The Wire: Spring 2023 – Seven common questions about cryptocurrency and blockchain – answered
(Estimated read time 5 minutes)
Seven common questions about cryptocurrency and blockchain – answered
Over the last few years, cryptocurrency has moved towards the financial mainstream. In fact, CoinGecko reports that, as of 2 February 2023, the global cryptocurrency market has a total market capitalisation of $1.13 trillion.
Even though cryptocurrencies are still somewhat in their infancy, the market is constantly evolving at a rapid pace, and it can often take time to keep up with all the new developments.
So, to help you to better understand the world of crypto, here are the answers to seven common questions about cryptocurrencies and the blockchain.
1. What exactly are cryptocurrencies? How do they work?
Simply put, a cryptocurrency is a form of digital currency designed to be used as an alternative way to pay for goods and services.
The best way to understand cryptocurrencies is to imagine them like other traditional forms of currency. You can use them to buy goods, or invest in them with the intention of selling when the price rises to turn a profit. This is similar to the way people buy traditional currencies on the foreign exchange market.
Of course, there are some stark differences between traditional currencies and cryptocurrencies. For instance, traditional currencies tend to be backed by a commodity or government to stabilise them. Meanwhile, cryptocurrencies operate on a decentralised structure independent of any centralised bank or financial institution.
2. What is the blockchain?
The “blockchain” is the name given to the code that records ownership of cryptocurrencies.
The blockchain is a public ledger that acts as a record of any “mined” cryptocurrency – more on this later – and any transactions made using it.
When a coin is mined or someone makes a cryptocurrency transaction, it is recorded with something called a “hash”. These hashes can only be read when linked together chronologically – in a “block” – and it’s the fact this chronological link (the “chain”) can’t be altered that makes them secure.
Crucially, these blocks cannot be altered or deleted once they’ve been added to the blockchain. This essentially validates transactions and ensures that they’re legitimate.
So, whenever a cryptocurrency transaction occurs, this new chain of unique data lends transparency and security to trades, ensuring that no one can falsify transactions.
Without the blockchain, cryptocurrencies wouldn’t survive. This is because it allows trades to occur automatically and instantaneously, and is entirely transparent, which promotes integrity and trust in transactions.
3. What types of cryptocurrencies are available? And how has their price changed over the years?
If you’ve read anything about cryptocurrencies in the past, there’s a good chance you’ve seen “bitcoin” mentioned frequently. This is the most prevalent, and was one of the first forms of cryptocurrency to hit the market back in 2008.
Source: Google Finance
The above chart shows bitcoin’s value over the years. As you can see, bitcoin’s price remained relatively low until a significant spike at the end of 2017. This eventually settled down, and it wasn’t until 2020 that prices started to rise rapidly.
As you can see from the chart, the value of bitcoin has been somewhat volatile. Despite hitting a high of £34,966 on 1 April 2022, the value of the cryptocurrency has since fallen to below £19,000. Had you purchased bitcoin at its peak, the value of your holding would be substantially lower in 2023.
However, bitcoin isn’t the only digital currency available; the second-largest cryptocurrency on the market is ethereum. This cryptocurrency went live in mid-2015, and its price saw similar spikes during Covid-induced lockdowns.
Source: Google Finance
The table above shows the price movements of ethereum since its inception. As you can see, ethereum’s price remained low until a significant spike in 2020. Then, much like bitcoin, it rose to all-time highs in 2021, hitting £3,462 for every ethereum coin by 12 November 2021.
Of course, crypto investors aren’t limited to these two currencies. Forbes reports that roughly 21,910 different cryptocurrencies existed as of December 2022.
4. How are cryptocurrencies created?
The process for generating cryptocurrencies is called “mining”. Here, cryptocurrency miners will use computers to solve complicated mathematical problems that, when solved, generate coins.
As previously mentioned, the blockchain is composed of data that external computers have verified. These cryptocurrency miners are the ones verifying the code. Miners are then awarded cryptocurrencies when the complex maths problems are complete and verified.
