The Beginner's Guide to Investing in Cryptocurrencies
In this article, we review what are cryptocurrencies and how you can personally invest in them.
Recent years have seen a plethora of cryptocurrencies being launched, starting with Bitcoin during the Great Financial Crisis in 2008. Today, the total market capitalization of these cryptocurrencies is approaching $2 trillion dollars. Collectively, they are emerging as an important component in the future of finance. It is, therefore, imperative for individuals to get familiarized with them as part of their financial literacy. In this article, I will describe what cryptocurrencies are and the different ways of acquiring them.
What are cryptocurrencies?
Cryptocurrencies are native tokens that exist on blockchains, whose transactions are recorded on the native ledger. Depending on the design of the blockchain, the functional use cases of cryptocurrencies can differ. Bitcoin, the world's first cryptocurrency, is used as a store of value due to its absolutely limited supply — although increasingly it is also used as a means of payment, thanks to the development of the layer 2 Lightning Network.
Ethereum, as the second-largest cryptocurrency, is used as a utility token to pay for smart contract-based transactions (called "gas fees") that utilize the computing power of the Ethereum blockchain. Other smart contract platforms and Ethereum competitors, such as Cardano, Solana and Polkadot, all have their own native tokens. In addition to paying for transaction fees, these tokens can also serve as governance tokens that enable holders to exercise their governance rights, such as voting for protocol and parameter changes.
There are also many other emerging cryptocurrencies and use cases. One hot area at the moment is decentralized finance (DeFi). Many DeFi blockchains have emerged in the past year to recreate traditional financial services but in a decentralized manner, thereby vastly increasing efficiency, reducing costs and eliminating censorship. These financial services span from borrowing and lending to asset management, insurance, derivatives and trading. The tokens associated with these DeFi protocols offer a range of utilities to their holders, including the protocol's usage rights, a share of the protocol's transaction fees, the right to produce and verify blocks, and governance of the network.
The tokens described above often provide attractive upsides as the blockchain's use cases expand and the ecosystem grows. Therefore, the next thing to learn about how to acquire them:
How to acquire cryptocurrencies (3 methods)
The first way to acquire cryptocurrencies is to directly buy from the company or development team at an initial stage via public or private sales. For example, Polkadot raised $145 million in 2017, selling 50% of the network's then-10 million dots. The advantage of this method is that the token price is usually lower, as the protocol is still at an early stage of development. However, the risk of the project being a scam also increases, as it is still unproven or lacks a track record. The company or development team can often just run away with users' invested funds. We have seen many instances of scams and frauds in the "initial coin offerings" (ICOs) mania in the last bull cycle in 2017.
The second method is to acquire tokens via centralized exchanges, such as Binance, Huobi and Coinbase. By the time these tokens are listed on major exchanges, the projects would have become more established. Therefore, the risk of scams is reduced. In addition, centralized exchanges often offer a simple and convenient way for users to purchase and store cryptocurrencies, without the hassle of storing their private keys. That being said, they are centralized entities that can be subject to the risk of hacks and data breaches. It's almost inevitable that an exchange will get hacked at one point or another. For instance, in 2019, major South Korean exchange Upbit suffered a massive breach, with 342,000 ETH being stolen.
The third way to acquire cryptocurrencies is via a decentralized exchange, which is part of the DeFi movement. As its name implies, this kind of exchange does not have a centralized authority. Instead, trades are executed via automated liquidity pools and smart contracts directly between buyers and sellers. The main advantage of using a decentralized exchange is that security is vastly improved, as cryptocurrencies remain in the custody of the user rather than a centralized exchange. The downside is that these exchanges are still not easy to use and require users to have a certain level of technical sophistication. Furthermore, the range of cryptocurrencies available on decentralized exchanges may not be as vast as centralized ones. That being said, we expect these disadvantages to disappear over time as the DeFi space continues to advance and mature.
To summarize, cryptocurrencies are exciting innovations that represent the future of finance. It is imperative for the sovereign individual to become literate with them, and further, to own them in order to be part of the future. This article has explained the various ways in which individuals can buy cryptocurrencies, including via private and public sales, as well as centralized and decentralized exchanges. Each method carries its own advantages and downsides. Which method is used ultimately depends on the judgment, experience and level of sophistication of the individual.
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