capitalization exceeding $1 trillion.
Despite the asset’s speculative nature, some have made substantial fortunes by taking the risk of investing in early-stage cryptocurrencies.
The Benefits and Drawbacks of Cryptocurrency
Cryptocurrencies were designed to revolutionize financial infrastructure. However, as with any revolution, there are tradeoffs. There are many differences between the theoretical ideal of a decentralized system with cryptocurrencies and its practical implementation at the current stage of development for cryptocurrencies.
The following are some of the benefits and drawbacks of cryptocurrencies.
Advantages of Cryptocurrency
Cryptocurrencies represent a new, decentralized money paradigm. Centralized intermediaries, such as banks and monetary institutions, are not required in this system to enforce trust and police transactions between two parties.
Thus, a cryptocurrency-based system eliminates the possibility of a single point of failure, such as a large bank, triggering a global crisis, such as the one triggered in 2008 by the failure of institutions in the United States.
Cryptocurrencies promise to make transferring funds between two parties easier, eliminating the need for a trusted third party such as a bank or credit card company. These decentralized transfers are protected by the use of public and private keys, as well as various incentive systems such as proof of work or proof of stake.
Cryptocurrency transfers between two transacting parties are faster than traditional money transfers because they do not use third-party intermediaries. Flash loans are a good example of such decentralized transfers in decentralized finance. These loans, which are processed without the use of collateral, can be completed in seconds and used in trading.
Cryptocurrency investments can be profitable. Over the last decade, the value of cryptocurrency markets has skyrocketed, reaching nearly $2 trillion at one point. Bitcoin was worth more than $550 billion in crypto markets as of May 2022.
One of cryptocurrency’s most prominent use cases is the remittance economy. Currently, cryptocurrencies such as Bitcoin serve as intermediary currencies to facilitate cross-border money transfers. As a result, a fiat currency is converted to Bitcoin (or another cryptocurrency), then transferred across borders and converted back to the destination fiat currency. This method simplifies and reduces the cost of money transfers.
Disadvantages of Cryptocurrency
Cryptocurrencies are pseudonymous, despite their claim to be an anonymous form of transaction. They leave a digital trail that can be deciphered by agencies such as the Federal Bureau of Investigation (FBI). This allows governments or federal authorities to track ordinary citizens’ financial transactions.
Cryptocurrencies have become popular among criminals for nefarious purposes such as money laundering and illegal purchases. The case of Dread Pirate Roberts, who ran a drug marketplace on the dark web, is well known. Cryptocurrencies have also become popular among hackers, who use them to carry out ransomware attacks.
In theory, cryptocurrencies are supposed to be decentralized, with their wealth distributed among many parties via a blockchain. In practice, ownership is extremely concentrated. According to an MIT study, just 11,000 investors held roughly 45% of Bitcoin’s soaring value.
One of the conceits of cryptocurrencies is that anyone with a computer and an Internet connection can mine them. However, mining popular cryptocurrencies requires significant energy, sometimes as much as entire countries consume. Mining has been concentrated among large firms with revenues in the billions of dollars due to high energy costs and the industry’s unpredictability. According to an MIT study, 10% of the mining capacity is accounted for by 10% of the miners.
While cryptocurrency blockchains are extremely secure, other crypto repositories, such as exchanges and wallets, can be compromised. Many cryptocurrency exchanges and wallets have been hacked over the years, with millions of dollars in “coins” stolen in some cases.
Price volatility affects 20 cryptocurrencies traded on public markets. Bitcoin’s value has fluctuated dramatically, reaching as high as $17,738 in December 2017 before plummeting to $7,575 in the months that followed.
As a result, some economists believe that cryptocurrencies are a passing fad or speculative bubble.
How Do You Purchase Cryptocurrency?
Investors can buy cryptocurrency from popular crypto exchanges like Coinbase, apps like Cash App, or brokers. Another popular way to invest in cryptocurrencies is through financial derivatives like CME’s Bitcoin futures or other instruments like Bitcoin trusts and Bitcoin ETFs.
What Is the Purpose of Bitcoin?
Cryptocurrencies represent a new financial paradigm. Their promise is to simplify existing financial architecture in order to make it faster and less expensive. Their technology and architecture decentralize existing monetary systems, allowing transacting parties to exchange value and money without the need for intermediary institutions like banks.
Can You Produce Cryptocurrency?
Mining is the process by which cryptocurrencies are created. Bitcoin, for example, is created through Bitcoin mining. The procedure entails downloading software that contains a partial or complete history of network transactions.
Though anyone with a computer and an Internet connection can mine cryptocurrency, the industry is dominated by large firms due to the energy and resource-intensive nature of mining.
Which Cryptocurrencies Are the Most Popular?
By far, the most popular cryptocurrency is Bitcoin, which is followed by Ethereum, Binance Coin, Solana, and Cardano.
Are cryptocurrencies considered securities?
Previously, the SEC stated that Bitcoin and Ethereum, the top two cryptocurrencies by market capitalization, were not securities. SEC Chair Gary Gensler stated in September 2022 that cryptocurrencies are securities and has directed SEC staff to begin working with crypto developers to register their crypto.
However, he clarified that he was not speaking on behalf of the SEC and was only speaking for himself. He urged those just getting started in crypto to register their coins because “it’s far less expensive to do so from the start.”
In Conclusion
Cryptocurrencies are digital assets that are protected by encryption. As a relatively new technology, they are highly speculative, and it is critical to understand the risks before investing.
Investing in cryptocurrencies and other initial coin offerings (“ICOs”) is extremely risky and speculative, and this article is not a recommendation by Investopedia or the author to do so.
Because each person’s situation is unique, it is always best to consult with a qualified professional before making any financial decisions. Investopedia makes no representations or warranties about the accuracy or timeliness of the information provided on this site.
