Introduction to the Financial Markets

6 Lessons
6 Hours

Introduction to Cryptocurrencies

Welcome to Introduction to Cryptocurrencies! In this video, you will learn what cryptocurrencies are, how they work, what a blockchain is, how to invest in cryptocurrencies, and the main factors affecting its price.

In finance and economics, for something to be considered as money, it must perform three functions: (1) be a means of storing wealth, (2) be a medium of exchange, and (3) be a unit against which to value other goods. Basically, money has value because we all agree it has value.

Cryptocurrency

Cryptocurrency is probably the next evolution of money. Many things in the world are now digital – photo albums, pen friends, magazines and newspapers. The next one will be money.

A cryptocurrency is a medium of exchange, like government issued currencies, but not issued by a government. Just like anyone can create his own website, anyone can create their own cryptocurrency – anybody can do it.

How Cryptocurrency Works

If there is no bank or government behind a cryptocurrency, then how do we issue money and verify transactions? The answer was given by an unknown Japanese coder who created Bitcoin in 2009, with the alias Satoshi Nakamoto. A cryptocurrency is a digital currency in which encryption is used to regulate the generation of new units of the cryptocurrency and verify the transfer of funds. The most well-known is Bitcoin, which its anonymous inventor calls a peer-to-peer electronic cash system. In essence, any cryptocurrency can be viewed in a similar manner to traditional currencies.

When people access a website, their computer connects to the web server and downloads the data directly from that server. This is how much of the traffic on the internet works.

In a peer-to-peer protocol, the users transfer data between each other like a swarm without the need for a central server. Users downloading from a swarm are commonly referred to as peers. A reward system is in place – rewarding clients who contribute more to the network to ensure people maintain the network, and this is what cryptocurrencies really are – a decentralized peer to peer electronic cash system.

Blockchain Mechanism

To realize digital currency, you need a payment network with accounts, balances, and transactions. One major problem every payment network has to solve is to prevent one entity from spending the same amount twice. Usually, this is done by a central server – a trusted third party like a bank or government who keeps record of balances and verifies the transactions.

In a decentralized network, you don’t have a central server. You need every single peer in the network to do this job. A blockchain is a public ledger of all transactions or blocks, and every peer in the network has a list of all these. A transaction is a file that says, “Avramis gives 100 Bitcoin to Mario” and is signed by Avramis’ private cryptographic key, and subsequently broadcasts it to the entire Bitcoin network for verification. For a transaction to be successful, it must be verified and added to the sequential blockchain as new blocks.

Mining

Bitcoin uses a proof-of-work scheme or mining. Principally, anyone with a computer and an Internet connection can be a miner. Miners are those peers in the network competing for the following jobs (1) collect new transaction data, (2) verify transactions, and (3) add a block to the sequential blockchain.

Miners can collect new transaction data. The transaction is known almost immediately by the whole network, but only after a specific amount of time it gets confirmed. They verify transactions against the existing blockchain (existing ledger. They solve a cryptographic puzzle that allows them to add a block of recent transactions to the sequential blockchain. For this job, the miners get rewarded with a token of the cryptocurrency, for example with Bitcoins. When a transaction is confirmed and added to the blockchain, it is written in stone. It is no longer forgeable, and it can’t be reversed.

Advantages of Cryptocurrencies

All cryptocurrency transactions are (1) permanent, (2) anonymous, (3) fast and global, (4) secure, and (5) permissible.

Transactions are permanent. After confirmation, a transaction can’t be reversed. Not by you, not by your bank, not by Satoshi, not by your miner. Nobody. Transactions are anonymous. Neither transactions nor accounts are connected to real-world people or companies. Transactions are fast and global. Transactions are executed within minutes, no matter which country the two parties are located in. Compared to bank wires that can take hours at best, and days to transfer internationally. Transactions are secure. Cryptocurrency funds are locked in a public key cryptography system, making it very hard to steal. Transactions are permissible. You don’t have to ask anybody to use cryptocurrency. It’s a software that everybody can download for free.

The fast rise in Bitcoin prices can be attributed to two factors (1) limited supply and (2) pay to the bearer. Most cryptocurrencies have a limited supply. There is only x amount of coins in existence. In Bitcoin, the supply decreases over time, and will reach its final number of 21 million coins sometime around 2140. All cryptocurrencies control the supply of the token by a schedule written in the code. This means the supply of a cryptocurrency in any given moment in the future can roughly be calculated today. There is no surprise. Pay to the bearer. Like in the past, USD was exchangeable to gold at $35 per ounce. Cryptocurrencies don’t represent debts like today’s currencies – they are money as hard as coins of gold.

Cryptocurrency in Detail

Types of Cryptocurrency

Today, there are close to 1,000 different types of cryptocurrencies available in the market. Bitcoin is currently the most popular and biggest cryptocurrency in terms of capitalization. Among the many choices available, different cryptocurrencies provide different benefits over others. Some cryptocurrencies such as Litecoin and Ethereum provide faster confirmation times than Bitcoin.

