“Risk comes from not knowing what you are doing.” – Warren Buffett
Over the past year, cryptocurrency investing and trading has exploded. In 2017 there has been an average of 1000% growth across the major cryptocurrencies with some near 2000% growth. All of this has flooded the market with new investors who are eager to get involved, start trading and get a piece of the action. As new (and relatively inexperienced) investors come into this market, it is import to understand the key players and concepts behind cryptocurrency. Understanding these things can help new investors become more informed and make better decisions on how to invest. It can even prevent making a big and costly mistake.
How Cryptocurrency Works
Cryptocurrency is a digital form of currency that can be used as payment for goods and services. It uses cryptographic technology (blockchain) to mask and anonymize transactions, mine and the transfer of assets across different parties. It represents an alternative to the currently centralized currencies that heavily rely on any financial institution or government which was burdened with transaction costs, reversibility, and fraud. Cryptocurrencies are fiat which means they are a without intrinsic value established as money, often by government regulation. They have an assigned value only because the government uses its power to enforce the value of a fiat currency or because the exchange parties agree to its value. This means the value of a fiat currency is determined by the entity which backs or the agreement of the exchange parties. For cryptocurrency, the backed entity is the blockchain technology.
Bitcoin was the first cryptocurrency but since its inception and growth, there have been over 1380 other alternative cryptocurrencies which have been established and are now in circulation. As we move into the future, there will be many more creations and consolidations of cryptocurrencies. Some of the major (well established) coins will remain while other new ones will gain popularity and stand as strong alternatives. A good example of this can be seen with Bitcoin and Ethereum.
The evolution of cryptocurrency has been from academic experiment/research paper to alternative financial instrument for currency arbitrage. The future of cryptocurrency is relatively unknown but some speculate two possible directions. One path is an alternative form of payment. More-and-more retailers are starting to accept cryptocurrency as the form of payment and (good and bad) organizations around the world are starting to use cryptocurrency as an anonymous way to establish a platform or perform business functions without the oversight or regulation of governments. The other path is an extension of the current financial system as a way of making money. With the volatility and growth potential of cryptocurrency, it could be adopted into world financial systems as another instrument of investment. Financial instruments such as Colatorized Debt Obligations (CDOs), shorts, ETFs , indexes and mutual funds can/will be used to create ways to profit off the growth or stability of cryptocurrencies relative to other world currencies. In either path, the future of cryptocurrency will contain opportunities for growth that dwarfs the growth we have seen in the past few days.
Bitcoin and Cryptocurrency
Bitcoin is the original cryptocurrency. It started in 2008 as a research paper published by an unknown individual or group by the name of Santoshi Nakamoto. The paper was titled Bitcoin: A Peer-to-Peer Electronic Cash System. It described a peer-to-peer version of electronic cash which would allow online payments to be sent directly from one party to another without a financial institution. In other words, an alternative to the currently centralized currencies heavily relied on any financial institution or government which was burdened with transaction costs, reversibility, and fraud. The paper went on to define blockchain technology, how transactions would work, mine and privacy. In 2009 the source code for Bitcoin was uploaded to SourceForge and a few early supporters picked it up and started to use it. These represent the first Bitcoins that were mined.
In 2010 Mt.Gox was established as an exchange to trade cryptocurrency. This allowed the general public to gain access to a market to buy or sell Bitcoin. In 2011 Laszlo Hanyecz, a Florida man who exchanged 10,000 Bitcoins for two pizzas (worth ~$25 USD). This established purchase power, price relative to a major currency (USD) and legitimacy for Bitcoin. Also in 2011, Silk Road was established as an anonymous marketplace selling mostly illegal goods and services. The primary form of payment was Bitcoin and as such, cause a surge in the pricing. By mid-year Bitcoin had jumped up to $29, marking a 2900% increase in less than a year.
