Here’s A Helpful Guide To Understanding Cryptos
By Jesús Cedeño
November 3, 2021—Just about everybody with internet access has heard about Bitcoin and cryptocurrencies these days. They may not really understand them, but they have heard of them.
New Economic System
Cryptocurrencies and blockchains (the technology that makes most of them work) were created to show that a new kind of economic system is possible. One where central banks, commercial banks and other traditional financial institutions are no longer in control.
Investing in cryptocurrencies is a hot topic all over the world, with over $133 billion worth of crypto being traded every day and a global market capitalization that exceeds $2.6 trillion.1
However, there have been several warnings issued relating to cryptocurrencies. Some of these warnings are aimed at the potential dangers to individuals and others are targeted at pointing out the risks to the entire financial system as we know it.
“The ubiquitous nature of crypto assets, their ease of purchase, and their perception as good investment opportunities or stores of value are likely to keep people interested.”
Crypto Basics
Before getting into the warnings and discussing Bitcoin’s recent price, there are a couple of things everyone needs to understand about cryptocurrencies:
First of all, not all cryptocurrencies are created equally. Most cryptocurrencies (including big names like Bitcoin, Ether and Litecoin) are what is known as unbacked or volatile. This means they have no real intrinsic value and their price is set by how much people are willing to pay for them. These are the cryptos people use as investment opportunities. Other cryptocurrencies are known as pegged cryptos or stablecoins because their value is fixed to an existing currency or commodity (most of them are fixed to the US Dollar). Examples of these are Tether USD, Circle USD, Binance USD and DAI. These aren’t useful as investments but are more useful for day-to-day payments and transactions than their unbacked counterparts.
Unbacked cryptocurrencies are extremely volatile. Their prices can go wildly up or down in a very short time. This year’s bitcoin prices are a perfect example of this. On April 13th, 2021, 1 Bitcoin was worth just over 63,000 USD. The price then dropped to 49,000 USD on April 24th and even further down to around 30,000 USD by mid-July. Then it went back up to a new all-time high of just under 67,000 USD on October 20th. And these wild ups and downs aren’t exclusive to Bitcoin. Any unbacked crypto can behave just as unpredictably1,2.
Unregulated And Outside Control Of Governments
So far, most cryptocurrency transactions and trading have been largely unregulated. In other words, outside the control of governments and the traditional financial institutions. But this is changing. As cryptocurrencies become more mainstream, the crypto and traditional finance systems are becoming more interconnected2. So governments have started taking action. In some countries, like China, the government has cracked down hard on crypto, to the point of making any transaction illegal3. Other countries are friendly to cryptocurrencies but state that there is an urgent need for more regulation. And El Salvador has even become the first country to declare Bitcoin as legal tender4.
High Risk
Cryptocurrencies are a very high-risk investment. Their extreme volatility means that people could lose a lot of money very quickly. And since the sector is unregulated, there is no authority or institution protecting investors; they are effectively on their own if things go wrong5.
Many experts and central banks have repeatedly issued warnings to investors regarding the risks to their personal finances6. But some experts say that the stakes could be even higher.
Recently, Jon Cunliffe, the Bank of England’s Deputy Governor of Financial Stability recently spoke about cryptocurrencies. He said that while the risk is low at the moment, that might change. As cryptocurrencies become more popular, the more they will integrate into the traditional financial system. And this will increase the risk of a crypto collapse affecting the whole system in a way similar to the 2008 crisis triggered by the sub-prime mortgage backed securities collapse2. Other experts agree with this opinion and are calling for tighter regulations on crypto7.
Crypto Gains Ground
With all the warnings surrounding crypto, one would probably think that people would be staying away from cryptocurrencies. But it’s exactly the opposite.
For example, a poll conducted by the UK’s Financial Conduct Authority revealed that 2.3 million people in the country are holding crypto, representing a 25 percent increase over the last year8. Globally, crypto’s total market capitalization has increased over 600 percent from 410 billion US dollars in October 2020 to over 2.6 trillion USD in October 20211.
Prices Have Rebounded
While Bitcoin prices are still extremely volatile, they are tending to recover a lot faster. Before this year, Bitcoin registered its all-time high price of about 19,000 USD in December 2017, just before crashing to 7,500 USD in February. Bitcoin wouldn’t reach the $19,000 price range again until December 2020 in the middle of an upward trend that concluded with a new ATH of 63,500 USD in mid-April, when it crashed again. But this time recovery happened a lot faster and even saw a new ATH of $66,800 on October 20th1. Even major crackdowns on Bitcoin in China haven’t had as big an impact as some would have predicted9.
Bitcoin Soars, Despite Warnings
So what’s going on? Why is Bitcoin’s price still going up despite the warnings and issues?
Remember that Bitcoin has no real intrinsic value. Its price is driven by people’s interest in it. It’s the reason why a single tweet from one celebrity can make the price dramatically go up or down. So if the price is going up, it means people are interested.
What’s keeping them interested?
First of all, there has been increasing institutional support for cryptocurrencies. In the US, financial and tech companies like Square, Microstrategy, Michael Saylor and Tesla have announced the purchase of millions of dollars worth of Bitcoin, claiming that it’s a better store of value. There are even some cities, most notably Miami, that are considering putting part of their treasuries in Bitcoin10.
