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Cryptocurrencies are the financial equivalent of the Wild West, evolving, morphing and multiplying at breakneck speed. Understandably, this can be incredibly confusing for investors.

In fact, according to a recent Pew Survey, 40% of Americans who invested or traded crypto, report knowing virtually nothing about how this asset class works.

To help untangle the ‘crypto web’, we’ll be diving into the world of cryptocurrencies, with the goal of forming a clearer picture of what this asset class is all about.

If you find this topic interesting, click here to view additional articles from my archive.

Investing in cryptocurrencies is a little different than investing in shares of a company.

Stock represents ownership of a business entity and a claim to profits the company generates. Owning a cryptocurrency represents ownership in a digital asset with $0 intrinsic value.

When a company intends to launch a new cryptocurrency (i.e., launch = list it on a crypto exchange), they usually set out all the relevant crypto details in a Whitepaper (i.e., technical, financial and commercial information about the project can be found here).

Orders on crypto exchanges work the same way as orders in the stock market.

Coinbase (NASDAQ:COIN) is one of the most popular exchanges in the U.S. Other options include Gemini (run by twins Cameron and Tyler Winklevoss, of FB fame), and newer brokers such as Robinhood (NASDAQ:HOOD) and SoFi (NASDAQ:SOFI).

Since the crypto market is global, cryptocurrencies can be traded 24 hours a day, 7 days a week.

Imagine your rich uncle just gifted you 10,000 bitcoins. How would you go about storing and accessing these coins? This is the problem Crypto Wallets aim to solve, which are like bank accounts for the storage of cryptocurrencies.

Once your cryptocurrency trade is complete, the exchange where the trade took place will hold your crypto in what is known as a custodial wallet. With custodian wallets, both you and the exchange have access to that wallet.

Instead of using custodial wallets (the default solution offered by crypto exchanges), investors can move their crypto to a non-custodial wallet, where only you, and not the exchange, hold the keys (i.e., have access).

With non-custodial wallets, your assets are backed by something called a private key. This functions as a password to your crypto wallet and you must shroud this in secrecy and never tell anyone about it.

In choosing a self-custody wallet, it pays to remember that different crypto currencies require different blockchains which in turn require different wallets. When choosing a crypto wallet, a good rule of thumb is to check which wallets are recommended by a coin’s community.

A hot wallet is any wallet that requires an internet connection to access it.

A cold wallet, also known as hardware wallets, are physical devices like USB sticks that you plug into your computer and only connect to the internet when they’re docked. This makes them more secure, albeit a little cumbersome to use.

While cold wallets are considered the absolute safest place to store your crypto (as they are entirely offline and cannot be hacked), they also pose a risk:

A common question new crypto investors often ask, is: can I buy fractional bitcoin? The answer is yes. If fact, you can buy as little as 0.00000001 BTC.

What the general public calls bitcoin, is actually comprised of subunits called Satoshi (analogous to dollars and cents):

Satoshi is actually the only thing Bitcoin’s software understands and recognizes as a unit. Bitcoin is just a human shortcut for 100 million Sitoshis.

Cryptocurrency exchanges charge fees for different types of user behavior, including trading fees, deposit/withdrawal fees, as well as interest/ borrowing and liquidation fees, and it is important for investors to be aware of these.

When comparing exchanges, trading fees can vary by more than an order of magnitude, ranging from 0.1% to more than 1%.

Even on the same exchange, depending on what service you’re using, trading fees can differ significantly (e.g., Coinbase App vs Coinbase Pro App).

Based on historical trends observed in equity markets, it is safe to assume that crypto fees are in a race to the bottom, especially as competition between exchanges heats up.

As a crypto investor, you have to be prepared for volatility (i.e., extreme price swings). Crypto, in general, is more volatile than traditional asset classes, and price swings of 10% or more in just a few hours are very common.

In fact, since 2012, Bitcoin has crashed 80% or more on three different occasions:

Heightened periods of volatility and/or moonshot gains tend to attract swing traders and momentum chasers who typically don’t stick around very long

Unlike for stocks, the median holding periods for most crypto are measured in days, with the so-called “blue-chip” cryptos typically held the longest.

As of Dec. 2, 2021, here is how 21 of the largest cryptocurrencies rank by their median holding periods:

Dollar cost averaging is a popular investment strategy where the same amount of money is invested in an asset (e.g., crypto, stocks, etc,) at regular time intervals (e.g., every month).

However, given the inherent price volatility of crypto, dollar-cost averaging can be a risky strategy for investing in this asset, especially in the short and medium terms.

For example:

Below chart shows the pattern of DCA (dollar-cost averaging) returns since bitcoin’s inception. As can be seen, the returns have been dropping with each passing year:

Instead of parting with their coins (i.e., selling them and incurring capital gains), many crypto investors choose to hold them for the long term, and when they need access to cash, they take out loans using their crypto holdings as collateral.

