78% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.

What are cryptocurrencies?

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A cryptocurrency is a type of digital money created from code. They function autonomously, outside of traditional banking and government systems.

Cryptocurrencies use cryptography to secure transactions and regulate the creation of additional units. Bitcoin, the original and by far most well-known cryptocurrency, was launched in January 2009. Today there are over 1,000 cryptocurrencies available online.

Cryptocurrencies differ significantly from traditional fiat currencies. Nonetheless, you can still buy and sell them like any other asset. You can now also trade on the price movements of various cryptocurrencies via CFDs and spread betting

Cryptocurrencies fall under the banner of digital currencies, alternative currencies and virtual currencies. They were initially designed to provide an alternative payment method for online transactions. However, cryptocurrencies have not yet been widely accepted by businesses and consumers, and they are currently too volatile to be suitable as methods of payment. As a decentralised currency, it was developed to be free from government oversite or influence, and the cryptocurrency economy is instead monitored by peer-to-peer internet protocol. The individual units that make up a cryptocurrency are encrypted strings of data that have been encoded to represent one unit.

Bitcoin is credited with being the first decentralised cryptocurrency. Like all cryptocurrencies, it’s controlled through a blockchain transaction database, which functions as a distributed public ledger. Bitcoin was created by Satoshi Nakamoto – whether the name refers to an individual or a group is unknown. 

A feature of most cryptocurrencies is that they have been designed to slowly reduce production. Consequently, only a limited number of units of the currency will ever be in circulation. This mirrors commodities such as gold and other precious metals. For example, the number of bitcoins is not expected to exceed 21 million. Cryptocurrencies such as ethereum, on the other hand, work slightly differently. Issuance is capped at 18 million ethereum tokens per year, which equals 25% of the initial supply. Limiting the number of bitcoins provides ‘scarcity’, which in turn gives it value. Some claim that bitcoin’s creator actually modelled the cryptocurrency on precious metals. As a result, mining becomes more difficult over time, as the mining reward gets halved every few years until it reaches zero.       

Key features of cryptocurrencies

There are a number of key principles that govern cryptocurrency use, exchange and transactions.

Cryptography

Cryptocurrencies use advanced cryptography in a number of ways. Cryptography evolved out of the need for secure communication methods in the second world war, in order to convert easily-readable information into encrypted code. Modern cryptography has come a long way since then, and in today’s digital world it’s based primarily on computer science and mathematical theory. It also draws from communication science, physics and electrical engineering. 

Two main elements of cryptography apply to cryptocurrencies – hashing and digital signatures:

  • Hashing verifies data integrity, maintains the structure of the blockchain and encodes people’s account addresses and transactions. It also generates the cryptographic puzzles that make block mining possible.
  • Digital signatures allow an individual to prove that they own a piece of encrypted information without revealing that information. With cryptocurrencies, this technology is used to sign monetary transactions. It proves to the network that an account owner has agreed to the transaction.

Blockchain technology

A blockchain is the decentralised, public ledger or list of a cryptocurrency’s transactions. Completed blocks, comprised of the latest transactions, are recorded and added to the blockchain. They are stored in chronological order as an open, permanent and verifiable record. A peer-to-peer network of market participants manage blockchains, and they follow a set protocol for validating new blocks. Each ‘node’ or computer connected to the network automatically downloads a copy of the blockchain. This allows everyone to track transactions without the need for central record keeping. 

Blockchain technology creates a record that can’t be changed without the agreement of the rest of the network. The blockchain concept is attributed to bitcoin’s founder, Satoshi Nakamoto. This concept has been the inspiration for other applications beyond digital cash and currency.   

Block mining

Block mining is the process of attaching new transaction records as blocks to the blockchain. In the process – using bitcoin as an example – new bitcoins get produced, adding to the total number of coins in circulation. Mining requires a specific piece of software that is used to solve mathematical puzzles, and this validates the legitimate transactions which make up blocks. These blocks get added to the public ledger (blockchain) about every 10 minutes. As the software solves transactions the miner is rewarded with a set amount of bitcoins. The faster a miner’s hardware can process the mathematical problem, the more likely it is to validate a transaction and earn the bitcoin reward.       

The main cryptocurrencies

Bitcoin

Bitcoin is credited as the original and most well-known cryptocurrency. Satoshi Nakamoto, a person or group of people under the name, created it in 2009. Arguably, its characteristics more closely resemble commodities rather than conventional currencies. This is reflected in that fact that it is now used more as a form of investment than a method of payment. As of June 2018, there were around 17 million bitcoins in circulation (there may be a finite number of 21 million available). Traders can either purchase bitcoin through an exchange, or speculate on its prices movements via CFDs and spread betting. Learn more about bitcoin

Ethereum

Ethereum is relatively new in the cryptocurrency world, having launched in 2015. It operates in a similar way to the bitcoin network, allowing people to send and receive tokens representing value via an open network. The tokens are called ether, and this is what is used as payment on the network. Ethereum’s primary use, however, is to operate as smart contracts rather than as a form of payment. Smart contracts are scripts of code which can be deployed in the ethereum blockchain. The limit on ether also works slightly differently to bitcoin. Issuance is capped at 18 million ether per year which equals 25% of the initial supply. So, while the absolute issuance is fixed, relative inflation decreases every year. Learn more about ethereum

Litecoin 

Litecoin is one of several clone cryptocurrencies produced from bitcoin. In late 2011 it 'forked' off the bitcoin ledger. Charlie Lee, the creator of Litecoin, intended it to be a faster version of bitcoin, with quicker individual transaction times. He also increased the maximum number of coins available to be mined. Litecoin’s total is 84 million compared to bitcoin’s 21 million.

Ripple

Like bitcoin, ripple is a digital currency based on mathematical formulae, and has a limited number of units available to be mined. Created in 2012, it is both a payment network (RippleNet) and a cryptocurrency (Ripple XPR). The network is designed to allow the easy transfer of any form of currency, including pounds, euros, dollars and bitcoin. It acts as a payment method for financial institutions, and can also be traded, but was never intended to be used to buy or sell things.

 Zcash

Created in late 2016, Zcash claims to provide extra security or privacy. It allows private transactions (and generally private data) in a public blockchain. Users are offered the choice of 'shielded' transaction, or a proof of construction called a zk-SNARK. Like bitcoin, the Zcash total coin supply is 21 million. 

Please note that we only offer bitcoin and ethereum spread bets and CFDs on our platform.

Summary

Bitcoin and other cryptocurrencies can best be described as potential currencies. As noted above, they are not widely accepted today as a medium of exchange. They have significant limitations holding them back from developing into fully-fledged currencies. There are also questions around whether cryptocurrencies are just part of a financial bubble. But it’s possible, though unlikely, that they could become more widely used in the future as a medium of exchange. The potential uses of the blockchain technology behind cryptocurrencies is also a matter of interest. It’s possible that this technology will be adopted for other purposes, including legal transactions, security programs and voting systems. 

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 78% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.