Crypto for Beginners: What is Cryptocurrency and Should I Buy It?
Note: This is a 14 minute read. If you don’t have 14 minutes to research this question, you probably shouldn’t be investing in crypto.
Over the last few weeks, I’ve had no fewer than twenty conversations with separate people asking about cryptocurrency. Understandably, most people I speak with don’t know much about cryptocurrency or the underlying technology it relies on called blockchain that makes this new industry possible, but heard a little about it and want to know more.
This article is for those wondering about how cryptocurrency works and whether to invest. It covers what crypto is from a basic technical explanation, pros and cons of investing, and best practices for due diligence and security. This article is intended to serve as merely a primer on cryptocurrency and hopefully benefits you as one of many resources you consider before making a decision.
What itch does cryptocurrency scratch?
New technologies are widely adopted when they solve meaningful problems at scale. I will use Bitcoin as an example. Bitcoin, the first cryptocurrency, is a nine-year old technology that solved a problem with global implication. The white paper for Bitcoin describes the project as a “peer to peer electronic cash system” designed to allow people to send money back and forth without needing a centralized institution, like a bank. If I use a bank to send you money, I have to rely on a trusted, third-party intermediary to make sure the money goes from my account to yours. A bank is centralized, meaning the money I am sending must pass through a central repository before you receive it.
Bitcoin, by virtue of the underlying technology that allows it to exist called the blockchain, eliminated the need for the intermediary institution. The blockchain allows what’s called a “trustless” exchange, meaning I do not need to put faith into a bank sending money to you after it leaves my account. Bitcoin allows users to make a trustless, direct exchange because it was created to incentivize people to verify each transaction on the blockchain.
These people are called Bitcoin miners, and they use specially built computers (or miners) to verify transactions on the blockchain by processing each “block,” or a group of transactions, and are rewarded for successfully doing so in the form of a fraction of a Bitcoin. Thousands of miners will verify a block, so the aggregate computing power of these miners is relied on to ensure the transaction is correct. I now sent you money and verified its arrival by relying on the miners, who in turn are rewarded for their contribution.
Because thousands of miners are verifying the transaction rather than one central repository, the network is decentralized, and is designed to intentionally not rely on a central authority. The blockchain, therefore, must be designed to defeat fraud as the bank no longer does this for you.
Blockchain is innovative because it is “computationally infeasible” to defraud it. If a hacker wants to steal my money by editing my transaction to send him the money instead of you, the hacker must edit the specific block where your transaction occurred in the blockchain. To do this, the hacker must deploy more computing power than was used by all the miners that verified the block with your transaction, which is an enormous amount of computing power, and doing so would be so expensive that the cost of changing one block would be orders of magnitude more expensive than the possible profit the hacker could have from stealing your Bitcoin, even with a large transaction. Further, the hacker must then repeat this process on every block after our transaction block in order to redo computations on later blocks to be consistent. It’s just too expensive and logistically complex to make an attack worth my effort.
Further, each transaction is stored in a public ledger, which anyone can see. Transparency is an additional measure inherent to this technology which promotes trust in the ecosystem for blockchain based exchanges of value. So, if you want to know if your money arrived, you can see where it came from, where it went, and how many times it was verified in order to confirm receipt of funds. This radical transparency is integral to decentralized technology and even extends to the way code is written and published, as almost all blockchain projects are open source.
The brilliance of the blockchain is that it solves a problem which everyone on earth can benefit from: we can now send money back and forth, anywhere in the world, nearly instantly, with low fees. This was the vision of the anonymous and elusive Satoshi Nakamoto, Bitcoin’s creator, whose true identity is unknown but can be thanked for gifting the world with his creation.
As Bitcoin grew, though, it encountered problems with scaling to millions of users. Transaction times are much longer because of high activity on the network and fees are much higher now because of the growing price of Bitcoin as it relates to the cost of transactions on the network, so other technologies are stepping in to solve these problems. Alternative coins, or “altcoins,” are attempting to fulfill the vision of Satoshi by establishing an inexpensive and nearly instant medium of electronic currency exchange. These “altcoins” are also cryptocurrencies and are competing for market share once dominated nearly entirely by Bitcoin, which is now only at 33% market dominance at the time of this writing, down from 90% at the beginning of 2017. The landscape is changing.
The change is partly because currencies are not the only use for blockchain. Ethereum is the second largest crypto right behind Bitcoin in terms of market capitalization, but is built for a different purpose. The creator, Vitalik Buterin, became frustrated that Bitcoin did not have a scripting language for application development, so he set out to build a new protocol which could not only send value over the internet, but could serve as a sort of base layer for the creation of new technologies “on-chain,” or on the blockchain, called DAPPs. A DAPP is a decentralized application built on a network like Ethereum, and many of the cryptocurrencies available now rely on Ethereum as the technical foundation for their application.
It may be helpful to think of Ethereum as the base layer for a global supercomputer which allows development of decentralized applications and exchange of value. Decentralized applications have enormous potential to disrupt many industries, but that exceeds the scope of this primer on cryptocurrency, so we can dig into that topic later.
Ok, I know how it works, but should I buy crypto?
