A quick guide to cryptocurrencies
Cryptocurrency is making the news on several fronts, with promises of quick money – and warnings of large losses as a result of fraud, scams and market volatility. Despite all the cautions, including from the Financial Conduct Authority (FCA), many people are still making significant investments and putting large amounts of capital on the line.
Before assessing the opportunities and risks cryptocurrencies present, we take you through the basic concept, explore what all the buzz is about, and bring you bang up to date with an overview of regulatory changes on the horizon.
How are cryptocurrencies made?
How secure are cryptocurrencies?
What other risks are involved with investing in crypto-assets?
So why do people in invest in crypto-assets?
What are cryptocurrencies?
Unlike the pounds and coins you carry around in your purse or wallet or have in your personal bank account, cryptocurrencies (also known as a crypto-assets) are digital money. That means they exist only as internet-based ‘tokens’, which can be used to transfer value online and outside of the control of governments or central banks.
As such, cryptocurrencies are hailed as a way of achieving financial freedom from established institutions and a relatively quick method of moving funds globally. But it also makes the currencies very unpredictable – they can rise and rise, and then suddenly fall, much more easily than traditional currencies like dollars, pounds and euros.
Consider the case of bitcoin, for example (often abbreviated to BTC). It’s the world’s largest crypto-currency and even accepted as a payment method by some businesses, usually on higher-end items such as watches and electronics. However, like most digital currencies, it is still mainly seen as a long-term investment – an asset to be traded, much like gold or stocks. As an example of its unpredictability, consider that the price of one bitcoin fell from an all-time high of $67,567 per coin in November 2021, to a recent low in June 2022 to $17,744.
How do cryptocurrencies work?
There are thousands of cryptocurrencies on offer today, and their transactions are recorded using Distributed Ledger Technology (DLT). The mostly widely known example is the blockchain. Think of it as a virtual spreadsheet, which keeps a record of all the buying, selling and trading of crypto-currencies around the world, to stop people from spending the same ‘coin’ twice. The blockchain doesn’t belong to any single organisation or network, but is managed instead by a huge web of volunteers. What’s more, the information contained in it is accessible to everyone.
You can use a cryptocurrency exchange to buy your bitcoins or other crypto. These act as a brokerage where people can transfer traditional hard currency, like pounds, dollars or euros, from their banks into digital currencies, usually for a fee.
After that, you’ll have the option to leave the cryptocurrency sitting in the exchange, or you can move it to what’s known as a digital wallet.
Wallets generate a pair of alphanumeric digital keys – a public key and a private key – which are needed if you want to transact. The public key is rather like an account number. It is used to identify the user. The private key, to continue with the traditional banking analogy, is similar to a PIN number. You use these keys to send and receive cryptocurrencies.
You can access your digital wallet through your smartphone or other device and then use the cryptocurrency to pay for goods and services. This can be done by scanning a QR code for a retailer that accepts cryptocurrency, for example.
You can also have what’s known as a ‘cold wallet’ on a physical device that keeps your cryptocurrency completely offline. Many look like USB drives. Being offline helps protect your crypto-assets from hacking and online attacks. However, you can also risk losing it all too – if you misplace the wallet, for example, or it gets stolen.
How are cryptocurrencies made?
Cryptocurrencies are created with an encrypted code (similar to a string of numbers and letters), through a process called mining. In the case of bitcoin, this involves using computing power to solve mathematical puzzles on the bitcoin network. Every time a new block is added to the blockchain, new bitcoins enter circulation. The people (known as ‘nodes’) who solve the computational puzzle receive some bitcoin as a reward for contributing to the network.
How secure are cryptocurrencies?
It would be very hard to counterfeit cryptocurrency. That’s because all the computers that store and update copies of the blockchain have to ‘agree’ on the correct version of the public ledger.
Crypto-assets are also quite difficult to hack thanks to users’ constant review of the system and blockchain technology, which records data with timestamps.
But this does not mean there are no security risks. Hackers can still infiltrate digital wallets and steal crypto-assets if they know a user’s private key. And if they get hold of personal information, such as your name or address, they may be able to use phishing attacks to infiltrate your transactions.
Fraudsters are also capitalising on the growing excitement around cryptocurrency, by asking you to move money and offering fake investments. Many advertise on social media – often using the images of celebrities to promote dodgy cryptocurrency investments. The ads then link to professional-looking websites and often claim that the organisation has a UK presence, by listing an impressive-sounding London address, for example.