Over the next few years, popularity continued and multiple exchanges emerged allowing buying and selling of Bitcoin. The FBI shut down Silk Road and yet the price and popularity of Bitcoin was undamaged. It peaked in 2013 at $100. However, in 2014 several events caused the cryptocurrency to experience its first crash. Firstly, Mt.Gox, the most popular exchange which handled 70% of the Bitcoin transactions reported a hack which resulted in the mass theft of 850,000 Bitcoins. The exchange closed shortly after. In addition, the Chinese government issued bans on the use and acceptance of Bitcoins by financial institutions. The combination of these two major events caused the currency to drop to $200 and relatively flat line for the next two years.
In 2016 Bitcoin started to grow again. Popularity increased and many other alternative cryptocurrencies started to enter the market. Bitcoin was not showcased on the news, tv shows, documentaries and other facets of pop culture. As new investors entered the market the price began to rise. Coinbase and other companies offered easy access and trading to people of all ages and areas. By the end of 2017 Bitcoin reached a peak of $19000. A growth of almost 2000% in less than 12 months. Bitcoin is now traded on 130 exchanges and there are even rumors about it becoming an ETF traded on some of the big financial exchanges of the world like NYSE and London.
Most Profitable Cryptocurrency
Altcoins are the alternative to Bitcoin. Examples include: XRP, Litecoin, Novacoin, Platinumcoin, and Bitswitft. They came into popularity around 2013. Some were created as an attempt to emulate the success and growth of Bitcoin. Others were created to provide fixes to the shortcomings and problems of Bitcoin such as more powerful hashing algorithms and easier to mine. Most of the altcoins are similar to Bitcoin, they share the source code of the original Bitcoin software. They also all have a mining process and use blockchain technology for verification and managing transactions.
At this moment there are over 1380 different altcoins traded over 130 exchanges. This number is sure to increase as cryptocurrency popularity continues to grow and as new problems and flows are identified with Bitcoin. New altcoins are developed and established every few weeks.
Despite their similarities to Bitcoin, altcoins can be difficult to gain access to due to their lack of maturity. Major exchanges like Coinbase do not provide the ability to trade these smaller and lesser-known altcoins. Furthermore, those exchanges that do trade altcoins can be unknown and even risky due to lack of established credibility.
Similar to Bitcoin, these altcoins share similar triple digit+ growth potentials. They are very closely linked to the growth of Bitcoin and as it grows, so does the altcoin market. In some cases, it is not uncommon to see even greater growth with altcoins than with the major cryptocurrencies. This is the area where overnight cryptocurrency millionaires have come from. They have picked a relatively unknown and cheap altcoin and as it grew in popularity, they amassed a small fortune. It is also important to note, altcoins also possess great volatility and risk. The fluctuations in their price can drastically vary and there is the substantial risk investors might lose some or all of their principal investment. When investing in altcoins it is always important to research the mission, team, and technology behind the coin. Ensure these underlying assets are sound and have the potential for growth or impact in the future could mean the difference between bust and boom.
Blockchain the underlying technology behind cryptocurrency. It is the network of peer-to-peer nodes which manage, validate and verify transactions of cryptocurrency. Blockchain is broken into three functionalities:
- Digital Ledger
- Decentralized Peer-To-Peer Network
- Verification and Validation Engine
As a decentralized peer-to-peer network, blockchain uses a series of machines all over the world to build an interconnected network sharing processing power, resources, and information for creating a closed system. This network is similar to that of the internet where all of the data of the web is stored across a variety of servers all over the world. To access the internet you join a network which connects all of these servers and the information they house. This decentralized network removes the need for a financial system or institution to facilitate transactions and creates a system that cannot be compromised if one of the nodes is.
As a digital ledger for cryptocurrency, blockchain records all transactions that take place on it. It keeps a log of these transactions and only adds new ones. It then replicates this ledger across all of the nodes (links) in the chain. At any given moment any part of the blockchain has a full record of all transactions that have taken place. This functionality prevents external financial systems or parties to be needed for storage, backup or audit of transactions.
As a verification and validation engine, blockchain uses the network and the digital ledger to validate any transaction that takes place on it. It runs through all previous transactions to verify the starting and ending balances of the transaction match up the information multiple ledgers across the network have. This prevents fraudulent activity of making up cryptocurrency amounts or transferring insufficient funds.
