Sometime back, the Chairman of the US Securities and Exchange Commission (SEC), Gary Gensler approached the Congress seeking more authority to better police cryptocurrency trading—the “asset class” that is “rife with fraud, scams and abuse in certain applications”— “to protect investors in this growing and volatile sector”.
As more and more investors loaded their portfolios with digital tokens, trading in cryptocurrencies reached a record capitalisation of $2 trillion in April 2021, while the regulatory oversight of the market remained patchy. This perhaps prompted the Chair of the SEC to observe that unless SEC oversees crypto-lending and platforms like peer-to-peer Decentralised Finance (DeFi) sites that facilitate lenders and borrowers to transact in cryptocurrencies without the involvement of traditional banks, “I worry a lot of people will be hurt”.
And, now, perhaps alerted by the puffery advertisements, it is our government that is rushing in to ban crypto trading. Cryptocurrencies though attracted the mainstream media’s attention for quite some time, there appears to be a widespread confusion about them. We shall therefore take a look at their basics. But before getting into cryptos let us first recap our understanding of the ‘money’.
We all know that for something to function as money it must essentially have a legal tender status, i.e., sellers must, as a legal requirement, accept notes and coins in payment. Indeed, you would see this guarantee clearly stated in the dollar bill: “This note is legal tender for all debts, public and private”. In the case of Indian currency notes, you would see an undertaking: “I promise to pay the bearer the sum of one hundred rupees”, duly signed by the Governor of the Reserve Bank of India (RBI), the note issuing authority. It is only on such clear declarations that these notes have become money.
As against this fiat money that is issued by the RBI and “guaranteed by the Central government”, cryptocurrency is a virtual thing. Unlike fiat money such as rupee or dollar that people are mandated to use by their respective nations, cryptocurrency is an opt-in currency. It is used by people on their own volition. It is controlled by the will of its users. It functions independently of any government and financial institutions like banks. Indeed, it is headless and is distributed globally. But like any other money, cryptocurrency, of course, can be stored, exchanged, and can also be used to make payments, of course, only as long as people accept it.
Among the cryptos, bitcoin is the most popular digital currency. It was first conceptualised in 2009. Out of the $2 trillion market value of the cryptocurrencies, bitcoin alone has a share of about 44%. There are many other cryptocurrencies: Ethereum, Tether, Binance Coin, etc.
Bitcoin is a digital currency. It is secured by cryptography. They operate on blockchains—an open distributed ledger in which encoded transactions of this currency are recorded. It is this unique feature of decentralised nature of their transactions that allows them not to be controlled by governments or by any other centralised authority.
Every bitcoin is represented by a unique code: a 26-35 long case-sensitive string of alphanumeric characters. These coins are created by solving complicated mathematical puzzles in a computer-intensive process called, ‘mining’. Minors receive two types of rewards for mining: new coins created with each new block and transaction fees from all the transactions included in the block. Mining thus performs two functions: one, ensures monetary supply and two, performs an important function: the decentralised emergent consensus mechanism that underpins bitcoin’s security. These coins are stored in ‘wallets’—digital directories. They are accessed through the use of a unique private key, a cryptographic equivalent of a password.
Bitcoins are used as a transfer of value. Coins can be broken up into smaller unique units. These transactions are crowd-controlled. Suppose if Ms Uma wants to send 1 bitcoin to Ms Hemalata, she uses her private key to sign a message with the transaction-specific details. This message is broadcast to the network. When a majority of those viewing the blockchain agree that coin No. xxxx can be transferred from Ms Uma’s ‘wallet’ to the wallet of Ms Hemalata, the transaction will be cleared and a new entry is made in the blockchain.
Trading bitcoins for fiat money such as dollar, Indian rupee, goods, services, or other cryptocurrencies can be carried out through Crypto exchanges. These exchanges are legitimate companies that mostly operate on a market place model. They, like any other exchange, provide an online platform for trading in cryptocurrencies. They thus form a bridge between cryptos and traditional financial systems. These exchanges also offer various financial products such as instant loans against pledging collateral in bitcoin.
Now, coming to its intrinsic value, it must be said that bitcoins are not backed by physical assets. Nor do they have backing of the Central Bank/Government. This phenomenon raises a question: What then gives bitcoin value? The answer is simple: some people believe that it has value. They think it can be used to store and exchange value. So, it’s the belief of the people that is imparting them value. In other words, once people lose their faith, it automatically loses its value.
To make it more explicit, let me draw your attention to the basics of a security. A security, such as a share issued by a company, is backed by the assets owned by it. So long as the company is a going concern, there would always be some or the other asset available for the security-holder to rely upon. But in the case of cryptocurrencies there is no such thing to fall back right from its very issue.
So, bitcoins are essentially speculative assets. In the words of Jerome Powell, Fed Chairman, “they are highly volatile and therefore not really useful stores of value”. Huge swings are witnessed in their prices, for their value essentially depends on their supply and the market’s demand for them.
For instance, when Tesla announced in February about its accepting bitcoins, its value shot up to $65000 per bitcoin but in mid-May when Tesla declined to accept, its price fell sharply. One of the reasons often quoted for such high volatility is its huge concentration in 2% of accounts.
As against this reality, the acolytes of cryptos even compare them with gold, for it has a limited supply: the rate at which new bitcoins are introduced is designed to slow over time and its supply is finally capped at 21 million and once this number is achieved (expected to achieve by 2140), there will be no more mining of bitcoins. Because of this in-built ceiling on its number, it is claimed that bitcoin is not subjected to inflation. Secondly, they claim it to be durable, for a huge globally distributed network of independently operated computers track bitcoin ownership. This mechanism is expected to ensure that no bitcoin is lost and no fake bitcoin is introduced.
Over it, votaries of bitcoins claim that cryptocurrency is a decentralised apolitical money but the truth remains that its mining is very much in the hands of men/women and its greedy market makers. In a similar vein, their claim for integrity of data in the blockchains is not certain, for it cannot ensure that the people who put data in them are good actors.
Though bitcoins are virtual, they are nonetheless need to be produced. And this production involves real cost. Bitcoin mining consumes lots of electricity for it involves solving complicated cryptographic math problem using series of computers with specialised chips, in which many miners compete to solve. One estimate reveals that globally, crypto mining consumes as much power as a nation like Belgium consumes. It is thus sure to cause stress on a country’s energy resources, besides increasing carbon emission.
Recently, another allegation emerged against bitcoins: as they need lot of processing power to work, cryptocurrency miners are reported to be buying graphics cards and processors in large numbers. Coupled with dwindling availability of high-end chips, this huge demand from crypto miners simply made chip prices shoot up.
As transactions in cryptocurrencies are not transparent, it is alleged that cryptos are being increasingly used for money laundering and for illegal cross-country transfers, such as payments under narcotic trade. In view of these adversities, countries like China, Indonesia, Turkey, etc., banned its trading.
Coming to taxation, the US treated them as property and Canada as a commodity, while Australia treated it as an asset for capital gains tax purposes. India is yet to define its policies.
Lastly, the big question is, do cryptocurrencies succeed? The answer is divided: the acolytes are gung-ho about them, while the conservatives opine that they are less likely to succeed for, reasons such as technical, economic, regulatory, political, social, human, structural, governance, trust, etc. can pose a great challenge. For instance, cryptos claim that they employ open-source code. Yet, they can be hacked and according to current reports, crypto assets are often lost or stolen forever. And it is worth remembering that on the blockchain, transactions are instantaneous, irreversible and anonymous. Market participants/regulators have thus no recourse to recoup funds.
In a nutshell, what does all this mean to investors? It simply means: Caveat emptor—buyer beware!
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