Cryptocurrency has been a buzzword in the world of finance and technology. However, despite its growing popularity, many people still have questions about what cryptocurrency really is and how it works. Journalist WILLIAM KUMWEMBE engages finance expert Partha Dutta, a chartered accountant, on how cryptocurrencies work.
Firstly, what is cryptocurrency?
Cryptocurrency is a digital or virtual form of money that uses cryptography for security. Unlike traditional currencies, such as the US dollar or Euro, cryptocurrencies operate on decentralised networks based on blockchain technology. This means they are not controlled by any central authority, like a government or financial institution, making them free from traditional banking regulations. Bitcoin, introduced in 2009, was the first cryptocurrency, and since then, thousands of cryptocurrencies have emerged.
How does cryptocurrency work?
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Cryptocurrencies rely on blockchain technology, a decentralised ledger that records all transactions across a network of computers. When a transaction is made, it is grouped with others in a “block” and then verified by a network of computers, known as “nodes”. Once verified, the block is added to the blockchain, and the transaction is completed. The key to cryptocurrency’s security is cryptography, which ensures that transactions are legitimate and that no one can alter or counterfeit the currency. Blockchain’s decentralised nature also makes it resistant to hacking or fraud, as there is no single point of failure.
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What are some popular cryptocurrencies?
There are a number of them on the market. First is Bitcoin: It was created by an anonymous individual or group known as Satoshi Nakamoto. Then there is Ethereum, which is known for its smart contract functionality. It is more than a cryptocurrency; it is a platform for decentralised applications (dApps). And then there is the Ripple. Focused on facilitating cross-border payments, Ripple aims to make financial transactions faster and cheaper, especially in the banking sector.
Why are cryptocurrencies considered volatile?
Cryptocurrency prices are known for their volatility, with prices often experiencing dramatic rises and falls in short periods. This volatility is due to several factors. Firstly, there is market speculation: Cryptocurrencies are still relatively new, and their value can be heavily influenced by speculation. News of regulatory changes, technological developments or influential endorsements can cause sudden price swings. And, also, there is a limited supply: Many cryptocurrencies, like Bitcoin, have a finite supply. For example, only 21 million bitcoins will ever exist. As more people buy and hold cryptocurrency, the limited supply can drive up prices, especially when demand surges. And then there is the element of regulation: Since cryptocurrencies operate outside traditional financial systems, they are not as heavily regulated.
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How do I buy cryptocurrency?
To buy cryptocurrency, you typically need to choose a cryptocurrency exchange. Popular platforms include Binance, Coinbase and Kraken. These exchanges allow you to buy, sell and trade cryptocurrencies. And then one needs to create an account. You will need to provide personal information, and depending on the platform, you may be required to verify your identity. The next step is deposit funds: You can usually deposit money via a bank transfer, credit card, or sometimes PayPal. After depositing, you can use these funds to purchase cryptocurrencies. From there, you can store your cryptocurrency. Once you have purchased cryptocurrency, you’ll need to store it. You can keep it on the exchange or transfer it to a private wallet (software or hardware) for added security.
What are the risks associated with investing in cryptocurrency?
While cryptocurrency offers exciting opportunities, it also comes with significant risks. They include market volatility. As mentioned earlier, cryptocurrency prices can fluctuate wildly, leading to potential losses for investors. Also, there are security risks associated with it. Despite the security of blockchain technology, cryptocurrency exchanges and wallets can be vulnerable to hacking. If an exchange is hacked, or if users lose access to their wallets, recovering their funds can be difficult, if not impossible. Further, there are regulatory uncertainties. Governments are still figuring out how to regulate cryptocurrencies. New regulations or crackdowns could affect the value and legality of certain digital assets. Last but not the least is the element of fraud and scams. The lack of regulation and anonymity associated with cryptocurrency has led to an increase in fraudulent schemes. Investors need to be cautious and avoid scams, such as fake initial coin offerings or Ponzi schemes.
Why are people investing in cryptocurrencies?
There are several reasons people are drawn to cryptocurrencies: firstly, there is potential for high returns: Many early investors in Bitcoin and Ethereum have seen substantial gains. Cryptocurrencies are known for their volatility, which means they can rise (or fall) in value rapidly, offering the potential for significant profit. Also, there is a sense of decentralisation. Cryptocurrencies operate independently of governments and central banks, appealing to people who value financial independence and privacy. There is a hedge against inflation: Some investors view cryptocurrencies, particularly Bitcoin, as “digital gold” because they are limited in supply. This can make them attractive as a hedge against inflation or currency devaluation. Another vital aspect is technological innovation: Many are investing not only in the currency but also in the underlying blockchain technology, which has wide applications beyond digital money, such as in supply chain management, voting systems and healthcare.
What is the future of cryptocurrency?
The future of cryptocurrency is a hot topic. Some believe it will revolutionise the financial system, while others are more skeptical. Governments around the world are exploring or developing their own digital currencies, which could coexist with or challenge decentralised cryptocurrencies. As cryptocurrencies become more popular, regulatory frameworks are likely to evolve, offering more clarity for investors and users. Increasingly, traditional financial institutions are beginning to embrace cryptocurrency, offering investment products like Bitcoin ETFs (exchange-traded funds) and blockchain-based services.
