What is a Cryptocurrency?
In the past, currency has been issued by governments and managed by financial institutions (banks), which are in turn regulated by the financial arm of the government (e.g., in the United States, the Federal Reserve System regulates banks). In other words, money has been inseparable from nation states and banks. We have historically placed our trust in these third parties to manage our money. Now the rise of cryptocurrency is promising to separate currency from both nation states and banks.
By definition, cryptocurrency is a digital currency that relies on cryptography (the process of writing or reading secret codes) for security rather than established third parties (e.g., governments and banks). Because cryptocurrency takes the form of code rather than currency (e.g., coins and bills), the currency is impossible to counterfeit. Most importantly, because the currency theoretically belongs to no single person, business or government, it is also immune to outside interference.
To understand how cryptocurrency works, it is important to understand blockchain technology. Simply put, if bitcoin is the train, blockchain is the rails on which it runs. While bitcoin is actual currency, blockchain is ledger technology that speeds up network transactions. As already noted, historically we’ve trusted governments and banks to manage our money. Now these trusted third parties are essentially being replaced by blockchain technologies.
Blockchain-based currency exchanges are managed by a distributed database (one with many connected computers based in many different locations). In theory, anyone trading blockchain currencies can see every transaction that has ever taken place in the blockchain, since all data is stored in the cloud. As such, all the accounting is autonomous (run by a network of computers and not by a centralized group of people).
Types of Cryptocurrencies
Bitcoin was the first digital currency to reach the market, and it has the highest market cap at close to $39.4 billion. Bitcoin is a popular currency for consumers and merchants who want to be free of banks and traditional finance. Other cryptocurrencies have made up ground in popularity and application use by speeding up the transaction period.
Ether is the currency of the decentralized network idea known as Ethereum. Smart contracts application has raised a lot of investment dollars from Fortune 500 companies: JP Morgan, Cisco, Thomson Reuters and UBS. Their investments backs the idea that Ethereum is currently the most versatile and sophisticated form of cryptocurrency. However, its pricing and market capitalization has been quite volatile as the price has moved from under $10 to $400 and back to $200, with a current market cap of $25 billion.
A slightly different technology to bitcoin in that it does not rely on mining protocol is a cryptocurrency named Ripple, with a market capitalization of around $7.4 billion. Ripple is both a transport protocol and a currency (XRP). Its main appeal has been its lighting-fast transaction, causing Ripple to gain popularity and establish partnerships with major Chinese Banks.
Government Regulations May Not Disappear
Although demand for cryptocurrencies is rising at a rapid rate, what digital currencies really need is government regulation. The word of the government, and acceptance of a currency for taxes, gives that currency value and, more importantly, instills investor confidence.
Even more desired by cryptocurrency investors is an exchange-traded fund (ETF). This would allow institutional investors to trade in bitcoin. So far, regulators are not accepting bitcoin ETFs; the SEC has rejected two applications for bitcoin-backed exchange-traded funds, the Winklevoss Bitcoin ETF and the SolidX Bitcoin Trust. The futures market may end up being another explorable option for cryptocurrency investments. The Commodity Futures Trading Commission considers bitcoin a commodity. What’s more, according to Coindesk, an increasing number of governments are issuing guidance on bitcoin, for example, Japan, Jersey, Malta, Sweden, and Switzerland.
With no centralized authority and the ability of buyers and sellers to operate entirely under the radar, there are legitimate fears that in the future, cryptocurrencies will increasingly be used to support criminal activities, such as tax-evasion, money-laundering, and even the financing of terrorist activities. In some jurisdiction, such as New York State, legislators have already started to crack down on cryptocurrencies. The state’s Bitlicense requires virtual currencies to comply with most of the regulations already imposed on banks and other financial operators, including payday lenders. Other government bodies, including the European Union, are also currently working to place restrictions on cryptocurrencies, which they consider a threat to both financial and personal security.