In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) explores explores the latest and most fashionable investment trend.
They are everywhere on the news, in (young) people’s daily conversations, and probably in a corner of your head if you have already invested a bit of money in them. Cryptocurrencies are a daily drama, as it allows people to make or lose big money in record time. Everyone’s heard of it, but few people actually understand where cryptos come from and how they work. You may not necessarily need that to invest in them in the short term, as simply following Elon Musk on twitter might be a quicker and more efficient way to predict its evolution. But in the long run, and to understand the impact it will have on society, you need to know what’s going on. For some, it might become an actual currency in the coming years and will compete with the national currencies. For others, regulation will eventually tame cryptos and people will therefore lose interest in them. What’s for sure is that a public debate will arise at some point, and you might as well have the keys to understand cryptos so you can forge your own opinion. So here we go.
What is a cryptocurrency?
In a nutshell, it’s a virtual currency. What makes it a completely different and original currency is that it is not centrally managed; in other terms, it is the user who has full control over the cryptocurrency in their possession (peer-to-peer). This process is done through the implementation of Blockchain technology: the latter is a distributed and decentralized data storage and transmission technology at its core. The most frequently used analogy is that of a ledger that is accessible to all, indestructible and unpublishable once the data is embedded in the system. Like cryptocurrency, the Blockchain also relies on peer to peer to operate in a decentralized manner. Note that Blockchain can be used for much more than cryptocurrency; being a database, this technology represents a potentially huge evolution in the way we (businesses) deal with data. However, it was with the advent of Bitcoin, the first of many cryptocurrencies, that the distributed blockchain was seen as a potential successor to existing storage technology. The main cryptocurrencies are Bitcoin- the world’s most widely used and legitimate cryptocurrency-, Ethereum – founded in 2015 and known for its enhanced architecture using “smart contracts”-, Litecoin – released in 2011, similar to Bitcoin but with a higher programmed supply limit (84 million units vs 21 million).
Where do cryptos come from?
Before cryptos as we know them were invented, some early cryptocurrency proponents already shared the goal of applying cutting-edge mathematical and computer science principles to solve what they perceived as practical and political shortcomings of “traditional” currencies. It goes back to the 1980s when an American cryptographer named David Chaum invented a “blinding” algorithm that allowed for secure, unalterable information exchanges between parties, laying the groundwork for future electronic currency transfers. Then, the late 1990s and early 2000s saw the rise of more conventional digital finance intermediaries, such as Elon Musk’s Paypal. But no true cryptocurrency emerged until the late 2000s when Bitcoin came onto the scene. Bitcoin is widely regarded as the first modern cryptocurrency, because it combined decentralized control, user anonymity, record-keeping via a blockchain, and built-in scarcity. It all began in 2008, when Satoshi Nakamoto (an anonymous person or group of people) published a white paper about the Bitcoin. Nakamoto then released Bitcoin to the public. In 2010, the very first Bitcoin purchase was made: an Internet user exchanged 10,000 Bitcoins for two pizzas. At today’s prices, that would be the equivalent of about 500 million euros: that’s a lot of money for a pizza. By late 2010, dozens of other cryptocurrencies started popping out as more and more people started to mine and exchange cryptos. It grew in legitimacy when it became accepted as a means of payment by major companies, such as WordPress, Microsoft or Tesla. As of May 2021, the cryptos’ market cap is $2 trillion.
How do cryptos work?
There are several concepts that you should know about in order to get how cryptos work. Cryptocurrencies use cryptographic protocols, or extremely complex code systems that encrypt sensitive data transfers, which make cryptos them virtually impossible to break, and thus to duplicate or counterfeit the protected currencies. These protocols also mask the identities of cryptocurrency users.Then the crypto’s blockchain records and stores all prior transactions and activity, validating ownership of all units of the currency at all times. Identical copies of the blockchain are stored in every node of the cryptocurrency’s software network — the network of decentralized server farms, run by miners, that continually record and authenticate cryptocurrency transactions. The term “miners” relates to the fact that miners’ work literally creates wealth in the form of brand-new cryptocurrency units. Miners serve as record-keepers for cryptocurrency communities, using vast amounts of computing power, often manifested in private server farms owned by mining collectives that comprise dozens of individuals. The scope of the operation is quite similar to the search for new prime numbers, which requires tremendous amounts of computing power. Miners’ work periodically creates new copies of the blockchain, adding recent, previously unverified transactions that aren’t included in any previous blockchain copy — effectively completing those transactions. Each addition is known as a block, which consist of all transactions executed since the last new copy of the blockchain was created. Sincce the cryptocurrencies’ supply and value are controlled by the activities of their users and highly complex protocols built into their governing codes, not the conscious decisions of central banks or other regulatory authorities, which is why cryptos are said to be decentralized. Although mining periodically produces new cryptocurrency units, most cryptocurrencies are designed to have a finite supply — a key guarantor of value. Generally, this means miners receive fewer new units per new block as time goes on. For instance, if current trends continue, observers predict that the last Bitcoin unit will be mined sometime around 2150.
Why are cryptocurrencies so successful?
You may be wondering why crypto-currencies are gaining so much momentum today. With no intrinsic value, and no commodity to fall back on, economically speaking it makes no sense for this market to reach such an astronomical price. There are two rationales that often come up in the argument for cryptocurrencies. On the one hand, the anonymity via cryptography provided by blockchain technology: as there is very little regulation in this industry yet, one can end up with astronomical amounts of money without necessarily having to pay taxes on it, as there is no centralized body to follow what is going on. The second reason is more sociological: since there are people mining and trading cryptocurrencies, the logic is that they must have value. The consequence is that other people join the rush, and so on until it becomes a global phenomenon. You could call it a crowd movement, or a 21st century digital gold rush.
But these two reasons don’t necessarily answer the question of why Bitcoin and all these other cryptocurrencies are valuable. To get a clear answer, we need to go back to the basics of economics: any value applied to a commodity or currency is subjective. That is, if we, as individuals, see value in it, the commodity in question has value. The snowball effect resulting from a group of people’s growing interest in a commodity is at the origin of any bubble, and from that point of view cryptos are a massive bubble. Which does not mean that it is a bad investment: after all, a bubble is a bubble when it blows up, but it might never happen.
To sum up, if you want to invest in cryptocurrencies, there are a couple of things you should consider. First, if you’re aiming for the long-term (if you believe cryptocurrencies will keep increasing in value as “deflationary currencies”) or the short-term (pure speculation). Second, you should examine the specific characteristics of the cryptos and see which best fits you in terms of anonymity, growth potential and liquidity. Last but not least, follow the latest regulation announcements on cryptos, such as central banks or governments comments on cryptos, which are a pretty good indicator of the crypto’s evolution on both the long and short term.
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About the author
Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021).