We’ve lots of information elsewhere on our website about how to avoid online scams, but as a general rule you should:
- Be wary of online adverts promising high returns on investments in crypto-asset or crypto-asset-related products.
- Never give anyone permission to set up a cryptocurrency wallet, upload ID documents or manage investments for you.
- Never download software from a source you’re not sure of. It could be used to steal your personal details and take control of your bank accounts.
If you’re in doubt, do some digging to see if the company is legitimate. You can check with Companies House to see if the firm is registered in the UK, for example, or see if anyone has posted concerns online by Googling the firm’s name, directors’ names and the product you are considering. And always report suspicious activity – it builds awareness of fraud and helps everybody in the long term.
What other risks are involved with investing in crypto-assets?
You should also consider the volatility of cryptocurrencies, which we touched upon earlier in this post when we mentioned bitcoin’s dive by almost 70% in 2022.
Remember, too, that the sector is largely unregulated. In the UK, for example, the FCA currently only has oversight to check that crypto-asset firms have effective anti-money laundering and terrorist financing procedures in place. Cryptocurrencies themselves are not regulated and, as such, are not protected by compensation schemes if anything goes wrong. “As a result," the FCA said last year in a web post on the risks of investing in crypto-assets, “if you buy crypto-assets you should be prepared to lose all the money you invest.”
High-profile examples of this abound, including the collapse of cryptocurrency exchange FTX in 2022. Its former boss, Sam Bankman-Fried, was once nicknamed the 'King of Crypto’ and took every opportunity to describe his firm as "the most regulated" in the industry. However, these ‘permissions to operate’ (which did not extend to the UK), ultimately proved useless at protecting customers and investors – the company’s filings revealed that more than one million people and businesses could be owed money following its collapse.
On a more positive note, however, efforts are underway to better control the crypto industry and improve its reputation. In February 2023, the government published proposals that it said “will provide clarity to consumers and businesses”. These include laying down rules on crypto-asset promotions, enhancing data-reporting requirements, and “a robust world-first regime for crypto lending”.
So why do people in invest in crypto-assets?
In short, because the returns promised can be huge. In comparison to putting your money in a savings account, for example, where interest is generally fairly modest and can take a while to build, some may view investing in crypto as a better opportunity.
There’s a danger to this, however. The BBC reported in 2021, for example, how students were increasingly turning to cryptocurrency investment to fund life at university. The article cited an unstable part-time job market and loss of earnings during the pandemic as some of the reasons young people were struggling financially. Like quick loans and payday loans, the lure of getting cash fast can make crypto superficially attractive – but both carry huge risks.
Cryptocurrencies have other benefits, though. Moving money between countries can be faster than via traditional methods, and the cost of cryptocurrency transactions (especially internationally) are relatively low compared to other financial services.
And then there’s its accessibility. All you need is a computer or smartphone and an internet connection to get started. Opening a current account can take a little time, but the process of setting up a cryptocurrency wallet is comparatively fast, with no background or credit checks. This also means you can maintain a level of privacy.
Finally, you often hear converts to crypto talk enthusiastically about its transparency. As all transactions take place on the publicly distributed blockchain ledger, anyone can look up the data, including where, when, and how much someone sent from a wallet address, and how much that wallet contains. It means you can prove when your cryptocurrency was sent and received, and show you have the funds available for a transaction too.
Final thoughts
Excitement about cryptocurrencies hasn’t gone away – and doesn’t look to any time soon. Whether you take the plunge and invest, or stick to more traditional routes like opening a savings account, protecting your cash remains our number one concern.
To help understand what you’re potentially getting into, and to be confident you’re making a sound decision, ask yourself:
• Are you comfortable with the level of risk and can you afford to lose the money? Generally, the higher an investment’s potential return, the greater the danger of losing your money, so bear that in mind.
• Do you understand the investment and are you able to get your money out easily? It's important you know exactly what you’re putting your money into so if something doesn't make sense do your research and, if necessary, seek professional financial advice.
• Are the investments regulated and am I protected if the investment provider goes out of business? As we established earlier in this post, much of the trading around crypto-assets actually isn’t regulated, which potentially exposes investors to huge risks.
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