What is cryptocurrency?
E*TRADE from Morgan Stanley02/03/23
Summary: Learn what cryptocurrency is, how to invest, and the risks.
While it can serve other purposes, cryptocurrency, commonly called crypto, is decentralized digital money that uses blockchain technology to make peer-to-peer payments. Cryptocurrencies like Bitcoin are created through a process called mining, which uses computer power to solve complicated math problems that ultimately produce a fixed supply of virtual coins. While many cryptocurrencies are created in the same way, some others may be created through different methods.
A decentralized payment system
Unlike the US dollar, cryptocurrencies have no physical form, aren’t stored in a central place, and aren’t governed by a central authority such as the Federal Reserve.
The blockchain is vital to crypto’s decentralized nature. Every crypto transaction is recorded in the blockchain—a public ledger available to other users—and a new “block” is added to the chain with the most recent transactions. In Bitcoin, blocks occur every 10 minutes, but it varies from cryptocurrency to cryptocurrency. There are thousands of copies of the blockchain file on computers around the world, making it extremely hard to alter.
While traditional currencies use a trusted third party such as a credit card company or bank to verify that the funds are available to complete a transaction, cryptocurrencies rely on a network of computers to confirm the spender’s coins and the transaction. The method by which a particular cryptocurrency network ensures validity of transactions on that network is known as a consensus mechanism.
Some well-known cryptocurrencies
Although there are more than 10,000 cryptocurrencies, a small portion account for the majority of the market. Some of the most well-known include:
- Bitcoin was the first cryptocurrency and launched in 2009. It is considered the most liquid crypto.
- Ethereum is the second most liquid cryptocurrency. The Ethereum network is a decentralized cloud-based software that creates a virtual computer that allows third parties to create applications (called smart contracts) that run on the “computer.” These application developers use ether, the currency of the network, to pay the network for the processing power and data storage their applications require.
- Tether represents one US dollar. As the leading “stablecoin,” tether generally has very little volatility, though it has ranged between $0.92 and $1.06 since 2017.
- USD Coin is an open source, smart contract based stablecoin which tracks the US dollar.
Some cryptocurrencies could be classified more as currencies, others more as securities, and still others somewhere in between.
Top 10 cryptocurrencies by market cap
Source: Coinmarketcap.com, as of 1/18/2023
Investing in cryptocurrency
There are a few ways to gain exposure to cryptocurrencies:
- Directly buying them from an exchange or receiving them as rewards from certain credit cards or e-commerce sites. Prices can be volatile.
- Products such as exchange-traded funds (ETFs), trusts, futures, and mutual funds that track cryptocurrencies or groups of cryptocurrencies. Because these products track crypto prices which are volatile, the prices of these products may also be volatile. Additionally, these products might not track cryptocurrency prices as closely as intended and may therefore diverge from the underlying crypto price.
- Equity ETFs that invest in companies participating in the cryptocurrency market, for example: mining, marketing, consulting, payments equipment, financial services, and other blockchain-related businesses. Equity ETFs have high correlation with Bitcoin.
- Stocks of companies that generate most of their money from products related to cryptocurrency. These companies may own a lot of cryptocurrencies, make money from cryptocurrency, market with cryptocurrency, or support crypto businesses. Their performance tends to move with the market but will also have company-specific drivers.
Know the risks
Risks unique to cryptocurrencies include but are not limited to:
Cryptocurrencies rely on cryptography to make changes to the blockchain, connect blocks, and ensure they stay in the correct order and to encrypt the users’ passwords when they are requesting transactions. Increasing processing power and techniques like quantum computing could eventually crack encryption, which may allow hackers to access crypto wallets.
Flaws in the code could cause an unpredictable supply of cryptocurrency or cause the network to stop working as expected.
Laws that prohibit or discourage activity in cryptocurrency can suppress demand or disrupt the network.
Cryptocurrencies are extremely volatile—significantly more than the S&P 500® and Nasdaq-100®.
Many cryptocurrencies including bitcoin and ethereum have concentrated ownership with the top 100 addresses holding 15-38% of the supply. If one or more of the addresses that hold the majority of total coins was forced to sell, or had their assets stolen and sold, the price could be impacted.
Lack of central governance
Since cryptocurrency is not issued or controlled by a particular person or group, there may not be any recourse if it’s lost or stolen.
Association with illegal activities
New technologies like cryptocurrency are often used to perpetrate fraudulent investment schemes.
Because cryptocurrencies are relatively new, there may be unforeseen risks in the future that are not evident now.
Following the hype of crypto can seem exciting but proceed with caution. Before getting started, investors should get educated and consider how and whether cryptocurrency exposure fits into their portfolio in a way that aligns with their risk tolerance and financial goals.