We hear of people becoming millionaires overnight with bitcoin, the world’s first cryptocurrency.
With more and more time, we see some skeptics turned into supporters, and within this brave new world of finance, everyday investors can no longer ignore what cryptocurrency is, or will become.
Today, while the average person only knows cryptocurrency as an investment asset that can make or lose you lots of money, there is so much more to the world of digital currencies.
Cryptocurrencies are revolutionising the finance industry (and the world at large) by serving as an alternative means of exchange, a yet-to-be-determined store of value that is not subjected to the inflation-inducing actions of a central bank, and an alternative investment asset.
Added to all these is the anonymity and protection from fraud that cryptos offer as a decentralised currency.
On the other side of the same token, cryptocurrencies also provide a potent mechanism for money laundering; inherently, there is a lack of any supervisory measures.
As a natural consequence, every investor should seek to understand what cryptocurrencies are, what they do, why they appeal to people, how to use them, and for what.
A better understanding of cryptocurrencies will help you enjoy their benefits while protecting you from their inherent risks.
“Every informed person needs to know about bitcoin,” said Leon Louw, a famous South African author and two-time Nobel Peace Prize nominee, “because it might be one of the world’s most important developments.”
That advice applies to cryptocurrencies as a whole.
In this article, we’ll provide you with all the information you need to understand the basics of cryptocurrencies to make informed decisions when it comes to investing in them.
We’ll look at:
The easiest way to understand cryptocurrency is to see it as a form of digital currency.
While you might not know what cryptocurrency is, you are most certainly familiar with what a currency is.
Cryptocurrencies can be used in the same way of the currency you are familiar with, except with encrypted technology.
So, first, let’s understand what the crypto in cryptocurrency means.
Crypto is shorthand for cryptography. Cryptography consists of two words – “crypt” and “graphy.” “Crypt,” derived from the Latin word “Crypta,” (which was used for vaults and chambers hidden below ground level) means hidden, and “graphy,” derived from the Latin word “Graphia,” means writing.
Bringing the two together, cryptography is a way of hiding information such that only the intended recipient can access, read, and process it. In other words, this is the code that creates encrypted information.
Cryptocurrency is thus a digital or virtual means of exchange that is created upon cryptography technology. This enables users to facilitate the exchange of goods and services between two or more parties in a secure, encrypted manner.
But how does the use of cryptography make cryptocurrency different from paper money?
The central bank is responsible for controlling the supply of the dollar (or any other currency).
They can reduce or increase the supply. Also, they maintain oversight over it such that they know who makes which transaction. Remember that this is why people trust paper money in the first place. A 100 USD note is just a piece of paper; it is the government backing and oversight that confers value.
However, when you buy an iPhone from your friend and pay (electronically) in dirham, the government can access that transaction and trace the buyer and the seller through the banks that facilitate such transactions.
In contrast, cryptocurrencies use a decentralised system.
No single central authority controls the supply of a cryptocurrency. For example, Bitcoin, the largest and first cryptocurrency, has a fixed supply of ₿21,000,000 (the bitcoin available in the world cannot be more than 21 million, so it is a finite resource.)
Also, the identities of the buyer and seller are hidden under a series of codes (the public key).
So when you buy some goods and pay with a cryptocurrency, the transaction will not show your first name and last name. Instead, the wallet from which you pay or receive the money is represented as a series of codes.
If the identities of the seller and the buyer are hidden under a series of codes, how do we know who owns what?
Cryptocurrencies use a decentralised ledger system called blockchain. But how does this work?
When a cryptocurrency transaction is completed, a ledger is created to record it. When you buy your iPhone with cryptocurrency, a ledger is created (A bought iPhone from B at the cost of 0.01BTC, for example).
When a series of ledgers have been created, they are formed into a block. Once a block is made, it is joined to a previous block. So the blocks form a blockchain (a series of blocks linked into one another, like a chain).
The below infographic explains the process of a blockchain transaction.
So a blockchain is a database of blocks of crypto transactions (also known as ledgers).
When a block is added to the blockchain, there is a timestamp that shows when the block was added.
