What is Cryptocurrency?

A version of this article was published by RBC Global Asset Management on Feb. 3, 2021.

Cryptocurrencies – in particular, Bitcoin – have captured the attention of investors lately. Strong performance in late 2020 and early 2021 has fueled the frenzy. Yet, amid the excitement, many struggle to understand the complexity and nuance of the space. Let's explore.

What is cryptocurrency?

There are few similarities between cryptocurrencies and traditional currencies (such as dollars or euros). You can use both to purchase goods and services. However, that's pretty much where the resemblance ends. For example:

• Unlike dollars, you can't hold cryptocurrencies in your hand. They are completely electronic.
• They're global.
• Transactions are largely anonymous, although everything is tracked and records kept in vast databases.

How does all this work? As an example, let's take a deeper dive into Bitcoin. It was the first and is now the largest cryptocurrency in the world.

A 2008 white paper laid out the plans for Bitcoin. The currency was designed to support a platform where individuals could securely hold, send, and receive items of value digitally – without the need for a trusted intermediary like a bank. The solution lay in the creation of a distributed, decentralized database to help manage and authenticate transactions. This is called a blockchain.

What's blockchain technology and how does it support Bitcoin and other cryptocurrencies?

If you're a visual learner, imagine a physical chain where every link is a group of transactions (or block). As transactions occur, they're timestamped and then added to the chain in a new link.

On the surface, the concept of the blockchain is simple. However, the true ingenuity of the system rests in its use of a decentralized network. Bitcoin uses a network of thousands of computers to host its blockchain. Unlike most databases, these computers are not all under one roof. Also, each computer or group of computers is operated by different parties. Called “Bitcoin miners,” they verify every transaction in the blockchain. Bitcoin maintains the integrity of its network by providing economic incentives for its miners to behave honestly.

While more details are beyond the scope of this article, the important takeaway is that it works. Since Bitcoin's blockchain was launched over 10 years ago, it's been operating securely, with nearly 100% uptime. What's more, the Bitcoin blockchain has never been hacked and regularly processes more than $2 billion in daily transactions. All without a central, organizing figure.

How has Bitcoin performed?

Now that we've covered off some of the basics of cryptocurrencies, let's turn our attention to the price movements Bitcoin has seen over the years.

The investment characteristics of Bitcoin are best captured by two features:

1. High returns. The price of Bitcoin has risen in eight of the past 10 calendar years, posting triple digit or greater returns in six of those years. Though current price levels diminish the movements outlined in the chart above, Bitcoin's impressive track record is highlighted by a 5,428% gain in 2013.

2. High volatility. Achieving these high returns has not been easy. The price of Bitcoin has experienced six different peak-to-trough declines of more than 70%. What's more, high levels of volatility are often seen from day to day. Most recently, in January 2021 the price of Bitcoin fell in excess of 25% in just 32 hours.

These same characteristics have raised questions over Bitcoin's suitability as a currency for day-to-day purchases. There's the infamous story of a developer who paid 10,000 Bitcoins for someone to deliver two pizzas to him in 2010. Based on Bitcoins valuation at the time, those pizzas cost a reasonable $30. However, given Bitcoin's current price, those 10,000 Bitcoins would be worth approximately US$350-million today. Pretty expensive pizza!

Certainly, stories like this will give individuals reason for pause before making day-to-day purchases with Bitcoin.

However, an alternate use case has emerged for Bitcoin as a form of “digital gold.” This is supported by several factors apart from its high returns:

• Scarcity and value. Bitcoin was designed to have a set number of coins – 21 million. It will reach this level through ongoing minting by 2140. Also like gold, Bitcoin is a widely trusted and sought after asset.
• Liquidity and ease of verifying ownership. With proper custodial practices, anyone can prove they own Bitcoin and sell it at any time.
• Low correlation with other asset classes. The Bitcoin market is largely driven by factors that have little-to-no impact on traditional asset classes. This includes changes in how widely it is traded and regulatory developments. For investors, this is desirable in the same way that a low correlation between stocks and bonds helps reduce volatility in an investment portfolio. However, extremely high volatility leaves questions over how well Bitcoin can deliver on this benefit of diversification.

What do investors need to consider before they enter the space?

If you are contemplating an investment in cryptocurrency, it's important to remain mindful of:

• Investor behaviour. High levels of volatility have been associated with cryptocurrencies since their inception. This is not likely to change anytime soon.
• Custodial challenges. While the Bitcoin database is very secure, the history of crypto is plagued with stories of fraudulent entities stealing funds and major exchanges being hacked. This has led to significant losses for investors with little recourse, as owners are anonymous by design. Ownership is established through a private key or password. If that key is lost or stolen, the associated crypto is also lost. This underscores the importance of working with best-in-class partners to avoid potential fraud.
• Trade execution. The venues that cryptocurrencies trade on are not as regulated or mature as the exchanges on which other financial assets trade. As a result, there is a potential risk of market manipulation. This may be difficult to monitor and correct under current rules.
• Regulations. The regulatory environment for cryptocurrencies is constantly evolving. Enhancements –particularly related to anti-money laundering – are required to bring crypto regulations closer in line with that of other assets. These changes could impact the ease of trading and the price of certain cryptocurrencies. In addition, there have been some attempts from government agencies to regulate and monitor the flow of cryptocurrencies. However, their anonymity and global portability may make added regulation difficult.
• Numerous options. Though crypto headlines tend to be dominated by Bitcoin, there are over 6,000 cryptocurrencies in the world today. Each one relies on the breakthroughs made by Bitcoin's blockchain network. However, they are individually optimized for different uses. The list includes Ethereum which offers added functionality through the use of smart contracts, and Ripple which offers increased capacity by running its blockchain on a more centralized network.

In conclusion

Despite the progress and growth we've seen in recent years, it's still relatively early days for cryptocurrency and blockchain. While the future is not clear, it's becoming increasingly apparent that the underlying technology offers many benefits. In fact, many large public companies are exploring uses for blockchain technology. These innovations may offer investors another way to participate in the cryptocurrency arena.