Trading Cryptocurrency

One way people trade cryptocurrencies is to invest in a new one, with the anticipation that it achieves the success of Bitcoin; but this is very risky and should not be attempted with large amounts, as from the hundreds of new currencies, only a handful will ever make it. Another way is trading in a more mature cryptocurrency like Bitcoin that may not provide the same upward spike in value again, but will experience a more natural and gradual growth

Investing in Cryptocurrency

There are three ways that you can invest in cryptocurrencies: (1) mining, (2) trading in an exchange, and (3) through CFDs.

The original way to acquire Bitcoin was to mine them. In 2009, every block mined brought a reward of 50 Bitcoins to those who managed to solve the computational program. Due to the evolutionary nature of the code, it has become progressively harder to solve, as rewards halve every 4 years. Today, every block mined brings a reward of 12.5 Bitcoins, and in 2020, it will give 6.25 Bitcoins per successful proof of work. The need for knowledge of programming, combined with expensive computer hardware and electricity bills, makes it harder to access for the vast majority.

You can buy cryptocurrency through an exchange. Anyone can create an anonymous cryptocurrency account and buy cryptocurrency through an exchange. A cryptocurrency exchange is like a stock exchange, or like a currency exchange in a foreign airport. To trade in an exchange, you need a cryptocurrency wallet where you store encrypted passwords that represent coins. Most first time buyers often find the process of buying cryptocurrencies to be somewhat difficult, cumbersome, and even sketchy. There are shady providers are all over the Internet. There are three main drawbacks to this approach: (1) cryptocurrency isn’t a centrally controlled and regulated fiat currency like government issued currencies, (2) funds are in the exchange account, not individual accounts so whilst Bitcoin is extremely secure, exchanges aren’t, and hackers, malware and operational glitches have previously stolen large amounts, and (3) if you forget your login details or someone cheats you, there is essentially nothing you can do about it. There is no third party or a payment processor, as in the case of a debit or credit card – hence, no source of protection or appeal if there is a problem.

Cryptocurrency CFDs

Trading Bitcoin CFDs with a regulated broker solves the problems of exchange trading. There is no need for complicated wallets, you can always reset your passwords, and you trade with a regulated broker. You can trade with leverage – skilled traders will be able to use this to their advantage – but it does increase risk. You can take both long and short positions and thus, offers the opportunity to make profits in both rising and falling markets. You can buy fractions of a Bitcoin instead of a full one, and the cost of trading CFDs is lower than physical trading. Trading using CFDs is much faster than a cryptocurrency transaction in an exchange or through mining.

What Affects Cryptocurrency Price

Like any asset, the price of cryptocurrencies is determined by the forces of demand and supply. Here is a tip – Bitcoin supply is limited to 21 million coins and while the demand for it is increasing exponentially, so does its price. However, the creation of new cryptocurrencies indirectly increases the supply, as people look for cheaper alternatives. As new cryptocurrencies come into play, people may prefer to own those currencies, thus, new technology may make Bitcoin obsolete

Cryptocurrencies are a rival to government currency and may be used for illegal activities such as black market transactions, money laundering, or tax evasion. Regulation by governments seems to be the big unknown that causes extreme volatility and can make or break cryptocurrencies. Anti-money laundering and counter-terrorist financing compliance makes it difficult for companies to accept.

Government or company acceptance of cryptocurrencies pushes prices up (e.g. when Japan endorsed Bitcoin as legal tender in 2017). Government or company restrictions on cryptocurrencies pushes prices down (e.g. the 2017 China ban on Bitcoin).

Cryptocurrency

A type of digital currency used as a medium of exchange.

Bitcoin

The first cryptocurrency created that has remained the largest and most popular.

Satoshi Nakamoto

The alias the creator of Bitcoin goes by.

Peer-to-peer protocol

Where users transfer data between each other like a swarm without the need for a central server.

Peer

Users downloading from a swarm.

Blockchain

A public ledger of all transactions or blocks that is shared to every peer in the network.

Mining

Entails collection of transaction data, verification of transactions, and solving cryptographic puzzles to add a block of recent transactions to the sequential blockchain.

Advantages of cryptocurrency

  • Permanent
  • Anonymous
  • Fast and global
  • Secure
  • Permissible

Types of cryptocurrency

  • Bitcoin – the largest and most popular cryptocurrency
  • Alternative cryptocurrency – also known as altcoins; refers to any cryptocurrency that is not Bitcoin (e.g. Litecoin, Ethereum)

Trading cryptocurrency

  • Invest in altcoins (e.g. Litecoin, Ethereum)
  • Invest in Bitcoin

Cryptocurrency exchange

A platform where users can buy, trade, and sell cryptocurrency; similar to a stock exchange and foreign exchange counter.

Cryptocurrency CFDs

A type of CFD that allows individuals to trade and profit off cryptocurrency trading without having to own actual cryptocurrency.

What affects the price

  • Forces of demand and supply
  • Government regulations
  • Company acceptance

In our next video, we will talk about pips, lots and position size. Thank you for watching!