Cryptocurrencies – a kind of online money – have continued their march into the mainstream over recent years with the stock exchange listings of American brokers Coinbase and Robinhood, and adoption by mainstream investors and even countries, such as El Salvador.
Investors have made huge sums by throwing their cash behind new digital currencies, but their volatile nature means savers can just as easily lose their money.
The first cryptocurrency was Bitcoin, which was created in 2009 and is still the best known. There has been a proliferation of cryptocurrencies in the past decade and there are now thousands available on the internet, but Bitcoin remains the most well known. Ethereum, Dogecoin, Ripple and Litecoin are some of its most prominent rivals.
These digital currencies are associated with cryptography, the process of converting legible information into an almost uncrackable code, to track purchases and transfers.
Cryptography was born out of the need for secure communication, but it has evolved in the digital era with elements of mathematical theory and computer science to become a way to secure communications, information and money online.
Here is everything you need to know about cryptocurrencies.
How do cryptocurrencies work?
Cryptocurrencies use decentralised technology to let users make secure payments and store money without the need to use their name or go through a bank. They run on a distributed public ledger called blockchain, which is a record of all transactions updated and held by currency holders.
Units of cryptocurrency are created through a process called mining, which involves using computer power to solve complicated maths problems that generate coins. Users can also buy the currencies from brokers, then store and spend them using cryptographic wallets.
Cryptocurrencies and applications of blockchain technology are still nascent in financial terms and more uses should be expected. Transactions including bonds, stocks and other financial assets could eventually be traded using the technology.
What are the most common cryptocurrencies?
- Bitcoin: Bitcoin was the first and is the most commonly traded cryptocurrency to date. The currency was developed by Satoshi Nakamoto in 2009, a mysterious figure who developed its blockchain. Proponents say institutional investors are buying into the coin as a store of value, similar to gold, however critics say the coin is in a bubble and fundamentally worthless.
- Ethereum: Developed in 2015, ether is the currency token used in the ethereum blockchain, the second most popular and valuable cryptocurrency. Ether has had a turbulent journey. After a major hack in 2016 it split into two currencies. It has proved hugely popular as a launch pad for other cryptocurrencies, with other digital coins using Ethereum's blockchain to build apps and payments services.
- Ripple: Ripple is another distributed ledger system that was founded in 2012. Ripple can be used to track more kinds of transactions, not just of the cryptocurrency. The company behind it has worked with banks and financial institutions, including Santander.
- Litecoin: This currency is most similar in form to bitcoin, but has moved more quickly to develop new innovations, including faster payments and processes to allow many more transactions.
Why would you use a cryptocurrency?
Cryptocurrencies are known for being secure and providing a level of anonymity. Transactions in them cannot be faked or reversed and there tend to be low fees. Their decentralised nature means they are available to everyone, although they can be complicated to set up and few stores accept them for spending.
Perhaps the most popular use of cryptocurrency is as a speculative investment, with users buying up the coins in the hope they will go up in value, or that one day might be useful as an alternative to traditional currencies.
Bitcoin's volatile price has led to sudden peaks in interest as its value goes up. This has caused a surge in professional and amateur speculators investing in bitcoin and other cryptocurrencies, seeing them either as a quick way to make returns or as part of an investment portfolio.
Are there concerns about cryptocurrency?
There are big concerns about digital coins as a source of fraud. They are also entirely unregulated and some are open to market manipulation. Speculators who buy digital coins should be aware they could lose all their money, according to British financial regulators.
While Bitcoin is decentralised, it is highly volatile and has been known to move when popular individuals, such as Tesla chief executive Elon Musk, so much as mention the names of digital coins.
What should you avoid?
Other smaller coins can be more volatile still. Some have been accused of being outright fraudulent. Others have seen investors spend their money being digital coins only for the developers to make off with the cash themselves.
One of the most common practical uses of cryptocurrency is to finance illegal activities, such as buying illegal goods on the dark web. Many black market internet stores accept payments in cryptocurrency because they can be highly anonymous and do not require cash to change hands.
Do you have to pay tax on cryptocurrency in the UK?
HMRC has declared that cryptocurrencies are not exempt from the digital services tax - and they do not count as commodities or money either.
The digital services tax puts a 2pc sales levy on online marketplaces, search engines and social media services which hold a global revenue of over £500m and UK sales of over £25m.
This article is kept updated with the latest advice.
