In August 2021, the volume of cryptocurrency transactions in the world reached the $1 trillion mark. Before we talk about cryptocurrency as an investment tool, let’s break down the basic concepts: what it is and how it works, how new cryptocurrencies appear, about mining, tokens and blockchain.
What is cryptocurrency
Cryptocurrency is a digital medium of exchange. It differs from all the usual rubles, dollars and euros by the lack of physical embodiment and by the fact that it is not connected to any state system, as it is issued directly on the Internet. But it can be used in the usual ways – when buying goods and services or as a means for investment.
Bitcoin, the first and most famous representative of the cryptocurrency, appeared on the market in 2008. The first year it was worth about $1, and in 2021 its rate ranges from $29,000 to $60,000. There are already over 5,000,000 different cryptocurrencies in circulation
All of the more recent cryptocurrencies are called altcoins, the best known today: Etherium (ETH), Cardano (ADA), Binance Coin (BNB), Tether (USDT), Solana (SOL), Ripple (XRP), Dogecoin (DOGE), Polkadot (DOT), USD Coin (USDC), Terra (LUNA). The current ranking of cryptocurrencies by capitalization can be found on FOREX.
The main advantages of cryptocurrency are:
- decentralization – it is not controlled by private companies or the government;
- cheap transfers;
- smooth operation of the system;
- deflationary – the price of cryptocurrency increases over time.
Disadvantages of cryptocurrency:
- high fees for cashing out – up to 5%;
- in case of loss of the wallet access code or erroneous transfer it is impossible to get money back;
- there are no guarantees for reimbursement from cyber-attacks, or insurance against bankruptcy of the company in which the money is invested;
- Volatility – the exchange rate fluctuates more frequently and with greater intensity than in fiat currencies.
Despite the risks and rate fluctuations, the cryptocurrency is gaining popularity – according to Fortune Business magazine, its transactions reached $1 trillion in August 2021.
In April 2021, Intertrust Group conducted a survey among investment fund directors about their development plans for the next five years. The list of questions included the perceived weight of cryptocurrency in portfolios – 98% of respondents intend to invest in cryptocurrency, an average of 7.2% of their portfolio.
Blockchain is a registry of all transactions and balances of all e-wallets for each type of cryptocurrency. With each transaction, it is updated with new information, and once created, it cannot be changed or deleted. Records in the registry are arranged in chronological order.
Blockchain technology guarantees the safety of data and ensures the transparency of all processes in the network. Each block of information contains data about the previous and subsequent blocks, and the registry itself is decentralized – data is stored simultaneously on thousands of computers belonging to users of the system. To change a record in any block, it is necessary to have simultaneous access to more than half of the network computers, which is technically impossible.
The basis for blockchain technology was laid in 1998 when the bit-gold protocol was created for decentralized operation, and the concept of public key cryptography, which provides data security, was developed at Stanford in 1976
A new cryptocurrency could emerge in two ways:
- By introducing a new technical “chip” that would give the emerging cryptocurrency an advantage over its competitors (e.g., reducing the power required to issue in pircoin, or increasing the speed of transactions in the system in lightcoin).
- A fork – the division of the blockchain into two parts as a result of technological disagreements within the community over changes in the blockchain protocol (this is how Bitcoin Cash appeared after BTC miners argued about the adoption of Segregated Witness technology).
- A distinction is made between a hardfork and a softfork. A new cryptocurrency is created only after a hardfork, whereas a softfork is essentially just a technical upgrade. Adopted changes in the protocol do not force users to update the software, and the transition to a new version is done gradually.
Mining is the process of adding new blocks to a blockchain. Each block in the network has its own cryptographic fingerprint (hash) – a sequence of bytes that meets a number of requirements. To add a new block, this sequence must be calculated. The operation is performed every time one of the users sends a transaction request to the network.
The users solve the mathematical search problem. Because it requires an investment (computing power), the calculation is paid – it is one way to make money on cryptocurrency. Any network user can participate in the process, they become a miner, and the first one to get a successful hash wins. The program for calculating the hash is also often called a miner.