Coinbase, a major crypto exchange, advertises this as a major feature of their platform. They’ll lend you up to $1 million in dollars, using your crypto holdings to back up your loan.

For traditional securities, investors typically need to wait 30 days after selling shares before they can repurchase the security or they risk losing their tax deduction (i.e., capital loss deduction). This is called the ‘wash sale’ rule:

Here’s the thing though, unlike financial instruments, cryptocurrencies generally aren’t subject to the wash sale rule in the United States:

For sophisticated crypto investors, this a huge deal:

As described above,

Of course, like with any strategies, there are caveats:

The US government has taken notice of these nuances, and is actively working to close the crypto wash sale loophole (Joe Biden’s Build Back Better bill includes a provision to get rid of the wash sale loophole for crypto).

Now that we have a better idea of how crypto trades, let’s talk about how crypto works, starting with the Blockchain, the technology that underlies all cryptocurrencies.

At its most basic, blockchain technology is way of storing data.

A digital currency blockchain consists of individual blocks of data, with each block making a reference to the previous block, thus creating a chain of blocks.

Cryptography is used to ensure the chain remains immutable to attacks from hackers looking to change the data.

A key element of a blockchain technology is immutable data (i.e., data cannot be changed after the fact).

The immutable quality of the data, combined with its distributed nature, ensures its integrity and protects it from loss, manipulation, or hacking.

To understand the proliferation of cryptocurrencies, we to go back to the blockchain, the technology that underlies digital currencies:

This explosion in crypto diversity is largely due to the ease of creating new currencies by using smart contracts, pioneered by Ethereum (more on smart contracts later).

With smart contracts, new coins can simply piggyback on an existing, and well-established blockchain networks.

When learning about cryptos, you may hear the terms “coin” and “token” frequently used.

Although they may sound interchangeable, there is a difference.

The term coin generally refers to any cryptocurrency that has its own, standalone blockchain:

The term token or digital token on the other hand, refers to any cryptocurrency that is built on top of an existing blockchain:

Ultimately, the biggest benefit to creating a new coin (i.e., a new blockchain) versus a new token (i.e., using an existing blockchain) is that with new coins, there is less reliance upon other teams to make technical improvements to the blockchain.

To keep any cryptocurrency system running, there has to be a way to release new coins into the market, and a way of tracking all coin related transactions.

This is where Crypto Mining comes in. The mining process creates new currency units and maintains the integrity of the blockchain ledger, which helps to prevent illicit transactions.

But since cryptocurrencies are decentralized, there’s no one entity that does all this, the way a traditional bank does. Instead, the responsibility of running the system falls to a network of participants (i.e., data mining individuals and companies).

Below are the largest crypto mining companies in the world (most are based in China):

The crypto mining process works as follows:

Crypto miners need incentives to participate in the ecosystem, and this is where Mining Rewards come in.

Mining rewards are financial incentives awarded to miners who are first to solve any given blockchain puzzle:

Unlike some other crypto currencies, Bitcoin has a finite supply; only 21 million units will ever exist (over 18 million units have been minted so far).

Because of the decreasing reward and increasing difficulty level, it will take until around the year 2140 to mint the entire stock of Bitcoin.

Since crypto mining is essentially the rapid solving of complex mathematical equations, miners use powerful mining rigs (i.e., specialized computer hardware and software configurations) to make these computations as quickly as possible.

The more computing power you have, the easier it is to mine a cryptocurrency.

But harnessing all this computer power does NOT come cheap. According to Digiconomist, a single Bitcoin transaction takes 1,544 kWh, which is equal to 53 days of power for an average US household.

In 2010, Satoshi Nakamoto, the yet to be identified founder of Bitcoin, described the revenue model which BTC miners follow:

Below is a snapshot of the estimated cost of mining bitcoin around the world, using pricing and relative costs from March, 2022:

To fully understand cryptocurrencies, we need to understand ‘fiat money’.

Currency autonomy can be thought of as a spectrum that shows how easy (or difficult) it is to manipulate any given currency.

The greater the autonomy, the more difficult it is to manipulate a currency. In terms of autonomy, fiat money has less autonomy than gold coinage which in turn has less autonomy than bitcoin (in other words, fiat money is the easiest to manipulate).

Here are two contrasting examples of the ‘autonomy principle’:

Launched in 2009, Bitcoin is the best known (and oldest) cryptocurrency.

Bitcoin was created by a person (or group) who called himself Satoshi Nakamoto.

Satoshi’s stated goal was to create “a new electronic cash system” that was “completely decentralized with no server or central authority.”

After cultivating the concept and technology, in 2011, Nakamoto turned over the source code and domains to others in the bitcoin community, and subsequently vanished. To this day, Satoshi’s identity has not been confirmed.

When it hit the market back in 2009, Bitcoin was trading at around a few cents per coin.

Flashing forward, we see that bitcoin reached an all-time high price of more than $68,000 in November 2021.

