The cryptic world of cryptocurrencies

What are cryptocurrencies?

Essentially, a cryptocurrency is a digital method of payment that is decentralised. This means transactions are not verified by a central bank or other centralised authority, but by a network of volunteers using cryptography (hence the name).

At the heart of most cryptocurrencies is something called blockchain technology. Blockchain was invented for Bitcoin – the first cryptocurrency – and is essentially a decentralised ledger (a record of information) of all Bitcoin transactions across a peer-to-peer network.

Unlike traditional currency (called ‘fiat’), cryptocurrencies have no central clearing authority and their supply is not determined by a central bank. They also have no intrinsic value, meaning they are not redeemable for another commodity, such as gold, and they have no physical form.

So how do they get their value?

Dr Christoph Breidbach, from the UQ Business School, reminds us that the same question applies to any form of currency.

Dr Christoph Breidbach from the UQ Business School.

“I have a €20 note in my wallet – what is it really? It’s just a piece of paper,” he says.

“If I gave you a coin from a Roman Emperor right now, you couldn’t buy a coffee – hence, it is not valuable to you. But 2000 years ago, it was really, really valuable.

“What we really need to ask ourselves is: what is money? It’s socially constructed, an illusion.”

How do you buy something with cryptocurrency?

Let’s say Jo wants to buy a couch from Wei.

In an electronic transaction with fiat currency, like $AUD, Jo would transfer Wei money from her account, and it would arrive in Wei’s account. Behind the scenes, the transaction is verified by Jo’s bank recording the money leaving her account and Wei’s bank recording the money arriving in his.

If Jo wanted to buy the couch with cryptocurrency – say, Bitcoin – the process is a little different. This is where the blockchain comes in.

As Bitcoin is decentralised, there are no banks involved. To verify a Bitcoin transaction, the request from Jo is shared to every computer in the Bitcoin network, which add her request to a shared list of recent transactions known as a block.

To verify the transactions in the block, a group of users in the Bitcoin network join a race to solve a complex mathematical equation with computing technology in what is known as the proof-of-work concept. Whoever solves it first is rewarded with new Bitcoin. This process is known as mining.

Their record of the ‘block’ (which includes Jo’s transaction) then becomes the official record, and it is added to the rest of the blocks to create a chain.

Once it has been verified, the Bitcoin can be sent to Wei, and the transaction is complete.

Because so many different computers are competing to verify the equation (proof-of-work), it makes the Bitcoin blockchain very secure, as rewriting the blockchain would require the attacker to control 51 per cent of the network – something essentially impossible for such a big coin.

Smaller coins, however, have been victim to these attacks.

The risks to be aware of in cryptocurrency investing

The spectacular growth of cryptocurrencies like Dogecoin can make it tempting to jump on the bandwagon. But, like any investment, it’s important to understand the risks associated with investing in cryptocurrency markets.

According to Head of Currency at Queensland Investment Corporation (QIC) Stuart Simmons, there are several significant deterrents for institutional investors to keep in mind when considering investing in cryptocurrencies like Bitcoin.

“There’s extremely high volatility, which is a massive deterrent, and of course, it’s a speculative instrument,” Simmons says.

“Then there’s the lack of a valuation anchor. So, because you don’t have cashflows and a traditional element of fair value, cryptocurrencies can go to zero; there’s no anchor to gauge whether it’s particularly cheap or expensive, the price simply is what it is.

“There’s also unquantifiable risks associated with it, such as fraud or theft, which is magnified by the lack of regulation and a safety net for these risks.”

Simmons also points to the direct (and very significant) influence powerful investors can have in cryptocurrency markets.

“Another big deterrent is the potential for manipulation, where big investors might actively try to influence the direction of the market,” he says.

“An institutional investor doesn’t want to be caught out with their board having bought cryptocurrencies and tried to justify it on the basis of capital growth, and someone’s just put out a tweet so it’s dropped 30 per cent.

“Traditional investments can’t be easily manipulated in this way.”

UQ graduate (Doctor of Philosophy ’13) and Honorary Senior Fellow at UQ’s School of Business, Dr Rand Low, believes in the potential of blockchain technology, but warns individual investors of going all-or-nothing in the crypto markets.

“Cryptocurrency prices are unpredictable and volatile,” he says.

“I would advise against anyone investing a substantial stake of their savings or income in cryptocurrency.

“However, I would encourage people to own some cryptocurrencies to understand the technology and the scale of disruption that can occur if they become adopted as a payment system globally.”