Friday, December 2, 2022

What is…? Cryptocurrency

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Cryptocurrencies are a very hot topic right now, and not just for traders. People who have never even thought about the world of finance are jumping in to the crypto scene with both feet and no parachute. So what is cryptocurrency and exactly why is it causing so much hysteria?

As this episode is intended to be a brief introduction to cryptocurrency I will try to keep it short. There is a lot to learn about this new technology and we will be getting into many more specifics in season 2 (What now…? episodes 8 and 9) and season 3 (Cut Loose…! episodes 5 and 6).

Cryptocurrency is not considered a currency by most of the governments of the world. It is considered a store of value digital asset and is generally treated as such when the taxman comes calling. Currently El Salvador is the only country where a cryptocurrency (BitCoin) is considered actual currency. Despite this, cryptocurrency is becoming more widely accepted as a form of payment (we even accept it here!). It is also a genuine investment and trading opportunity.

I LIKE ANALOGIES

When it comes to crypto currency most experts don’t think analogies can explain crypto, and maybe they’re right. Or maybe they are just boring, patronizing, cryptophiles who don’t want their precious baby simplified for the masses. Well I like analogies, and I think I have found one that will make crypto a little easier on the brain. It may not be perfect, no analogy is, but it still helps me today when I try to understand how the crypto-world works.

Let’s say crypto didn’t involve computers.  Take away the technology and I believe the concept becomes easier to understand. 

JEREMY THE ENTREPRENEUR

Jeremy creates a new way of shopping.  He has a ledger and on page 1 of the ledger is a complex equation. The equation can only be solved through trial and error.  Jeremy eventually solves the problem and gets 50 units of JBucks.  The first thing he does is go to the next page and writes down that Jeremy has 50 JBucks.  At the top of the next page is another complex equation.  The rules of Jeremy’s new shopping system say that he can’t turn to page 3 until the page 2 problem is solved.

Jeremy uses some of his JBucks to buy a pizza from Papa Jim for 10 JBucks.  He writes in the ledger that he now has 40 JBucks and Papa Jim has 10 JBucks.  To make sure that Jeremy doesn’t cheat the system, he gives a copy of the ledger to Papa Jim.  Papa Jim updates his ledger with the transaction and, at the same time, he sees the equation.  Papa Jim starts to try and solve it as well. 

Jeremy then wants to buy a kite from Lazlo.  The rules of Jeremy’s JBucks system say that he has to tell everyone who is involved about his kite purchase.  So Jeremy, Lazlo, and Papa Jim get on a conference call and explain the transaction. Jeremy transfers 10 JBucks to Lazlo.  Jeremy and Papa Jim write this in their ledgers. They also offer Lazlo a copy of the ledger of his own which he accepts.  In the meantime Papa Jim solves the second problem.  Because he was the one that solved the problem Papa Jim’s ledger becomes the authorized ledger.  As per the rules of the system, Papa Jim provides a copy of this authorized page to everyone else. Now everyone starts recording transactions on page 3 of the ledger.  Page 1 and 2 are set in stone and can never be changed. Page 3 provides a new equation to solve as well as adding 50 JBucks to Papa Jim in the ledger.

Jeremy’s system continues with everyone who is involved in transactions being offered the opportunity to maintain a copy of the ledger. Every time an equation is solved that page ends and the person who solved it sends out the authorized copy of that page. This is added to everyone’s other pages as the authorized ledger.  What a great new system Jeremy has made!

HOW DOES IT RELATE TO CRYPTO?

Now we can see that there are clearly efficiency issues with this type of system.  As more people get involved it becomes impossible to have a conference call with every involved person every time someone decides to move some JBucks around.  The ledgers themselves would become massive, requiring libraries to hold all of them.  On a small scale, however, the system would work and it would be secure without being centralized.  The invention of computers and the internet with their massive data capabilities and constant interconnectivity make Jeremy’s JBucks system work on a worldwide scale.

  • Crypto Coin = JBuck
  • Block = A page in the ledger
  • Block-Chain = The ledger
  • Nodes = The locations where the copies of the ledgers are stored
  • Crypto Miners = People who maintain ledgers and solve the equations
  • Hashes = Trial and error answers to the equation
  • Target Hash = The correct answer to the equation
  • Hash Rate = Speed at which a person can come up with possible answers

It’s that easy!

TRADING CRYPTOCURRENCY

Trading cryptocurrency is not so different from trading any other product, but it is the small differences that can be important. Most disappointingly for keen crypto traders, regulators generally clamp down hard on leverage when it comes to crypto. As we know, leverage can increase profits but also magnify losses. Most regulators see the volatility of the crypto market and take it on themselves to protect retail traders by minimizing the amount they can trade. Most commonly regulators only allow brokers to offer leverage of 1:2 on cryptocurrency.

SO WHY TRADE CRYPTOCURRENCY?

The first reason to trade crypto is the sheer potential for profit. In the year 2020 the price of bitcoin rose from just over USD 7,000 per coin to almost USD 29,000 per coin. This is a single year rise of 300%. For those who got in early, in 20017 BitCoin started at less than USD 1,000 per coin and rose to a 2017 high of over USD 19,000, a 1,800% single year rise. The opportunity for losses can also be high with Bitcoin losing over half it’s value in May 2021 due, in part, to a comment on U.S. sketch show, Saturday Night Live.

Secondly, cryptocurrency trading hours are second to none. Crypto is available 24 hours a day, 7 days a week. The only restrictions to trading times for cryptocurrency would be those of your broker or crypto exchange.

The benefits are many, but so are the risks. Any investment in cryptocurrency should be considered in conjunction with a solid risk-management strategy.

Series 1 – What is…?
Episode 4 – Cryptocurrencies
Next – Equities

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