To minimize the time for calculation and to successfully compete with other willing users, users buy special equipment – mining farms. The installations must not only calculate quickly, but also consume as little energy as possible – then mining will be profitable.
Tokens and smart contracts
A token is a digital asset on one of the blockchains, analogous to securities on a traditional stock exchange. If a company has a need to attract investment, it creates tokens and sells them to investors.
The process of issuing tokens is called ICO (Initial Coin Offering). The model is named after the IPO (Initial Public Offering).
What makes it different from securities is that investors can buy any part of a token, not the whole token. This splitting of the token creates opportunities for small investors.
Like securities, tokens come in several varieties:
- Security tokens are tokens with rights to securities in the tangible world. Sold to raise money for a startup with a promise to redeem them after a specified period of time at a fixed markup. The user’s rights are fixed in a smart contract.
- A smart contract is a computer algorithm that performs the function of forming, controlling, and providing ownership information or other programmed conditions.
- Application tokens – game tokens that work as payment within some kind of application.
- Debt token – an analogue of a short-term loan or promissory note.
- Asset backed tokens – “raw” tokens. They are backed by liquid assets from the real world – oil, gold, commodities or services. The company issuing these tokens has a legally binding obligation to deliver the commodity or pay its real value.
- Governance token – tokens whose owners get the right to participate in the fate of a project – to vote for a decision option.
- NFTs are non-interchangeable tokens. They are needed to create a digital copy of a unique object – a work of art or any collectible object. NFT, unlike other tokens, can only be a single copy.
IEO (Initial exchange offering) is a more secure form of ICO. The tokens are sold through a cryptocurrency exchange, so the tokens undergo a listing procedure – possible liquidity, security and a check of the organizers’ reputation.
Exchanger and crypto exchange
If there is a market for cryptocurrencies and tokens, there should be a place for various financial transactions involving them. Such platforms are created on the network by analogy with traditional exchanges and exchanges.
An exchanger can quickly buy or sell a specific cryptocurrency. They have a simple interface and no registration procedure is required. Of the disadvantages – less favorable rate due to additional commissions and weak protection against hacker attacks.
Cryptocurrency exchanges have favorable rates, a larger selection of cryptocurrencies, no restrictions on the amount of transactions – they provide all the opportunities for full-fledged trading.
When choosing a crypto exchange for trading, you should check the license from the financial regulator, the history of hacking attacks and their consequences, methods of deposit and withdrawal of funds, the possibility of token trading. It is also worth looking at the list of partners – whether there are large companies, it affects the reputation of the exchange.
Stablecoins and smart contracts
Stablecoins are a tool created to stabilize the price of digital assets. It links cryptocurrency to fiat currencies, most often U.S. dollars. Stablecoins are issued on cryptocurrency exchanges. They are backed by real dollars or government bonds and are essentially more like electronic money in payment systems such as WebMoney or PauPal, with the only difference being transaction transparency.
Stablocks come in the following varieties:
- Fiat-backed stablcoins are pegged to a specific real currency at a 1:1 ratio. The issuer keeps an amount in the bank in the currency in proportion to which it issues the stablcoins. Examples: BUSD and BGBP.
- Cryptocurrency-backed stablcoins are tied to a cryptocurrency. Stablecoins are issued on the basis of smart contracts. Price stability is most often achieved by collateral redundancy – there is more cryptocurrency in a blocked account than is nominally needed to collateralize a stabelcoin. Examples are Synthetix and Maker DAO (DAI).
- Stablecoins tied to commodity markets. Most often it is an asset from a precious metals, oil or real estate market or a combination of several assets. Thus, Tiberius Coin (TCX) is tied simultaneously to 7 metals, which are used in the manufacture of high-tech equipment, and SwissRealCoin (SRC) is secured by a portfolio of Swiss real estate, which holders can choose a particular object by voting.