News/finance/crypto currency

Cryptocurrencies: What Are They?

Interest in cryptocurrencies has soared in recent years. Understandably, investors have questions—here are answers to some of the most common.

In a decade and a half, the cryptocurrency industry has boomed. From the now-ubiquitous tales of "bitcoin millionaires" to the increasing number of companies jumping into the crypto arena, it's hard to ignore the news—or the feeling that not owning cryptocurrency means missing out.

Bitcoin has been the financial equivalent of a bungee-cord jump over the past half-dozen years, trading as low as $1,000 in early 2017 before soaring to a record over $68,000 about four years later, then plunging to around $16,000 by late 2022. After nearly tripling in value during 2023, as of mid-February 2024, bitcoin was moving close to $52,000. Some attributed those gains in bitcoin and other riskier assets to the Federal Reserve's pledge to move away from historically high interest rates to combat inflation.

Bitcoin prices were already elevated ahead of January 10, 2024, when the Securities and Exchange Commission (SEC) approved exchange-traded funds (ETFs) linked to spot bitcoin, in what was recognized as the first time U.S. regulators have approved a cryptocurrency's use in a widely held, actively traded investment product common to many individual investors' portfolios.

Yet, whether spot bitcoin ETFs achieve widespread acceptance and "success" as an investment vehicle remains to be seen. SEC Chair Gary Gensler left little doubt at the time of the announcement that the regulator continues to be skeptical of any product linked to cryptocurrency. "While we approved the listing and trading of certain spot bitcoin ETP shares today, we did not approve or endorse bitcoin," Gensler said in a statement. "Investors should remain cautious about the myriad risks associated with bitcoin and products whose value is tied to crypto."

However, as the crypto world continues to evolve, investors will likely want to know more, even if they're far from making any potential investment decisions. Here's a few basics.

What is bitcoin? Bitcoin is a virtual, digital, or "crypto" currency—so called because of the cryptography, or unchangeable coding techniques, involved in the blockchain code on which they exist. The intent of bitcoin is to allow online payments to be made directly from one party to another through a worldwide payment system without the need for a central third-party intermediary like a bank. Bitcoin is not issued by any central bank or government and is still not considered legal tender (meaning a national currency established by statute) in most countries. Like physical gold, bitcoin's value stems from a combination of its perceived scarcity and the perception that it can be a store of value, an anonymous means of payment, or a hedge against inflation, though none of these characteristics have yet to establish a long-term track record.

That said, early 2024 marked a milestone for bitcoin specifically. On January 10, the Securities and Exchange Commission decided to approve trading for the first time in ETFs that hold spot bitcoin cryptocurrency. It was the first time crypto was allowed as an underlying asset in such a widely held, actively traded investment product common to many individual investors' portfolios. The spot market, also known as the cash market, refers to forums where securities and other assets can be immediately exchanged between buyers and sellers. However, it's important to know that an investor who buys one of the new spot bitcoin ETFs is not purchasing bitcoin. The new ETFs are securities designed to track the price of the underlying cryptocurrency.

What is cryptocurrency, and how is it valued? Fiat currencies like U.S. dollars and euros are forms of money issued by governments to serve as legal tender. Cryptocurrencies like bitcoin, on the other hand, are "non-fiat" or non-governmental forms of "digital cash" to be used for electronic payments.

The idea of "digital cash" isn't new—it started with credit cards, PayPal, Venmo, and others to satisfy the need for easy, traceable electronic payments. But those payments are tied to fiat currencies managed by central banks, whereas cryptocurrencies are managed by technology, specifically cryptology.

Proponents believe the value of a cryptocurrency is based on the quality of the cryptology, the number of cryptocurrency units created, and the technology that limits the creation of additional units. Like any traded item—think baseball cards—the value often depends on supply and demand: The fewer units available, the higher the price potential buyers are willing to pay.

What's the relationship between cryptocurrencies and blockchain? Blockchain, the underlying technology that supports cryptocurrencies, is an open-source, public recordkeeping system operating on a decentralized computer network (in this case, the internet) that records transactions between parties in a verifiable and permanent way. Blockchain provides accountability because the records are intended to be immutable, which presents potential applications for many businesses. While blockchain has often been associated with cryptocurrencies, it has many potential uses beyond payments. They include "smart" contracts, in which a digital token is attached to and thus verifies legal documents and other agreements, as well as in supply chain management and financial services. Note that ownership of bitcoin or other cryptocurrencies is not an investment in blockchain, the technology, or its current or future uses.

