A beginner's guide to crypto

Every other week seems to be about cryptocurrency crashing to the depths or soaring to new highs, the launch of a new coin, or investors signalling cryptos will be the death of markets.

Cryptocurrencies, as a technology, have actually been around for over a decade, but the recent surge in popularity is pushing the conversation into the mainstream. So here's your entry-level crypto guide.

In the first of this four-part series, we will break down what a cryptocurrency actually is and how it works or creates value. Later in the series, we'll be speaking with crypto bulls and bears to hear their case before wrapping up with five predictions for the future of cryptocurrency. 

What are cryptocurrencies? 

To begin, cryptocurrencies are more than just Bitcoin, Ethereum and Dogecoin. For better or worse, there is a vast range of cryptos and ways in which crypto technology is being used - including by central banks around the world.

So if you put aside the conversation of whether or not it's currently at a fair value (Ed's note: it's not), you need to ask: what is it? 

Broadly speaking you can break cryptocurrencies down into a few categories:

1. Bitcoin

Bitcoin has been around for over a decade. It was first launched in 2009 by the pseudonymous Satoshi Nakamoto alongside the seminal white paper Bitcoin: A Peer-to-Peer Electronic Cash System. Bitcoin's defining characteristic is that there are a finite number of Bitcoin that will ever exist, 21 million to be exact.

These coins have a staggered release, which has been compared to "mining" and lent Bitcoin the title of "digital gold". Bitcoins are intentionally released on a time-decay algorithm, which means that the number of Bitcoins that can be mined reduces by 50% every four years. In 2009, mining a single block on the blockchain would reward you with 50 Bitcoin, by 2012 there were only 25 per block, 12.5 by 2016 and 6.25 by 2020. 

The final Bitcoin will not be mined until the year 2140.

2. Altcoin

This is just a catch-all for cryptocurrencies that are "alternatives to Bitcoin", and they're often called "smart contracts". These come in a wide range of functionality, use-cases and technology some of which we will cover in this series. It includes more well-known cryptos like Ethereum, Ripple and Litecoin. Largely, the underlying intention of altcoin is to create a new means of exchange, that is, to be used in place of money. But there are some exceptions... which brings us to: 

3. Memecoins

These are also alternatives to Bitcoin, but really deserve their own category because, well, they're a bit of a joke. In most cases, the entire underlying intent is just to have a laugh and if you want to throw money at it, you can, as long as you don't mind losing it. 

This includes Dogecoin, Safemoon, Garlicoin and a number of other names which are not fit for print. Some are more open about their origins than others. 

They are created to appeal to the social media investor crowd and the HODL-mentality (which is either Hold On for Dear Life or just a typo, depending on who you ask). It is a highly, highly, highly speculative asset class. 

4. Stablecoins

Unlike other forms of cryptocurrency, which are decentralised by nature, stablecoins are a digital currency backed by a fiat currency (e.g. the US dollar). Pegging it against a fiat currency reduces the volatility and speculation that occurs with other cryptocurrencies. One prominent example is Facebook's Diem Association coin (formerly called Libra), which will be staked against USD. Facebook has been researching this project since at least 2017 and it is finally due to launch this year in a limited format. Other examples include Tether (USD), Gemini Dollar, and Binance (USD). 

5. Central Bank Digital Currency (CBDC)

Now that pundits and private corporations have joined the cryptocurrency bandwagon, what is left but for the central banks to explore the territory? 

A CBDC is a cryptocurrency owned and released by central banks. So far, the People's Bank of China (PBoC) and the Bank of England (BoE) have announced they will be creating and using their own cryptocurrencies. The RBA has created a research team alongside CommBank, NAB, Perpetual and ConsenSys, and will be releasing a report on its pilot in mid-2021. 

What are cryptocurrencies for? Are they actually usable? 

There are three purposes or qualities that define what money is:

1. A medium of exchange
2. A store of value
3. A unit of account 

By no means is cash or gold the be-all and end-all of currency and value. The intentions for Bitcoin and most altcoins are varied, but (with the exception of Memecoins) they're largely designed to replace the concept of money.

Decentralised Finance (DeFi) underpins the ethos of many crypto-creators. The idea is to create a platform to trade and exchange currency without involving a third party, such as a bank. 

If you consider the fact that many countries, including the US, don't have access to instant bank transfers as we do in Australia, or some countries don't have stable fiat currencies or economies (think: Venezuela), then you can see how decentralised finance is an appealing goal. But cryptocurrencies are still a long way from this goal. As crypto goes on, coins have set up new goals to be competitive in the market: such as less energy-intensive coins. 

We are starting to see a number of partnerships between popular crypto and big business, even some overseas property developers are taking crypto as finance (but it appears more of a marketing gimmick). But using Bitcoin or altcoin for exchange is very risky due to the volatility, the financial cost and the time it takes to exchange. 

By the numbers... 

• There are thousands of different cryptocurrencies and since most of the technology is open sourced, it is relatively easy to go and create your own coin by "forking" (or using the base code to create new protocols). 
• But... thousands of cryptos have failed as well. Not only have they failed to keep up the technology development, but some are outright scams and Ponzi schemes. 
• The market cap of Bitcoin tipped over the US$1 trillion mark in May and was the fastest asset of any kind to reach this milestone. 
• Ethereum is the second-largest cryptocurrency by market-cap and has consistently held this position throughout periods of volatility. Many other cryptos are forked off Ethereum's code base. 
• Over the year, the coin price of Dogecoin went up over 9000%. This coin has actually been around since 2013 when it was started as a joke. There is a report circulating from Galaxy Digital Research which performs an interesting deep-dive and bull case into Dogecoin specifically.
• The volatility of cryptos is wild and somewhat unpredictable:  
  

The volatility over a two-week period is striking, but the top players tend to stay the same. Prices are in USD. Source: coingecko.com. 

What's all the fuss about? 

Cryptocurrencies are increasingly hitting the mainstream. Not only are CBDCs lending credibility to the technology, but there are more use-cases for the product. There are a number of prominent fund managers and investors with crypto as part of their portfolio offering, albeit as a small percentage.

It might be getting thrashed in the market right now, but in the background, cryptocurrencies are gaining legitimacy in unexpected places. 

1. A crypto-rewards credit card from the Gemini - Mastercard partnership
2. Fidelity Investments plans to launch a crypto ETF 
3. Coinbase IPO 
4. PayPal allows users to pay in a select number of cryptocurrencies
5. A number of famous athletes are choosing to be paid in cryptocurrency (the NBA's Sacramento Kings or the now highest-paid NFL star are some examples) 

So, in some quarters it appears, the idea of cryptocurrency is more appealing than cold, hard cash. And, as a teaser to the final part of the series, there are some staunch crypto bulls who believe that crypto-salaries are the future. 

In the next part of the series, we ask investors their bull or bear case for cryptocurrencies, and how you can do the unfathomable: valuing a cryptocurrency. 

Read the series: 

Disclaimer: Now here's the bit where I declare I have a small holding in some cryptocurrencies. In truth, more as background research than as an investment strategy. Per the full disclaimer below, this content has been provided for educational purposes only and does not constitute financial advice. 

Never miss an insight

Enjoy this wire? Hit the ‘like’ button to let us know. Stay up to date with my content by hitting the ‘follow’ button below and you’ll be notified every time I post a wire. Not already a Livewire member? Sign up today to get free access to investment ideas and strategies from Australia’s leading investors.