Technology has changed the way people work, communicate, shop and even pay for goods. With the quick wave of a smartphone, consumers can pay for items at digital registers. Now, a new payment system is emerging: cryptocurrency. Probably everyone heard about Bitcoin by now. It was the first cryptocurrency to go mainstream, but others are growing in popularity. There are more than 2,000 different types of cryptocurrencies, and more are developed every day.
What is cryptocurrency?
In 2009, an Internet figure by the pseudonym of Satoshi Nakamoto started a form of cryptocurrency he termed as Bitcoin, a digital currency that runs on decentralised network and allows users to transact directly without a need of financial institution. In his white paper “Bitcoin: A Peer-to-Peer Electronic Cash System”, Satoshi Nakamoto illustrates the mechanism to secure the decentralised transaction system. The mechanism, more commonly known as Blockchain, is a distributed ledger that records transactions completed through technology-based shared database or registry.
How do cryptocurrency markets work?
Cryptocurrency markets are decentralised, which means they are not issued or backed by a central authority such as a government. Instead, they run across a network of computers. However, cryptocurrencies can be bought and sold via exchanges and stored in ‘wallets’ .
Unlike traditional currencies, cryptocurrencies exist only as a shared digital record of ownership, stored on a blockchain. When a user wants to send cryptocurrency units to another user, they send it to that user’s digital wallet. The transaction isn’t considered final until it has been verified and added to the blockchain through a process called mining. This is also how new cryptocurrency tokens are usually created.
What is blockchain?
A blockchain is a shared digital register of recorded data. For cryptocurrencies, this is the transaction history for every unit of the cryptocurrency, which shows how ownership has changed over time. Blockchain works by recording transactions in ‘blocks’, with new blocks added at the front of the chain. Blockchain technology has unique security features that normal computer files do not have.
How secure is cryptocurrency?
Cryptocurrencies are usually built using blockchain technology. Blockchain describes the way transactions are recorded into “blocks” and time stamped. It’s a fairly complex, technical process, but the result is a digital ledger of cryptocurrency transactions that’s hard for hackers to tamper with.
In addition, transactions require a two-factor authentication process. For instance, you might be asked to enter a username and password to start a transaction. Then, you might have to enter an authentication code that’s sent via text to your personal cell phone.
While securities are in place, that doesn’t mean cryptocurrencies are un-hackable. In fact, several high-dollar hacks have cost cryptocurrency startups heavily. Hackers hit Coincheck to the tune of $534 million and BitGrail for $195 million in 2018. That made them two of the biggest cryptocurrency hacks of 2018, according to Investopedia.
What is cryptocurrency mining?
Cryptocurrency mining is the process by which recent cryptocurrency transactions are checked and new blocks are added to the blockchain.
Checking transactions
Mining computers select pending transactions from a pool and check to ensure that the sender has sufficient funds to complete the transaction. This involves checking the transaction details against the transaction history stored in the blockchain. A second check confirms that the sender authorised the transfer of funds using their private key.
Creating a new block
Mining computers compile valid transactions into a new block and attempt to generate the cryptographic link to the previous block by finding a solution to a complex algorithm. When a computer succeeds in generating the link, it adds the block to its version of the blockchain file and broadcasts the update across the network.
Why cryptocurrency is an unstable asset?
Theoretically and legally, cryptocurrencies such as Bitcoin, Ethereum etc, are not money despite what some people may think. Money serves three functions: it is a medium of exchange, a unit of account and a store of value. To legally qualify as money, a means of payment must be granted a status by a country’s laws as its official monetary unit. This legal tender status allows debtors to pay their obligations/liabilities by transferring them to creditors as recognised and approved by law.
Recent research found that 80% of the world’s central banks were either not allowed to issue digital currency under the existing laws, or their legal frameworks are ambiguous and do not clearly permit them to do so. China, however, passed a law in 2020 allowing its central bank to issue a digital currency, hence the birth of the world’s first official digital currency, the Digital Currency Electronic Payment (DCEP).
Cryptocurrency supporters say it is an investible asset. Investible, yes but asset, that’s quite dubious. There is an income stream associated with a financial asset. Granted, there are assets with a zero yield such as commodities, but they are traded because they have a practical use for production or consumption. Cryptocurrencies have neither an income stream nor a practical use.
For something to serve as a store of value, it has to be liquid, universally accepted, and have a stable value. Cryptocurrencies including bitcoin certainly do not have any of these characteristics.
Contrary to the conventional wisdom that the finite supply of bitcoins and cryptos is a benefit and protects value, it is in fact a big problem for them being considered as money.
The maximum number of bitcoins that can ever be mined is 21 million. At the time of writing, there are already 18.7 million bitcoins in circulation. The last bitcoin would be mined in 2040. All cryptocurrencies have a finite supply and the speed at which they can be increased is uncertain and not controllable by anyone. These supply limitations make cryptocurrencies unsuitable as legal tender because the static money supply would deprive central banks of the ability to conduct countercyclical policy.
Conclusion
If you look at the historic returns of Bitcoin, in the last year 12 years, from 2009 till date, Bitcoin has given over 200% CAGR. Cryptocurrency’s volatility is not for the faint of heart. In the past few days we have seen how the prices of cryptocurriencies get affected from a mere tweet. There’s still a gray area attached to it making this too volatile of an investment product. In March 2020, the Supreme Court of India set aside the Reserve Bank of India’s banking ban on cryptocurrency trading. Since early this year, the Indian government has been mulling a ban on private cryptocurrencies. With legal cloud hovering over it and no risk mitigation, it doesn’t make sense to make it a prominent part of asset allocation.