Paypal, an important worldwide payment processor, has also started supporting cryptocurrency transactions11.
Many people see this support as somehow validating cryptocurrencies’ usefulness as investment opportunities or stores of value12.
Alternative to Fiat Currencies
And the importance of a good store of value can’t be understated. All over the world, as economies start to reactivate as COVID-19 appears to start slowing down, governments (including the US) are issuing billions of dollars worth of their native fiat currencies. And the thing with fiat currencies is that their value isn’t linked to anything tangible (the Gold Standard has long been abandoned). A dollar is worth one dollar because the US government says so. That’s it. But as more dollars start circulating, its value is expected to go down. In other words, inflation. So people are looking into ways to protect the value of the money they earn by converting it into something that won’t suffer the effects of inflation. Gold and other commodities have served as stores of value for centuries, but they aren’t widely available or easy to purchase. Cryptocurrencies, on the other hand, can be easily bought anywhere by anyone with a smartphone or computer and an internet connection13.
Societies and governments recognize that cryptocurrencies pose potential threats to both personal finance and to the system as a whole. Add to that the investment risks and a lack of understanding about them.
Gaining Momentum
Cryptos have proven their ability to gain momentum. The ubiquitous nature of crypto assets, their ease of purchase and their perception as good investment opportunities or stores of value are likely to keep people interested. That’s a perception reinforced by increasing institutional support.
If you have some extra cash lying around, investing in cryptocurrencies is something you may want to look into.
But remember that, as with all high-risk investments, don’t put in any money you can’t afford to lose. And never, no matter what, make the mistake of taking out a loan to buy cryptocurrencies.
References
1. Cryptocurrency Prices, Charts And Market Capitalizations [Internet]. CoinMarketCap. [cited 2021 Oct 30]. Available from: https://coinmarketcap.com/
2. Is ‘Crypto’ A Financial Stability Risk? – Speech By Jon Cunliffe, Bank Of England, Deputy Governor, Financial Stability Given At [Internet]. [cited 2021 Oct 30]. Available from: https://mondovisione.com/media-and-resources/news/is-crypto-a-financial-stability-risk-speech-by-jon-cunliffe-bank-of-englan/
3. China declares all crypto-currency transactions illegal. BBC News [Internet]. 2021 Sep 24 [cited 2021 Oct 30]; Available from: https://www.bbc.com/news/technology-58678907
4. Hernandez J. El Salvador Just Became The First Country To Accept Bitcoin As Legal Tender. NPR [Internet]. 2021 Sep 7 [cited 2021 Oct 30]; Available from: https://www.npr.org/2021/09/07/1034838909/bitcoin-el-salvador-legal-tender-official-currency-cryptocurrency
5. Browne R. Most young crypto traders don’t realize it’s not regulated, UK markets watchdog says [Internet]. CNBC. 2021 [cited 2021 Oct 30]. Available from: https://www.cnbc.com/2021/10/19/young-traders-treat-crypto-investing-like-a-competition-fca-says.html
6. Consumer Warning on Virtual Currencies | Central Bank of Ireland [Internet]. [cited 2021 Oct 30]. Available from: https://www.centralbank.ie/consumer-hub/consumer-notices/consumer-warning-on-virtual-currencies
7. Experts debate Bank of England’s cryptocurrency risk warning | Digital Payments [Internet]. FinTech Magazine. [cited 2021 Oct 30]. Available from: https://fintechmagazine.com/digital-payments/experts-debate-bank-englands-cryptocurrency-risk-warning
8. Experts warn of ‘terrifying’ lack of understanding of cryptocurrency risks as popularity soars [Internet]. The Independent. 2021 [cited 2021 Oct 30]. Available from: https://www.independent.co.uk/news/business/cryptocurrency-bitcoin-risks-fca-b1867856.html
9. Rivers ML. China’s Supposed ‘Bitcoin Ban’ Fails To Crash Market As Twitter Adds Crypto Payments In Historic First [Internet]. Forbes. [cited 2021 Oct 30]. Available from: https://www.forbes.com/sites/martinrivers/2021/09/25/chinas-supposed-bitcoin-ban-fails-to-crash-market-as-twitter-adds-crypto-payments-in-historic-first/
10. Huang R. Institutional Support Is Coming To Bitcoin [Internet]. Forbes. [cited 2021 Oct 30]. Available from: https://www.forbes.com/sites/rogerhuang/2021/02/24/institutional-support-is-coming-to-bitcoin/
11. PayPal Launches New Service Enabling Users to Buy, Hold and Sell Cryptocurrency [Internet]. PayPal Newsroom. [cited 2021 Oct 30]. Available from: https://newsroom.paypal-corp.com/2020-10-21-PayPal-Launches-New-Service-Enabling-Users-to-Buy-Hold-and-Sell-Cryptocurrency
12. 5 reasons why bitcoin cryptocurrency prices are on the rise. The Economic Times [Internet]. 2021 Feb 12 [cited 2021 Oct 30]; Available from: https://economictimes.indiatimes.com/markets/stocks/news/5-reasons-why-bitcoin-cryptocurrency-prices-are-on-the-rise/articleshow/80764149.cms?from=mdr13. Bitcoin’s time to shine is fast approaching [Internet]. Fortune. [cited 2021 Oct 30]. Available from: https://fortune.com/2021/04/29/bitcoin-inflation-hedge-debate/
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