What is cryptocurrency? The online digital currency phenomenon, how it works and risks involved explained

Cryptocurrency has attracted a lot of attention of late - largely due to record market gains and social media following - but what is the digital currency sweeping the internet? Here National World speaks to Resolver consumer expert Martyn James to talk about all things crypto, from how the online phenomenon works to the risks involved for potential investors…

Weirdly, or worryingly, depending on your view, one of the most common questions I’m asked by people is ‘how do I get into investing in cryptocurrency?’

Let me be clear up front, my answer at the moment is ‘don’t’.

There are a lot of reasons for that, but let’s take a look at cryptocurrency, how it works and the pros and cons of taking a punt in investing.

What is cryptocurrency?

Cryptocurrency is basically a digital currency that you keep online in a digital wallet. You can use it to buy things, but at the moment, people are mostly investing in cryptocurrency because of the extraordinary jumps in value that have been reported in the media.

The name comes from the ‘encryption’ which makes the currency hard to fake.

Money’s value long since ceased to be related to the actual value of the metal in the coin itself. It’s basically worth what the bank says it’s worth at any given time, so digital currency isn’t actually too much of a stretch when you think about it.

Cryptocurrency has a kind of Wild West spirit to it, in that investors in it like to see themselves as rule breakers and risk takers (or for some illegal activities, law breakers). Because the currency isn’t linked to banks or Governments, it’s a ‘people’s currency’. But it’s not regulated either (in this country) which means if things go wrong, there’s nowhere to turn. And just like with the Gold Rush, only a few people benefitted, while most were left empty handed.

Where does cryptocurrency come from?

Cryptocurrency comes originally from computers that are used to work out rather complicated sums and processing tasks. In return for this, once a certain threshold is reached it generates one coin or token of cryptocurrency. This can be bought, sold or used to buy things. This production of the currency is called ‘mining’. Most people don’t mine the currency – it’s way too expensive and time consuming – they invest by buying existing currency.

If all that seems rather weird, think about the internet. Rather like electricity, we don’t really consider how the internet appears for our daily delectation, or where it lives. The term ‘the cloud’ gives us a nice fluffy impression of where our data goes or knowledge is obtained. But really, it’s just banks of computer servers that prop up the system, all around the world.

Now all those mining computers humming away use huge amounts of power, so there’s a debate about how good for the environment this process is (not very). This led to a huge drop in the value of the currency recently when businesses decided it was not ‘environmentally friendly’ and bailed.

What are the risks with cryptocurrency?

One of the most basic risks is losing your wallet! Or more precisely, your password. Because accessing your online wallet is vigorously password protected, if you forget your password you could effectively lose all your investment.

But the main risk is the sheer volatility of the currency.

Like any form of speculation, the value of Bitcoin and the other currencies is governed by supply and demand. But unlike speculating in the value of something tangible or useful, like gold, for example, or sugar, cryptocurrencies rise and fall depending on people taking a punt on how much people will want them in the future.

The answer to that is we simply don’t know.

No one’s really buying things with the currency yet, so the big rises and falls in values are driven by some very random events.

Much has been made of Elon Musk talking up cryptocurrencies, then changing his mind. The actions of just one individual caused huge price fluctuations in currency valuation.

Is cryptocurrency a good investment?

We grade investments by ‘risk’ in the UK, with the highest risk investments the more speculative ones. Highest of all are unregulated investments.

These are ways of investing your money not covered by the UK regulator, the Financial Conduct Authority (FCA). This includes things like ‘land banking’ (investing in strips of land abroad on the off chance they are developed), Property portfolios, (where you’re locked into a collection of foreign property with other investors) and now cryptocurrency.

As with any investment, the main issue is how quick you can react if you sense a fluctuation in the market. We all like to think we could beat the odds, but in practice, the things that govern the value of cryptocurrencies are so random you’ll have little to no time to cash in your currency before it drops in value.

That’s why this kind of investment is woefully unsuitable for anyone who isn’t an experienced investor or doesn’t have lots of money they can afford to lose. Just this week I’ve spoken to three people with average jobs who’ve lost £85k between them in just a single day.

High risk investments are ultimately a form of gambling.

And as any gambler knows, you don’t spin the wheel if you’re not prepared to lose all your cash. Never forget the house rules either – there are always far more losers than winners.

For now, cryptocurrency is unsuitable for anyone who isn’t willing to risk losing everything – and much more needs to be done to tighten up the rules around investing and interfering in the value of currencies.