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What is a Cryptocurrency? | IslamicFinanceGuru

What is a Cryptocurrency?

As part of our work on halal investment at IFG we are covering cryptocurrency and blockchain technology in a lot of detail. You can read all of the series of our article on this topic here.

In this article we give an introduction to what cryptocurrencies are and provide a brief overview of its pros and cons.

For more halal investments see here.

What is a cryptocurrency

Cryptocurrencies are a form of digital currency. They utilise cryptography to regulate the generation of units of currency and verify the transfer of funds. Cryptocurrencies work independently of central control and typically use a decentralised p2p network to verify and record transactions on a blockchain.

Transactions are made over the P2P network and are recorded on a public ledger (blockchain). The network collectively verifies that the requested transactions are valid. This differs from traditional verification methods where a third party – e.g. bank – bears sole responsibility for transaction verification.

Cryptocurrency and fiat currency

Similarities

  • Both can act as a form of payment and a store of value.
  • Like fiat currencies, a lack of consumer confidence and trust can render their functions invalid. Both are susceptible to this problem.

Differences

  • Fiat currencies are centralised, while cryptocurrencies are decentralised. The central banks/ governments usually have control over fiat currencies. Due to the P2P network, cryptocurrencies are not maintained or controlled by any single entity.
  • Unlike fiat money, cryptocurrency transactions are final. They cannot be forcibly reversed.
  • Fiat money is subject to inflation and does not have a set supply. Governments/ central banks can change the supply levels or void fiat money entirely. Conversely, cryptocurrencies have a fixed supply of money that cannot be changed. For example, new Bitcoin is released every 10 minutes and will cap off at a total of 21 million coins in 2140.

Cryptocurrency and crypto tokens

Cryptocurrencies are sometimes used synonymously with crypto coins. They are assets that run on its own blockchain. Bitcoin, Ethereum, and Litecoin are all examples of crypto coins.

On the other hand, Tokens do not have their own blockchain. Instead, they run on another blockchain. ERC20, for instance, is a popular token that runs on the Ethereum network.

Some notable tokens:

  • Currency token- tokens that have the sole purpose of acting as a means of payment for goods and services
  • Utility token- otherwise known as ‘work tokens’, they redeem access to a particular service, product, or platform. Businesses that issue the token can only grant access.
  • Security token- act as traditional securities; they grant the owner with certain rights such as ownership and entitlement to a share of profit or repayment. They are usually classed as financial securities and register with a regulator.
  • Asset token- tokens that are backed by assets e.g. gold.
  • Stable token- to combat cryptocurrency volatility, these currency tokens peg to a particular currency, e.g. USD

Cryptocurrency wallets

Cryptocurrency wallets- or digital wallets- allow individuals to send and receive cryptocurrencies and crypto tokens. They house a private key and a public key. The public key to identifies your account on the network and can be searched in the ledger. It is used to receive funds much like bank account numbers. The private key signs off transactions and proves ownership of the public key. ‘Hot wallets’ are connected to the internet, while ‘cold wallets’ are not.

There are three types of cryptocurrency wallets:

  • Software wallets are stored on a computer/browser and are accessible via a password.
  • Hardware wallets are cold wallets stored in an external device e.g. USB stick.
  • Paper wallets are physical copies or printouts of you public and private keys.

Pros of cryptocurrencies

  • Easier, quicker, and cheaper to transfer funds
  • Anonymity online- an advantage for those who value their online presence and data
  • Online ledger provides excellent transaction transparency
  • Inflation is unlikely

Cons of cryptocurrencies

  • Market fluctuations mean that cryptocurrencies are not the safest a medium of exchange
  • Cryptocurrencies are highly volatile investments
  • Trust and comprehension are vital to the success of cryptocurrencies; there is a growing number of people who are losing trust in it because they do not understand it.

References:

https://medium.com/@medipedia/the-various-types-of-crypto-tokens-26bab8f6622c

https://www.investopedia.com/terms/c/cryptocurrency.asp

 

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