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Cryptocurrencies are a digital means of exchange which use cryptography as a means of security.
With a track record going back over a decade, cryptocurrencies are clearly more than just a fad. But they remain widely misunderstood by many people, with doubts persisting about their genuine value and practical use.
It is increasingly possible to use cryptocurrency to make purchases. Last year, for example, the payments giant PayPal announced a service allowing its UK customers to buy, hold and sell cryptocurrencies through their accounts.
Mainstream investors are also taking more than a passing interest in cryptocurrencies. In what it referred to as a ‘hedge against monetary and market risks’, investment firm Ruffer spent about £550 million (equating to 2.5% of the £20 billion it has under management) on buying Bitcoin last summer.
However, concern over the safety of cryptocurrencies as an investment class remains front and centre in the minds of financial regulators around the world. Cryptocurrencies and their volatile behaviour has prompted the UK’s financial watchdog, the Financial Conduct Authority, to describe them as “very high risk, speculative investments”.
“If you invest in cryptoassets,” it warns, “you should be prepared to lose all your money.”
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The simple answer is that they aren’t, outside the confines of blockchain technology, which we’ll come to later.
Even more fundamentally, the current legal status of cryptocurrencies varies considerably from one country to another. While the use of cryptocurrencies is unfettered within the European Union, specific countries, such as Turkey, have banned the payments made in cryptocurrencies.
The FCA is the UK’s financial regulatory watchdog. Its stance is clear-cut when it warns investors that “if you buy… cryptoassets, you are unlikely to have access to the Financial Ombudsman Service or the Financial Services Compensation Scheme”.
The FSCS is a lifeboat arrangement which comes to consumers rescue in the event of a financial calamity such as a provider going bust.
In December 2020, the FCA also advised customers of cryptoasset firms to check the status of their providers and to ensure that they were allowed to carry on trading as per the watchdog’s revised rules on registration.
For providers who can’t confirm they are operating under the new rules, the watchdog advised customers to withdraw their holdings.
Most cryptocurrencies operate without the backing of an authority, such as a central bank or government. This fundamentally differentiates them from traditional currencies, such as the pound sterling or the dollar.
Instead of governmental guarantees, the way cryptocurrencies work is underpinned by something called blockchain technology (see below).
Rather than existing as a physical stack of notes or coins, cryptocurrencies are confined to the internet. Think of them as virtual tokens, whose value is determined by market forces generated by the people who want to buy or sell them.
Nowadays, an estimated five thousand cryptocurrencies exist. Bitcoin is far and away the largest, with a market capitalisation of around £540 billion.
The market capitalisation of a cryptocurrency equates to the unit price of a currency, multiplied by the number of units in existence. Other major cryptocurrencies include Ethereum and Tether, with market caps of around £240 billion and £57 billion respectively.
Cryptocurrencies can be bought with traditional cash such as sterling and can then be used themselves to buy an expanding array of day-to-day goods and services. Cryptocurrencies have the same value in each country, making person-to-person transfers around the world easier, while negating the issue of exchange rates.
Only a limited number of Bitcoins actually exist – cryptocurrencies are likened to a digital form of an asset such as gold, where a perceived store of value is then subject to the laws of supply and demand.
Currently, this is the main appeal of cryptocurrencies: that they are able to be traded on exchanges similar to the way stock market investors buy and sell shares and other commodities.
In essence, a blockchain is a type of database. Blockchain first came to prominence as the technology that underpinned Bitcoin when the cryptocurrency was originally mooted in a paper on peer-to-peer electronic cash systems in 2008.
The paper was credited to Satoshi Nakamoto, thought to have been a pseudonym for either an individual or group of people. Part of the cryptocurrency’s design meant that there would only ever be 21 million Bitcoins created.
The blockchain is essentially a public ledger of every Bitcoin transaction that takes place. A record gets distributed across numerous computers and cannot be tampered with or changed retrospectively. According to supporters of cryptocurrencies, blockchain transactions are more secure than traditional payment mechanisms.
A short Bank of England video demonstrates the blockchain process in more detail and also explains how ‘mining’ works, the mechanism through which new units of currency such as Bitcoin are produced.
This ‘mining’ requires huge volumes of computing power and thus uses significant amounts of energy. Environmentalists have warned that the proliferation of cryptocurrencies could have a significant impact on global attempts to reduce energy consumption.
The most common places to buy Bitcoin and other cryptocurrencies are specialist exchanges. This includes a range of trading platforms and apps that allow investors to buy cryptocurrencies using either traditional currencies and/or other cryptocurrencies.
According to research by the FCA, about three-quarters of Brits who had bought a cryptocurrency did so through an online exchange.
To open an account, would-be traders are typically asked to provide passport details, a phone number and an email address. The costs of trading can vary from one exchange to another. Some providers impose a flat fee per trade, while others will charge a percentage of the overall transaction amount.
The performance of cryptocurrencies can be notoriously volatile with roller coaster peaks and troughs. In 2013, an individual Bitcoin was worth just a few dollars. At the time of writing (February 2022) its price stood around the $44,000 mark. A huge increase on nine years ago, but some way off the all-time high of nearly $68,000 it achieved towards the end of 2021 .
In the summer of 2020, the FCA published research into the UK’s growing appetite for cryptocurrencies.
The FCA estimated that nearly two million adults owned cryptocurrencies, although the findings suggested that about three-quarters of consumers held cryptocurrencies to the value of £1,000 or less.
The most popular reason for holding cryptocurrencies, said the FCA was ‘as a gamble that could make or lose money’.
According to the FCA, more than one million adults increased their holdings in high-risk assets such as cryptocurrencies during the first seven months of the Covid-19 pandemic of 2020.
Even before the pandemic upheavals of 2020, cryptocurrencies were surrounded with questions about their security, practical use and long-term viability. Hence the stark and repeated warnings from financial regulators that people should approach investments in this area with extreme caution.
If more mainstream investment houses dip their toes in the cryptocurrency waters, we may see digital assets improve in value, with their usage normalised and more widespread.
Several central banks, including Nigeria, have already introduced their own digital currencies, although progress has been more stifled in key economic bloc areas such as those of the US and the European Union.
In the uncertain times in which we live, it is possible that the entire concept may prove vulnerable or unsustainable in the face of as yet unforeseen challenges.
To paraphrase the regulators, “buyer beware”.
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Associate Editor at Forbes Advisor UK, Andrew Michael is a multiple award-winning financial journalist and editor with a special interest in investment and the stock market. His work has appeared in numerous titles including the Financial Times, The Times, the Mail on Sunday and Shares magazine. Find him on Twitter @moneyandmedia.
