Short Introduction to Cryptocurrencies

Short Introduction to  Cryptocurrencies
Photo by Pierre Borthiry / Unsplash

There is no denying that cryptocurrencies have gotten more popular in the last year. It could be a side effect of spending so much time home or just the stories of overnight millionaires. Regardless, anyone with any interest in the financial market can benefit from knowing a bit more about  cryptocurrencies.

Please note that many of links in the article bellow are referral links. Using those links helps this blog out. Also, this article is written for education and entertainment. This is not financial advice.

What is a cryptocurrency?

Lets start with the Wikipedia definition :

A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it.
Individual coin ownership records are stored in a digital ledger, which is a computerized database using strong cryptography to secure transaction records, to control the creation of additional coins, and to verify the transfer of coin ownership.

Cryptocurrencies are purely digital : individual coins do not exist. A person owns digital currency because the ledger of that currency indicates a balance in that persons digital wallet. That ledger is distributed among many individuals and is synchronized over time. Currency can be transferred between wallets through a transaction, which becomes only official once it is accepted by multiple individuals with a copy of the ledger. Bellow is an example of a simple transaction ledger, with wallet A starting with 15 coins and both wallet B and C starting empty.

Source Wallet Destination Wallet Amount Source Balance Destination Balance
A B 5 10 5
A C 5 5 5
B C 5 0 10

Wallets are protected with public/private cryptographic keys, where money can be sent to a wallet using the public key, but can only be retrieved from a wallet using the private key.

There are several good resources on the Internet to learn about cryptocurrencies. A good start are the guides on Coinbase, which covers important vocabulary such as blockchain, or bear/bull market.

How do I buy cryptocurrency?

You need an exchange to transform your government issued currency (CAD, USD, etc.) into a cryptocurrencies. Much like international currency exchange, you should choice your exchanged based on reputation, the currencies you can exchange and government backing. Novices to cryptocurrency should favor publicly listed exchanges such as  Coinbase (US) and Coinsmart (Canada). As with any financial transaction, if you plan on sending any significant amount of currency, please read up on the exchange.

Once you own some cryptocurrency, you can convert them into other cryptocurrencies using those same exchange, or transfer them to your private wallet. Funds stored in a private wallet can also be trade on decentralized exchanges (DeFi), which facilitates the trade between to individuals without the need for an intermediaries. Most transactions involving cryptocurrencies will involve fees, some of which can be very expensive. Exchanges are usually very transparent about these fees, but always exercise caution on any transaction. Also note that if you make a mistake with a destination wallet address, you could loose the currency involved in the transaction.

Where should I store my cryptocurrency?

It depends on the amount of currency and how much you trust your exchange. For a couple of thousand of dollars, it might be easier to keep it on the exchange. Trading on an exchange usually involves lower fees. If you have accumulated a significant amount of currency, plan on keeping it for a while or plan on using a decentralized exchange, you might want to move it to your own separate wallet.

Please note that a wallet doesn't store currency, it stores a public/private key that is used to identify your wallet on a ledger and how much currency is stored in that wallet. The private key should be protected at all cost, as it allows for currency to be removed from the wallet. They are often protected by a password, which is just as important as the key itself. If the password or the private key are lost, then the currency can never be recovered. Millions of dollars are lost in unrecoverable wallets. Some wallet allow for the generation of a recovery key, which allows the private key to be rebuilt. That recovery key is as precious as the private key itself. It should never be stored on a computer but kept in a secure, locked location.

The most common type of wallet is Metamask, a software wallet that can be integrated in most browsers. Metamask is convient to use, but also an easy target for criminals as currency can be stolen if the computer is compromised.

A hardware wallet that is showing Ethereum (ETH), Bitcoin (BTC) and Cardano (ADA).
Photo by Max Saeling / Unsplash

A more secure solution are hardware wallets, which store the private key of the wallet and should only be connected to a computer when completing a transaction. The private key is never transferred to the computer, keeping it out of reach of criminals. The most common hardware wallet are Ledger and Trezor. Ideally, the wallets should be purchased directly from the manufacturer, as to avoid any changes of tampering.

How do I make money?

Given the volatility of cryptocurrency markets, the most common strategy is to buy a currency when it is worth less, and sell it when it increases in value. Some people have made millions of dollars buying a cryptocurrency at pennies and selling them when they are worth dollars. However, this strategy requires foresight and a lot of luck. For every crypto millionaire, hundreds of people has lost a significant amount of money. As such, short term trading in crypto is often compared to gambling.

Some cryptocurrencies can be mined : they are given to a wallet when a non-trivial tasks is completed. For example, Bitcoins can be earn through computer resource intensive task, also known as proof of work. Some currencies leverage proof of stake, where currency owners can stake (lock) their coins to earn the right to validate transaction. Each validation then earns them a rewards. Proof of coverage and proof of space are two other types of mining found in specialized cryptocurrencies. It is important to note that some popular cryptocurrencies leveraging proof of work have step energy requirements, causing great harm to the environment.

Liquidity pools are a popular  strategy as they generate a continuous passive stream of income. A person can invest in a liquidity pool by locking funds in a pool for a fixed amount of time. Those funds are then used for for loans, thus empowering the economy. The investor is rewarded, usually with a fixed rate of return. However, liquidity pools require trust, as individuals can create fraudulent pools and steal the currency from them. As such, investing in a liquidity pool is always a risk, which is often reflected in the high reward rates.

What cryptocurrency should I buy?

Asking which cryptocurrency to buy is the equivalent to asking which stock will increase the most. Financial markets are unpredictable as they are driven by emotions: greed, fear, hope, etc. Like any investment: greater risk brings greater rewards. To better understand the risk involved in cryptocurrencies, it is helpful to break them down into three categories :

Low Risk - Stable Coins : These are cryptocurrencies that provide stability by being backed by by a reserved asset. Thus, the price of stable coins never vary as it is mapped to their reserved asset. A popular example is USDC, where each USDC dollar is backed by a US dollar. One stable coin to avoid is USDT, also known as Tether, given is checkered past and the lack of proof of sufficient reserved assets. Given their price never change, stable coins are popular for liquidity pool, facilitating transaction and offering shelter in volatile markets.

Photo by Dmitry Demidko / Unsplash

Medium Risk - Bitcoin and Ethereum : These two cryptocurrencies have the largest market cap, which is the total dollar market value of all available coins. In the already volatile world of cryptocurrency, these coins are considered "safe than most", as their value have eventually always increased. However, be warned that after a market correction, it can take months or even years before the value of these currencies go back up. In addition, transactions fees in both of these currencies is astronomical, making these currencies ideal for accumulating wealth and horrible as an every-day trading currency.

High Risk - Everything Else :  With hundreds of different cryptocurrencies available on the market, it can be difficult to determine which one to buy. Given the lack of regulation in this market, many cryptocurrencies are backed solely by the reputation of those involved in the project.  This creates one of the biggest barrier to entry to cryptocurrencies, the ridiculous amount of research required to determine the potentiel of a particular project. Inadequate research can lead an investor to lose his money in a scam. However, proper research combined with a lot of luck can be valuable investment opportunity. CoinMarketCap is a good resource to start reaching some of the popular higher risk coins.

Given the volatility of cryptocurrencies, the golden rule is to never invest any money you cannot afford to lose.

In Conclusion

This might be the first article you read on cryptocurrencies, but it should not be the last. People looking to make money quickly and with no effort should stay away from cryptocurrency. However, for those willing to put in the research and the time, investing in cryptocurrencies can be very rewarding from an educational and financial point of view.