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What Is Cryptocurrency And How Does It Work?

| 20th September 2021

This information is not meant to provide investment or financial advice as Howlader & Co are not investment professionals. The digital currency market may experience a high degree of volatility. Clients should be aware of the risks associated with cryptoassets and consult with an investment and/or legal professional before any investment is made. Howlader & Co cannot guarantee future financial performance.

More than a decade since the emergence of Bitcoin in the distant corners of the net, cryptocurrency has undoubtedly arrived in the mainstream.

Once touted by some to be a mere flash in the pan, 2021 has seen bitcoin become legal tender in El Salvador (albeit alongside some controversy), while major investment firms such as Ruffer have made significant, and profitable, forays into crypto.

Though increasingly ubiquitous – 2.3 million Brits were holding cryptocurrency in June of this year – many people are still unsure and unclear about this exponential trend.

Unsurprisingly, several of our clients have been coming to us to see how these investments might affect them from a tax and accounting perspective.

In this blog we answer two questions: what is cryptocurrency and how does cryptocurrency work?

What is cryptocurrency?

As the best-known cryptocurrency, Bitcoin is sometimes mistakenly considered synonymous with the term.

In fact, Bitcoin is simply one of thousands of cryptocurrencies.

A cryptocurrency is a fully digital, exchangeable currency. The ‘crypto’ element of the name refers to cryptography – the algorithms behind the currency ensuring its validity.

A third party, the blockchain (more on that shortly), ensures the security and verification of all transactions. It also is used for the creation of the cryptocurrency through “mining”.

Cryptocurrencies’ value derives from their scarcity, and hinges on supply and demand – as does a traditional fiat currency, which is usually regulated by a government or central bank. Note that there is a limit of 21 million bitcoins and 89% of these have already been generated.

Their cost of production can also impact their value with the “mining” process being resource intensive.

Perhaps the most crucial differentiator between crypto and FIAT currencies is cryptocurrency is decentralised. There is no central government or bank regulation, management, or control. All transactions are peer-to-peer via the blockchain.

What is the blockchain?

Blockchain technology is what underpins cryptocurrency.

A cryptocurrency blockchain is often compared to a ledger. Every transaction using the cryptocurrency is recorded on the ledger.

What makes this so effective is that no one person or organisation holds this ledger. Indeed, a blockchain consists of thousands of computers across the globe which continually validate and verify the transactions using their shared computing power.

Fraud, duplication, or other issues become practically impossible.

Data added to the blockchain is referred to as a block. When a new block is added, all preceding blocks are rendered unchangeable. As the blockchain grows, it becomes more and more secure.

Blockchain technology is a serious disrupting force in the financial sector. Fast, 24/7 365-days-a-year transactions with an internet connection the only requirement – advocates see this as the democratisation of money.

We’re still at a relatively early stage in its uptake, but it’s interesting to see blockchain tech being used in non-financial settings, such as in healthcare.

How do you get cryptocurrency?

Most users buy cryptocurrency via an online exchange.

There are numerous of these exchanges available. Some may be more user-friendly, while others allow greater anonymity, requiring no personal information.

Decentralised and autonomous, once you have registered with an exchange and connected a payment method, purchasing crypto is quick and straightforward.

You can store your crypto in the exchange, or you may prefer to move it to your own digital wallet. Those with particularly large crypto investments may opt for an offline digital wallet such as an external hard drive.

We can’t stress enough the importance of knowing your passwords (and, if storing offline, ensuring the safety of your wallet). A result of its decentralised nature, you – and only you – can access your wallet.

In its early days, some saw mining as a way of getting cryptocurrency.

If you have a computer and can get online, you can mine crypto. However, the mining process involves the solving of immensely complex mathematical puzzles and often requires such vast amounts of computer power and electricity that it has become increasingly dominated by specialist mining companies.

That being said, there are still ways to mine cryptocurrency as an individual; For example, Norton antivirus has added a crypto feature to allow users to mine Ethereum

What can cryptocurrency be used for?

There are multiple uses of cryptocurrencies – with new opportunities to spend and exchange tokens occurring regularly.

Some choose to operate in the crypto space in a similar manner to forex traders – buying and selling currencies and riding the peaks and troughs of the market.

It’s an immensely volatile market, and not for the faint of heart. However, with Bitcoin up from around $10k USD a year ago to almost $50k USD, the motivation behind trading and investment in cryptocurrency is evident.

Another way of investing cryptocurrency and seeing returns is through staking. Cryptocurrency holders can lend their assets to a decentralised project with the intention of seeing a return. An example of this is the Bumper project, seeking investment into their liquidity pool while touting huge ROI.

Cryptocurrencies are increasingly accepted for purchase of goods and services, both online and physically. And we’re not talking about shady operations, with the likes of Whole Foods, Amazon and Microsoft all taking Bitcoin payments.

What are the arguments against cryptocurrency?

While some consider the volatility of cryptocurrency to be its greatest strength (in that it can present lucrative investment opportunities), others have been badly stung by the market. 

With the likes of Elon Musk causing a slump in the Bitcoin market with a mere tweet, no one should invest without prior consideration of the risk involved.

Since investing in cryptocurrency is hugely accessible, many users have jumped into the market without carrying out the due diligence necessary or having the financial security to make such behaviour advisable.

The environmental impact of cryptocurrency mining has been widely criticised but has also been a focus for innovation; we’d expect to see the crypto carbon footprint being reduced going forward.

What is cryptocurrency and how does cryptocurrency work?

We hope this blog demonstrates that cryptocurrency doesn’t have to be a mysterious entity.

However, we have purposely kept our discussion of what cryptocurrency is and how it works to the basics.

There are numerous specialist cryptocurrency publications online which provide greater detail around crypto and blockchain tech, which should be a starting point for anyone considering venturing into the space.

It goes without saying that we will be monitoring developments in the cryptocurrency world. If you require a bitcoin or cryptocurrency accountant or if you’d like to chat further on this subject, do get in touch.