This is the first installment in our two-part blog series examining the rise of cryptocurrency and its implications for investors and the broader economy.

Cryptocurrency has evolved from a curiosity to a notable force in the economy over the course of a little more than a decade. What was once of interest only to tech-savvy risk-takers is now offered as an investment option by some brokerage firms and at least one multinational financial services firm.

Cryptocurrency’s road to relevance has been fraught with risk, however, and the future is wildly uncertain. Let’s take a look at how the nature and development of cryptocurrency is likely to impact its future role in the economy.

What Is cryptocurrency?

Cryptocurrency, sometimes called crypto, is any form of currency that exists digitally or virtually rather than in the form of a physical unit such as paper or metal coinage. There are thousands of cryptocurrencies, each of which its creators claim has particular advantages or purpose-specific features. Some of the best known are Bitcoin, Ethereum, Litecoin, and Ripple.

Every aspect of cryptocurrency – from how units (typically called coins) of the currency are created through recorded transactions to how coins and related data are stored – is dictated by computer software code.

Both advocates and critics of cryptocurrency have argued that cryptocurrency is simply software. The code of the cryptocurrency also defines things like maximum coin supply and mining rewards. Cryptocurrency coins are “created” through processes including mining, staking, farming, and more. Early coins were created only through a process called mining, which involves using computer power to solve complicated mathematical problems that generate coins as a reward.

The first cryptocurrency, Bitcoin, was founded in 2009 and remains the best known today. Holders of cryptocurrencies may not have created their coins, however, as coins may be bought from brokers or from online cryptocurrency exchanges. Cryptocurrencies don’t have a central issuing or regulating authority and don’t rely on banks to verify transactions. The software code written by the developer of the cryptocurrency is effectively the regulator.

A decentralized system, typically a blockchain, is used to issue newly mined coins and to record and verify transactions. A blockchain is a distributed online database that serves as a ledger describing specific transactions. Blockchains also solve the infamous double-spending problem in which digital data like a cryptocurrency coin can be copied and pasted for repeated use without the involvement of a central authority. Cryptocurrencies wouldn’t be possible without blockchain technology, which, at its simplest level, involves creating unalterable data structures.

Cryptocurrency received its name because encryption is used to verify currency creation and transactions. The aim of encryption is to provide security and safety. Encryption is used in the process of recording newly minted coins that are issued to public blockchain ledgers and when transmitting cryptocurrency data between cryptocurrency owners’ crypto wallets. Crypto wallets don’t store cryptocurrency; they hold private keys – the passwords that provide access to cryptocurrencies recorded on a blockchain.

Cryptocurrencies and applications of blockchain technology are still emerging in financial terms, and more uses are possible in the future.

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Why was cryptocurrency created?

Many experts agree that the idea for cryptocurrency first emerged in 1983, when American cryptographer David Chaum published a conference paper outlining an early form of anonymous cryptographic electronic money. The concept was for a currency that could be sent anywhere in the world untraceably and in a manner that did not require centralized entities like banks.

Many current cryptocurrency advocates argue that the technology also can facilitate faster and cheaper transactions than traditional payment networks and that it has the potential to foster innovation and financial inclusion.

“When you look at the number of people who are underbanked or unbanked, both in the United States and globally, it’s indicative of a system that does not work for everyone,” said Sam Bankman-Fried founder and former CEO of the cryptocurrency exchange FTX. “It’s a product of payments infrastructure that is difficult and clunky enough to use that it just does not work for most people.”

Is cryptocurrency actually a currency?

Cryptocurrencies were originally intended to be an alternative to central bank-controlled fiat currencies, but many experts argue that, in practice, most – if not all – cryptocurrencies are not used as currencies.

A central bank-controlled fiat currency is issued by a monetary authority as legal tender. Rather than carry around cumbersome quantities of cocoa beans, salt, or other early forms of currency, societies turned to minted, central bank-controlled fiat currencies as an alternative. A fiat currency is widely used as a currency in transactions due to its portability, broad acceptance as a relatively stable store of value and a unit of exchange, and the long-term backing of the issuer.

Products like cocoa beans and salt are now typically considered commodities rather than currencies. A commodity has actual value that is determined by how it can be used, while the value of all currencies in use today comes entirely from the social agreement that it can be exchanged for something of actual value and by faith in the issuer. A cryptocurrency, on the other hand, is decentralized, meaning that anyone may create a cryptocurrency for any purpose and with any set of software-defined rules governing its creation, behavior, and even duration of existence.

Cryptocurrencies with no expiration date may cease to exist for other reasons, including frauds and scams, poor design, and loss of interest. Over 2,000 cryptocurrencies have died since Bitcoin was born in 2009, according to Coinopsy, a site that tracks dead cryptocurrencies. The code for almost all cryptocurrencies is public so anyone can check how coins are created and managed, according to cryptocurrency advocates. However, some understanding of the programming language used to create the cryptocurrency may be required to accurately access a cryptocurrency.

Use of cryptocurrencies as currency in any type of transaction is extremely rare, mostly because social agreement that a cryptocurrency can be exchanged for something of actual value is extremely limited, as is knowledge about and faith in the issuer. Each cryptocurrency may demonstrate some attributes of a currency, according to many experts, but on the whole, their main source of value lies in the software-defined restricted supply and in the possibility of increasing demand.

Much of the interest in cryptocurrencies, therefore, is to trade for profit, with speculators, at times, driving large, temporary spikes in cryptocurrency prices. The use of cryptocurrencies for trading rather than as a form of currency has prompted key regulators to argue that they should be treated as securities or commodities rather than as currencies and should be regulated as such.

>> For more insights on how cryptocurrencies affect different industries, contact us to learn more and see a list of the industries we cover.

Image credit: Rodnae Productions via Pexels

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