The combination of the three functionalities makes blockchain a technology that can be applied in many different areas. Companies and organizations are looking into alternative applications for blockchain technology such as:
- Digital Identity Management
- Voter Audit
- Financial Institution Infrastructure
- Smart Contracts
- Tax Record
A wallet is a digital construct which allows for the storage and sending/receiving of cryptocurrency. Each wallet contains a set of private and public keys which are used for transferring cryptocurrency. Access to these public and private keys allows anyone access to the cryptocurrency within the wallet. It is important to protect and backup wallets to ensure your money stays secure and with you. Most wallets only store one type of cryptocurrency, however, there are a few variants which store multiple types. Some wallets even allow for conversions between different cryptocurrencies within the wallet using third-party integrations. There are three main types of wallets ordered by how secure they are: 1. Web 2. Mobile 3. Hardware.
Web wallets are those which you access when online. They are used for making online purchases or trades via web-based exchanges. Examples include: Bit.go and Coin.space. These wallets are potentially the least secure because they are backed up and protected online. They are subject to any phishing, malware or DDOS attack. The security around them is only as strong as the application used.
Mobile wallets are only accessible through your mobile phone and are used when transferring to someone for payment of goods and services like Venmo. Examples include: Breadwallet and Bither. They are more secure than web wallets because your phone and the wallet application act together as multi-factor authentication/security. However, if your phone falls into the wrong hands then your wallet is subject to quick theft.
Hardware wallets are physical devices that generate and store private and public keys. Examples include: TREZOR and KeepKey. These devices use cutting-edge cryptography methods and techniques to securely mask and hide the keys. This information is not backed up or available online or on the web. As such, it is not subject to any malware, phishing or DDOS attacks. These represent the highest form of security for cryptocurrency and are often only used for large amounts because they do offer easy liquidity.
Choosing a good and secure wallet can mean the difference between secure funds and theft.
Buying and Selling Cryptocurrency
An exchange is a digital marketplace where transactions across different currencies (crypto and non-crypto) are facilitated. Exchanges allow the conversion, buying and selling of currencies. When cryptocurrency first started with Bitcoin, there was only one exchange, Mt.Gox. Now Mt.Gox has been closed and there are over 130 different exchanges which allow trading of Bitcoin and altcoins. Some exchanges are more developed than others and allow conversion from banks and credit cards of world currencies into cryptocurrency. Other exchanges only deal in cryptocurrency conversions and trades. For the major cryptocurrencies: Bitcoin, Bitcoin Cash, Ethereum and Litecoin it is relatively easy to use exchanges like Coinbase that allow simple conversions and trading. For altcoins, multiple exchanges and conversions might be necessary for trading. For example, USD to XRP would require a conversion from USD to Bitcoin using one exchange and then Bitcoin to XRP using another exchange. The same process would need to be followed when trying to sell.
The major exchanges at this moment are Binance, GDAX/Coinbase, and Bitstamp. However, as we move into the future, companies like Robinhood (free stock trading application) will provide their own exchanges allow for buying and selling across crypto and non-cryptocurrencies. The ultimate goal is a one-stop-shop where users are able to buy and sell any cryptocurrency using their native home currency. This is all about capitalizing on the currency growth and volatility.
Coinbase is a US-based company established an online platform to provide cryptocurrency exchange, storage, and transfer. It was started in 2011 as an exchange during the boom year of Bitcoin and provided services to trade and store Bitcoin. In 2012 it added the ability to buy and sell Bitcoin using bank transfers. In 2017 Coinbase extended functionality to Ethereum, Litecoin and Bitcoin Cash. They also launched a mobile app that allowed for users all over the world to access and trade the four main cryptocurrencies.
As of today, Coinbase is the most popular cryptocurrency exchange on the market. Its mobile app is the most downloaded on the IOS and Android platform. Coinbase is now a cryptocurrency trading platform which provides:
- Security and Backups
- Digital Wallets for Currency
- Easy-To-Use Interface
- Ability to exchange USD and other world currencies into cryptocurrencies