Understanding Cryptocurrency: How Digital Cash Will Change the World

Published: 29/09/2017 and written by Patrick Smith

Understanding Cryptocurrency: How Digital Cash Will Change the WorldDespite the fact that the many countries around the world, including the UK, continue to produce new notes, it seems that the future for physical currency could be a short one. Digital currencies are slowly becoming ever more present in today’s society and it’s time that we took notice of them. Mr Lender has put together a handy guide to help you understand cryptocurrency and how it could affect the future of global currencies.

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What is Cryptocurrency?

In recent years, the birth of cryptocurrency is beginning to change the way that we see and use money. But what is it? According to Investopedia, “a cryptocurrency is a digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of this security feature.” Investopedia also say that the allure of cryptocurrency is that it’s decentralised; cryptocurrency is therefore “theoretically immune to government interference or manipulation.”

Cryptocurrencies first entered the global market in 2009 when the Bitcoin was invented by someone under the alias Satoshi Nakamoto. To this day, no one knows who Nakamoto is. By 2015 there were 14.6million Bitcoins in circulation with a value of around $3.4billion. At the time of writing this post, there are now more than 16.5millions Bitcoins*. The success of Bitcoins then led to the introduction of other cryptocurrencies such as Ethereum, Ripple and LiteCoin.

How do cryptocurrencies work?

Understanding cryptocurrencies can be quite time consuming and complex, though we’re going to try and break it down into simple terms. Essentially a cryptocurrency works in a similar way to a standard bank – it needs accounts, balances and transactions, just as you would find in a normal bank. However, the difference between a digital currency and a regular bank is the lack of a central server.

With a normal bank, the central server will keep track of any transactions and will prevent a payment or transfer being made twice. With a digital currency, algorithms are used to keep track of these transactions instead. This algorithm is essentially a file which states ‘Person A gives X amount of Bitcoins to Person B’ before being signed by Person A’s private key.

These transactions will then be confirmed by ‘miners’ to ensure the transactions are only being processed once, and that they haven’t been tampered with in any way. As there is no centralised network, anyone in the world can become a miner. To avoid one person taking over and monopolising the system, miners must work to earn their place. To begin mining, a potential miner must purchase hardware to be able to work through the transactions. As the number of transactions produced by a cryptocurrency grows, the demands for mining also grow – resulting in increased hardware demands. If during the period of validation the miner is able to successfully contribute to the process, they’ll be rewarded in Bitcoin.

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How to buy Bitcoins

While there are many different forms of cryptocurrencies, Bitcoins tend to dominate the market. In order to buy Bitcoins, the customer needs to install a virtual wallet onto a personal computer or mobile. This is fairly similar to an internet banking app in that it keeps track of cryptocurrency balances and transactions.

As with everything today, purchasing Bitcoin can be carried out through an app. Coinbase is one such app which allows you invest in a number of different currencies – including the digital type. Coinbase is incredibly user friendly, and setting up a virtual wallet is a simple process, allowing you to invest in a number of different currencies simultaneously.

Why invest in cryptocurrencies?

While the presence of cryptocurrencies is essentially to provide a decentralised system to carry out transactions in which the government and banks have no involvement, people may choose to invest in cryptocurrencies on a personal scale as a means to make money. Like any other global currency, cryptocurrencies have a value and are affected by changes to the market. This means that an investment of a few hundred pounds may see a much larger return in a few years time.

However, unlike regular currencies, the fluctuations in value on a day to day basis are much greater so there is a great deal more risk involved. For example, on 15th September China ordered the trading of cryptocurrencies to stop. This caused the value of Bitcoin to fall from $5,000 to just $2,972, before rising to around $3,600 later in the afternoon. It’s this fluctuation in value and risk which attracts so many people to the currency.

Trading in cryptocurrency is also a great way to make purchases and send money worldwide without the need to factor in an exchange rate. Even the banks are looking into cryptocurrencies as it’ll reduce the cost of transferring funds between accounts.

What do the critics say?

One of the main disadvantages of cryptocurrencies is that it’s irreversible. With a regular bank, you may be able to get your money back if it gets transferred or paid into the wrong account. You are usually protected in some way or another with a normal bank account. However with a cryptocurrency, there is no way to reverse the transaction and get the money back once it’s been confirmed.

Another factor to consider with cryptocurrencies is that it is entirely anonymous and anyone can have access to it. While this is a benefit and a major advantage of using this form of currency, the anonymity of the system makes it the perfect disguise for criminals.

Jamie Dimon, Chief Executive of JP Morgan, claimed Bitcoin is “a fraud” which will “eventually blow up”. He said he would sack anyone at the company who was found to be trading in Bitcoin. Dimon said “the currency isn’t going to work. You can’t have a business where people can invest in a currency out of thin air and think that people who are buying it are really smart.” He then went on to say “If you were in Venezuela or Ecuador or North Korea or a bunch of parts like that, or if you were a drug dealer, a murderer, stuff like that, you are better off doing it in Bitcoin than US dollars.”

However David Coker, a Bitcoin expert at the Westminster Business School, said Dimons criticism of the cryptocurrency was surprising considering JP Morgan were working on their own form of digital currency known as Quorum.

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The future for cryptocurrencies

As cryptocurrencies become ever more recognised on a global scale, an increasing number of companies are beginning to accept them as a form of payment. Bitcoins are now accepted by Reeds Jewellers in the US, Dell, Expedia, PayPal, Microsoft, and even a private hospital in Poland. A house has even gone on sale in Peckham, London for £1.65million – though the owner is also willing to accept 500 Bitcoins. A London property developer is also allowing its tenants to pay their deposit in Bitcoin.

As with any currency, there is a strong risk of inflation and a financial crisis if too much is produced at once. In order to try and reduce the risk of inflation in terms of Bitcoin, it has been stated that no more than 21million Bitcoins can be in circulation by 2040. However this poses the question of how miners will be rewarded for successfully validating transactions when this cap is set in place. While the initial cost of the hardware used to validate transactions will have paid for itself after a few years, the cost of the electricity to run the hardware is still present – meaning if miners aren’t being paid for carrying out the work, they may decide to stop altogether. This then leads to the question of how transactions will then be verified without a miner.

It’s also highly likely that cryptocurrencies may become the norm and replace physical cash as we know it. According to the Business Insider, Japan are looking at making their own form of cryptocurrency in a bid to wean consumers off physical cash. It has been reported that the digital currency, known as J-Coin,  will be ready in time for the 2020 Tokyo Olympics. Unlike Bitcoin, the J-Coin will be exchanged at a one to one rate with the Yen, meaning there will be no fluctuations in exchange rates. While this will be beneficial in terms of making fee-free transactions, it doesn’t make it a worthy investment opportunity.

As we edge ever closer to a paperless society it’s almost inevitable that physical cash becomes a thing of the past. Many people hold a strong belief in cryptocurrencies and trust that making an investment now will lead to huge financial gain in years to come. Whether they will always remain decentralised and free from government intervention is another question entirely, and whether we can truly avoid a digital financial crisis is yet something else to consider. Though what we do know is that cryptocurrencies are in the early stages of development, but are most definitely on course to becoming a part of everyday life.

*Correct as of 28th September 2017.

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