With so many mentions of Bitcoin in recent headlines, many people are now familiar with the term "cryptocurrency." Cryptocurrencies are digitized currencies that are raising many questions as they rise in popularity.
Currency Is a Medium of Exchange
To understand what cryptocurrencies are, it is important to reflect on the meaning of money. We value money for what it can do for us, yet we do this as automatically as we breathe.
For centuries, we have used various forms of currencies to trade and buy; currency is a medium of exchange, and usually, we refer to it as fiat money. Fiat money is simply the term we use for legal tender as declared by a government. In Latin, fiat means “it shall be.” However, money was not always a piece of paper with intricate designs like it is today. At one point, it took the form of a feather, a stone and even a shell.
Money’s value depended on its appearance or condition, and at times it was merely valued because of its beauty or practicality. However, the real value was ultimately based on its availability since the item was often difficult to acquire or produce. (For related reading, see: The History of Money: From Barter to Banknotes.)
Differences Between Cryptocurrencies and Fiat Money
Fast-forward some centuries, and money has taken a new form. The evolution is without a doubt an interesting one, which is perhaps one of the reasons why cryptocurrencies have become popular. Bitcoin and many of its competitors are digital and decentralized currencies secured by cryptography (digital signatures) and, in some cases, are anonymous as well.
The main difference between cryptocurrencies and fiat money is a government backs fiat money. However, fiat money is not backed by any physical reserves (although it has been in the past), which it has in common with cryptocurrencies. Their value depends on the faith we place in them.
Sure, it is easier to put your trust in the government declaring a currency to be its legal tender, but why is the government backing fiat money? The central banks play a significant role since they are ultimately in control of regulating the supply of money by printing what they estimate the economy will need.They also supervise other financial institutions and act as a “bank for banks” by providing financial services to them. In short, the central banks control the money supply. In the United States, the central bank is the Federal Reserve. It was created in 1913 with the goal of alleviating financial crises and banking panics. (For related reading, see: How the Federal Reserve Manages Money Supply.)
Popularity of Cryptocurrencies After Financial Crisis
Bitcoin shares a similar story in the sense that the surge in the popularity of cryptocurrencies came after the United States’ financial crisis of 2008. The crisis caused mistrust in the banking systems and led to some banks filing for bankruptcy, which caused more discontent among many citizens. The financial crisis brought to light issues that come with storing your money through a centralized, government control system, and it helped propel the rise of cryptocurrencies.
Based on a System of Mathematics
Created in 2009, Bitcoin was the first cryptocurrency ever created, and it started with a value of $0.0001. The system behind Bitcoin is based on mathematics, rather than physical elements like gold or silver, or trust in a government.
To understand the current value of cryptocurrency, we need to take a look at how it operates. We know it is decentralized since no bank or government controls it. So, who controls it, then? The answer is simple, yet complicated. Since there is no middleman, transactions occur peer-to-peer, without a third party, and no single individual controls the network. Any time a transaction occurs, it is added to the ledger, which keeps growing, and it is the blockchain that powers the system.
Peers, or miners, verify each transaction through a series of events that involve complex mathematical equations requiring supercomputers to do the work. To send someone one unit of cryptocurrency (or a fraction of one), the system will first verify you have that amount available in your account. It will then trace that back to its origin to ensure a secure transaction and prevent double-spending.
Unlike a traditional bank, whose ledger is private, cryptocurrency ledgers are public, accessible by any computer running the software and connected to the network. It keeps a running tab of all users and their transactions (think of it as all the ledgers syncing with one another to stay up to date).
The network relies upon multiple users running the software 24/7 (the blockchain) and miners who keep it secure by performing useful services. They “mine” the coins, help keep the system running smoothly, and secure the network. “Mining” is the process of creating new bitcoins, and the miners also play a vital role in verifying the transactions. In exchange, they are rewarded for their work by receiving transaction fees (optional at the time) and, through a fixed formula, they also “mine” the new coins, or bring them into existence. (For related reading, see: How Does Bitcoin Mining Work?)
A Finite Supply
The supply of Bitcoin is limited to 21 million coins, and those 21 million coins may be divided into sub-units up to eight decimal places (the smallest available bitcoin is currently 0.00000001, or one Satoshi, named after its founder). Fiat money, on the other hand, theoretically has an unlimited supply because an infinite amount of money can be printed.
The value of each Bitcoin depends on the faith we put into it (the more users and wider acceptance, the higher its value) and the basic law of supply and demand. As demand increases and supply decreases, the value or price goes up, and vice versa. The current issue with this model is due to its market cap at the moment, its price is volatile, but the upside is because of its limited supply and calculated creation, demand follows the level of inflation and sets the price.
This is not to say cryptocurrencies are flawless. Price manipulation, the risk of declining value, and a competitor taking over are a few of the risks associated with cryptocurrencies, along with its volatility. Recent headlines have shown just how much the price of bitcoin and other cryptocurrencies can change in a week.
Is Crypotcurrency a Bubble?
One of the biggest questions that this volatility brings up is “Is cryptocurrency a bubble?” We're all familiar with bubbles, the most recent one being the U.S. housing bubble that peaked in 2006. A bubble occurs when the price of an asset is significantly higher than its intrinsic value.
Bubbles are based on suspension of disbelief, our willingness to abandon logical thinking and believe what we are experiencing is real. Many bubbles have five stages, starting with displacement, or the “falling in love” phase. Following this phase comes the boom stage when FOMO (fear of missing out) comes into play, and the demand drives the price up. Then comes the euphoria stage, when we seek proof that the valuation we are seeing is real.
The profit-taking phase comes next when some investors start to see signs of failure and try to take their profit. Lastly, panic sets in, and the bubble bursts. Prices drop as fast or faster than they rose, and many are left with losses and disappointment. But hindsight is always 20/20, and it’s not always easy to identify a bubble when you are caught up in it. (For related reading, see: 5 Steps of a Bubble.)
What Will Tomorrow Bring?
No one can predict the future, and we don’t know what the value of any cryptocurrency will be tomorrow or if they will even still exist in a year. The same can be said for any asset, commodity or even currency.
What we know for sure is Bitcoin has grown since its creation in 2009 partly because there is a demand for it. While it is not illegal to own it or trade it, many people question its legitimacy. If you happen to have any gains, the IRS views cryptocurrency as property, so taxes are due on those gains.
Cryptocurrencies may not be the currency of the future, but they are valued by some already, and some think they are here to stay.
Think about your hotel rewards, credit card points, airline miles, and even your Starbucks or Dunkin’ Donuts rewards program. All those perks have value because we see a benefit to using them and they are all digital currencies; they allow us to obtain goods or services in exchange for virtual payment. Instead of dollars, we are paying with digital points, and akin to cryptocurrencies, they are peer-to-peer. I move 125 “stars” from my Starbucks account to theirs, and I get to sip my venti caramel macchiato.
We value these digital currencies since we trust they will be there when we decide to cash in our points, yet all we have is faith the company will be there tomorrow to fulfill its promise.
(For more from this author, see: 5 Estate Planning Topics to Cover With Parents.)
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