Cryptocurrencies have yet again gone through one of the many roller coaster rides in the past few months. They can synonymously be used for volatility – they are that highly erratic. In this article, we will try to decode the entire episode and present it to you from scratch.
To begin with, cryptocurrency is a digital asset or a form that is secured by cryptography. Cryptography refers to the process of converting legible information into an almost uncrackable code. The first-ever cryptocurrency, Bitcoin, was introduced in 2009 by a mysterious individual (or a group of people) with the pseudonym Satoshi Nakamoto. The creator's objective was to eliminate the intermediaries (eg, banks) in the backdrop of the 2008 debacle, also known as The Great Recession. Therefore, it did not want any third party's involvement, which raises the transaction cost (by way of transaction fees) and risk via exposure to mortgage lending. Additionally, the value of fiat currency is dependent on money circulation in the economy, which can fluctuate depending on the monetary authority. These interventions, per se, are not wrong; however, the component of uncertainty and dependence on third-party necessitated the absence of intermediaries in the eyes of Nakamoto.
The next big question arises: if no intermediary involvement is present, then who develops and verifies these digital currencies? Through the process of mining, these digital coins are created and verified by way of blockchain networks. Simply put, blockchains are digital ledgers where the transactional data are stored in an encrypted, decentralised format such that no person can own, control or manipulate the particulars.
Mining is a laborious procedure involving solving complex computational puzzles. Nonetheless, it still appeals to various individuals (known as miners) because of its reward in terms of ownership of the new crypto tokens. Initially, mining could be done with basic devices. When crypto participants and engagement increased, the activity became further complicated. It can no longer be solved by basic computers and instead requires supercomputers. Cryptos have a fixed supply; hence, unlike government-backed fiat money, their supply cannot go up suddenly. The disadvantageous element of this process is the carbon footprint it accounts for.
A University of Cambridge study has stated that mining of the largest cryptocurrency by market capitalisation – Bitcoins, consumes more than 120 Terawatt Hours (Twh) each year, using more electricity annually than countries like Malaysia or Sweden. Furthermore, studies claim that mining should follow the adoption rate of other broadly adopted technologies, and Bitcoin could alone produce enough carbon dioxide emissions to push global warming above 2°C within less than three decades.
It goes without saying that other much smaller cryptocurrencies have a far lower energy footprint due to their much smaller scale. However, if scaled up, they are equally carbon-heavy.
However, proponents of cryptos say that mining is increasingly being done with electricity generated from renewable sources. Nevertheless, environmentalists continue to decry mining since miners will keep up consuming coal (it is the cheapest source) for electricity generation, thus giving us its ecological aftermath.
Apart from environment lovers, government and monetary officials view these digital assets as potential threats due to their operation outside government control, which can potentially overturn an economy if not supervised.
Several risks are associated with cryptocurrencies. Firstly, a high degree of market manipulation due to the lack of backing by any tangible assets questions their intrinsic value, marking their price discovery in uncharted territory.
Secondly, asymmetrical information raises the likelihood of money laundering, hacking, cyber extortion, and more, damaging consumer protection and systemic stability.
Some risks are familiar with other financial products; however, crypto's information opacity disrupts the adjustment. For example, as per a Wall Street Journal finding, Hamas, the Palestinian militant group, saw a spike in Bitcoin donations during the violence between Israel and Palestine in mid-May. Hamas, which rules the Gaza Strip, is designated as a terrorist entity by the US, the European Union (EU) and other Western nations and has sanctions imposed upon it. Nonetheless, its funding remained unaffected due to anonymous digital transactions.
In another such instance, according to the analytics firm Elliptic, DarkSide, a hacking group, shut down a critical US oil pipeline in May and collected over $90 million in hard-to-trace Bitcoin from 47 victims. That hack ended after Colonial Pipeline paid nearly $5 million as ransom to regain control of systems needed to supply gasoline to the Eastern US.
Despite these complications, cryptocurrencies are seeing huge public acceptance. There are multiple reasons for broader acceptance of these digital assets, owing to their higher yields on the back of low-interest rates, hedging against inflation, or their growing acceptance by corporate leaders. For example, digital assets are pretty popular in Argentina as a way for locals to hedge against cyclical economic crises, including repeat currency devaluations, defaults and hyperinflation, with the recent imposition of foreign exchange controls and now a three-year recession made worse by the pandemic.
The massive monthly rally of cryptos in early 2021 and the big sell-off in mid-May, as per market observers, was caused by Elon Musk's tweets. The American electric car maker, Tesla, announced in its February, 2021 filing to the market regulator that it had bought $1.5 billion worth of Bitcoins and would soon start accepting the digital currency for payments. A few weeks back, its CEO Musk hinted as much by adding '#bitcoin' to his Twitter bio. Followers and the general public went into a frenzy, and the market price surged. However, the plunge in crypto prices in mid-May was sparked when the Tesla chief tweeted the company’s u-turn on Bitcoin acceptance and criticised it for the environmental hazard posed by aggressive power mining.
Elon Musk has a track record of influencing the market price of asset classes. Back in 2018, Musk and Tesla, each paid $20 million to the Securities and Exchange Commission (SEC) to settle fraud charges for tweeting about a potential buyout of the car-making company, leading to a spike in share prices followed by a fall when the buyout could not be negotiated. Many regulators are worried about the concentration of social power among a few individuals and organisations to influence prices of various asset classes, which can hamper price stability.
Another key reason for slumping prices of crypto in the early morning of May 19 in Wall Street was attributed to China, after the country barred its financial institutions from dealing in cryptocurrencies. China accounts for more than 70% of all bitcoin mining in the world. Due to its cheap energy, the country's Inner Mongolia Autonomous region accounts for around 8% globally, a more significant share than the US. The move is part of the government's target of achieving carbon neutrality by 2060.
China had such a ban in 2017, but the 2021 ban has a broader scope. The ban prohibits institutions from accepting or settling payments in crypto or providing exchange services to convert crypto to fiat currencies, including the Chinese yuan.
In India, are cryptocurrency banned? No, they are not 100% legal, so it is all right for us to trade in crypto exchanges like WazirX or CoinDCX. However, they are not legal tender of money, so you cannot purchase any goods or services and make payments in these digitised currencies. Back in 2018, the Indian central bank had issued a circular to refrain financial institutions from having any relation with any crypto assets or crypto organisations; however, the ban was lifted by an Indian Supreme Court decision in the very same year.
The Supreme Court in March 2020 said the central bank could notify cryptocurrencies as ‘other similar instruments’ under the definition of the term 'currency' in the Indian Foreign Exchange Management Act (FEMA). Therefore, the trading in crypto can fall within the purview of the central bank. In May 2021, the central bank came out with a circular reiterating its commitment to upholding the Court's decision. However, it did ask institutions and other entities to carry out due diligence processes in line with customer protection and economic stability as per the FEMA Act. The Indian Finance Minister in her 2021-22 budget hinted that the government would take a ‘calibrated approach’ towards digital assets. Hence, some regulation or oversight by the government is expected.
We will get to know whether these computerised assets are the future of payments in years to come. However, administrations need to acknowledge the public involvement and bridge the loopholes these instruments carry with themselves as soon as possible.
Subscribe to The Pangean
Get the latest posts delivered right to your inbox