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How does cryptocurrency work?

Cryptocurrency is digital money. It’s not a physical asset like coins or cash, but does hold value. It’s developed on a wide network of computers, and works over a ‘peer-to-peer network’, meaning there are no third parties such as banks involved. Every cryptocurrency transaction is made on an enormous, global database known as a blockchain.

You buy cryptocurrency through brokers or specialist exchanges. Once bought, it can be stored on a digital wallet, which is basically a smartphone app, or you can move your cryptocurrency onto an external flash drive for – potentially – greater security. Major brands such as PayPal and credit card provider Visa are enabling digital currency payments, but it’s far from widely accepted by retailers. Mostly, people buy cryptocurrency as an investment, hoping that it will grow in value over time.

What are the pitfalls and are they regulated?

Cryptocurrency is prone to massive swings in value within days. Take Bitcoin, for example. Its value hit an all-time high in April of $65,000, but tanked by 10% a month later after electric car maker Tesla abandoned plans to accept crypto as payment.

Vitally, cryptocurrencies aren’t regulated. You won’t receive the protection of the Financial Services Compensation Scheme (FSCS) or Financial Ombudsman Service (FOS) if anything goes wrong. So, if an exchange goes bust, you won’t necessarily get your money back. Firms dealing in cryptocurrency must only be registered with the Financial Conduct Authority (FCA) to prevent money laundering.

The risks involved have prompted regulators around the world to crack down on the crypto market. A couple of months ago, the FCA banned the world’s biggest exchange, Binance, from carrying out any cryptocurrency regulated activity in the UK. So, it’s little surprise that people don’t trust technology as much as they trust banks: around 54% of people trust banks, compared to just 8% trusting technology companies to protect their money, according to a recent Ipsos survey.

Oliver Lindsay.

Oliver Lindsay, 32, has invested £7,000 in cryptocurrency, even though he acknowledges that he could be in for a roller-coaster ride with it. It’s crazily volatile, he says. But I believe it’ll be more stable over time because it’s the future. A creative designer by trade, Oliver dipped a toe in digital currency after hearing about its potential from friends and initially invested £200 in Bitcoin two years ago. Its value rocketed towards the end of 2020, so I invested more money, he says.

His cryptocurrency portfolio has now risen in value to about £11,000. He drip-feeds money into a range of cryptocurrencies such as Ethereum, Cardano and Solana on the Coinbase exchange. Yet while he’s currently in profit, it’s been an unnerving journey to get there. At one stage my portfolio plummeted by 40% in a single day, he says. You need to be high-conviction to not freak out when there are such massive drops in value.

Oliver is one of millions of investors who have piled into cryptocurrency, despite its rocky track record. Since Bitcoin was created in 2009, it’s become the ninth most valuable asset by market cap, but also one of the most volatile. Its success has seen thousands of smaller cryptocurrencies enter the market such as Ripple, Tether and Litecoin. However, understanding the world of cryptocurrency can be tricky, and around 13% of people say it’s too complicated to use.

How can you avoid crypto scams?

Cryptocurrency’s soaring popularity has sparked interest from cyber-criminals. Some of the most common scams include fake currency exchange websites, and phishing emails attempting to get people to enter keys to digital wallets.

Fake copycat websites can look identical to the real ones. However, you can check the FCA register to ensure you’re buying from a reputable source.

How can you make money?

Phil Waldron.

Some investors make hefty gains from cryptocurrency. However, this is likely to be tricky if you’re relying on short-term market movements. No-one can predict where the market will move next. Phil Waldron, 38, hopes to make money by buying and holding crypto. He invested £3,000 in May across seven different cryptocurrencies. Before investing, he learnt about the basics through the finance community on Finimize. His investment is now worth about £3,600.

However, taking a punt on crypto wasn’t always profitable. He was hit hard in 2017 from spread-betting on cryptocurrency. This was too risky, I wasn’t doing it right, and suffered major losses, he says. With regards to the spread-betting, it was just me as a novice engaging in very bad practice, this was not specific to cryptocurrency. Ultimately the highly leveraged positions you take can make you profit quickly but far more often drag you into bigger losses, especially if you are a retail investor. Phil mainly invests in Bitcoin and Ethereum. I also hold other, smaller coins. It’s a bit like a portfolio of stocks – I’m diversifying to spread risk, as they are all different, says Phil, who works in procurement.

Is cryptocurrency bad for the environment?

Yes. It uses enormous amounts of computer power to create cryptocurrency by solving complex mathematical equations. Back in 2017, Bitcoin surged in value, and this pushed up its energy demands to the level of a small country.

In fact, a single transaction of Bitcoin has the same carbon footprint as 680,000 Visa transactions, or 51,210 hours of watching YouTube, according to the Cambridge Centre for Alternative Finances. However, eco-friendly, renewable cryptocurrency mining facilities are being developed around the world. Even so, cryptocurrency’s carbon footprint is likely to worsen as with greater demand comes higher energy consumption.

What should you consider before you invest?

Ask yourself if you’re comfortable with the level of risk and the prospect of losing your money. You can learn more about cryptocurrency on a variety of financial websites and apps, including Coinbase, which has plenty of research resources, and Forbes, and Investopedia. Phil Waldron says he understands the risk he’s taking. My crypto could all tank and be worthless, but then again, I believe crypto is part of the future, a bit like people moving from VHS to DVD.

However, he adds that anyone thinking of investing should only hold a small amount in digital currency. I’ve got other savings too, with ISAs and stocks and shares – crypto is only a very small percentage of my overall portfolio, he says. Whatever you do, don’t bet more than you can afford to lose.

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