What is a cryptocurrency? – Forbes Advisor Australia

With a track record going back over a decade, cryptocurrencies are clearly more than just a fad, but they remain widely misunderstood by many people, with doubts persisting about their genuine value, practical use and long-term application.

There is also considerable concern with regards to their volatile nature and potential for exploitation. According to data from Scamwatch, Australians lost $158 million to investment scams between January and May of this year, the majority of which related to cryptocurrency ‘investments’.

In the truest sense, cryptocurrencies are a digital means of exchange which use cryptography as a form of security. However, in recent times, the term ‘cryptocurrency’ has evolved as a stand-in description for, more broadly, a decentralised financial system (DeFi), a highly volatile asset class that can nose-dive or surge on the back of a Tweet, a space for bad actors to steal vulnerable investors’ identities and money, and a form of digital payment.

Mainstream investors, as well as Australia’s financial institutions, are also taking more than a passing interest in cryptocurrencies.

The Commonwealth Bank is trialling crypto trading through its banking app, ANZ recently minted $30 million of Australian stablecoins called A$DC, and National Australia Bank (NAB) is also expected to release its own stablecoin (linked to fiat currency, the Australian dollar) by the end of 2022. However, concern over the safety of cryptocurrencies as an investment class remains front and centre in the minds of financial regulators around the world. 

How are cryptocurrencies regulated?

The simple answer is that they aren’t, outside the confines of blockchain technology, which we’ll come to later.

Even more fundamentally, the current legal status of cryptocurrencies varies considerably from one country to another. While the use of cryptocurrencies is unfettered within the European Union, specific countries, such as Turkey, have banned the payments made in cryptocurrencies.

In Australia, cryptocurrency is legal but largely unregulated. Many crypto-assets and other digital assets are commonly not considered to be financial products so the platforms where you buy and sell crypto may not be regulated by the corporate regulator, the Australian Securities and Investment Commission (ASIC).  

The Australian Prudential Regulation Authority (APRA), which regulates the financial services industry, has plans for a policy roadmap for financial entities engaging in crypto activity. A draft standard is expected in late 2022. However, APRA has been keen to point out that it will not strangle innovation, with chairman Wayne Byres stating in a speech reported by The Australian Financial Review newspaper: “Much like our approach to climate risk, its underlying message is primarily one of ‘by all means innovate, but proceed with care and in full knowledge of the risks.”

Australia’s Board of Taxation is also developing a policy framework for the taxation of transactions and assets involving cryptocurrency.

Consumer group, CHOICE, meanwhile, continues to rally for better protections for consumers, some of whom have lost vast sums in crypto scams or through market volatility. 

“As it stands, enforceable protections in the unregulated cryptocurrency market are somewhere between negligible and non-existent,” CHOICE states.

“In a submission to the federal government, CHOICE is calling for a regulatory regime to help put an end to consumer harm.”

How do cryptocurrencies operate?

Most cryptocurrencies operate without the backing of an authority, such as a central bank or government. This fundamentally differentiates them from traditional currencies, such as the US or Australian dollar.

Instead of governmental guarantees, the way cryptocurrencies work is underpinned by something called blockchain technology (see below).

Rather than existing as a physical stack of notes or coins, cryptocurrencies are confined to the internet. Think of them as virtual tokens, whose value is determined by market forces generated by the people who want to buy or sell them.

Nowadays, an estimated five thousand cryptocurrencies exist. Bitcoin is far and away the largest, followed by the likes of Ethereum and Tether. The market capitalisation of a cryptocurrency equates to the unit price of a currency, multiplied by the number of units in existence. Even after the crypto meltdown in May of 2022, the market was still valued at about $US910 billion.

Cryptocurrencies can be bought with traditional cash such as Australian dollars and can then be used themselves to buy an expanding array of day-to-day goods and services. Cryptocurrencies have the same value in each country, making person-to-person transfers around the world easier, while negating the issue of exchange rates.

