Bitcoin, Litecoin, Ethereum, Ripple and ZCash. You’ve probably heard the names before and wondered what they are.
They’re virtual currencies, sometimes referred to as cryptocurrencies, and they’ve suddenly become a hot market with investors.
Earlier this week, the price of a single bitcoin, the cryptocurrency invented by a mysterious software programmer named Satoshi Nakamoto in 2009, soared to a record high of nearly $11,000. In fact, the value of bitcoin has risen 10-fold in the course of the last year.
But what is a cryptocurrency and why have they become so valuable?
It turns out there are about 800 cryptocurrencies, and investors have poured over $120 billion into them in the past few years, according to a recent report from investment bank Goldman Sachs.
In fact, in the last two months alone, cryptocurrencies and the entities that create them have reeled in more money than more traditional Internet startups, through a process called an Initial Coin Offering, or ICO. These are essentially public fundraising events for digital currencies, similar to initial public offerings, or IPOs.
How does it work?
Cryptocurrency is a purely digital currency, which means it’s a form of money that exists exclusively online. As its name suggests, it also relies on a technology called encryption, which encodes information about how the currency is used in transactions, to keep it secure. And just like cash, cryptocurrency can be used for payment, or as an investment.
Here’s where it gets complicated. Cryptocurrencies are created using something called blockchain, or distributed ledger, software. That means the code produces an encrypted record of the value of each virtual coin and the transactions it’s involved in, distributing that record across numerous networks on the Internet. Distributed ledger is different from the way your bank keeps track of your dollars, in a centralized database that only it controls, cryptocurrency experts says.
Theoretically, “everyone on the Internet can access and store a copy [of a cryptocoin] with the history of all transactions that have ever happened,” says Niksa Orlic, a virtual currency expert and the chief executive officer of Geolux, a consultancy that provides hardware and software development services, based in Samobor, Croatia.
The distributed aspect of cryptocurrency potentially makes it more secure against hackers than the cash in your bank account, Orlic says, because hackers would have to break into millions of computers to steal a particular cryptocurrency, rather than one centralized network.
Cryptocurrency is also controversial, and law enforcement officials have often had concerns about its potential use in illegal activity, including the online bazaar Silk Road, which was shut down in 2013 for narcotics trafficking, funded with bitcoin.
Where do you find it?
There are two ways to obtain cryptocurrency. One is by purchasing it on a trading exchange such as Coinbase, Gemini, CEX.io or Bittrex. At these exchanges, you can buy various digital currencies using either your bank account or a credit card.
The other way is through a process called mining. This is a complex and labor-intensive procedure that involves using computers that have large amounts of processing power, to create new units of a cryptocurrency using algorithms, or complicated mathematical formulas.
Miners essentially help track and update the networks containing distributed ledgers. You can think of it as payment in kind for taking care of the network. For example, successful Bitcoin miners get 12.5 bitcoin for each successful new block they help add to Bitcoin’s distributed ledger network, Orlic says.
Here’s something else to keep in mind: most cryptocurrency networks limit the number of units of cryptocurrency that can be in circulation. For example, the bitcoin network will stop producing bitcoin once there are 21 million in circulation. The limits help to ensure that the virtual currency has value, experts say.
How do you use cryptocurrency?
Unfortunately, you can’t store cryptocurrency in a standard bank account yet–although some banks appear to be working on it. Once you have your digital currency, you need to set up a digital desktop wallet or purchase a hardware wallet for added security. A wallet will allow you to store the currency, and use it in transactions.
While the list of merchants who take bitcoin for payment is still small, it’s ever-growing and includes big names like Dell, Microsoft and Expedia who accept it through various bitcoin trading partners.
What are the risks?
Cryptocurrencies have experienced an enormous run up in value over the past few months. The increases have been driven by venture capital and private equity investment money flooding into the virtual currency market, says Joshua Rosenblatt, a partner at law firm Frost Brown Todd, in Nashville, Tennessee, and an expert in digital payments.
“Investors have been seeking these outsized returns,” Rosenblatt says.
While cryptocurrency has been fertile territory for experienced hedge fund and venture capital investors, the average investor needs to exercise caution, financial experts say.
Cryptocurrencies can be extremely volatile, which means their values can be subject to big swings up and down. In late 2014, for example, bitcoin traded at close to a $1,000 a coin. Just five months later, in the spring of 2015, it’s value had fallen by nearly half.
One reason for the wild fluctuations, says Douglas Feldman, founder of ZAF Capital, in New York, is that it’s still early days, and the number of people using cryptocurrency is still relatively small. “If [cryptocurrency] usage was widely accepted, the values wouldn’t fluctuate meaningfully,” Feldman says.
For more information on the risks associated with cryptocurrencies and ICOs, the Securities and Exchange Commission (SEC), which sets regulations pertaining to market investments, has published some guidelines, which you can find here.
Key Takeaways: A cryptocurrency is a highly encrypted virtual currency that can be used to buy and sell goods and services, or as an investment vehicle. Banks won’t let you store it, so you have to set up a special digital wallet if you want to own it. Cryptocurrency is highly volatile, and can be subject to big swings in value. It’s still early days for cryptocurrency, but there’s plenty of interest in it, from big and small investors alike.