What’s This Bitcoin Thing All About? An Introduction to the What, How, and Why of Cryptocurrencies

Cryptocurrencies such as Bitcoin and Ethereum became the craze of 2017. The value of Bitcoin grew by more than 1,200% last year, while lesser-known cryptocurrencies like Ripple jumped by 35,000% in 2017. Yes, you’re reading those numbers right. According to Reuters, this means if you invested $100 in Ripple at the beginning of 2017, your investment would be worth $35,000 at the start of 2018.

With numbers like these, there’s no wonder why people are flocking to cryptocurrencies. But the problem is that people assume investing in cryptocurrencies is a sure thing, which is never true. Even worse, many don’t fully understand how cryptocurrencies work, putting them at risk for getting caught up in a scheme. Just like with anything, doing research is a critical part of making a smart decision.

What is cryptocurrency?

Cryptocurrency is defined as a digital asset used as a medium of exchange. The “crypto” refers to cryptography, used to secure and verify cryptocurrency transactions.

Cryptocurrencies can be used to purchase goods and services anywhere in the world that accepts it as payment. More businesses are now accepting cryptocurrencies, such as Bitcoin, just as they would traditional payments, but you may also convert cryptocurrencies to dollars and other hard currency through exchanges.

Besides basic transactions, cryptocurrencies are often used as tradable assets, much like stocks, and frequent trading activity is what has been partially responsible for driving up value.

Why are people attracted to cryptocurrencies?

Cryptocurrencies offer certain advantages for those that value personal privacy and systemic transparency. Instead of having an owner, like most financial institutions, cryptocurrencies use a decentralized system maintained by blockchain technology.

Blockchain involves a network of connected databases accessible by all users—think of it as a massive spreadsheet that can be updated by anyone connected to the system. It allows users to analyze and verify transactions and it makes the system more transparent, as users are able to police transaction records for irregularities, which they cannot do with financial institutions, as they do not have access to the central server.

At a time of decreasing trust in major financial institutions, blockchain serves a need. With users able to observe transactions, hacking and other corruption become easier to identify.

How do cryptocurrency transactions work?

All confirmed cryptocurrency transactions are recorded on a public ledger, which is accessible by all users of the cryptocurrency. Fortunately, for privacy purposes, this ledger does not show the specifics of the transaction (like who purchased what). It only shows that a transaction took place. Transactions are recorded as hashes, or long strings of random numbers assigned to each transaction, and the ledger displays transactions as a series of hashes, which build on top of other hashes as more transactions occur.

Individuals on the network verify transactions by analyzing the ledger with their computers, and once they verify the transaction, the payment goes through. The process isn’t too different from a financial institution needing to clear a check before they disperse funds.

In order to make the transactions more secure, vendors can request multiple verifications, made by different individuals. However, the more verifications requested, the longer a transaction takes. One common complaint from cryptocurrency users is the amount of time it takes to clear a transaction, but this will likely improve as the technology advances.

Mining for Bitcoin

Individuals who help verify the ledger are known as “miners,” and can earn Bitcoin for their work auditing the public ledger. Each miner audits one block at a time, with each block holding 1 MB worth of transactions. The mining process helps prevent double spending and other errors, as miners can reject a block if they discover a discrepancy. If miners disagree on a transaction, they engage in what is known as “forking.” This means that a new blockchain begins, as the potentially fraudulent transaction is thrown out.

Miners can be rewarded with Bitcoin for each verified block. But this doesn’t mean that miners automatically earn money after they finish a block—that would be much too easy. After verifying a block, they must be the first to solve a numeric problem. This process is known as “proof of work.” Problems are solved using computing and can take a long time to solve, since it’s essentially a guessing game, but once they solve the problem, they are rewarded with Bitcoin, or whichever cryptocurrency they’re mining for. This amount can vary, depending on when the problem was solved.

This type of computational mining is very intensive. It is estimated that the average electricity used to mine bitcoin alone has surpassed the annual energy usage of 159 countries.

Problems with cryptocurrencies

Like any new system, cryptocurrencies are not without their problems.

The one major downside is the lack of regulation. For example, all financial assets you keep at Vantage West are federally insured by the National Credit Union Association (NCUA), but there is no such agency to protect users of cryptocurrencies. Like cash, if your cryptocurrency is stolen, there’s nothing you can do about it. There have been a number of cases of cryptocurrency exchanges being fraudulent or going belly up and taking all of their users’ holdings with them.

Furthermore, many financial experts are skeptical that cryptocurrencies can ever achieve wide adoption due to their volatility. A major reason fiat currencies like American dollars are so effective is you are assured that the cost of a gallon of milk today is about the same as it was last year and will be next year. Inflation or deflation of major currencies occurs very slowly over many years. In contrast, the value of Bitcoin just fluctuated about 30% over the past week from the time this article was written.

What does the future hold?

Despite many current shortcomings, major financial institutions like Visa and American Express are hiring specialized developers to research and develop with these blockchain technologies. But that is not a guarantee that cryptocurrencies can or will succeed in the long term.

As for Vantage West, we will continue to evaluate the evolution of the technology as well. There may come a day that cryptocurrency has wide enough adoption to be taken seriously as part of our member services mix, but we’re not there yet.