Cryptocurrency: What it is, how it works -- and will the bubble burst?

By Daniel Uria
There are hundreds of cryptocurrencies in circulation -- with bitcoin being the most popular. As of Monday, it carried a value over $8,000. File Photo by Dave Hunt/EPA-EFE
There are hundreds of cryptocurrencies in circulation -- with bitcoin being the most popular. As of Monday, it carried a value over $8,000. File Photo by Dave Hunt/EPA-EFE

May 21 (UPI) -- In an increasingly digital world, cryptocurrencies like bitcoin have been rising in popularity -- a tool for decentralizing money on a global scale without an intermediary.

"It relies on a mixture of clever computer science, cryptography and other economic incentives," Massachusetts Institute of Technology assistant Professor Christian Catalini told UPI.


Most cryptocurrency transactions are focused on investment, speculation and trading, especially in portions of the world where people have lost faith in government currency.

Transactions rely on "miners" who use computers to validate and add timestamp transactions to a "blockchain" -- a continually growing digital ledger secured with cryptography.

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Only a limited number of cryptocurrencies are produced, unlike government-backed notes, to ensure sufficient values.

A few months ago, Venezuelan President Nicolas Maduro launched the cryptocurrency "petro," backed by the nation's oil reserves and other natural resources. It's an attempt to cope with a failing Venezuelan economy and circumvent U.S. sanctions imposed in December.


Cryptocurrency has been widely adopted by younger people, particularly South Korean millennials. Twenty-three percent of South Koreans in their 20s said they've purchased virtual currencies, according to Korea Financial Investors Protection Foundation.

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In March, the word "cryptocurrency" was added to the Merriam-Webster dictionary.

What cryptocurrencies exist?

The world's two most valuable cryptocurrencies -- bitcoin and ethereum -- belong to the same family, but have some key differences.

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Bitcoin software was made available to the public nearly a decade ago and was valued for the first time in 2010. It was intended to act as a form of money usable on the Internet, designed to be simple and exclusively allow transactions in value.

"It is extremely limited in terms of additional functionality, which is a design choice to make it extremely robust and secure," Catalini said. "It's not very customizable in terms of what else you can do with it."

By contrast, ethereum was launched through a crowdfunding campaign in 2014 out of a desire to create a cryptocurrency that's more expandable and programmable than bitcoin.

"Ethereum was designed from the ground up to be more of a platform for software application," Catalini said.


Ethereum is fueled by its own form of currency called "ether," which incentivizes developers to write quality applications.

"It has a programming language on top of it, which allows it to build much more complex instruments and contracts and small programs that use the cryptocurrency in the background but then can do other things like a sophisticated lending contract, or mortgage contract or prediction market," Catalini said.

Throughout the years, bitcoin has also become more decentralized than ethereum through the process of mining, in which new cryptocurrencies are created and transactions are recorded and verified.

Catalini likened the process of mining to a lottery, in which computers work to solve cryptographic puzzles and the new currency is awarded to whoever is able to solve it.

"It's a tool for allowing the network to operate and be secure, without knowing the identity of who is participating," he said.

There are hundreds of various cryptocurrencies in addition to bitcoin and ethereum -- ripple, EOS, litecoin, tron, IOTA, Qrum and aeternity -- all of which are listed on exchanges and carry a market cap.

They are all available in limited number. There are about 17 million bitcoins, 100 million ethereum and nearly 40 billion ripple. Their values differ, too. As of Monday, each bitcoin carried a value of $8,481. A far less popular cryptocurrency called 42-coin listed a value of over $30,000 -- one of only a few valued higher than bitcoin -- but has just 42 in circulation.



Due to the differences between various forms of cryptocurrencies, regulators in the United States and other countries have struggled to find ways to regulate them.

MIT senior adviser and former chairman of the Commodity Futures Trading Commission Gary Gensler said he believes "well over a thousand" cryptocurrencies are operating outside of U.S. law and will need to come under regulatory compliance.

Due to years of mining, bitcoin has become one of the most decentralized forms of cryptocurrency and is now perceived as a commodity.

Earlier this month The Wall Street Journal reported government regulators are working to determine whether ethereum and other cryptocurrencies are securities, which would make them subject to regulation by the U.S. Securities and and Exchange Commission.

"There's been a lot of intracoin offerings and those are not decentralized offerings and don't look a lot like bitcoin and ethereum because the team has a lot of control over them," Catalini said. "That's why you're seeing all this debate by the SEC about how to regulate these things that look like unregulated securities at the moment."

Ethereum is believed to exist in a "gray zone" between a commodity and security. Its creation through a crowdfunding campaign is considered an illegal securities sale by some regulators, but ethereum has grown and decentralized over time and begun to resemble bitcoin.


"Both of them are probably commodity-like instruments," Catalini said. "There's still some debate if ethereum is a commodity yet or if it looks more like a security because the team still has a lot of influence over it."

In 2014, the Internal Revenue Service ordered that bitcoin be subject to capital gains taxes, as a property, in the United States.

Pros and cons of cryptocurrency

Investing in cryptocurrency can yield great financial returns, but investors also face a potentially volatile market, as well as potential scams or theft.

Bitcoin prices reached record levels last fall, climbing as high as $11,000 for a single bitcoin. At the start of 2017, its value was about $1,000.

Catalini said investing in cryptocurrency presents a big upside, but says potential backers shouldn't invest a single dollar they can't afford to lose immediately.

"This is a very experimental space and so there's still a lot of uncertainty." he said. "Even more established cryptocurrencies like bitcoin are still far from successful and the verdict is still out on which cryptocurrency will become the leading one in the market."

As bitcoin's value soared and would-be investors became more interested in cryptocurrencies last year, bad actors emerged and began presenting misleading initial coin offerings and other scams.


To combat these harmful practices Facebook and Google began implementing plans to block cryptocurrency advertisements.

"It's important for people to do due diligence and make sure that the teams they're looking at are serious teams and this isn't just the promise of a quick return," Catalini said.

Like other forms of property, cryptocurrencies are also subject to theft. In December, nearly $70 billion worth of bitcoins were stolen from a cryptocurrency mining service called NiceHash.

Catalini said most cryptocurrency thefts occur during the process of attempting to convert them to U.S. dollars or store them in a wallet.

"If that piece of software isn't secure, then it's really easy to lose your bitcoin or to be hacked and have someone steal them," he said.

Catalini also warned anyone hosting cryptocurrency that losing their private key -- a password made up of 51 alphanumeric characters that allows a person to send and receive coins -- could result in permanent loss of their funds.

Argentine entrepreneur Wences Casares launched a startup known as Xapo, which is designed to protect his clients' private keys in encrypted computer servers. As of this month Xapo protects about $10 billion worth of bitcoin, Bloomberg reported.


Catalini speculated that as cryptocurrency ownership becomes more commonplace, new forms of security will emerge to help people protect their funds.

"The same way when banking evolved and moved online we developed services around that to make it secure to bank online, we're going to see more services emerge over time to help people manage their bitcoin and other crypto assets," he said.

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