What are cryptocurrencies and how do they work?
Guide Summary
- Cryptocurrencies are digital currencies that operate using blockchain technology. Transactions are analysed in ‘blocks’ to verify them using either mining or validation (depending on the coin).
- You can invest in cryptocurrency by purchasing them directly through a crypto exchange, or through regulated funds that track currency prices, and companies involved with cryptocurrency infrastructure.
- While crypto may offer potential diversification benefits or innovation exposure, it also carries high risks like price volatility, regulation issues in certain countries, and security threats. Understanding how it works is essential before considering investment.
How does cryptocurrency work?
Cryptocurrencies use a technology called blockchain. Think of it like a digital record book (ledger) of every transaction. Instead of this information being stored in one place – like a bank – it’s shared across thousands of computers across the world.
When you send or receive cryptocurrency, your transaction is added to a ‘block’ of data. Before it’s accepted, it has to be verified by the network in one of two ways:
- Miners (used in bitcoin) do this by using powerful computer hardware to solve complex puzzles. Solving these puzzles validates a ‘block’ of transactions, adding it to the blockchain, and generating a fixed amount of new cryptocurrency as a reward. Miners are constantly competing to solve these puzzles.
- Validators (used in newer systems like Ethereum 2.0) ‘stake’ (lock away) some of their own cryptocurrency, and the network selects a validator at random to check and approve a block of transactions. If they do this honestly, the block is added to the blockchain, and the validator earns a reward – either in the form of transaction fees or newly issued cryptocurrency.
Why has cryptocurrency become popular?
Cryptocurrency has captured global attention for a number of reasons:
- Decentralisation and independence from banks and government means no single person or institution is in charge. This appeals to those who want more control over their money.
- Volatility has fuelled speculation with prices swinging sharply both up and down, attracting those hoping to profit from big movements.
- Blockchain innovation and technology has opened the door to powerful new ideas such as Web3 – giving users ownership of digital services, and NFTs (non-fungible tokens) – digital collectibles with unique ownership.
Is cryptocurrency a long-term asset?
There are arguments to support the idea that cryptocurrencies have value as a long-term asset, as well as scepticism around cryptocurrency’s short-term ‘hype’ potential:
Long-term value argument:
- Growing institutional adoption of cryptocurrencies in balanced portfolios by large traditional financial institutions such as BlackRock, Fidelity, and Morgan Stanley. Typical allocations range from 1-3%.1
- The store-of-value narrative has gained traction during periods of economic uncertainty, as investors look for a hedge against inflation and ways to store value independently of banks or governments.
- Financial innovation has benefitted from the development of blockchain technology and its role in the evolution of smart contracts (automatic financial agreements removing the need for banks or lawyers), Web3 (the broader movement to a decentralised internet).
Short-term ‘hype’ argument:
- Speculative bubbles and herding trends have been identified as a driving force behind some retail investors’ adoption of cryptocurrencies, often triggered by social media noise.2
- Regulatory concerns have arisen surrounding consumer protection, money laundering and financial stability as infrastructure and regulation remain underdeveloped.
2Journal of Financial Innovation
Common risks of cryptocurrency
Like any investment, cryptocurrencies comes with its own risks, some of which are unique:
- Extreme volatility – Price swings can be very turbulent and very reactive to the news cycle. For example, in May 2021, Bitcoin fell around 31% in a single day in response to regulatory concerns and influential social media activity.3
- Regulatory uncertainty – Many countries are still figuring out how to regulate cryptocurrency. Some countries have embraced it and others have imposed strong restrictions or even bans. These regulations can have an impact on prices, purchasing, and the operating capabilities of platforms.
- Security threats – As cryptocurrency is a digital currency, it is open to issues around hacking, scams and theft. Unlike deposits with regulated UK financial institutions, cryptocurrency deposits are not protected by the UK’s Financial Services Compensation Scheme (protects your money up to £85,000 if an institution goes out of business).
- Emotional Investing – Cryptocurrency prices are strongly influenced by investors’ emotions, and those emotions, in turn, are closely tied to price movements.4
4Journal of Behavioral and Experimental Finance
What is staking, mining, wallets and crypto ETFs?
If you were investing directly into cryptocurrencies, there are a few technical terms worth getting familiar with, to understand how crypto networks operate and how coins are stored and earned:
- Staking – The process of locking away some cryptocurrency to support the crypto network. In exchange, it’s possible to earn rewards. This process is used by coins running on a Proof of Stake (PoS) System such as Ethereum, Solana and Cardano.