There are basically two polar opposite schools of thought on answering this question, with lots of middle ground between them. I will try to be fair to both positions.
Should I buy crypto?
Position 1: No, cryptocurrencies are a fad and “will come to a bad ending.” This is the position of investment tycoon Warren Buffet, who is one of the leading minds in the financial world, so we should listen up. Berkshire Hathaway, of which Buffet is the CEO, does not have any holdings in cryptocurrencies and does not intend to ever enter this market in any form, even to short them.
Some investors, like Buffet, are more conservative in their investment approach and are deeply reluctant to encourage anyone to invest in a technology which they believe is sheer speculation. This is true in my experience, as an unsettling number of new crypto investors do not care about the technology but are rather looking to turn a quick profit playing the crypto markets. The cryptocurrency market is volatile and frequently fluctuates between 25% of it’s total market capitalization, meaning in one day it could go from a $800 billion market to a $600 billion market, with most coins shifting downward in value for a time. As a whole, though, the market is trending upwards, and is projected to reach a trillion dollar market cap soon. This volatility, for some, is too much, and with the stock market portfolios reporting performance at 20% in 2017 it is hard for more traditional investors to argue their clients should move money into what they believe is a speculative and volatile market.
Volatility is a concern, but so are unjustifiably high valuations. It is not uncommon for cryptocurrency projects to have very high valuations, in the billions, but are too new to offer a minimum viable product or meaningful traction. High valuations of cryptocurrencies with no product or little traction make many people nervous, not just conservative, traditional financial professionals. Worse, some coins are created with the purpose of scamming investors as there is little to no regulation from the SEC or IRS on cryptocurrencies at the moment. The fear is that over-valued companies and scam companies will have such a negative effect on the market that institutional money will rapidly pull out at some point, causing a chain effect where other institutional investors and the average Joe also execute sell orders, and a bubble will pop. Who knows when or if this will happen, but it seems to be a reasonable line of logic. The answer is we just don’t know; crypto is uncharted waters.
Others might tell you that cryptocurrency is an ineffective way of accomplishing what technologists are trying to do for environmental and technical reasons. First, the Bitcoin network is an enormous power hog, and the cost to run the network and verify transactions consumes enough power to run a country, and that’s just Bitcoin. Environmentalists have fair concerns about technologies that consume enormous amounts of energy resources and the effect they are having on a world already fraught with serious climate challenges.
Others are disbelievers from a technical standpoint, and maintain that blockchain based solutions are often not solving problems that require the blockchain to solve, but could be accomplished through other means that don’t require creation of a token or ecosystem specific to that technology.
Position 2: Cryptocurrency is the future and there is no stopping advancement of blockchain based technologies as serious contenders to global financial and economic systems. Bitcoin already made a tremendous impact in financial markets, growing to a quarter trillion dollar market cap at the time of this writing. Cryptocurrency is programmable money: faster, more efficient, less expensive, and more secure than fiat money. This innovation simply cannot be ignored any longer.
Supporters of blockchain based technologies can be heard saying things like “blockchain is the airplane of our time” and “Web 3.0 will be built using the blockchain.” The idea is that blockchain is so revolutionary and disruptive it will change the internet as we know it forever, and with it major changes to every industry that relies on the internet for fast, private, and secure transactions at a global scale. A new internet is being built right before our eyes, and the technologies emerging now are the pioneers in a new infrastructure which will replace the old system.
So, imagine what that would look like. If these technologies are going to accomplish what they claim to be doing, are the high valuations justifiable? If a company like Request Network can create a decentralized payment system like Paypal with real time tax accounting, what’s that worth to global ecommerce? Or if Ethereum and its Chinese counter-part, NEO, can create the technological environment for digital identities that allow us to establish we own property using digital ledgers, how big is the market disruption from those technologies and others like them? How valuable is Sia’s decentralized cloud storage at scale? It could be enormous, so the less risk-averse are getting in early. Maybe these high valuations are what the future of the internet looks like if its crowd-financed from all over the world.
That’s another thing, cryptocurrency is unique from historical technology investment opportunities because anyone can get in early. You don’t have to be an accredited investor with a high net worth and contacts in Silicon Valley to invest in cryptocurrency. Emerging technologies during Web 2.0 were financed by the elite; cryptocurrency and the associated technologies are building the next generation of the internet and with it opportunity is available to the masses.
The floodgates are open and average people, with average incomes, are able contribute to the future of the internet and be rewarded for it. Sure, there are degrees of speculation involved, but with 100x returns possible, how can you afford NOT to be in cryptocurrency? If you missed out on Amazon or Apple stock, you know what I mean. This argument is compelling, in part because the internet is due for an overhaul for privacy, efficiency, and shifting of power away from centralized institutions toward The People, and in part because this disruption brings unprecedented egalitarian financial opportunity.
Finally, the narrative that “this is a bubble and it is going to pop” has been repeated ad nauseum since Bitcoin was just a few dollars. Some of the more skeptical believe this narrative is driven by the banks PR machines because the banks are threatened by blockchain’s disruptive capabilities. Maybe so.
It can’t be denied something unique in the digital world was created.
