By Nick Gertsema, CFP®, ChFC®, RICP®, AIF®, CEO & Wealth Advisor
You see them in the news everywhere, and it seems like there’s always a new one introduced. The new one that comes out is always the next big thing, so the fear of missing out is real. So, what exactly are these cryptocurrencies?
To understand how cryptocurrencies work, we must first understand the technology behind them. Blockchain is a specific type of database that records information that is difficult to hack, change or cheat. The system records and maintains transactions across several computers in a peer-to-peer network. It’s similar to many people working on the same document, except there’s no delete key and everyone can see the changes in real-time. This requires supercomputers with the ability to talk to each other.
To keep it simple:
- A piece of data is created, called a block, which is stored and cannot be altered.
- A new piece of data is entered and a new block is created and chained to the existing block. This is updated across all computers (nodes) in the system and cannot be altered.
- The resulting blockchain will show all users a complete history of the data and all chains.
Cryptocurrency (crypto) is decentralized digital money that relies on blockchain. When we hear the term currency, we usually think of fiat – currency backed by the full faith and trust in the government that issued it.
Unlike fiat money, there is no federal bank or government that controls the value of cryptocurrency. Since there is no centralized source of value, crypto is commonly called decentralized finance. Internet users and the free market broadly determine the value. Crypto can then be exchanged for goods and services from companies that accept them, much like fiat money.
Unfortunately, you still have to convert your crypto to a fiat currency before you can spend it. If you’d like to invest in crypto, it has to be purchased with fiat currency. Followers of cryptocurrency believe that as it becomes more common, more vendors will accept crypto as a form of payment.
There are now more than 13,000 cryptocurrencies in existence – Bitcoin, Dogecoin and Etherium, to name a few. Think of them as Euros and American dollars, both being different types of fiat.
So, what’s the big deal?
Proponents of cryptocurrencies believe that this could drastically change how we think of currency. The theory is that since cryptocurrencies are not tied to a particular government, one government could not manipulate the coin’s value, and it would indeed be a free market. It could eventually provide a banking alternative and could help countries that do not have stable governments. Crypto also removes the human element from banking, which some say would reduce costs.
Cryptocurrency is still in its infancy, and opponents believe that the technology is too slow. It also requires a significant amount of technology to sustain the cryptosystems. There is also the concern that gangs and criminals could use crypto to fund their illicit activities.
Where does this technology lead us?
I think cryptocurrency is just one of the first few applications of blockchain technology. Blockchain can change the way we look at databases and recordkeeping and could impact many other industries such as medical records, supply chains, voting and any other business that would benefit from the technology.
Investing in cryptocurrencies can present more questions. Whenever you consider a new investment, it is crucial to understand what you are investing in and the possible risks. Weigh the potential rewards and then determine whether these fit in with your portfolio. As with any new technology, there will be risks and things can change quickly.
Be sure to have a conversation with your advisor before you consider a potentially risky investment like cryptocurrency.