Cryptocurrencies have taken over the financial world in recent years. Many of the current assessments as to what cryptocurrencies actually are and do is grossly misinterpreted by both lay people and experienced economists. In many ways cryptocurrencies are quite a simple concept with effective real-world applications.
The first cryptocurrency was introduced in 2009 by Satoshi Nakamoto and was called Bitcoin. It is the most well-known and popular currency, though many suggest it has some flaws in terms of its usability compared to other cryptocurrencies. But because it was first to market, it had gained widespread adoption.
Cryptocurrencies are a response to a lack of faith in the financial system. Systemic financial shocks, such as the 2008 crisis, along with a lack of trust and faith in banks and financial institutions in general, has motivated many to turn to alternative financial avenues.
Cryptocurrencies are also faster, more efficient and far cheaper than traditional banking methods, though they do have their share of risks.
There are thousands of cryptocurrencies on the market; however, it is widely regarded that only a few are going to make the cut into mainstream society. And many of the cryptocurrencies on the market have no useful application, often described as “a solution in search of a problem”.
What is Cryptocurrency?
A cryptocurrency is simply a digital token that uses cryptography to secure its transactions and to control the creation of additional units. This can be contrasted to the money we use for everyday purchases, also known as “fiat” money.
Fiat money is controlled by central authorities such as the Federal Reserve. Governments can engage in policies of money printing, known as quantitative easing, in order create additional currency units. This issue with this is that it dilutes the value of money, putting savers at a disadvantage.
With cryptocurrencies, the number of units is fixed so this does not happen. Cryptocurrencies also have a number of other features which makes them advantageous to fiat currencies. Transactions are anonymous and with some coins, private.
There is a difference between the two, in that anonymous transactions can be tracked and monitored, though it would take time, sophistication and resources.
Because all of the transactions are stored on the blockchain for transparency, it is possible for powerful entities to figure out who sent cryptocurrencies to whom, using the blockchain and IP address in conjunction with other available data. Private cryptocurrencies such as DASH, Zcash and Monero are more secure
Another huge benefit of cryptocurrencies is that they are quick to lightning quick, depending on the particular cryptocurrency. Transfers can happen near instantaneously, and the cost is practically free.
What this means is that you can transfer a certain amount of cryptocurrency units to a friend halfway across the world, immediately, for a tiny cost. This can have huge advantages over international wire transfers which can cost $40 and take a week or longer to complete in some instances.
Cryptocurrencies have a number of features which make them preferable to fiat money. They use adaptive scaling, which means that it works equally well in both large and small scales.
Bitcoin, for example, is programmed to allow for a single transaction block to be mined every 10 minutes. This algorithm adjusts every 2016 blocks to get easier or harder, based on how long it took for the blocks to be mined.
If it took 13 days, it would be made harder to mine a block, and if it took 15 days, it would be made easier (14 days being the preferred time). Ironically, this particular version of adaptive scaling has led to problems and other cryptocurrencies have different methods to manage the supply and demand of their coins.
Bitcoin is one of the slowest coins at present, partly due to its scaling solution, and partly due to the fact that it has the largest holders and volume. But it has implemented a technological solution called Segregated Witness which should address the problem in the coming months.
Other attributes of cryptocurrencies which differentiate them from fiat money is that they are cryptographic, meaning they use a system of cryptography to create new coins; they are decentralized, meaning there is no centralized regulatory authority dictating the operation of the cryptocurrency system (though some coins can have large shareholders who also happen to be core developers, eventually resulting in centralization); and they are digital, meaning they are not tied to a physical object, like the US dollar when it was tied to gold pre-1971.
How Do Cryptocurrencies Work?
Cryptocurrencies work off of something called the blockchain. A blockchain is essentially a ledger of transactions, a transaction being a transfer of cryptocurrencies from address A to address B. Miners verify these transactions using their computers to solve algorithms and once verified the transaction is just another block on the chain – the blockchain.
And this blockchain is constantly growing. It is not possible to get a block wrong or make a mistake, as each block builds on the last block in a sense. Everything has to add up, and it does.
This cryptographical structure is what makes cryptocurrencies so appealing. There is no trust issue on the level of transaction verification.
It eliminates the needs for third parties to regulate and verify these transactions, such as Visa or Mastercard, which take a cut, along with a financial institution, which takes a cut, along with a regulator, who takes an indirect cut in the form of taxation.
Cryptocurrencies use either proof of work or a proof of stake. Proof of work is the standard mode of operation. You are the only miner with the solution which can validate the block on the chain.
This requires high computing power hardware as well as lots of electric power. Bitcoin uses a proof of work (POW) method.
An alternative method is the Proof of Stake (POS). POS does not involve mining but “forging.” The forgers/validators have a “stake” judging by how many coins they have in a wallet and for what length of time.
This allows building a trusted and distributed network with loyal validators (high stake of coins). The validators earn the part or whole of the transaction fee. This is more energy efficient and there is no need for expensive hardware.
Each validator owns a stake in the network. The issue with POS is that there could be a small amount of people owning a majority of tokens.
