Crypto Currencies -
What you need to know?

Crypto currency basics

Crypto currency is a digital currency that is created by “mining” Cryptos. Mining is a process where some people verify transactions and perform the role of auditors. After that, they need to solve a problem to get paid. Only when they do both correctly, they can get paid. For mining cryptos, they need oodles of computing power. Know more about mining here.

Cryptos uses cryptography during its creation and for verifying transactions that are taking place. It uses blockchain technology and functions on the basis of distributed ledgers that this technology facilitates. Till now, Cryptos have all been outside government purview. It is entirely controlled by third parties.

Sovereign governments create the fiat currencies, regulate their supply and ensure a stable currency environment to facilitate commerce. The Crypto creators have their own rules, which sometimes may work at cross purposes with the governments.

Crypto “Currency”?

A currency needs to have certain features for it to be treated as a currency. It should be universally accepted as legal tender and the value associated with the currency should not be disputed. We need to have trust in the system & faith that value it represents is real. For eg. a Rs.500 note would be accepted and goods worth that value can be purchased anywhere, anytime.

Also, the currency value should be stable and should not swing wildly. There should be a proper trustworthy mechanism to regulate, monitor & facilitate commerce using the currency. Governments & central banks have been performing that role all along.

Crypto currencies suffer from several deficiencies. Firstly, it is too volatile to function as a currency. It is too volatile to be suited for commercial transactions. A contract signed at one point in crypto currency may yield a different value by the time contact gets completed. 

For instance, a commercial complex costing Rs.750 crores once signed with a builder will be valuable for both sides only if the value is the same when the project is completed. If the builder had to spend Rs.750 crores but the currency depreciated and he is now getting the equivalent of Rs.500 Crores, he will make a huge loss. It can happen in the reverse as well. This is the problem when a very volatile currency like Bitcoin is involved. That is one reason why Cryptos are not suitable in commercial transactions.

The shadowy world of cryptos and Internet does not inspire trust. There are very few things one can buy today using Cryptos. In fact, there is an allegation that most of what one can buy with cryptos are illegal items. Dark web is known for selling contraband & Cryptos by association have developed an unsavory reputation.

Hence, Cryptos are not so much a currency at all!

Governments and Crypto

Crypto currency can at best be treated as one of the esoteric asset classes into which one may invest money. But it is a very volatile asset class. Governments do not look kindly at it. In fact some governments have banned Cryptos, some have put restrictions on it.

Some governments are even toying with the idea of a crypto currency of their own. Even Indian government is toying with such an idea. A government backed Crypto will have the benefits of trust, stability with containment of volatility. Such Cryptos will be hybrid structures which will not have all controls like the current currency regime but will still have institutions at the back end to support the digital payment regime ( which may still be peer-to-peer and largely anonymous )..

In India, we already have the UPI backbone (which  is one of the most advanced public payment systems in the world) and the India Stack providing a robust digital infrastructure. Currently, the digital revolution is already well underway, powered by the normal currency.

This whole digital infrastructure, which is powering the digital, cashless revolution has the potential to move a step ahead with crypto currencies and blockchain technology. When governments are involved, they will make available as much crypto currencies as are needed to support growth, contain inflation and maintain stability in the system, unlike the current Crypto systems of today.

Why are Bitcoin prices shooting up?

The number of Cryptos is limited which is one of the reasons why their prices are going up. In the case of Bitcoin, which is the most popular Crypto Currency, the number of Bitcoins is limited to 21 million. Already under 19 million Bitcoins have been mined and are in use. 

It is creating an artificial scarcity and new miners are getting less and less bitcoins for the same work. Every four years, as per their algorithm, the bitcoins paid for a block of work done halves.  Hence, some people believe the prices can only go up.

But there are other factors at play which make the proposition much less certain.

Problems with Cryptos as assets

For one, complete anonymity of people using cryptos is not seen very kindly by governments. Cryptos have been used for illegal activities like drugs, weapons etc. They are also used by terror organisations and those who launder money, making governments very wary of Cryptos. That is one of the reasons why so many controls are being imposed. The future cannot be predicted as serious government action, if warranted, can be initiated that can cripple them.

Cryptos are not clean assets. Tremendous amounts of energy are expended in mining cryptos, which uses vast amounts of energy ( 7000 MW at last count ) and increases carbon footprint. This will only increase in the future. It will hence come under increasing scrutiny by environmental activists and governments themselves. This can create problems for Cryptos.

Once someone pays to another through Cryptos, there is no way to reverse the transaction. This is a major problem if one has paid wrongly. Also, one needs to remember the account & password details. If that is lost, it cannot be retrieved. Further, if there is a device failure and cryptos have been stored there, it is lost forever.

There have been many instances of theft from the exchanges. Mt. Gox, the largest Bitcoin exchange in 2013, lost the equivalent of USD473 million or about 7% of Bitcoins in existence then! Nor was this an isolated instance. There have been many such incidents in the past years which does not in any way assuage the fears of people who invest in Cryptos.

Finally, the premise that the prices will shoot up due to scarcity is also flawed. Gold availability is also limited and the amount being freshly mined is low. Still, there it is not that the prices are booming.  In case of Cryptos, if at any point sufficient miners are not there as it is not commercially lucrative, then the whole edifice can even crumble. Looks highly improbable now, but a possibility still.

Hence, the future of cryptos as the nex-gen asset is not watertight. In fact, it is anything but. 

Future of Cryptos

One of the problems with Cryptos in the real world is volatility of the currency itself which is something that is stopping it from being used in commercial transactions.

The ostensible solution to that is what is known as DeFi, short for Decentralised Finance. It is a set of applications that together can help in buying/ selling of securities, Creating derivative products, lending etc. just like in the normal world, through Smart contracts. The currency used here is called Stablecoin which is pegged to a normal currency like USD, to take care of volatility.

In DeFi, Decentralised apps (DApps) and protocols span the entire spectrum from lending protocol, derivatives, decentralised exchanges, digital asset transfer etc. DeFi has the power to make the transactions less costly, swift and without the need for third parties. This has potential – the technology involved, I mean. Within the framework of private Cryptos, one is not so sure how far DeFi would go.

But as and when the government steps in and brings in cryptos, DeFi can play a very important role, as the proof of concept is already there.

Parting word 

Crypto currency sounds sexy. The vertical price rise is enticing. But caution is advised. Blockchain is a technology that seems to have tremendous applications, with potentially massive improvement in data security. But Cryptos are not exactly a must-have asset. There are lots of imponderables here and one needs to tread with caution.  

Go here if you have a high-risk appetite, can stomach massive volatility and also know that there is no recourse when things go wrong.

Articles to go through for more information on Cryptos –

For a good overview of Crypto currency refer to this entry –    https://en.wikipedia.org/wiki/Cryptocurrency

Advantages and Disadvantages of Cryptos –

https://honestproscons.com/advantages-and-disadvantages-of-cryptocurrency/

Understanding how Crypto currency by a sovereign government can function- https://www2.deloitte.com/content/dam/Deloitte/us/Documents/strategy/us-cons-state-sponsored-cryptocurrency.pdf

Crypto currency is a currency? –

https://sapficoandmore.wordpress.com/2018/04/25/cryptocurrency-what-currency/

A bit about Bitcoin volatility –

https://www.investopedia.com/articles/investing/052014/why-bitcoins-value-so-volatile.asp

Indian Government views on Cryptos –

https://www.livemint.com/market/cryptocurrency/fms-push-for-calibrated-approach-on-crypto-trading-calms-frayed-nerves-11615112421872.html