Cryptocurrency: What It Is and How It Works
Cryptocurrency: What It Is and How It Works
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Cryptocurrency is a digital medium of exchange that uses cryptography as a means of security.

With more than a decade of track record, cryptocurrency is clearly more than a fad. But they are still misunderstood by many, and doubts remain about their true value and practical use.

It is increasingly possible to make purchases with cryptocurrencies. Last year, for example, payments giant PayPal announced a service that would allow its UK customers to buy, hold and sell cryptocurrencies through their accounts.

Mainstream investors are also interested in cryptocurrencies. In so-called “currency and market risk hedging,” investment firm Ruffer spent around £550 million (or 2.5% of the £20 billion it manages) buying bitcoin last summer.

However, concerns over the safety of cryptocurrencies as an asset class remain a focus for financial regulators around the world. Cryptocurrencies and their volatile behaviour have led UK financial watchdog the Financial Conduct Authority to describe them as “high-risk, speculative investments”.

“If you invest in crypto assets,” it warned, “you should be prepared to lose all your money.”

Investing in crypto assets is speculative and your funds are at immediate risk. If something goes wrong, you are not entitled to compensation.

How are cryptocurrencies regulated?

The short answer is that they are outside the scope of blockchain technology, which we will discuss later.

More fundamentally, the current legal status of cryptocurrencies varies from country to country. While the use of cryptocurrencies is not restricted within the EU, some countries, such as Turkey, have banned cryptocurrency payments.

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The FCA is the UK’s financial regulator. Its stance was clear when it warned investors that “if you…buy crypto assets, you may not be able to use the Financial Ombudsman Service or the Financial Services Compensation Scheme.”

FSCS is a lifeboat program that saves consumers in the event of a financial catastrophe, such as supplier bankruptcy.

In December 2020, the FCA also advised clients of crypto asset firms to check the status of their providers and ensure they are allowed to continue trading under the regulator’s revised registration rules.

For suppliers who cannot confirm whether they are operating under the new rules, the regulator is advising customers to withdraw their holdings.

How do cryptocurrencies work?

Most cryptocurrencies operate without the backing of any authority like a central bank or government. This is fundamentally different from traditional currencies such as GBP or USD.

The way cryptocurrencies work is not a government guarantee, but is underpinned by so-called blockchain technology (see below).

Cryptocurrencies do not exist as physical stacks of paper money or coins, but are limited to the internet. Think of them as virtual tokens whose value is determined by market forces generated by those who want to buy or sell them.

There are an estimated five thousand cryptocurrencies today. Bitcoin is by far the largest, with a market cap of around £350 billion as of July 2022.

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The market capitalization of a cryptocurrency is equal to the unit price of the currency multiplied by the number of units in existence. Other major cryptocurrencies include Ethereum, which has a market cap of around £130 billion as of July 2022.

Cryptocurrencies can be bought with traditional cash such as British pounds and then used to buy more and more everyday goods and services with themselves. Cryptocurrencies have the same value in every country, facilitating person-to-person transfers around the world while negating exchange rate issues.

In fact, only a limited number of bitcoins exist—the cryptocurrency is likened to a digital form of assets like gold, where the supposed store of value is governed by the laws of supply and demand.

Right now, that’s the main advantage of cryptocurrencies: They can be traded on exchanges, similar to how stock market investors buy and sell stocks and other commodities.

What is blockchain technology?

Essentially, a blockchain is a kind of database. Blockchain first gained attention as the underlying technology of Bitcoin when cryptocurrencies were first discussed in a 2008 paper on peer-to-peer electronic cash systems.

The author of the paper is Satoshi Nakamoto, who is believed to be a pseudonym for an individual or group of people. Part of the cryptocurrency design means that only 21 million bitcoins will ever be created.

The blockchain is essentially a public record of every Bitcoin transaction that takes place. Data records are distributed across multiple computers and cannot be manipulated or changed later. According to cryptocurrency advocates, blockchain transactions are more secure than traditional payment mechanisms.

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A short video from the Bank of England shows the blockchain process in more detail and explains how “mining” works and the mechanics of generating new units of currency such as bitcoin.

This “mining” requires a lot of computing power and therefore consumes a lot of energy. Environmentalists have warned that the proliferation of cryptocurrencies could have a major impact on global efforts to reduce energy consumption.

How to buy cryptocurrency?

The most common place to buy Bitcoin and other cryptocurrencies is on specialized exchanges. This includes a range of trading platforms and apps that allow investors to buy cryptocurrencies using traditional currencies and/or other cryptocurrencies.

According to research by the FCA, around three-quarters of Britons who buy cryptocurrencies do so through online exchanges.

In order to open an account, potential traders are often asked to provide passport details, phone numbers and email addresses. Transaction costs may vary from exchange to exchange. Some providers charge a flat fee per transaction, while others charge a percentage of the total transaction amount.

How did cryptocurrencies develop?

As we all know, the performance of cryptocurrencies can fluctuate with the ups and downs of a roller coaster. In 2013, one bitcoin was worth just a few dollars. At the time of writing (July 2022), the price is around $22,000. A substantial increase from 9 years ago, but a far cry from the all-time high of nearly $68,000 set at the end of 2021.

UK interest in cryptocurrencies

In the summer of 2020, the FCA released a study on the growing demand for cryptocurrencies in the UK.

The FCA estimates that nearly 2 million adults own cryptocurrencies, although the results suggest that around three-quarters of consumers own cryptocurrencies worth £1,000 or less.

According to the FCA, the most common reason for holding cryptocurrencies is to “gamble, make or lose money.”

In the first seven months of the Covid-19 pandemic in 2020, more than 1 million adults increased their holdings of risky assets such as cryptocurrencies, according to the FCA.

What happens next?

Even before the 2020 pandemic upheaval, cryptocurrencies were besieged by questions about their security, practical uses and long-term viability. As a result, financial regulators have repeatedly issued clear warnings that people should invest in this space with extreme caution.

As more mainstream investment firms venture into the cryptocurrency space, we may see digital assets increase in value, normalize and become more widespread.

Several central banks, including Nigeria, have launched their own digital currencies, although progress has been slower in key areas of economic blocs such as the United States and the European Union.

In the uncertain times we live in, the whole concept may become fragile or unsustainable in the face of unforeseen challenges.

To paraphrase the regulator: “Buyer beware.”

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Jake Smith

Escrito por

Jake Smith

He is the editor of Eragoncred. Previously, he was editor-in-chief of Eragoncred and a financial industry reporter. Jake has spent most of his career as a Digital Media journalist and has over 10 years of experience as a writer and editor.