There are a number of hybrid systems and many coins have unique and differing attributes. Cryptocurrencies is one of the most innovative industries around and nothing stays static.
There is a large risk on the level of Bitcoin storage. This can be hugely mitigated by downloading a local wallet and storing all of your cryptocurrencies on your machine.
You will have to remember or write down a long passcode so if anything goes wrong you can recover your local wallet on a different machine. The only real danger when storing locally is that you forget or misplace your passcode, in which case your cryptocurrencies are gone.
This can happen. If this were not the case, it would mean that your cryptocurrencies could be stolen by the wallet operators! There is always going to be some risk on some level, and it is up to the individual to take the appropriate steps to secure their wallet.
But once this simple step is taken this is far safer than keeping cryptocurrencies in an online wallet. And the least safe method is to keep cryptocurrencies on an exchange, like the Tokyo-based exchange Mount Gox which filed for bankruptcy in 2014.
At the time it was the world’s leading Bitcoin exchange handling over 70% of the world’s Bitcoin transactions. It claimed that hackers stole all the Bitcoins, a claim which is viewed with skepticism by many.
Each wallet, online or local, has a receive address. When you want to send cryptocurrencies from one wallet to another, you need a receive address.
You can then go to your particular wallet and send the desired number of cryptocurrencies directly. There are many wallets available, one of the most highly regarded being the Exodus wallet.
It allows users to hold a number of different cryptocurrencies locally (29 at the time of this writing) and trade between them as well as to different wallets and exchanges. It connects to the shapeshift platform to transfer between cryptocurrencies, and it operates very quickly.
In a sense, this actually eliminates the need for exchanges for those who want to trade cryptocurrencies, at least for these 29 core cryptocurrencies. You would need to buy one of the 29 currencies from an exchange or some other third party, but after that you could keep it in Exodus and trade between cryptocurrencies.
It is far easier to have a secure multi-crypto wallet than 10 or more individual local wallets for each specific cryptocurrency.
Cryptocurrency Use Cases
Aside from the cost, security and speed of cryptos, there are a number of futuristic use cases of cryptocurrencies which might come to fruition soon. The most obvious use case of cryptocurrencies is as a means of money, but it has applications in the world of medicine, science, education, insurance and really anything that involves the storage and transfer of data of any kind.
Asset tokenization is one feature being developed by cryptocurrencies such as LAToken. The concept of tokenization is that you can take any item you have, and sell tokens, which are really shares on the asset.
For example, an artist might like to sell a portion of his painting to raise funds but would not be eager to sell the whole thing and would like to retain 90%. More commonly, it would make it easier for people to tokenize their cars and houses, as well as loans of all kinds.
This has the added advantage of allowing crypto owners to invest in real assets without any of the regulatory burdens, as well as providing relief to those struggling in debt. Shares, physical metals, stocks, bonds, loans, real estate, art and more can be tokenized which would greatly increase their liquidity.
And this would all be done without any financial intermediaries, brokers, accountants, huge fees, account opening or other delays. The larger institutions would no longer have a monopoly in these areas and people can become their own broker, banker and promoter. Tokenized Apple and Amazon shares are already traded on the LAT Platform, trading of tokens being backed by real estate.
IOTA is a popular coin with a potentially infinite number of use cases. Its coin is the Mi and it is connected with the internet of things.
It has no fees, is instantaneous (almost) and scales better than anything else, using a technology known as a Tangle, of which the technical details are a little beyond the ambit of this article.
Imagine, for example, a self-driving taxi which gets paid in Mi. The taxi would be owned by certain shareholders. The taxi drives around and then gets paid by users directly in Mi, using its own internal algorithm to calculate the route, the nearest passenger, the cost, fuel, maintenance etc.
At this point, everything would be connected to the internet, so the taxi would pinpoint your geo-location and the distance, and the fee would be paid over the web. This is the type of coin that gets investors interested.
It will most likely be years before the ideas start to actually materialize. However, they could make money in the meantime due to investor speculation which drives prices skywards, even though there will be no workable product for quite some time.
IOTA is certainly the most advanced and interesting coin out there, and it is definitely one for the future, the issue being it is not widely held on exchanges which makes it difficult to purchase.
Coins such as Ethereum have something called a smart contract feature which is built into the code. The smart contract essentially executes a certain function once specific criterion gets fulfilled.
Of course, the use cases of such coins are endless. Users get to write their own smart contract which can fulfill anything. It is limited only by the human imagination, which is limitless.
In the event of a natural disaster such as a hurricane, insurance companies would pay out calculated fees to clients in the cryptocurrency token based on the criteria set out in the smart contract. The digital contract is agreed to and once the condition comes to pass, the payment process is automated and streamlined.
It can save a lot on third party costs and error. Smart contracts can improve data integrity and enable the accurate and streamlined recording of data of all kinds. These smart contracts could be used to fulfill contractual obligations of all types, from securities to digital identities to mortgages to transport.
