All cryptocurrencies run on blockchain technology. If you are considering making a long-term investment in a cryptocurrency, we recommend that you try to get a basic understanding of blockchain technology, as well as the technology platform that your chosen cryptocurrency runs on. Even if you are only interested in short-term speculation or trading and not long-term investing, it’s a good idea to understand the basics of how blockchain technology works.
Blockchain technology is an encrypted, decentralized, peer-to-peer database. Its strength lies in the fact it is decentralized. For example, let’s say that a stock exchange has a single database of all the owners of every piece of stock traded, which is continuously updated. The database is stored in a single physical location, on one server. What if the database is hacked, destroyed, or otherwise corrupted by a computer virus or act of nature? Of course, the database would probably be backed up in at least one other location, but it is still relatively vulnerable, and can be easily tampered with. Blockchains, though, are decentralized peer to peer databases, where the content files are broken up, encrypted, and stored differentially on thousands of nodes all over the world that communicate with each other to produce a seamless whole. This makes fraud or hacking extremely difficult, because changes to the transaction and ownership records must be agreed by a majority of all the pieces (blocks) to become valid. This is the reason why cryptocurrency transactions take some time to process, because any changes to the publicly distributed “ledger” must be agreed upon and verified everywhere. This solves the “double spending” problem that would naturally plague any digital currency. There is no sole authority or central server to be manipulated.
Blockchain technology is seen as a potentially “disruptive” technology, with the power to change the world. It has many potential applications, and where applied, should replace the power of any central authority with rules which cannot be bypassed: there will be government, but government which cannot be abused, embezzled, or bribed. There can be “forks”, which we will get into a little later; they effectively change the rules, but are, at the very least, open and transparent.
Why Should I Be Excited About Cryptocurrency?
Cryptocurrency (and blockchain technology on the whole) is something new and it has the potential to significantly change the way that the world works economically. Early investors or speculators in new, successful, disruptive technology can earn spectacular returns, although not without risk. For example, $10,000 invested in Microsoft stock in 1986 would have been worth more than $3 million within 25 years. The same amount invested in Apple stock in 1980 would be worth approximately $4 million today. So, over the medium or long term, even relatively small investments can grow into significant, potentially life-changing sums.
Looking at a shorter time horizon, the larger cryptocurrencies fluctuate in value dramatically, as they are subject to an enormous amount of short-term speculative interest. There has been sizeable buying and selling by investors during 2017, keeping the price volatilities of cryptocurrencies high. An asset which rises in value by a large amount is statistically likely to either continue to rise, or fall by a similar amount soon, because volatility “clusters”. If volatility is high today, it is also likely to be high tomorrow. This means that there are likely to be speculative opportunities in cryptocurrencies during 2017 and into 2018 at least, either in buying, or in selling short. For example, below is a weekly chart of Bitcoin, the largest cryptocurrency, against the U.S. dollar, over the past 2 years leading up to September 2017:
Note how the price has more than doubled within the past 6 weeks, and has risen by 500% over the past 5 months. The indicator at the bottom of the chart is the average volatility of the price over 4 weeks. It has been steadily rising, suggesting that volatility will probably increase, or at least maintain its existing level. Price charts of other major cryptocurrencies over the same time frame show a similar story. Compare this level of price movement to national currencies, which typically only fluctuate by maybe 15% over the course of an entire year against a basket of other currencies, and it is obvious that cryptocurrencies offer a profit opportunity that must be taken seriously.
The Potential of Cryptocurrency
We said at the beginning of this section that cryptocurrency is something new and potentially disruptive. The potential for disruption lies in the fact that cryptocurrency might completely replace national currencies such as the euro and the U.S. dollar as the foundation stones of the global financial system. Governments and central banks have the power to devalue their currencies, which we are all forced to use, degrading our savings, removing their ability to act as a “store of value”, and forcing us all to become speculators into our old age. If cryptocurrency was safe and fully exchangeable, who would not prefer to save their cash in cryptocurrency? Politically, cryptocurrency is a libertarian and monetarist dream, so if you like those political philosophies, you will certainly appreciate what cryptocurrencies have to offer. If national governments are unable or unwilling to halt the advance of cryptocurrencies, it seems likely that the global financial system will be changed back to something like the gold standard, which would probably remove the worst excesses of inflation and manipulation. However, many economists contend that the gold standard brought its own problems of excessive deflation, unnecessarily prolonging economic depressions.
You might have heard of the “war on cash”, which refers to the increasing move away from cash towards debit and credit cards, which has been encouraged by many governments on the basis that restricting or replacing cash transactions makes life harder for criminals and terrorists. Governments also must see another potential advantage: without cash, it will be easy to force negative interest rates upon their populations, should they wish, either overtly (such as Switzerland and Japan are doing now) or covertly by the means of bank charges. As cryptocurrency is effectively private, its full acceptance should kill the concept of negative interest rates.
By now you probably understand why cryptocurrencies are very controversial and why their widespread adoption as a means of exchange will either face severe opposition from governments (as we are seeing now in China), or perhaps governments will try to seize control of the dominant cryptocurrencies, or even start their own versions! Governments are likely to say they need to keep control over currencies for the purposes of prevention of crime and tax evasion, which to be fair, are valid concerns. The question remains whether governments will be able to stop or block cryptocurrency use within their borders. If they cannot, then it is likely to be a great long-term investment. If governments can find a way to block or restrict the use of cryptocurrencies, it may not be as successful as an investment.