We recently hosted Dave Donabedian, CFA, chief investment officer at CIBC Private Wealth, on the Wealth Your Way podcast. The topic of discussion was cryptocurrencies.
Are you curious about crypto?
There’s been a tremendous amount of hype about how cryptocurrencies are the “next big thing” in the digital revolution, and how they have the potential to transform not just traditional financial services, but also other industries.
A number of high-profile celebrities have endorsed both cryptocurrencies and crypto companies. There are also watercooler stories that most of us may have heard, such as the one about the crypto millionaire who made a fortune overnight, and then lost it all just as quickly. Even the president of El Salvador had his crypto moment in the spotlight when he declared Bitcoin would be legal tender in his country.
But as many new crypto investors have learned, cryptocurrencies are extremely complex and difficult to understand, which can make them especially challenging for potential investors.
As with any investment, we recommend starting with the basics, which is why we’ve put together an overview of some of the essential cryptocurrency concepts to help you get started.
What are cryptocurrencies?
Bitcoin, the first cryptocurrency, was created by Satoshi Nakamoto, which is a pseudonym for the person or team who wrote about the technology in a 2008 whitepaper. The basic concept is relatively simple: Bitcoin is a form of digital cash that allows for secure and seamless peer-to-peer transactions across the internet.
Cryptocurrencies are not issued by a government, and there is no central authority providing oversight. Instead, cryptocurrencies are managed by peer-to-peer networks of computers, which run on free, open-source software.
While Bitcoin is the oldest, largest, and most established cryptocurrency, there are now thousands of others. Some have a similar design and purpose as Bitcoin, while others are based on different technologies or were created with other functions in mind. For example, Ethereum is a cryptocurrency that can be used to run applications and create contracts.
The blockchain ledger
The blockchain is an essential feature of many cryptocurrencies. It is similar to a bank’s balance sheet or ledger because it keeps a record of every on-chain transaction. However, unlike a bank ledger, the blockchain is distributed across the entire network of computers.
The mining process
Most cryptocurrencies are mined through a decentralized network of computers. With Bitcoin and many other cryptocurrencies, miners collectively work to verify and record new transactions and create new units of cryptocurrency by solving complex mathematical equations using specialized computers known as mining rigs.
Determining consensus and securing the blockchain
Because cryptocurrencies operate without a central authority processing transactions, they must ensure that the same unit of cryptocurrency can’t be spent twice. They do this with a system called the consensus mechanism, which allows all of the computers in the network to agree on which transactions to include in the blockchain.
Proof of work and proof of stake are the two major consensus mechanisms that cryptocurrencies use to verify new transactions, add them to the blockchain and create new tokens.
Proof of work
Proof of work is the protocol used by Bitcoin and is proven to maintain a secure and decentralized blockchain. With proof of work, miners compete to solve complex mathematical puzzles. The winner gets to update the blockchain and is rewarded with cryptocurrency. However, proof of work requires a significant amount of energy and can be difficult to scale.
Proof of stake
Proof of stake generally relies on a network of validators who contribute or stake their own cryptocurrency in exchange for the chance to validate new transactions and earn a reward in a process that is similar to that of proof of work. However, because proof of stake blockchains do not require miners to perform energy-intensive, duplicative processes (competing to solve the same puzzle), the networks require substantially less energy to operate.
Where do cryptocurrencies get their value?
The economic value of cryptocurrency is based on supply and demand. Supply refers to how much is available. In the case of Bitcoin, there is a finite supply—there will never be more than 21 million Bitcoin available. Conversely, demand refers to how much people want the cryptocurrency, and what they are willing to pay for it. The value of a cryptocurrency is determined by a balance of both of these factors.
There are many risks associated with cryptocurrencies, especially for investors. Cryptocurrency prices have historically been volatile, and wild price fluctuations can result in significant losses and stress.
Cryptocurrency transactions cannot be reversed, unlike bank transactions. This means if you make a mistake and enter the wrong amount or address, you could risk losing your cryptocurrency and may not be able to get it back again.
It is also important to note that cryptocurrencies are relatively new, and there are many nuances that are not widely understood yet. Issuance and trading are not well regulated, which means additional oversight and regulation is likely in the future.
Should you invest in cryptocurrencies?
Bitcoin and other cryptocurrencies are speculative investments and don’t fit within traditional asset allocation models. They are not a commodity (such as gold), nor are they a traditional fiat currency, backed by a government. Additionally, cryptocurrencies are difficult to value as most traditional valuation metrics don’t apply.
Though some traders have been successful taking advantage of the changes in prices of Bitcoin or other cryptocurrencies, we believe most investors should treat cryptocurrency as a speculative asset class to be traded outside of a traditional long-term portfolio.
CIBC Private Wealth’s Wealth Your Way podcast series is an educational offering on a variety of topics designed with our clients and the rising generations in mind. You can listen to our conversation about cryptocurrencies with Dave Donabedian here.