What Is Cryptocurrency, Anyway?

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Investors are always looking for the next "big thing." Throughout 2017, cryptocurrencies have been experiencing a surge in market valuations with Bitcoin and Ethereum trading above $4,000 and $300, respectively, as of August.

With the price of one Bitcoin (BTC) trading well above the price of one ounce of gold, more and more people are jumping on the cryptocurrency bandwagon: On August 8, 2011, there were only 8,638 BTC transactions. Fast forward six years, and the daily number of BTC transactions has surged to 260,955! (See also: Here's Everything You Need to Get Started With Bitcoin)

So what exactly are cryptocurrencies, and should you invest?

What is cryptocurrency?

Basically, cryptocurrency is a digital or virtual asset that uses cryptography as a security measure. Designed by somebody under the pseudonym "Satoshi Nakamoto" back in 2009, Bitcoin was the very first cryptocurrency. Today, there are over 1,050 cryptocurrencies (often referred to as "coins") with funny names, including Dogecoin, Veritaseum, Factom, and Counterparty. However, their valuations are no joke: The total market capitalization of all coins stood at $151 billion as of August 23, 2017.

Unlike currencies issued by nations, cryptocurrencies can be issued by anybody with access to the right technology. Capitalizing on this fact, tech entrepreneurs all around the world are launching coins every day with the promise that once products or services are available, the coins will be redeemable for those products and services. For example, the developers behind Siacoin provide a decentralized storage marketplace in which hosts compete for your business, and those behind Monero deliver a private and untraceable cryptocurrency. Research firm Smith & Crown reports that so far in 2017, 65 projects have raised over $520 million in coins.

Should you invest in cryptocurrency?

The upside potential of a coin is huge, but this doesn't mean that cryptos are for everybody. There are a few important details you should know before you dive in.

There is high volatility

Take for example Neo (formerly AntShares) which was trading at $1.50 per coin on June 10, 2017 and peaked at $51.94 per coin on August 13, 2017. There are very few places that you can get a 3,362 percent return in just two months. But what goes up eventually comes down and Neo traded at $31.76 on August 18, 2017. Could you stomach over a 38 percent drop in value of your investment in just four days? With big price swings on a daily basis, coins aren't for investors with low tolerance to risk.

Investing requires some tech know-how

Buying and trading cryptocurrency requires you to be comfortable using some desktop or smartphone applications. Attention to detail is critical to avoid losing your hard-earned coins. Here are some important things to note:

• Typing one wrong character in your 33- to 34-character long Bitcoin address when doing transactions could mean that your money ends up in somebody else's account.

• Sending cryptocurrency into the wrong address (say, for example, sending Ethereum Classic coins into an Ethereum wallet address) will make your cryptocurrency disappear. Most exchanges won't even help you try to recover the misplaced coins for small amounts (Bittrex sets a $5,000 minimum) and will charge you a hefty fee for the recovery.

• All exchanges recommend doing a small test amount before doing a large deposit or withdrawal.

The rules are always changing

With more and more people buying and selling cryptocurrencies, more government agencies at different levels are creating laws that affect consumers in different ways. For example, here are a few regulations that have been placed in recent years:

• In 2014, The IRS deemed a cryptocurrency as property. This means that the same general tax principles used for reporting the sale of a piece of land would apply to the sale of 10 BTC (around $42,330 at the time this article was written).

• In 2015, the New York State Department of Financial Services (NYDFS) passed the BitLicense regulatory framework, requiring Bitcoin companies serving New York residents to keep detailed records of all users in that state. Claiming concerns for user privacy, Kraken and Bitfinex decided not to serve users residing in this state.

• In mid 2017, the Hawaii Division of Financial Institutions (DFI) created regulatory policies that required exchanges to hold cash reserves equivalent to the value of cryptocurrencies held by Hawaii residents. This requirement prompted all exchanges, including Coinbase, to stop operating in Hawaii or postpone their plans to open in that state.

Transaction wait times can vary

Despite the claims that cryptos are the way of the future, it surely can feel that you're back in the stone age waiting for a Bitcoin transaction to clear. In order to verify transactions, exchanges rely on a number of confirmations from the network. Depending on the volume of transactions and other factors, the wait time can vary from a few minutes to several hours. Waiting for a purchase of $5,000 worth of Litecoin could be a nerve racking experience for a new (and even experienced) investor.

This delay in transaction time also means that you won't necessarily get the price you wanted when buying or selling your coins. On Saturday August 19, 2017, Bitcoin Cash was trading as high as $996.92. By Tuesday August 22, 2017, one coin was now trading around $582. If you had been trying to dump your coins on Tuesday, you would probably have done so at a price much different from the one you originally wanted.

There are liquidity issues

With over 1,000 cryptocurrencies to choose from, you may end up with a "winner" that performs well for some time. But as government laws or exchange rules evolve, your coin of choice may be dropped from several exchanges.

IOTA is a great example. U.S. residents could buy IOTA from Bitfinex, but on August 11, 2017 the exchange announced that it would stop accepting new U.S. customers and will discontinue services to all current ones over the next 90 days. If you held IOTA, you're now forced to seek a new exchange to trade and/or wallet to store your coins. In the very worst case scenario, you may have to liquidate your position to avoid losing your money. Just ask owners of SpaceBIT, Quebecoin, and DAO.

The bottom line: Trade cautiously

There are several individuals who are making money trading Bitcoin and other cryptocurrencies. If you had purchased $100 BTC on January 1, 2011, you would have acquired 333.33 coins at $0.30 each. By August 24, 2017, that original investment would be worth over $1.4 million!

However, make sure that you understand all the potential risks involved with these virtual currencies. Given their inherent volatility, don't bet the house on cryptocurrencies. Additionally, to have a true picture of how much money you're making with cryptocurrencies, include all applicable fees. Remember that every cryptocurrency transaction, whether it's a purchase, sale, deposit, or withdrawal has a fee from an exchange, financial institution, or both. Happy trading!

[Disclaimer: The author owns some Bitcoin and Siacoin. He received no payment from any of the cryptocurrencies or exchanges mentioned in this article.]

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