Cryptocurrency – virtual or electronic currencies – have been in the financial news a lot lately. However, they remain a mystery to most people. Here’s an overview of what cryptocurrencies are, how they work, what is driving interest in them, and the risks associated with them.

What are cryptocurrencies, how do they work and are they a legitimate form of payment?

It is estimated that there are more than 5,000 cryptocurrencies in existence. Bitcoin has the enviable position as one of the most widely recognized, but other popular cryptocurrencies include Dogecoin, Ethereum and Litecoin.

Bitcoin was created in 2009 by an anonymous person(s) under the alias Satoshi Nakamoto. Like other cryptocurrencies, Bitcoin uses a peer-to-peer network to generate a system for secure electronic transactions known as blockchain. Cryptocurrencies can be purchased or mined and are stored in a digital wallet.

Bitcoin and other cryptocurrencies are increasingly gaining acceptance around the world as a form of payment, but they do not currently have legal tender status in the U.S.

What is driving interest in them?

Supporters with a longer-term view find cryptocurrencies appealing to facilitate efficient and inexpensive domestic and global transactions because there is no exchange rate, among other features. In addition, cryptocurrency supporters consider the decentralized nature of blockchain to be more secure than other payment systems.

Further, the value of cryptocurrencies is not influenced by governments or central banks, which can devalue currencies over time through monetary policy. In contrast to supporters with a longer-term view, speculators are interested in cryptocurrencies because of the high volatility they exhibit and their potential for dramatic appreciation as demand increases.

What are the risks associated with cryptocurrencies?

There are many risks associated with cryptocurrencies. Most notably, they are highly volatile. Their value may fluctuate dramatically in a single day, making their use as a currency challenging. Without government support, cryptocurrencies may find stability difficult to achieve.

Additionally, cryptocurrencies are unregulated, leading to greater potential for fraud or loss of value. Further, the use of virtual “wallets” for storing cryptocurrency means there is risk of loss due to hacking. This risk is not unique to cryptocurrency. However, when added to the other risks, it becomes apparent that cryptocurrency will need to evolve significantly before wider adoption becomes a reality.

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Source: BTC Capital Management.

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