For this reason, cryptocurrency miners are essentially bookkeepers. They verify transactions and keep a current record of cryptocurrency account balances. In return for their efforts, they are paid a “bookkeeper’s fee” in the form of cryptocurrencies.
Anyone can start mining cryptocurrencies, though it’s worth keeping in mind that the computer hardware requirements are quite high. The better your computer, the faster it can solve mathematical equations and earn cryptocurrency.
For most people, the cost and complexity of mining cryptocurrency is prohibitive. So, instead you can purchase cryptocurrencies from an online distributor or from an individual who has mined the coins themself.
5. How can you spend cryptocurrency?
When cryptocurrencies were initially created, founders envisioned them as a new, decentralised way to pay for goods and services. In theory, this could still be the case, but as it stands, only some businesses accept digital currency.
This is partly because in-depth knowledge of the technology is needed to adopt the infrastructure necessary to accept cryptocurrencies as a form of payment. After all, the technology is still somewhat in its infancy, and traditional currency is still far more effective.
Though, this limitation doesn’t mean that cryptocurrencies are necessarily a poor investment. For instance, if you invest in gold, you generally can’t go into a shop and exchange it for goods!
Some companies have started accepting cryptocurrency as a form of payment. For example, Virgin Airlines and Virgin Mobile now accept bitcoin as an acceptable payment medium. As the technology advances and general understanding grows, it is likely that more and more businesses will embrace digital currencies.
6. What is a crypto wallet?
When you mine or purchase cryptocurrencies, they are stored in something called a “wallet”.
This is simply the name given to the place your digital coins are stored. Several different types of crypto wallets are available, each with varying benefits and levels of security. This can become quite complex, as there are two different sets of categories for crypto wallets: hot and cold wallets, or custodial and non-custodial wallets.
“Hot wallets” are connected to the internet, and while they’re usually more convenient and straightforward to use, it can be easier for fraudsters to target them since they’re connected to a network.
A “cold wallet” is simply a piece of external hardware, such as a hard drive or a USB stick.
It’s generally trickier for fraudsters to target cold wallets since they typically aren’t connected to an online network. Though, since you need to purchase an external piece of hardware, they can often be more expensive. Additionally, there is always a risk you could lose the hardware you’re using to store your coins.
Custodial wallets are storage spaces for your cryptocurrency that a third party manages. As such, the provider of these wallet types is responsible for the security of your investments.
Non-custodial wallets are wholly managed by yourself. Whilst this does give you more control over your digital currency, it means you’re responsible for its security.
It’s worth keeping in mind that a crypto wallet can be both hot or cold, and custodial or non-custodial. For example, custodial wallets are typically hot, whilst their non-custodial counterparts can be either hot or cold.
7. Are cryptocurrencies regulated?
As it stands, cryptocurrencies are unregulated in the UK. In fact, the government stated that the decentralised nature of cryptocurrencies would make complete regulation problematic.
This hasn’t stopped several financial institutions in the UK from attempting to regulate them as much as possible. A “cryptoassets task force” was created in 2018, which brought together the Treasury, the Financial Conduct Authority (FCA) and the Bank of England in an attempt to coordinate a joint response towards cryptocurrencies.
Currently, the FCA has the power to ensure that companies that deal with cryptocurrencies have effective anti-money laundering and terrorist financing procedures in place, though the cryptocurrencies themselves aren’t regulated in the UK.
However, the FCA has taken some action to protect UK consumers, such as issuing warnings about the risks involved, even going as far as banning the retail sale of certain products.
You should also remember that there is no consumer protection in the UK when it comes to cryptocurrencies. This means that, if you feel you’ve been mis-sold a cryptocurrency product, you can’t make a complaint to the Financial Ombudsman.
Similarly, if you’re trading cryptocurrencies through a company, and that company collapses, the Financial Services Compensation Scheme (FSCS) won’t be able to cover you.