This unfathomable jump in value happened in just over a decade.

Bitcoin and Ethereum are two of the most popular and biggest cryptocurrencies by market size and comparisons between the two are only natural.

There are a number of fundamental similarities between Bitcoin & Ethereum (Ethereum was created in 2015 by Vitalik Buterin, a Russian-Canadian programmer):

Despite the similarities, there are a number of important differences:

In Q4 of 2022, Ethereum plans to execute its long discussed switch to a proof-of-stake consensus mechanism (from PoW to PoS), heralding a new era for crypto (see above graphic, row 5)

Stablecoins are cryptocurrencies that never fluctuate in price (or at least that’s the idea) and are pegged to the dollar or other stable assets as a safety barrier against volatility.

USD Coin: USD Coin is an Ethereum token, that can be stored in any Ethereum-compatible wallet. The value of USD Coin is tied to the U.S. dollar.

Tether: similar to USD Coin, Tether is tied to the U.S. dollar.

Stablecoins are not risk-free and it is important to point out that the crypto selloff that started in earnest in May 2022 was preceded by the collapse of the Luna currency which was used to back up the value of Terra’s UST Stablecoin.

To bring some order to the digital currency marketplace, CoinDesk (a digital currency exchange) recently announced the launch of the Digital Asset Classification Standard (DACS).

The idea behind DACS is to organize and categorize digital currencies, and to develop appropriate crypto indices, which are imperative when trying to accurately evaluate and compare the performance of any digital currency (i.e., the performance of each digital currency must be compared against an appropriately constructed index).

In the US, there are currently no 100% pureplay bitcoin ETFs (there are ETFs that invest in bitcoin companies such as the Grayscale Bitcoin Trust BTC).

The race for a bitcoin spot ETF in American markets has been fierce, but the SEC as so far has not green lighted one.

The reluctance of the SEC to either approve such an offering or provide greater clarity baffles many in the industry, especially since other countries, such as Australia & Canada have already launched spot bitcoin ETFs.

Process of freely distributing a new cryptocurrency to people hopefully creating more demand. When a new cryptocurrency is created, it needs to gain users. One way of doing this through an airdrop. The group issuing the airdrop hopes new users will begin researching and sharing the coin creating more demand.

Atomic swaps are a mechanism where one cryptocurrency can be exchanged directly for another cryptocurrency, without the need for a trusted third party such as an exchange.

A system (ledger) in which a record of transactions made in cryptocurrency are maintained across several computers that are linked in a peer-to-peer network. The validity of each cryptocurrency’s coins is provided by a blockchain.

Block rewards are awarded for maintaining the blockchain. Maintaining the blockchain requires computer power and electricity or risking a large amount of cryptocurrency as a guarantee that you are trustworthy. Anyone doing this work is eligible to earn a reward.

A type of digital data storage that takes longer to access and quite often is not connected to the Internet. Also known as a “cold wallet”.

Digital currency (digital money, electronic money or electronic currency) is a type of currency available in digital form (in contrast to physical, such as banknotes and coins).

A system of independent computers that are simultaneously recording data. With distributed ledger technology, identical copies of the recording are kept by each computer.

A proposed set of rules and standards for creating new cryptocurrency using Ethereum as the foundation. ERC-20 describes crypto made with Ethereum technology that follow these rules and standards.

Cryptocurrency exchanges allow customers to trade cryptocurrencies for other assets, such as conventional fiat money, or to trade between different digital currencies.

Hard fork is defined as a decision to make a permanent change to the technology used by a cryptocurrency (i.e., the blockchain).

Process when a new cryptocurrency or token generally becomes available for the public to invest in. ICO’s as basically Kickstarter campaigns for crypto projects, where the public can send money to the project by investing in the ICO and receive project tokens in return.

In cryptocurrency networks, mining is a validation of transactions. For this effort, successful miners obtain new cryptocurrency as a reward.

A connection between two or more computers that allows them to directly share information, files, or other data.

A string of letters and numbers known only by the owner that allows them to access and spend their cryptocurrency.

Process for achieving consensus and building on a digital record known as a blockchain. With PoW, users compete with each other via their computers to solve a puzzle.

A process for achieving consensus and building on a digital record known as a blockchain. With PoS, users put up a collateral of tokens (or a “stake”) and use a process that is more energy and cost-efficient than previous solutions. As compared to PoW, PoS is estimated to be 2000 times more energy efficient, consequently reducing energy consumption by a whopping 99.95%.

Founder and creator of bitcoin, the most popular cryptocurrency. The smallest amount of bitcoin (0.00000001) was also named after him, it is called a Satoshi.

An agreement to exchange goods, services, or money that will automatically execute, without third party oversight, so long as established criteria are met.

A cryptocurrency wallet stores the public and private “keys” or “addresses” which can be used to receive or spend the cryptocurrency.

A collection of marketing documents that are designed to explain a complex product or service and persuade investors into believing in its benefits.

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