Cryptocurrencies are becoming more widely accepted around the world. As a result, the rise of Bitcoin should have been no surprise, had the rise been minimal. However, the value of a single Bitcoin has recently increased by multiple times. It is presently more valued than a number of international currencies, with the digital currency standing tall at a total value of $927 billion as of March 2021. Bitcoin’s boom is fast and parabolic growth raises several problems. In this article, we attempt to address the future of crypto and its possibility of replacing our fiat currency.
What is Cryptocurrency?
Cryptocurrency is a digital currency that is based on blockchain technology, a network of computers that enforces a distributed ledger. The term itself comes from the encryption methods that are employed to keep the network safe.The great bulk of the world’s currency is in the form of exchangeable units that are issued by governments and whose value is regulated by them. However, a cryptocurrency is different in a way that its value is driven solely by the currency’s supply and demand, implying that they are generally not issued by any central authority, making them immune to government intervention.
The mechanisms behind blockchain involve storing data in blocks that are chained together. As new data comes into a fresh new block, the block is filled with data and is chained onto the previous block; which makes the data chained together in chronological order. Thus, it is extremely difficult to go back and change the contents of the block unless the majority of the consensus network agrees to do so. This is because each block has its own hash code, as well as the time stamp and hash code of the block preceding it. A math function converts digital data into a string of numbers and letters, resulting in hash codes. If the information in the block is altered in any way, the hash code changes, making it even more difficult for hackers to track and hack the system.
Blockchain & Bitcoin
Blockchain is the foundation of the Bitcoin protocol. Bitcoin’s pseudonymous developer, Satoshi Nakamoto, described the digital currency as “a new electronic cash system that’s totally peer-to-peer, with no trusted third party” in a research paper introducing it. In short, they are both decentralized and distributed! Thus, this allows users to anonymously transfer bitcoins without the interference of a third-party authority (like a bank or government).
Although blockchain is the technology that underpins the cryptocurrency Bitcoin, it is not the only distributed ledger system based on blockchain technology. There are a variety of alternative cryptocurrencies that have their own blockchain and distributed ledger designs.
So, How does Bitcoin actually work?
Now that we understand the mechanism behind blockchain technology on bitcoin, we can move on to the implications of how the bitcoin system works. Bitcoin (and a few other cryptocurrencies), uses a decentralized consensus system known as Proof of Work (PoW) which requires members of a network to expend effort in solving an arbitrary mathematical puzzle that prevents individuals from altering the system. To do this, it requires nodes on a network to provide evidence that they have expended computational power in order to achieve consensus in a decentralized manner. This method of solving arbitrary puzzles by using large computational power is termed as Mining.
It is also imperative to note that cryptocurrencies like bitcoin need proof of work to validate and confirm transactions, as well as to issue new bitcoins into circulation. This is because cryptocurrency networks require some way of achieving both consensus and security. Proof of work is one such method that makes it too resource-intensive to try to overtake the network. Thus, by leveraging the “proof of work“ system, organizations across the globe can ensure the integrity of transactional data.
What is Money?
Money is something that we regularly use when buying or selling goods and services. It is issued by the government or central banks and can exist in the form of paper money or coins. Examples of fiat money are the US dollar, the pound sterling and the Chinese yuan. Fiat money has an unlimited supply, which means the government and central banks have no cap on printing money.
Functions of Money
Can crypto replace the fiat money that we use in our daily lives? To answer this question, perhaps it’s worth understanding the functions of money.
Medium of Exchange
Money’s most important function is to act as a medium of exchange to facilitate transactional trade for goods and services. Without money, it would be hard to trade, and all transactions would have to be conducted by barter (goods were exchanged directly for other goods), which is highly impracticable due to the lack of double coincidence of wants. To serve as a medium of exchange, it must be widely accepted as a method of payment in the markets.
Cryptocurrency is not a suitable medium of exchange at this point as it has not reached global adoption. Many countries like Turkey and China have banned the use of cryptocurrencies due to the lack of regulation and the market’s extreme volatility. However, bans on cryptocurrencies are often lifted as an increasing number of people start investing in it. As we enter an increasingly digitized age, it is likely that cryptocurrency is here to stay.
Unit of Account
Money acts as a unit of account, providing a common measure of the value of goods and services being exchanged.
Cryptocurrency’s volatile nature makes it unfit to replace fiat money. Over the past few months, cryptocurrencies have enjoyed new fame as large companies including Tesla and Meitu had invested $1.5 billion and $40 million respectively in cryptocurrencies, which sent prices surging. However, after the news came out that Tesla would no longer accept Bitcoin as payment for its electric vehicle, Bitcoin’s value fell by more than 10%. As a result, its volatile nature made it more difficult for the seller to price items in cryptocurrencies.
(Image 1: Bitcoin price volatility since 2020)
Store of Value
Money also serves as a store of value as it can be stored and retrieved at a later date without losing much of its value. People can choose not to spend money immediately as it can be kept for future purchases. Although money can act as a store of value, it is not as resistant to inflation as gold. Rising inflation will erode the purchasing power of money as people have to spend more money to buy exactly the same amount of goods and services as before.
In contrast to fiat money, cryptocurrencies such as Bitcoin are designed to have a limited supply, so they can resist inflation. However, since cryptocurrencies are highly volatile, they are not a useful store of value, particularly in the short term.
Monetary policy is a useful tool conducted by central banks to stabilize the economy by changing the size of the money supply. In a recession, central banks will buy government securities from commercial banks and this will increase the commercial bank’s accounts, called reserves. Commercial banks will, in turn, loan out some of the money they receive, increasing the supply of money in the economy, thereby helping to stimulate the economy.