The uses cases of these cryptocurrencies are incredible and are all possible. They will come to pass. However, it is more of a question as to when they will come to be.
What can happen in a lot of cases is that a company publishes a white paper with no actual demonstrable and measurable use cases. The concept gets investors excited and they invest millions.
And the company subsequently fails to back up its claims. This has already happened with the Tezos scandal and many others. Tezos is currently battling a very expensive lawsuit of investors claiming they were misled by the claims by the company. It raised over $232 million in July 2017 but is now facing lawsuits and much infighting.
Cryptocurrencies have amazing potential and are transforming the world of finance and beyond. However, it must be said that the most common use cases of cryptocurrencies, at the time of this writing, are to avoid paying taxes and as a speculative move to make profits.
Private coins enable this even further, such as DASH, Monero and Zcash. With DASH, the “money” is effectively laundered, being sent to multiple addresses before being sent to the intended address. There are also additional security features to ensure privacy and security.
Legality of Cryptocurrencies
The legality of cryptocurrencies is something that varies from country to country. As a general rule of thumb, it is not illegal to purchase cryptocurrencies in most countries.
What is illegal is when you make a profit on the cryptocurrencies and do not declare it for taxation. Generally, cryptocurrencies are a grey area for regulators and policy makers.
Because the law is not clear, it is not easy for people to understand their requirements, and aside from institutional investors and businesses there are hundreds of thousands of everyday investors, including teenagers and people in their early twenties who might be somewhat swept away with the cryptocurrency craze.
There are no laws to prohibit the exchange of cryptocurrencies, and it is not an offence to do so. The CFCT has even allowed the CME and CBOE to launch Bitcoin futures.
The stance of the IRS is that cryptocurrency is to be treated as a property for tax purposes. This means a capital gain or loss should be recorded as if it were an exchange involving property.
Investment losses can be written off. It should be treated like inventory if it is held for resale, and therefore an ordinary gain or loss recorded. If it is used as payment, it should be treated like currency.
The Security and Exchange Commission has not registered any ICO’s and has not approved any exchange traded products, despite two efforts from the Winklevoss twins to create a Bitcoin ETF. An ICO is an initial coin offering where investors purchase coins for a new cryptocurrency initially, often at a discount – the cryptocurrency version of an IPO.
Other countries have banned it outright. India has banned cryptocurrencies from its payment systems; the government does not consider it legal tender. The policy of China seems to change from year to year.
Crackdowns on Chinese exchanges often sends the price of Bitcoin plummeting, far more than any regulatory statements issued from the SEC and other Western regulatory entities. On September 4, 2017, China banned all funds and activities from raising funds through ICO activities, ICO’s being considered illegal.
The stance of the EU is similar to that of the US, and cryptocurrencies are largely treated the same as property in individual states for the purposes of taxation. The European Central Bank rejected the plans of Estonia to create their own digital currency to run along with the Euro, which came as no surprise to anybody.
The ECB will not allow any state to introduce their own virtual currency. Germany views cryptocurrency as a form of capital and in Ireland, the Central Bank of Ireland does not monitor Bitcoin.
Japan has gone a step further than the rest and actually treats digital currencies as legal tender. It is where major developments in cryptocurrencies are being made and Japan is leading the way in terms of regulatory acceptance. Japan welcomes Bitcoin investment of all kinds.
Russia is another country which has somewhat lessened its previously harsh stance on cryptocurrencies and is in the process of regulating cryptocurrency and integrating it into wider society.
The legality and regulation of cryptocurrencies is still in its infancy. But it is safe to say that the cryptocurrency world is moving far faster than the monolithic wheels of regulatory authority.
There is no set method to track and monitor Bitcoin transactions, and this is only a single cryptocurrency. It would be far easier to ban it outright from a regulatory perspective, which is what India recently did.
Aside from Japan and Russia, most countries around the world seem to have adopted a “wait and see” policy with regard to the regulation of cryptocurrencies. But in terms of individual investment cryptocurrency is, by and large, completely legal for buying and selling. Just remember if your cryptocurrency gets lost or stolen there is no recourse.
The Future of Cryptocurrencies
The future of the world lies in cryptographic and automated transactions, a mix of the internet of things, automated scripts and digitalized tokens. The benefits are undeniable.
There are no limits to the use cases and transactions can be sent almost instantaneously for free with many cryptocurrencies. They are a form of wealth redistribution that has never before been seen, with teenage millionaires and easy transfer of finance from rich to poor with no intermediary costs.
They have the potential to obviate the need for many large-scale institutions and for people to start taking control of their own financial affairs without any middle men.
At present, there are two broad forms of currency. There is the fiat-based money system and the free market of cryptocurrencies.
One is controlled by government interventionism and the other by free market variables, sometimes resulting in loss of property and other times resulting in significant gains with no regulatory oversight.
There are advantages and disadvantages to both systems. But the bottom line is that cryptocurrencies are the future and regulatory authorities need to work hand in hand with the new technologies to reach an adequate middle ground between freedom and regulation. Otherwise they may find themselves left behind.