Bitcoin (BTC), Ethereum (ETH), Bitcoin Cash (BCH), Litecoin (LTC), Monero (XMR), IOTA (MIOTA) - cryptocurrencies are ubiquitous in the media. Spectacular success stories and profits running into the millions if not billions have been reported - but is it advisable to invest in the virtual money and are digital currencies a new financial instrument?
What is a cryptocurrency?
Cryptocurrency is the umbrella term for virtual currencies that can act as a digital means of payment.
No banks are required for the payment transactions. Financial institutions are replaced by a decentralized network whose participants manage transactions and generate new units of the currency. This is made possible by the blockchain technology that underlies every cryptocurrency. A blockchain "composed of "block" and "chain" is often referred to as a "collective accounting system." In blocks of data, it contains encrypted information about any transactions made with a particular cryptocurrency. It acts as a database whose blocks are not located on a central server, but on the computers of the multitude of participants it manages.
Anyone can become a participant of this decentralized network and provide computing power to continue the chain of data. This is rewarded by receiving currency units (coin" or "token) of the corresponding cryptocurrency. This process is called "mining".
Once a transaction is recorded in the blockchain, it cannot be changed by any participant. This secures it and individual currency units cannot be used more than once. For this reason, there is no longer any need for established institutions, which have always been interposed in monetary transactions up to now.
Why do cryptocurrencies exist?
The goal of the first cryptocurrency Bitcoin was simply to create a payment system that works without financial institutions to allow consumers a certain degree of informational self-determination and anonymity. As a result, Bitcoin has been used in recent years as a means of payment for illegal transactions, among other things. While this circumstance diminished the social acceptance of cryptocurrencies, the underlying technology has nevertheless since been expanded and improved. Cryptocurrencies can now be used for much more than monetary transactions, providing a secure, fast and cost-effective alternative for the transfer of sensitive data.
In one pilot project, for example, the United Nations World Food Program is using Ethereum to distribute resources to refugees. The organization issues food coupons via the blockchain and affected people can pay in refugee camps via iris scan. This way, the financial resources reach those in need directly and corruption is no longer a problem for the organization.
Facebook also wants to introduce its own digital currency, Libra, to enable global payments via Facebook, WhatsApp and Instagram. The link to a basket of currencies is intended to protect Libra from fluctuations in value. Central banks have so far been skeptical about the social media giant's plans.
What cryptocurrencies are there?
In 2009, the first and probably still the best-known cryptocurrency was created: Bitcoin (BTC). In terms of market capitalization, the crypto-first cryptocurrency still accounts for the largest share of the virtual currency market. Ethereum (ETH) and Binance Coin (BNB) follow as the second and third largest cryptocurrencies.
In total, however, there are now around 5,000 different cryptocurrencies worldwide and it feels like the number of virtual currencies is growing every day. But why are there so many different currencies in the first place?
Improved technology
First of all, the technology has been improved and developed since Bitcoin appeared. This paved the way for currency alternatives that offer many advantages over Bitcoin and have their own focuses.
For example, Litecoin is faster than Bitcoin, Ethereum can be used not only to carry out currency transactions but also to conclude contracts, so-called "smart contracts", and Ripple is to be used by banks to speed up regular transfers.
How does a cryptocurrency work as a means of payment?
Using Bitcoin, Ethereum & Co. to buy coffee and toast in the supermarket? This type of payment has not yet become widely accepted, but it is possible in principle. Using cryptocurrencies as a regular payment system is still quite problematic, as there are no fixed exchange rates and the rates fluctuate greatly. In this respect, it is often risky for retailers to accept cryptocurrencies, for example. Nevertheless, more and more online stores are offering to settle open invoice amounts with cashless digital currencies. The Coinmap page lists all stores that accept cryptocurrencies.
So far, however, the virtual currencies have mainly been stored in so-called "wallets", digital purses, and secured with private keys in the form of numeric codes.
No investor protection
The fact that cryptocurrencies are inherently beyond any regulation by states consequently means that there is no investor protection whatsoever. Be aware that no one will tell you about the risks of your trading and inform yourself in detail.
High volatility
In principle, the value of a cryptocurrency is based on trust and acceptance. However, unlike established currencies such as the euro, the dollar and the like, which are monitored and backed by central banks and states, behind a cryptocurrency is merely a technical system in which anyone can participate and for which the stability of the currency plays no role.
Between January and April 2018, all cryptocurrencies together lost about seventy percent of their market capitalization. Increasing regulatory attempts by various countries, such as South Korea, unsettled investors and made them withdraw billions from the heated crypto market. As a result, the prices of individual currencies collapsed as quickly as they had risen.
Cryptocurrencies are extremely volatile and prices can change with radical speed. So, if you really want to trade cryptocurrency, you need to invest not only capital, but also a lot of time and attention in your investment. If you can keep a cool head with daily price fluctuations in the double digits, an investment in cryptocurrencies may be an interesting speculative addition to the other investments in your portfolio.
Price Manipulation
Individuals who own a large stake in a currency could use it to manipulate prices to their advantage. In the case of cryptocurrencies, there are no laws that prohibit this, nor are there any control bodies that prevent such practices.
Exchanging cryptocurrencies for fiat money
Cryptocurrencies cannot be easily exchanged for euros or dollars because there are no stable exchange rates. In most cases, it is necessary to first exchange them into one of the larger cryptocurrencies, such as Bitcoin, and then sell them for euros. Especially with young currencies from one of the numerous new issues, this can become a problem.
Sometimes transactions take quite a long time because the blockchain is overloaded. In the time you are waiting for the transfer, the rates can fall due to the high volatility and you lose money.
On top of that, you have no choice but to rely on the exchange rates provided by the traders. These are not subject to any controls either.
Crime and theft
Since cryptocurrencies ensure anonymity, it is not necessarily possible to track who owns them. This makes them perfect prey for cyberattacks. In January 2017, arguably the biggest heist to date took place: Hackers relieved the Japanese crypto exchange Coincheck, or rather its customers, of 500 million NEM, the equivalent of about €500 million at the time.
Software error
The oldest blockchain has been around since 2009 and has been working away ever since. So far, there have been two glitches that affected the Bitcoin based on it. It is not yet possible to predict whether this could repeat itself in the future or even whether far-reaching errors could occur.