Because every block has a preceding and succeeding block, and there is a timestamp to show when the block was added to the chain, every transaction can be verified.
Incredibly, these ledgers are added to blocks and blocks to blockchains on different computers operated by different anonymous individuals all across the world.
This vast global network of anonymous and decentralised blockchain ledgers is the real magic behind the curtain of cryptocurrencies!
Consequently, no one person can manipulate the ledger records. If you sold your PS4 and received 0.05BTC (bitcoin), no one can manipulate that transaction and say that the 0.05BTC belongs to them.
Therefore, every crypto transaction can be verified.
Cryptocurrencies arose from numerous frustrations attached to how central bank-managed paper money is governed.
The central government can just decide to print more money and increase the money in circulation (supply of money).
Governments can decide to print more money for various reasons, including as a desire to reinvigorate economic growth during a recession.
However, remember that in elementary economics when supply increases, the price reduces. In this case, when the supply of money increases, the value of money is reduced.
This is what economists call inflation.
What can be wrong with having more money in circulation?
Well, when the value of money reduces, it means the same amount will buy you fewer goods. If $100 could buy you a shirt and a trouser and a belt, inflation can reduce the value of money such that the same $100 will get you only a trouser and a belt. To buy the three together, you might need to add an extra $20, for example.
This subjection of the value of money to the whims of the central government was one major inspiration for cryptocurrencies.
Some people — namely libertarians — believe that the government should have less control over the private lives of citizens.
They believe that the government should not know how I spend my money (as long as I pay my taxes, that is). These people grew frustrated with the centralised control of governments that gave them access to transaction records.
This frustration also extends to the commercial banks that facilitate such transactions.
For decades, there have been several attempts to use cryptography to create a new currency.
The first cryptographic electronic money – ecash – was actually conceived by David Chaum way back in 1983.
In 1990, Chaum put ecash into practice by developing Digicash. In this electronic payment system, users needed a software to withdraw money from the bank and an encrypted key before sending it to recipients.
However, the company went bankrupt in 1999 because, according to Chaum, e-commerce was not yet fully integrated with the internet. Also, while the recipient of the money was untraceable, the sender could be traced.
In 1994, Daniel Lynch founded Cybercash, which introduced Cybercoin, another attempt at creating a cryptography-enabled currency. Unfortunately, it too could not provide complete anonymity as users needed a certificate to verify their identity.
Things began to change in 2009 when Satoshi Nakamoto, a pseudonym of a still unknown person/or persons, created bitcoin, the first decentralised cryptocurrency.
Satoshi used a unique type of cryptography called the SHA-256 encryption system as well as the then-emerging blockchain technology to create a revolutionary financial asset. The bitcoin was build on:
By combining these elements, bitcoin was able to solve the roadblocks that deterred trials before Satoshi.
With the birth of bitcoin, the stage was set for the creation of the numerous cryptocurrencies in existence today.
According to Coin Market Cap, as of May 25, 2021, a mind-boggling 10,045 cryptocurrencies were publicly available for trading.
The market cap of the whole cryptocurrency market is $1,574,095,665,314. That’s $1.5 trillion, comparable to the size of Apple Corp. ($2.12 trillion as of May 25), the largest company in the US.
Below is a chart detailing the 5 largest cryptocurrencies by value.
Ten years ago, BTC had a market cap of just $43.834 million. Now, its market cap is just over $1.5 trillion, a 3,490% increase.
What is behind this meteoric rise? For market cap to increase, either price or supply has to rise, or both. In the case of BTC, both supply and market cap have increased dramatically over the past decade.
Price can only increase if demand is increasing, and, for cryptocurrencies, an increase in supply means an increase in adoption (it means more people are interested in mining it).
In fact, a January 2021 survey of 60,000 users of BTC and ETH worldwide, conducted by Binance Research, shows that 97% of them expressed faith in digital assets.
As of February 2021, there were more than 68 million crypto wallets globally, up from just 8.02 million wallets in June 2016.
An increase in demand and adoption can only mean that many more people are finding cryptocurrencies valuable. But valuable for what, exactly?
