What a cryptocurrency is
A cryptocurrency is an entry in a ledger kept jointly by many computers, with no bank or authority in between. Unlike a share, there's no company behind it that makes profits.
Learning objective: After this lesson you can explain how a cryptocurrency fundamentally differs from a share.
When you transfer money, your bank records who owns what. With a cryptocurrency, thousands of computers around the world keep the same ledger together, and none of them can change it alone.
The actual invention
That was the real invention: people can agree who owns something without having to trust a bank. Whether that's useful in everyday life is another question.
The difference from a stock
The most important difference from a share: behind a share there's a company that bakes bread or sells software and makes a profit from it. There's nothing like that behind a coin. Its price depends entirely on what others are willing to pay for it.
Hard to value
That doesn't make a coin worthless, but it makes it hard to value. With a share you can ask whether the price fits the profit. With a coin there's no profit to measure the price against. That's why crypto swings so much more. Bitcoin has fallen more than 70 percent several times in its history, and many smaller coins more than 90 percent. So only put in as much as you could lose entirely.
Technically a cryptocurrency is a distributed ledger. Transfers are collected in blocks, and the blocks are chained together using cryptography. This solves an old problem of digital money. You can copy a file as often as you like, but money mustn't be spendable twice. Until then that needed a central authority to check. With cryptocurrencies the network agrees by itself, either through proof of work, where a new block costs a lot of computing effort, or through proof of stake, where deposited money serves as a pledge.
Valuation without cash flows
What's missing for valuation is what shares and bonds have: future payments to the owner. As a substitute, investors look at how scarce a coin is, how many people use it or what it costs to produce. None of these gives a reliable upper or lower limit. The high volatility follows directly. Where there's no yardstick for value, there's no price level the market reliably returns to.
Very different things
Very different things go by the name crypto. There are cryptocurrencies in the narrow sense such as Bitcoin, platform tokens you use for something on that platform, stablecoins tied to a currency such as the dollar, and tokens with no recognizable purpose. Their risks differ a lot. With a stablecoin everything depends on whether the reserves behind it really exist and are audited. So there you mainly carry the risk that the issuer can't pay, and less the risk of swinging prices.
Summary
- The invention is a shared ledger without a central authority.
- There's no company and no profit behind a coin.
- Without a yardstick for value there's no fixed price level, hence the big swings.
- Common mistake: putting in more than you could lose entirely in the worst case.
Did you get it?
What problem does the technology behind cryptocurrencies solve?
That the same balance can't be spent twice, without a central authority having to check.
Why is a coin harder to value than a share?
Because there are no future payments to the owner from which a value could be calculated.
What risk do you mainly carry with a stablecoin?
The risk that the issuer can't pay because the reserves behind it are missing or can't be checked.
Check your understanding
Your task
You put $2,000 into a coin, and it falls 70 percent. Calculate how many dollars you have left and by how many percent the coin must then rise to get you back to $2,000. Check your math in the drawdown calculator and write down the amount you could afford to lose completely.
Sources and further reading
- The original Bitcoin whitepaper by Satoshi Nakamoto describes how the double-spending problem is solved without a trusted central authority, through a chain of cryptographic timestamps. View source ↗
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