With major changes in the crypto market, investors are weighing whether or not they should buy digital currencies — here’s what to know before you buy.
Cryptocurrencies are getting a lot of hype. Major players now allow crypto to be purchased on their platforms, and there seems to be a shift toward embracing this still-new technology.
Before deciding whether to invest in cryptocurrency and jump in with both feet, investors should have a general understanding of what cryptocurrency is and how it works.
Intro to Cryptocurrency
Cryptocurrencies are digital currencies. Let’s parse that back a little to understand exactly what it means.
A digital currency exists electronically; there is no physical form necessary. A currency is an accepted medium of exchange.
In the United States, the dollar is the primary accepted medium of exchange. When we go into a store and we see items priced in U.S. dollars, we know their relative worth based on how many of these exchange units — dollars — we need to give for them.
The exchange unit of the dollar serves as a convenience. There was a time where you could have used beaver pelts or some other medium of exchange, but not everyone always had beaver pelts on them. Currency make exchanges — purchases and sales — much simpler.
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Most currencies are issued by governments, and controlled either directly or indirectly by them. Traditional currencies have physical form, and can be passed from hand to hand. They get their legitimacy from the issuing government; people trust the institutions behind the currency.
Cryptocurrencies are decentralized; there is no government issuing them and no middlemen, such as banks or brokerages, required for transactions.
Cryptocurrencies get their legitimacy from their users, who have to trust the technology behind them, not a governing entity.
There are currently over 6,700 different cryptocurrencies in circulation. If that seems like a lot, it is. There are about 180 traditional physical currencies in circulation worldwide.
A cryptocurrency is simply a medium of exchange that exists primarily in digital form. In most cases it is exclusively in digital form, but there are some exceptions.
Cryptocurrencies use blockchain technology. Blockchain enables very secure transactions and record keeping. Cryptocurrency could not exist without this technology; it provides the security necessary for the digital storage of value.
Cryptocurrency is decentralized and allows peer-to-peer transactions. We are used to peer-to-peer transactions: They are what we do physically with cash. Crypto allows for the same type of transactions digitally. Without cryptocurrency, you need some form of middleman, a bank or brokerage or someone facilitating the transaction.
When we consider what makes a good currency a primary attribute is stability. If the value of the U.S. dollar fluctuated widely from day to day, it would not be a good store of value and we would be reluctant to take it in exchange for our goods or services unless we had immediate need for it — holding it even a short time would be excessively risky.
Even a currency that only appreciates in value would lose effectiveness as a currency. The price you would be willing to sell a good or service would depend on your timeframe for the use of the funds. Only a stable currency promotes values free from changes in the underlying value of the currency. Though some fluctuation in currency value is inevitable, the more stable the better.
Cryptocurrencies, so far, have not generally exhibited stability, which makes it a difficult choice to invest in. They have been characterized by large changes in value over short periods of time — they are volatile. They are still relatively new, and continuing to gain acceptance, but stability is a major barrier to mainstream adoption as a medium of exchange.
Why would you use a cryptocurrency to purchase a cup of coffee today when that some currency might buy two cups tomorrow?