However, if cryptocurrencies replace fiat money, the power of the central bank may lessen. For example, the supply of Bitcoin is limited to 21 billion, which means more cannot be mined. Hence, cryptocurrencies are unable to help economies out of recession.
Advantages of Cryptocurrency
Hedge against Inflation
Inflation fears are rising amid improving economic conditions and expansive stimulus packages that increase the global money supply. Unlike holding cash which depreciates over time due to inflation, cryptocurrency should not be devalued by a government or central bank. This is because cryptocurrency introduces a peer-to-peer trading structure that eliminates the control of any centralized authority. On top of that, some cryptocurrencies such as Bitcoin and Ethereum have fixed, and limited supply, hence its value is based entirely on people’s willingness to hold it. In the long run, it may be appreciated as it is deemed as an asset. Therefore, cryptocurrency can act as an inflation hedge.
Low and Fast Transaction Costs
In traditional financial systems, middlemen like banks, brokers, agents, and legal representatives generally can charge varying fees when conducting electronic transactions. Nonetheless, cryptocurrency introduces one-to-one business dealings that take place on peer-to-peer trading or networking structure. It cuts the effect of middlemen out of the transactions and eliminates the need for third-party management services like VISA or PayPal to verify a transaction or maintain a cryptocurrency wallet. Thus, the transaction is conducted quickly with fees charged lower than traditional financial systems. In addition, cross-border transactions are conducted without concerns over currency exchange fluctuations, interest rates, or levies imposed by countries. Therefore, the remittance fee is generally reduced to a negligible amount.
In the peer-to-peer mechanism of blockchain technology, cryptocurrency transactions cannot be reversed once it has been authorized. In addition to the public and private key notion to create and verify transactions, the proof of work or proof of stake concept is employed as the consensus algorithm to validate and add block transactions to the chain. Therefore, the strong encryption techniques used in the distributed ledger ensure stronger consumer privacy and security against fraud and account tampering.
Data Privacy through Decentralization
Next, each transaction conducted is an authorized exchange between two parties, whereby the terms may be negotiated and agreed upon in each case. The exchange of information works on a “push system”. In this case, the cryptocurrency holder can only transmit information that is relevant to the recipient regarding the specific transactions, and nothing more than that. Thus, unlike the traditional financial system where information may be exposed to third parties at any point of the transaction chain, cryptocurrency protects the cryptocurrency holders’ privacy of financial history, which lessens holders being prone to the threat of account or identity theft.
Disadvantages of Cryptocurrencies
Despite the benefits of using cryptocurrencies, a string of issues hampering cryptocurrencies’ viability as an alternative to conventional currency cannot be overlooked.
Cryptocurrency exchange is vulnerable to cybersecurity risks. Several exchanges of Bitcoin and Ethereum suffer from Spam attacks, such as distributed denial of service (DDoS) and domain name system (DNS) attacks frequently, which can lead to cryptocurrency depreciation, loss of mining rewards, and potentially the closure of cryptocurrency exchanges (Febrero & Pereira, 2020, pp.1–12). Raising funds through “initial coin offerings” (ICOs) could be a precarious path. Roughly 10% of funds raised through ICOs were stolen by hackers (Irrena, 2018), including the infamous Coincheck hack, which had $534 million worth of crypto stolen in 2018, underscoring the risks of investing in cryptocurrency ventures online.
Existing blockchain systems are plagued with scalability limitations, which have become one of the main barriers to technology adoption in the mainstream. Scalability consists of three major dimensions: transaction volume, speed, and scope. As the number of users, miners, and transactions increases, keeping the vast amount of data synchronized at every node of an extensive validation network is a bottleneck for network expansion (Sohrabi & Tari, 2020). In the case of a large influx of transactions, the systems may be unable to process received events. The constraints in terms of network bandwidth and data storage inevitably offer challenges to blockchain protocols’ scalability for general applications.
Lack of Regulations
Cryptocurrencies may potentially pose a threat to national sovereignty since they fall outside the purview of many governmental policies as a result of their decentralized and unregulated character. In particular, taxation is most likely to be the most pertinent issue. Given the disintermediation coupled with the fact of anonymity, cryptocurrencies are the ideal candidate to qualify as a new tax haven (Matei & Baks, 2019, pp.232–41). In addition, as the underlying protocol determines cryptocurrency market capitalization in advance, central authorities are unable to interfere in the case of rise or fall in the deflation rate. Hence the risk of market manipulation is heightened. The asymmetries of information, along with inherent technical complexities, necessitate regulatory attention on consumer protection, as well as sufficient disclosure and transparency.
As the prices of a cryptocurrency fluctuate heavily based on the supply and demand of the currency’s market without any intervention from a central authority, it is no surprise that its high volatility is criticized by economists to be a speculative bubble. Furthermore, although it is acknowledged that the blockchain technology that runs most of the cryptocurrencies is known to be highly secured, crypto wallets and P2P exchanges itself are not immune to hacking. For these reasons, this has led to outright bans on buying, owning, and trading of cryptocurrencies by several countries across the globe.
Despite this, many analysts consider cryptocurrencies as having potential benefits, such as the ability to preserve value against inflation, the facilitation of exchange while being easier to carry and divide than precious metals, and the freedom to operate without the control of central banks and governments.
Researcher: Tee Jia Rou, Lee Jih Yih, Yap Li Wen, Vincent Tandry
Reviewer: Muhammad Bahari
Editor: Jennifer Ley
Download the article here: [download id=”5550″]
[yikes-mailchimp form=”1″ title=”1″ description=”1″]