There are many other reasons crypto detractors and supporters have for their position toward the market, but these capture some of the major sentiments you might see floating around the internet. Think about these two positions as a spectrum, and some can fall at different points along this spectrum, with extreme aversion on one end and radical pro-crypto supporters at the other, with various levels of caution and political ideologies mixed in between.
Okay, maybe this is interesting. How do I buy crypto?
You have options for how you want to buy crypto, and like stocks, some are lower risk than others. Only you can make the decision as to how you want to invest and at what risk tolerance, so to be knowledgeable about these decisions you have to conduct some due diligence. There’s few passive management options for crypto at this point where you can give some money to a broker and they invest for you, so you have to ride the learning curve.
First, you need to choose a coin. If you don’t want to research this much, there are some blue chip coins that are not going anywhere anytime soon at least, so check out the first few at the top of Coin Market Cap. Regardless of which coin you choose, you need to understand the technology behind it.
There are a few important questions you can ask which I personally find helpful. I only know to ask these because some of these questions were asked to me and my co-founder by the YCombinator partners when we interviewed (YC W15 represent!), so these are the questions the pros ask when deciding whether to invest in a new technology. With just the knowledge obtained from these answers, you can fairly quickly and responsibly decide which technologies are worth your time and money.
You might ask:
• Who is the team and why are they best prepared to build this technology?
• What does the white paper say? Is it written clearly, concisely, and provides a clear road map for development? (A white paper is a paper that every coin should have which explains the most important elements of its development and purpose.)
• How well is the team executing on their road map in a timely fashion?
• What traction does the product have? How many users? What is their growth metric?
•Do they have a minimum viable product?
• How big is the problem they are trying to solve? What’s the global market in billions?
• What is the market cap of this coin and possibility for growth?
•Where does this coin fit into my risk tolerance?
•Does competition exist? (Competition is good because it validates the startup’s hypothesis.)
Ok, you found a coin you like and looks promising after due diligence. So how much do you invest in it? The rule is that you should never invest more than you are willing to lose. This is true for any investment, but definitely important to consider when putting money into uncharted territory. Crypto is the wild west right now, so while there is gold in them hills, there is also uncertainty.
If you want to just put money into some of the major coins with good track records like Bitcoin, Ethereum, Litecoin, or Bitcoin Cash, Coinbase is a great place to start. If you want to venture deeper into altcoins, Binance is an excellent exchange.
Once you buy, please don’t forget that crypto markets are volatile. Those who invest with patience and a steady hand will be rewarded. You will see significant drops in the value of a coin you buy at some point and the worst thing you can do is panic sell, because there is always a rebound. The crypto market fluctuates in cycles and it can be uncomfortable or terrifying the first time you see a downward spike, but remember it is momentary. As a whole, the market is trending upward and to the right, so when in doubt, zoom out, and monitor the trend rather than daily performance.
Also, day trading is tempting, and you might read stories about guys killing it on day trading, but that’s generally a very bad idea and unless you have some serious financial skills you should avoid doing this because you’re going to hemorrhage money.
Don’t get lazy on security — you are your own bank
Remember how I wrote there is no intermediary between you and the recipient of your transaction? Traditionally, the intermediary also played the role of securing those funds, but now that role is abolished in the decentralized future, so you are your own bank in Cryptoland. You alone are responsible for storing and securing your cryptocurrency, so you need to pay attention to security best practices.
Here are some of my recommendations:
• Enable 2 factor authentication on your email account you use for signing up for exchanges where you buy your crypto. This is an option in the security settings.
• Enable 2 factor authentication on your exchange accounts. This is an option in the security settings.
• Once you purchase a crypto, transfer the coins you want to hold to an offline wallet, i.e., not on the exchanges, because exchanges can be hacked.
• Do not not not not not give anyone your private key for any reason, ever. There is no reason to give anyone this. Only you know this. If you give someone this key, its equivalent to giving them access to your bank account.
• Send test transfers when you transfer any amount to any address. Before executing the full transfer, send a nominal amount of crypto to the intended address first, then once you see it deposited send the remaining amount. Human error and problems with the blockchain can happen, so always send a test transaction first. Example: If you are sending 10 Ethereum to an address, send .1 Ethereum first to make sure it arrives.
• Create an offline wallet and back it up on USB drives, then store them in a safe in waterproof containers.
•When you go to an exchange to buy coins, make sure you typed the URL in correctly and there is a little “lock” symbol next to the URL in your browser. Hackers will go as far as to replicate an entire exchange’s interface and give it a domain name one letter off from the exchange’s URL in order to fool people into giving them their login credentials or private keys.
The best teacher is experience
These are the basics. If you want to know more about crypto, the best way to learn is to take some play money and get started. Most coins have a subreddit, Slack, Telegram, and website, so there are many resources available for doing your due diligence and lots of people you can ask more questions to in the coin’s community.
I don’t work in tech anymore, but it’s a unique moment right now. While politicians are abolishing net neutrality, technologists are building a decentralized internet for everyone through cryptography, and this future is being financed by The People. Only time will tell which technologies come out on top, but right now all boats are rising.