Making sense of cryptocurrencies

Updated 27 Feb 2018 – By Loanstreet


The recent global media interest in Bitcoin – and cryptocurrencies as a whole – was sparked by a series of seemingly negative news stories concerning the use of cryptocurrencies as payment for illegal actions and trade, as well as the implosion of some key players in the Bitcoin industry (especially the failure of Mt. Gox, one of the largest Bitcoin exchanges).

Despite the adverse media exposure, however, the prices of Bitcoin have increased well beyond USD500 per unit as of today (1 June 2014), and may continue to rise even further. This makes the price of a Bitcoin very close to half the value of 1 ounce of gold.

To understand what makes Bitcoin (and by extension, cryptocurrencies as a whole) so valuable, and to understand its implications on global funds transfers, we have to understand a little bit about what a currency is, what money is, and how the entire world's economic system works (or is supposed to, anyway). This article will provide you the context to unlocking the true power of cryptocurrencies.

Microeconomic Theory and Practice

At its heart, all trading, commercial and financial activity happens because as individuals, we are not self-sufficient, and we cannot meet all of our own needs and desires by ourselves; and because we can’t, we exchange the results of our work, whether goods or services, for the goods and services produced by other people.

This could be done by way of direct exchange or barter – I have a cow and I want some chickens, you have chickens and want a cow, and we haggle over how many chickens is worth a cow and vice versa. Money – an accepted medium of exchange – comes into the picture as a solution to this now obsolete obstacle.

There are many things that can be considered (and have been considered in the past) as money. Most old types of money came in the form of precious metals (e.g. copper, silver, gold) – something that had intrinsic value (valuable in and of itself, outside its use as money).

Other types of money include cowrie shells and even stones. It was China that first came up with the idea of paper money (what is a large part of what we now call currency) – essentially an I.O.U., or a token symbolising the real money backing it.

Today, currency is one of the most liquid (easily and quickly transferred without losing its value) and most widely accepted form of money. The main features of currency that make it usable as a form of money include its transportability, universal acceptability (usually enforced in law as ‘legal tender’), general consensus as to its value, and – what most people don’t really think about – its anonymity.

Using Cryptocurrencies

Most national currencies, if not all of them in fact, are what are called 'fiat' currencies. That is to say, their value does not come from their beauty, or their rarity, or because it’s backed (supported) by something tangible; their value is derived solely through government decree or law.

In a single-currency country, therefore, two implications arise: the only source of currency or money is the one who’s producing it, and the one producing the currency or money holds all the economic power of the country in its hands. Already, you can see the American and European central banks trying to inflate their way out of trouble through ‘quantitatve easing’; in simpler terms, making more money.

To some people, this suggests that fiat currencies are essentially worthless – which they are, for the most part.

What are cryptocurrencies, and what makes them special?

Just about every cryptocurrency out there is based on the very first one, Bitcoin (BTC). Bitcoin exists only as computer code, and therefore seems to be like a fiat currency (i.e. has no value except to be used as money), but the production of Bitcoins is by design both very, very difficult (it’s actually called mining) and has an upper limit, beyond which no more BTC will be created/mined.

This immediately makes it much closer to being like precious metals, which are also very difficult to mine and whose supply is limited. In addition, it is very difficult (infeasible, in fact) to counterfeit Bitcoins.

Bitcoins are stored in ‘wallets’, and are directly transferred from wallet to wallet without involving third parties (and outrageous transaction/processing/arbitrary fees).

The details of the inner workings behind cryptocurrencies are beyond the scope of this article; but here are the main takeaways for you to understand about them:

  1. While there are real-world businesses that accept cryptocurrencies, by and large they are meant for online shopping and funds transfers.
  2. Cryptocurrencies are pseudonymous – if you take the right precautions, it’s hard to prove that you obtained the currency by illegal means, and it is also hard to link anyone to any particular ‘wallet’. In fact, you can create a thousand or even a million wallets – this is why cryptocurrencies are used by criminals extensively. Some cryptocurrencies are even completely anonymous.
  3. Unlike the real world, you can make backups of your ‘wallet’ for safekeeping – in the case that your hard disk crashes, you can restore your wallet (which would otherwise have been lost and all your currency gone up in smoke).
  4. Because no single body is in charge of any cryptocurrency, they are used in all sorts of situations which, while legal, otherwise might violate terms and conditions of some particular body or other.

As of May 2014, there were more than 275 cryptocurrencies available, for trade, in online markets. The major ones (besides Bitcoin of course), include Namecoin, Litecoin, Dodgecoin, Peercoin and Mastercoin.

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