When trying to understand how cryptocurrencies work, a useful starting point is addressing the question of whether cryptocurrencies should be considered an investment or a form of electronic payment; and how the value of a cryptocurrency is maintained and controlled?
Are cryptocurrencies an investment or a form of payment?
Cryptocurrencies are considered both an investment and a form of electronic payment.
As a form of payment, cryptocurrencies offer autonomy outside the regular banking network. However, it is generally much more complicated to pay for goods and services using cryptocurrency, instead of using a fiat currency (one which is supported by governments or central banks).
It should be noted however, that cryptocurrencies are not legal tender so retailers or merchants are not obliged to accept payment in this form.
What consumers can do is send and receive payments globally, and while there is a fee when making a payment, it is only a small fraction of the typical banking charge incurred for overseas payments. Some cryptocurrencies such as EOS aim to charge no transaction fees.
Cryptocurrency transactions are discrete, untraceable, fully mobile, and available to people who don’t have access to a bank account. Worldwide, it is estimated that 1.7 billion adults are unbanked, and most of them have access to the internet so can acquire cryptocurrencies.
A potential downside of using cryptocurrencies as a form of payment is that transactions are non-reversible. Once you have made a payment, there is no way of legally getting your money back. For example, if the merchant fails to deliver what was promised, the only way to reverse a transaction is to issue a new transaction reversing the original payment.
Cryptocurrencies are also bought and sold as speculative investments. They do not pay interest or dividends and while they can potentially provide solid capital gains, their high volatility makes them a very risky proposition.
However, this same volatility is attractive to seasoned currency traders as it offers multiple opportunities to generate an investment gain, irrespective of whether prices rise or fall.
The Financial Conduct Authority – the organisation responsible for supervising the UK financial services industry – has stated that if retail investors choose to invest in cryptocurrencies, then “you should be prepared to lose all your money”.
How is the value of cryptocurrency maintained?
Just as fiat currencies would become worthless if governments decided to print more and more money (as governments have been known to do), cryptocurrencies would also become worthless if there was a never-ending or unregulated supply of the coins.
For cryptocurrencies to retain their value and spending power, the supply must be controlled and there are various strategies for achieving this. For example, the total number of coins or tokens generated could be stipulated and a maximum limit imposed; or the supply of new coins generated could be controlled by agreement. Bitcoin uses both strategies.
The maximum number of Bitcoins that will ever be produced is 21 million, and the supply of new Bitcoins is limited by controlling the rewards paid to Bitcoin miners. At present, Bitcoin has approximately 85% of its maximum amount of coins in circulation and inflation is currently about 3.4%.
However, other cryptocurrencies experience considerably higher inflation. The inflation rate of ZCash, where only 25% of total coins are in circulation is currently running at 45%.
Types of cryptocurrencies
Having explored how cryptocurrencies work, for more information about the different types of cryptocurrencies and which ones are regulated by the Financial Conduct Authority, please click here.