Many people answer the “what is cryptocurrency” question by focusing almost exclusively on its use as an investment asset.
However, the primary motivation behind bitcoin and the cryptocurrencies that have arisen in its wake is to develop alternative means of exchange.
Cryptocurrencies can be used as a means of exchange/payment method for goods and/or services. This means you can also receive money as a freelancer or consultant or pay a freelancer or consultant through cryptocurrencies.
A currency can act as a store of value if you can save it for a while, retrieve it later, and exchange it without deterioration in value.
Cryptocurrencies like BTC are a good store of value because they have a finite supply, and you can transfer them to another person at any time.
Unlike paper money, the supply of BTC cannot be increased, leading to a drop in value.
Even cryptocurrencies that are not finite in supply are still better than paper money in this regard because a central government cannot artificially determine the supply outside of the free market.
Since cryptocurrencies are a good store of value, they also qualify as an investment asset. That is, you can buy and keep them in expectation of a demand-driven increase in price.
As we have since, as the adoption of BTC increased, the price and market cap have grown exponentially.
In case you haven’t already done this regretful math, let’s do it for you.
One BTC 5 years ago was worth $530.04. It opened at $38,994.09 on May 25, 2021, providing a 7,256% return.
The high returns that are possible with cryptocurrencies are one of the reasons why they have become so sought after.
Cryptocurrencies are becoming popular for various reasons.
The major reason is the astronomic returns that crypto traders have made so far from buying and selling them. Keep in mind that many also have astronomic losses.
Today, there is no shortage of rags-to-riches crypto traders.
However, while these returns make the bulk of headlines surrounding bitcoin, this is not the only reason why the digital currency is so popular.
Another reason for the growing popularity is its use as a means of unfettered exchange.
Thirdly, the anonymity cryptocurrencies provide has been a welcome development, especially for libertarians. Fourthly, the security that blockchain technology provides is an attraction for those who are wary of being defrauded online. The system allows easy and decentralised verification of transactions and ownership.
Lastly, many are adopting cryptocurrencies because they just love adopting the new fad. These people love disruptive and revolutionary innovations and are always willing to jump on one.
Which brings us to the next question: Are cryptocurrencies a fad that will soon pass?
The truth is, only time will tell. And, within that vague response lies the high risk and reward potential inherent within cryptocurrencies.
Now to the elephant in the room: Is bitcoin legal in the UAE?
The largest of the cryptocurrencies, the legality of bitcoin is a prominent question for traders because laws regulating the crypto trade differ from country to country.
So if you have been thinking along this line, you are not alone.
Afterall, if someone can buy and sell online with anonymity, does that not mean they can perform illegal transactions?
This, along with the volatility of the crypto market, has been the major concern of some governments with the adoption of cryptocurrencies.
In the UAE, the issuance, listing, and trading of cryptocurrencies are legal, but a regulatory framework published by the Securities and Commodities Authority guides such activities.
So you can buy and sell cryptocurrencies in the UAE with no fear of legal consequences within the set guidelines.
Here is the real elephant in the room.
Out of all the traditional investment assets — stocks, bonds, and REITs — stocks had been considered the riskiest.
Now, cryptocurrencies are considered even more risky than stocks, even though they offer higher returns.
The prices of cryptos can increase as rapidly as they can drop.
“In 2015, Bitcoin’s price fluctuated between $200 and $500 per coin,” said Miranda Marquit, personal finance and investing expert.
“However, during 2017, the price suddenly rose, reaching a high of $19,891 in December, before dropping below $3,500 in December 2018. In 2020 alone, Bitcoin’s price has bounced between $3,858 on March 12 and $9,074 on July 5.”
The sudden movement from $200-$500 to $19,891 and then back to $3,500 tells you everything you need to know about the risk of cryptocurrencies.
When you think about the prospect of growing your money from $200-$500 to $19,891, you should also think of the possibility of seeing your $19,891 crash to $3,500.
In fact, as of March 7, 2021, one bitcoin was $61,243.09. Yet, by May 25, 2021, it opened at $38,994.09, a 36.3% drop.
