What is Cryptocurrency?

Cryptocurrencies are a digital medium of exchange that uses cryptography as a means of security.

With a track record stretching back over a decade, cryptocurrencies are clearly more than just a fad. But they remain largely misunderstood by many people, with lingering doubts about their true value and practical use.

It is increasingly possible to use cryptocurrency to make purchases. Last year, for example, payments giant PayPal announced a service allowing its UK customers to buy, hold and sell cryptocurrencies through their accounts.

Traditional investors are also more than fleetingly interested in cryptocurrencies. In what it calls a “currency and market risk hedge”, investment firm Ruffer has spent around £550m (or 2.5% of the £20bn it manages) to buy bitcoin last summer.

However, concerns about the security of cryptocurrencies as an investment class remain front and center for financial regulators around the world. Cryptocurrencies and their volatile behavior have prompted the UK’s financial watchdog, the Financial Conduct Authorityto qualify them as “very high-risk speculative investments”.

“If you invest in crypto-assets,” he warns, “you have to be prepared to lose all your money.”

Investing in any crypto asset is speculative and your capital is at immediate risk. You will have no recourse to compensation in the event of a problem.

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How are cryptocurrencies regulated?

The simple answer is that they are not, outside the limits of blockchain technology, which we will come to later.

More fundamentally, the current legal status of cryptocurrencies varies greatly from country to country. While the use of cryptocurrencies is unhindered within the European Union, some countries, such as Turkey, have banned payments made in cryptocurrencies.

The FCA is the UK’s financial regulatory watchdog. Her position is clear when she warns investors that “if you are buying…crypto-assets, you are unlikely to have access to the Financial Ombudsman Service or the Financial Services Compensation Scheme.”

The FSCS is a lifeboat arrangement that comes to the rescue of consumers in the event of a financial calamity such as a supplier going bankrupt.

In December 2020, the FCA also advised clients of crypto-asset companies to check the status of their providers and ensure they were permitted to continue operating under the watchdog’s revised registration rules.

For providers who cannot confirm they are operating under the new rules, the watchdog has advised customers to withdraw their holdings.

How do cryptocurrencies work?

Most cryptocurrencies operate without the backing of an authority, such as a central bank or government. This fundamentally differentiates them from traditional currencies, such as the British pound or the dollar.

Instead of government guarantees, the operation of cryptocurrencies is based on what is called blockchain technology (see below).

Rather than existing as a physical stack of bills or coins, cryptocurrencies are confined to the internet. Think of them as virtual tokens, whose value is determined by market forces generated by people who want to buy or sell them.

Nowadays, around five thousand cryptocurrencies exist. Bitcoin is by far the largest, with a market capitalization of around £350 billion (as of July 2022).

The market cap of a cryptocurrency is equal to the unit price of a currency multiplied by the number of units in existence. Other top cryptocurrencies include Ethereum, with a market capitalization of around £130 billion as of July 2022.

Cryptocurrencies can be purchased with traditional cash such as British Pounds and can then be used on their own to purchase a growing range of everyday goods and services. Cryptocurrencies have the same value in every country, which facilitates person-to-person transfers around the world, while negating the issue of exchange rates.

Only a limited number of Bitcoins actually exist – cryptocurrencies are likened to a digital form of an asset such as gold, where a perceived store of value is then subject to the laws of supply and demand.

Currently, this is the main appeal of cryptocurrencies: that they can be traded on exchanges similar to how stock market investors buy and sell stocks and other commodities.

What is blockchain technology?

In essence, a blockchain is a type of database. Blockchain first rose to prominence as the technology that underpinned Bitcoin when the cryptocurrency was first discussed in a paper on peer-to-peer electronic money systems in 2008.

The article was attributed to Satoshi Nakamoto, who was allegedly the pseudonym of an individual or group of people. Part of the design of the cryptocurrency meant that there would only ever be 21 million Bitcoins created.

The blockchain is essentially a public record of every bitcoin transaction that takes place. A recording is distributed over many computers and cannot be altered or modified retrospectively. According to cryptocurrency proponents, blockchain transactions are more secure than traditional payment mechanisms.

A short Bank of England video demonstrates the blockchain process in more detail and also explains how “mining” works, the mechanism by which new monetary units such as Bitcoin are produced.

This “mining” requires huge amounts of computing power and therefore consumes significant amounts of energy. Environmentalists have warned that the proliferation of cryptocurrencies could have a significant impact on global attempts to reduce energy consumption.

How to buy cryptocurrencies?

The most common places to buy Bitcoin and other cryptocurrencies are specialized exchanges. This includes a range of trading platforms and apps that allow investors to buy cryptocurrencies using traditional currencies and/or other cryptocurrencies.

According to an FCA study, around three-quarters of Britons who had bought a cryptocurrency did so through an online exchange.

To open an account, potential traders are usually asked to provide their passport details, a phone number and an email address. Trading costs may vary from exchange to exchange. Some providers charge a flat fee per transaction, while others charge a percentage of the overall transaction amount.

How did cryptocurrencies work?

The performance of cryptocurrencies can be notoriously volatile with roller coaster peaks and troughs. In 2013, an individual bitcoin was worth just a few dollars. At the time of writing (July 2022), its price is around $22,000. A huge increase from nine years ago, but a far cry from the all-time high of nearly $68,000 it reached towards the end of 2021.

The UK’s Appetite for Cryptocurrencies

In the summer of 2020, the FCA published research on the UK’s growing appetite for cryptocurrencies.

The FCA estimated that nearly two million adults owned cryptocurrencies, although the findings suggested around three-quarters of consumers held cryptocurrencies worth £1,000 or less.

The most popular reason for holding cryptocurrencies, the FCA said, was “as a bet on who could win or lose money.”

According to the FCA, more than one million adults increased their holdings of high-risk assets such as cryptocurrencies in the first seven months of the 2020 Covid-19 pandemic.

What happens next?

Even before the pandemic upheavals of 2020, cryptocurrencies were surrounded by questions about their safety, practical use, and long-term viability. Hence the stern and repeated warnings from financial regulators that people should approach investing in this area with extreme caution.

If more traditional investment firms dip their toes in the cryptocurrency waters, we could see the value of digital assets increase, with their use normalized and more widespread.

Several central banks, including Nigeria, have already introduced their own digital currencies, although progress has been more muted in key areas of economic blocs such as the United States and the European Union.

In the uncertain times in which we live, the whole concept may prove vulnerable or unsustainable in the face of yet unforeseen challenges.

To paraphrase regulators, “buyer beware”.