Insights from a 13-Hour Training Course on Cryptocurrency, Part 1 – Terms and Background
In 2017, I wrote about cryptocurrency – the digital rival to our traditional financial instruments – and for the longest time I avoided a deep dive into the topic because it felt like a fad. Four years later, cryptocurrency – Bitcoin, blockchains, digital assets and the rest – are still around. How big a role they all will play in our economy going forward remains to be seen, but I’m convinced they’re all here to stay.
As your advisor, it’s my job to provide insights on a wide array of topics and investments. I don’t need to be the expert in each area, but I do need to know enough to assist you with financial decisions. With that goal in mind, I recently obtained my Certificate in Blockchain and Digital Assets® by taking a 13-hour course given by the Digital Asset Council of Financial Professionals (DACFP). I’ll summarize what I learned in this article and a follow-up one. This first piece introduces some of the rationale for this digital form of currency and the key terminology. The second piece will examine the pros and cons of investing in cryptocurrency and how to decide if it’s right for you.
The Shortcomings of Traditional Monetary Exchanges
Digital currency’s initial supporters saw several shortcomings in how financial transactions are typically handled. They allow for fraud (think of a stolen credit card), can take days (a check being credited to an account) and can be costly (international transfers of sizeable amounts). The supporters realized that new technology could address these issues with a method that would be more transparent. This leads us to the first term to understand.
While most transactions require validation from financial or legal authorities, these digital transactions were verified by a series of computers across the world – thousands of them. For efficiency’s sake, all of these transactions are compiled in a block – to be verified at the same time. The information to be verified is stored in a huge database, and the trick is for one of these computers to verify the transaction before any of the others.
That is done by figuring out a complex equation that serves as the code for viewing the block of transactions. Once solved, this solution is required for the next round of transaction verification – in other words, it becomes a chain of blocks, or a blockchain.
The first and most common reward for the owner of the computer first solving the equation code has been to earn a Bitcoin. Bitcoin itself was introduced in 2008, with a promise that only a limited number of bitcoins would ever be created. These coins are created themselves through complex mathematics, requiring intensive computer power – a process called Bitcoin mining. To sustain its long-term value, Bitcoin’s creators are limiting the total number of Bitcoins in circulation to 21 million. To date, roughly 18.5 million have been produced.
One of the main advantages of the blockchain/bitcoin system are that there’s a certain amount of transparency as well as decentralization. In addition, Bitcoin can in certain circumstances demonstrate tremendous speed and cost savings advantages. An international exchange of more than $1 billion worth bitcoins in April 2020 took place. If done by traditional methods, transferring $1 billion it would have taken 1 to 2 days to settle and a fee of 1 to 8 percent ($10 million to $80 million). The Bitcoin version took place in 10 minutes for a cost of 68 cents!
The Confusing Array of Cryptocurrencies
With an example such as that, you may not be shocked to learn that Bitcoin’s annual volume is roughly the same as PayPal’s – with no employees and no cases of fraud. But Bitcoin is successful in part because it’s extremely limited in its functionality – send, receive or hold. That makes it more impervious to hackers, but also unsuitable for small, daily transactions. Other currencies, such as Ethereum and XRP (the No. 2 and No. 3 currencies respectively in terms of market capitalization), have been created to allow a greater range of transactions and at much faster speeds.
But that’s just the beginning. There are now more than 10,000 cryptocurrencies. A company can issue its own cryptocurrency, good only for products or services it sells – essentially tokens, like poker chips in a casino. There are various cryptocurrency funds, but with the proliferation has come confusion. Coming by solid information about all these options is hard to come by – an ironic result of a movement intended to create transparency.
What’s more, there’s now an expansion of what’s considered a “digital asset” to “any digital material owned by an enterprise or individual including text, graphics, audio, video and animations.” How exactly a market for such assets is created has yet to be determined.
So I’ll leave you on that note for now, because I think it points out the challenges of deciding on investing in digital assets of one form or another. Bitcoin has established the base for a new way of structuring financial systems, but the pillars of this new financial alternative seem, shall we say, unsteady at best. In the next installment, we’ll look at why cryptocurrency can be attractive and frightening at the same time as an addition to your portfolio.