The chart below illustrates the volatility of BTC compared with stocks and gold.
Source: Forbes
You can see how bitcoin is moving faster (whether upward or downward) than the others.
This is why someone like Warren Buffet is not a big fan of cryptocurrency.
Related to the above is the risk involved with Initial Coin Offerings (ICOs). An ICO is the counterpart to an IPO (initial public offering) in the stock market.
Many cryptocurrencies that get to ICO end up flopping, causing investors who bought at ICO to lose serious money.
A website that tracks “dead coins” currently has more than 2,000 cryptocurrencies on its list. According to the website, more than 60% of coins that go through ICOs flop!
Next, the crypto market is largely unregulated (though that is changing).
We have seen a case where a founder died without releasing the password of a coin (Quadriga). These stories can occur and are part of an additional risk when you trade in an unregulated market.
However, such cases can be prevented when you buy a cryptocurrency ETF, rather than individual cryptocurrencies, through Sarwa Trade.
[To learn more about ETFs and the protections they offer, read, “Why Invest in ETFs: Explaining the Popularity of the Go-To Fund]
Does it mean you should never trade cryptocurrencies?
No!
Crypto has its advantages. For example, it can be stored digitally, which makes it hard to seize and easy to send across borders. It can also be used as a store of value.
But at the same time there are some aspects of bitcoin that we need to keep in mind: while it has stood the test of 10 years of time, it’s still relatively brand new, so we don’t know what can and will happen next. Lingering questions remain: can bitcoin break down? Can someone eventually learn how to give it a bug?
Today, its value is mostly speculative at the moment, yet it has the potential to be incredibly valuable.
But we’re here to give you some sound advice. Don’t invest because of FOMO; invest because you understand its proposition and the potential behind it. A lot of people are investing in bitcoin because they see it as a kind of digital gold — an inflation hedge.
Believing in the value of something is a better reason to invest in it than, say, hype.
If you’re going to trade, you should thus be using a regulated, secure and low-cost platform.
The risk of an asset is not enough reason to avoid it.
What matters is the return-risk ratio. Said differently, does the investment provide a higher risk-adjusted return compared to others?
Experts measure this through the Sharpe ratio, which shows the returns of an asset relative to its risk.
“Bitcoin is fearsomely volatile, but it has more than made up for that with appreciation,” said William Baldwin, a senior contributor at Forbes.
“The Coin Metrics Bletchley Index clocks bitcoin’s Sharpe ratio over the past five years at 1.6. That compares (per Morningstar) with 1.1 for the Vanguard Balanced Index Fund, which is about as diversified as you can get using stocks and bonds.”
However, volatility should not be enough reason to ignore cryptocurrency.
As the Forbes chart above shows, $100 in bitcoin, despite the intervening volatility, has grown over five years to $10,000 while stocks and gold are still hovering between $200-$400.
Secondly, BTC shows almost zero correlation to the stock market, with a correlation coefficient of 0.01.
This means that when the stock market is falling, the BTC market does not follow suit. And as we know from the Modern Portfolio Theory, owning a portfolio of uncorrelated or negatively correlated assets minimises the risk of the investor.
Cryptocurrencies can thus be an additional way to further diversify your portfolio.
[To learn more about the importance of diversification, read “The Importance Of Diversification”]
Consequently, instead of ignoring cryptocurrencies totally, you should be seeking to invest in them in a careful and strategic manner.
Here are some ways you can do that:
[To learn more about ETFs and their benefits, read “Why Invest in ETFs? Explaining the Popularity of the Go-To Fund.” For stocks and bonds, read, “What are Stocks and Bonds?”]
It’s the same in the crypto market. Focus on long-term investments instead of short-term trading, and you’ll reduce your overall risk.
Now that you know why cryptocurrencies could belong in your portfolio and how you can further minimise your risk when buying them, it is time to start building your investment portfolio.
Schedule a free call with a Sarwa Wealth Advisor, and we’ll be happy to answer all your cryptocurrency questions and explain how bitcoin can be used to diversify your holdings.
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