- Mining – The process of solving complex mathematical puzzles using specialised hardware, to verify transactions. Miners can be rewarded with newly created coins and transaction fees. Whilst this process is crucial to the workings of Bitcoin (currently the largest crypto by market cap), the mining process isn’t practical for most investors due to the infrastructure required.
- Wallets – After purchasing cryptocurrency, investors usually use a digital wallet as storage. Hot wallets connect to the internet and are more convenient for quicker transactions. However, they’re also more vulnerable to online hacks and scams. Cold wallets are offline storage options such as hardware, which offer more secure storage as they aren’t connected to the internet. These wallets can be more difficult to use and keep safe.
- Crypto ETFs – A regulated investment fund traded on a stock exchange that gives investors exposure to the cryptocurrency market, without needing to buy, store, or manage digital assets directly. Some ETFs track the price of crypto assets, and others invest in companies that operate in the crypto and blockchain ecosystem.
The role of crypto in a diversified portfolio
Cryptocurrency is increasingly being considered by some investors as a way to bring added variety to a wider investment portfolio.
Because crypto assets often behave differently to traditional markets, they may offer:
- Diversification benefits – their performance may not always move in line with stocks, bonds, or other mainstream assets.
- Potential inflation hedging – certain cryptocurrencies, such as Bitcoin, are sometimes described as digital stores of value, though this remains debated and unproven over longer timeframes.
That said, it’s important to understand the nature of crypto as an asset class:
- It’s highly volatile, with prices that can rise or fall sharply in short periods.
- It’s generally considered a higher-risk investment, and may not be suitable for all investors.
- Crypto exposure through an ETF can provide a simplified route for accessing the sector, without needing to manage digital wallets or private keys.
Investing in cryptocurrencies summary
Cryptocurrency is a speculative and fast-moving asset class that’s drawn interest for its technological innovation and potential to behave differently from traditional investments. While it is prone to sharp price swings, it may offer diversification benefits when used cautiously.
Whether crypto has a place in your portfolio depends entirely on your goals, risk tolerance, and time horizon. For experienced investors, a small, controlled allocation may help introduce exposure without taking on the full risks of direct ownership.
FAQs
What is a crypto ETF?
A crypto ETF (Exchange-Traded Fund) is a type of investment fund that provides exposure to the cryptocurrency market without requiring you to buy and store digital assets directly. Instead, it tracks the price of one or more cryptocurrencies (like Bitcoin), or the performance of companies involved in the crypto ecosystem such as blockchain developers or mining firms.
Like other ETFs, crypto ETFs are traded on traditional stock exchanges and can be bought and sold through investment platforms.
Is it safe to invest in crypto via an ETF?
Crypto ETFs are considered a more regulated and accessible way to gain exposure to the crypto market. They don’t require managing wallets, private keys, or navigating crypto exchanges which can introduce technical or security risks.
However, they still carry investment risk. The value of a crypto ETF will rise or fall based on the performance of the underlying assets, which can be highly volatile. So while they simplify the process, the investment itself remains speculative.
Can I invest in Bitcoin through an ETF?
Yes. Some crypto ETFs are designed to track the price of Bitcoin specifically. These ETFs either hold Bitcoin directly (a ‘physical’ or ‘spot’ ETF) or track futures contracts based on Bitcoin prices.
This allows you to gain exposure to Bitcoin’s performance without needing to own or store the asset yourself.
What’s the difference between buying crypto and investing in a crypto ETF?
Buying crypto directly means purchasing digital coins (like Bitcoin or Ethereum) via a crypto exchange. You’ll need a digital wallet to store them securely, and you’re responsible for managing keys, transactions, and safety.
A crypto ETF, by contrast, is a stock market investment. You don’t own the crypto itself, you own shares in a fund that tracks crypto prices or related businesses. This removes some of the complexity and security concerns, while still giving you access to crypto market movements.
Is crypto a good investment for beginners?
Crypto is a high-risk, speculative asset class. Prices can swing sharply in either direction, and the market is still evolving with regulatory, technological, and security risks to consider.
That said, some investors choose to include a small allocation to crypto as part of a diversified long-term portfolio. If you’re new to investing, it’s important to understand the risks and not invest more than you’re prepared to lose. ETFs can offer a simpler way to access crypto exposure without needing to manage digital wallets or exchanges directly.