Only a limited number of Bitcoins actually exist – cryptocurrencies are likened to a digital form of an asset such as gold, where a perceived store of value is then subject to the laws of supply and demand.

Currently, this is the main appeal of cryptocurrencies: that they are able to be traded on exchanges similar to the way stock market investors buy and sell shares and other commodities.

What is blockchain technology?

In essence, a blockchain is a type of database. Blockchain first came to prominence as the technology that underpinned Bitcoin when the cryptocurrency was originally mooted in a paper on peer-to-peer electronic cash systems in 2008.

The paper was credited to Satoshi Nakamoto, thought to have been a pseudonym for either an individual or group of people. Part of the cryptocurrency’s design meant that there would only ever be 21 million Bitcoins created.

The blockchain is essentially a public ledger of every Bitcoin transaction that takes place. A record gets distributed across numerous computers and cannot be tampered with or changed retrospectively. According to supporters of cryptocurrencies, blockchain transactions are more secure than traditional payment mechanisms.

New units of currency such as Bitcoin are produced on the blockchain through ‘mining’, which requires huge volumes of computing power and thus uses significant amounts of energy. Environmentalists have warned that the proliferation of cryptocurrencies could have a significant impact on global attempts to reduce energy consumption.

How do you buy cryptocurrencies?

The most common places to buy Bitcoin and other cryptocurrencies are specialist exchanges. This includes a range of trading platforms and apps that allow investors to buy cryptocurrencies using either traditional currencies and/or other cryptocurrencies.

To open an account, would-be traders are typically asked to provide passport details, a phone number and an email address. The costs of trading can vary from one exchange to another. Some providers impose a flat fee per trade, while others will charge a percentage of the overall transaction amount.

How have cryptocurrencies performed?

The performance of cryptocurrencies can be notoriously volatile with roller coaster peaks and troughs. In 2013, an individual Bitcoin was worth just a few dollars. At the time of writing (July 2022) its price stood just above the $US20,000 mark — a huge increase on nine years ago, but some way off the all-time high of nearly $68,000 it achieved towards the end of 2021.

What is cryptocurrency mining?

Cryptocurrency mining refers to the process of generating crypto and verifying new coins. It is a hugely complex business, one involving reams of decentralised and global computer networks, and, as many environmentalists point out, is carbon-intensive.

In the US alone, it is estimated that Bitcoin mining creates some 40 billion pounds of carbon emissions. 

Australian appetite for cryptocurrencies

Despite the risks and lack of regulation, Australian investors have embraced cryptocurrency in recent years. A report by US crypto exchange Gemini found almost one in five (18%) of Australians bought digital currencies in 2021.

According to Gemini’s Global State of Crypto report, 43% of Australians first invested in crypto in 2021, with many citing inflation as a key reason. Furthermore, some 54% of Australians viewed cryptocurrency as a good way to diversify their assets, with 81% choosing to hold their crypto investments for the long term.

Data from trading platform eToro, reveals that more than one quarter of Australian investors aged 18-34 have at least 10% of their portfolios invested in cryptocurrency, making the asset class especially popular among Millennials.

What happens next?

Even before the pandemic upheavals of 2020, and the tumbling in crypto prices that began in November 2021, many experts have questioned their security, practical use and long-term viability. Hence the stark and repeated warnings from financial regulators and consumer groups that people should approach investments in this area with extreme caution.

If more mainstream investment houses dip their toes in the cryptocurrency waters, we may see digital assets improve in value, with their usage normalised and more widespread. How the sector will respond to mooted financial regulation in Australia is also yet to be seen.

In the uncertain times in which we live, it is also possible that the entire crypto concept may prove vulnerable or unsustainable in the face of as yet unforeseen challenges.

To paraphrase the regulators: “buyer beware”.

This article is not an endorsement of any particular cryptocurrency, broker or exchange nor does it constitute a recommendation of cryptocurrency as an investment class.