Why has bitcoin become popular? Like many new technologies or products, bitcoin attracted adherents interested in innovation and the perceived absence of governmental control. Traders saw it as an alternative to traditional investments like stocks, bonds, and cash, and trading momentum led to a rising, if highly volatile, price. All this attracted media attention, which has driven mainstream awareness and ultimately increasing acceptance and a market to trade it. While companies as varied as PayPal, Microsoft, Starbucks, and AT&T have accepted bitcoin as a form of payment, such transactions typically involve a third-party processor; thus, its use in everyday commerce still remains outside the mainstream.

Who oversees bitcoin? Bitcoin was created based on a paper written in 2008 by a "founder" who goes by the pseudonym Satoshi Nakamoto, but no person or agency currently regulates it to ensure that it maintains value and liquidity and works as a means of payment. It's governed by consensus of a private digital community according to guidelines based on the community, cryptology, and a network of computers.

Many individual countries may allow bitcoin to be used as a means of payment, regulate the terms under which its citizens can trade or mine bitcoin, and authorize the operation of cryptocurrency exchanges, but they don't regulate or control the existence or value of bitcoin itself or the blockchain code on which it operates. At least two countries, the Central African Republic and El Salvador, accept bitcoin as legal tender, according to CoinMarketCap.

Bitcoin is promoted by the Bitcoin Foundation, but the foundation also does not control or manage bitcoin's trading or value. The number of bitcoins in circulation is limited by and managed by the original computer code and traded through one of several digital, decentralized exchanges.

How many investors own bitcoin? No one knows for sure, but despite more than 85 million total owners as of June 2023, just 9.1% of account owners controlled more than 98% of the total bitcoin in circulation.

How many cryptocurrencies are there? Bitcoin is believed to be the first cryptocurrency and is the best known, most widely held, and as of early 2024, the most valuable, hitting $1 trillion in market cap in mid-February, according to the Bitcoin Rich List.

But bitcoin is among a cast of thousands.

In early 2024, CoinMarketCap's website listed around 9,000 cryptocurrencies, many of which were worth fractions of a penny and traded little, if at all. Bitcoin and a handful of others, dominate daily trading volume and market value, with bitcoin's market capitalization of about $894 billion accounting for a little more than 50% of overall market cap. Other popular cryptocurrencies include ethereum and tether.

Federal Reserve Chair Jerome Powell and SEC Chair Gary Gensler both have stated that they don't intend to outlaw cryptocurrencies. But in mid-2023, both the SEC and the CFTC had initiated formal charges against Binance and Coinbase, two of the largest crypto exchanges, for operating unlicensed broker dealers, exchanges, and clearing agencies, as well as violating numerous federal securities laws intended to protect investors.

Cryptocurrencies don't appear to be going away any time soon. In April 2023, European lawmakers approved the world's first comprehensive package of rules aimed at regulating cryptocurrencies, and in June 2023, the U.S. House Financial Services Committee and the House Agriculture Committee released a joint bill that creates a broad regulatory framework for cryptocurrency. This bill is expected to be taken up by Congress in 2024.

Bottom line Schwab continues to monitor cryptocurrencies as regulations and technology evolve. While some traders have made money on the change in price of bitcoin or other cryptocurrencies (and others have lost money), we suggest investors continue to treat them as a speculative asset primarily for trading with money outside a traditional long-term portfolio.

Cryptocurrency-related products carry a substantial level of risk and are not suitable for all investors. Investments in cryptocurrencies are relatively new, highly speculative, and may be subject to extreme price volatility, illiquidity, and increased risk of loss, including your entire investment in the fund. Spot markets on which cryptocurrencies trade are relatively new and largely unregulated, and therefore, may be more exposed to fraud and security breaches than established, regulated exchanges for other financial assets or instruments. Some cryptocurrency-related products use futures contracts to attempt to duplicate the performance of an investment in cryptocurrency, which may result in unpredictable pricing, higher transaction costs, and performance that fails to track the price of the reference cryptocurrency as intended. Please read more about risks of trading cryptocurrency futures here.