Cryptocurrencies have recently entered mainstream financial discussions as an increasingly-popular modern investment market. They are largely powered by a technology called blockchain, which has been hailed as a next-gen, decentralized, and secure method to record financial transactions.
These so-called “cryptos” primarily differ from traditional fiat (paper) currencies in that they are not officially backed or controlled by central banks, nor regulated by any national or international authorities. Given their anonymous nature, cryptocurrencies are not yet widely accepted as methods of payment, although attitudes may be rapidly changing in this regard.
How does blockchain work?
Cryptocurrencies are encrypted digital currencies that can be exchanged between buyers and sellers almost as easily as sending and receiving emails. The completely decentralized and electronic nature of cryptocurrencies drastically lowers transaction times and processing costs, compared to banks and other “middlemen.”
As mentioned above, this is all made possible by a process called blockchain.
With this technology, the bookkeeping process of cryptocurrencies is openly shared among the total network of people who own or trade the same digital currency. Everyone who has a certain cryptocurrency therefore has access to the same digital ledger recording all transactions involving that currency.
This builds trust, minimizes risk, and ensures transparency across all transactions.
How to own and trade cryptocurrencies
Here are three common ways you can buy or otherwise invest in digital currencies:
Own the cryptocurrency underlying asset
With this option, you directly buy from an exchange and therefore solely own the digital asset. Once bought, you can keep your cryptocurrency in a “wallet” (more on this below) instead of leaving it on the exchange. Your asset would then only be accessible with a personal private key used to verify your ownership.
- Pros: You have complete control over the digital asset; secured with a private key and wallet only you (should) have access to.
- Cons: You have sole responsibility of keeping the private key safe; digital wallets can also be potential targets for hacks or breaches.
Buy crypto-related securities
ETFs and ETPs are some examples of securities that are available to cryptocurrency-minded investors. These securities aim to either replicate the digital asset’s performance or act as a trust to hold these assets for investors. Some of these are also backed by large capital firms or are affiliated with cryptocurrency-focused businesses.
- Pros: These securities are publicly-listed and governed by exchange guidelines; they do not require investors to hold private keys.
- Cons: These securities can only be traded during exchange hours; price disparities between the security and actual digital assets could arise.
Invest in cryptocurrency CFDs
We’ve discussed contracts of difference in another Academy article; these are short-term financial instruments that allow you to invest in certain assets through a broker, without actual ownership.
Instead, investors can make profit by correctly speculating on that asset’s price movements. You might notice that the pros and cons of this option are basically the same as those of other (non-cryptocurrency) CFDs.
- Pros: You don’t have responsibilities of direct ownership or safeguarding private keys; more accessible as lower transaction fees are generally lower.
- Cons: You rely solely on the broker’s reputation as CFDs are unregulated; spreads (trading costs) might be wider when compared to directly trading the underlying asset.
Factors that affect cryptocurrency prices
Since cryptocurrencies are not traded in more traditional markets, these assets may not be affected by the same market forces that could affect stocks, for example.
However, just like any more established fiat currencies or tradable financial assets, there are different factors that affect the prices of different cryptocurrencies. These include:
Supply and demand
Some cryptocurrencies are more established or sought-after than others, and this will naturally drive the movement of prices according to the fundamental economic forces of supply and demand. A low supply of “coins” of a particular cryptocurrency combined with a high demand of that currency (due to external factors) will likely result in a positive surge in prices.
A cryptocurrency’s utility would refer to its “usefulness” with regard to its range of potential applications. Simply put, having better utility would lead some currencies to be seen as more valuable.
For example, some cryptocurrencies have begun to penetrate the retail domain, meaning some merchants and processors have introduced systems and processes to accept payments in these cryptocurrencies.
Sentiments of the market
Just as stocks are affected by public perceptions of a company’s leadership or products, the values of cryptocurrencies are also influenced by perceptions of the people behind it or its forecasted growth potential. As with stocks, it is important to do research on the digital currencies you intend to invest in, to determine whether their values are likely to increase or at least remain stable.
Difficulty of mining
Units of cryptocurrency are largely created by a process called “mining”, wherein computers around the world attempt to solve complex math problems and their owners are rewarded with “coins” when they succeed. A new record is then added to the blockchain and the cycle repeats.
A low difficulty might result in a larger supply of coins and a downward pressure on prices, and vice versa.
The bottom line
Just as any other investment, cryptocurrencies have their own level of risk. Remember that only you can determine whether you are ready or comfortable enough to jump on the bitcoin bandwagon. And we’re happy to guide you throughout your journey!
Keep looking through the Academy library to gain confidence in the cryptocurrency world as you build your knowledge about these new technologies.