Cryptocurrencies, blockchain and the decentralisation of the banking system

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The investment is associated with high returns, but also high risks

In order to understand what a cryptocurrency is (hereinafter crypto) we shall begin by explaining what a currency is. Obviously, we are not referring to just physical currency or a banknote, but rather its concept, which we can define as: "a unit of exchange which facilitates the transfer of goods and services". In other words, it is anything that we use the means of payment and unit of value for the exchange of goods or to fix the necessary cost to acquire them. A relevant point is that money does not have any intrinsic value itself, simply put, we as a society have agreed to trust that we exchange goods or services for an amount proportional to their value.

This definition of currency is also valid for a cryptocurrency, given that this can be used as a means of payment or unit to value goods or services, at least within the network of people who trust this currency. Therefore, what differentiates cryptocurrencies from traditional currencies is the use of a technology known as blockchain. This allows them to operate in a decentralised manner, in other words, without any issuing, regulating or controlling institution (regulators), and without intermediaries that facilitate the transactions (banks). This technology is nothing more than chain of blocks of encrypted information that detail all the transactions carried out between users of a crypto such as the well-known Bitcoin, which we will use an example for the rest of the explanation.

These blocks of transactions are Bitcoin's ledger, in a similar way to that which the banks and their supervisors make of guarantees in traditional transactions. The difference, however, is that in this case it is a decentralised system: there is no entity responsible for safeguarding this information, but rather each of the users of Bitcoin has a private copy of the global accounting of the currency that is updated when a new block is added to the chain.

But where do these blocks come from and how do we ensure that all the private copies are consistent and reliable? Well, this is the work of the "miners", a group of users who, through software installed on their computer, update the Bitcoin ledger by producing new blocks of information added to the chain of blocks of previous transactions. When two people carry out a transaction using Bitcoins, they issue the message so that everyone knows that this transaction has been carried out. When several have been carried out, the miners start working to create the next block of transactions in the chain, the first one to do so it will receive an economic compensation and at that moment that block will form part of the Bitcoin blockchain and everyone updates their private ledger.

The encryption system used has a random component that makes it practically impossible to break; when it is time to write the next block, all the miners start working at the same time to obtain the reward, but the one that finally does so depends on chance. This lack of predictability makes it so that even if a miner planned to insert a fraudulent transaction, the likelihood of their block entering the network is practically zero. Furthermore, a block is not considered valid until a few more have been produced that are more consistent with the transactions of the first, therefore, even if a malicious miner were lucky and managed to insert a false transaction, the following miner would discover this inconsistency and correct it immediately.

The use of blockchain goes beyond just cryptos, and as a decentralised record of information, it can be used to guarantee all types of transactions or secure exchanges of information. In the finance or business sector in general it can be used to replace intermediaries when the change of ownership is operationally complex or even when the transactions need a notary public, given that blockchain is precisely a record of transactions. Another interesting application is the storage of confidential personal information such as passports and medical records in such manner that it is possible to securely share this information with customs agents or specialist doctors without them having to have our information stored on their systems.

Having explained the functionality of Bitcoin and the blockchain, there remains the question that most people hope to find an answer for: is it a good investment opportunity? Bitcoin and other cryptos are, generally speaking, a currency, as we have previously mentioned. As such, their value essentially depends on the confidence that other individuals have in them as an exchange currency, and as a financial asset their price varies depending on supply and demand. It seems that cryptos are here to stay. There are currently more than 5,000 different cryptos, so, if we believe that they are going to continue to be around, we must work out which will be the "winner". There are differences in the implementations that may favour some over others: Ether, for example, is characterised for facilitating what is known as smart contracts, Litecoin as another alternative that requires less computer power to work, and the list goes on…

But the question was whether or not to invest in Bitcoin… Well, as we have seen in the last paragraph, we are discussing a financial asset which has all the complexity of a currency plus an additional layer of complexity of a new technology. Investment in new technologies is associated with high returns, but also high risks. In general, when we put together a portfolio we are looking for assets with a positive outlook such as a company with stable profits, barriers to entry, growth, etc. A currency does not have an expected return, rather it fluctuates due to changes in confidence or monetary policy that make it very difficult to predict, therefore, even though it could be part of the risk of a portfolio, it should not be the main catalyser for generating a return. Therefore, even though it may have randomly made a few lucky individuals rich, we always recommend the creation of professional portfolios.

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