Imagine a world with no controls on how you exchange money with people. There are no global boundaries on where goods and services are produced and you can use a ‘global currency’ to purchase anything anywhere without the help of a third party and no transaction costs. And since the currency is not controlled by a government, you have total freedom on how and where you spend your hard-earned money without the state watching over your financial activities.
Milton Friedman, arguably the most renowned economist of the 20th century, predicted the development of such currencies back in 1990. “I think the internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash. ”
Twenty years later cryptocurrencies currencies like Bitcoin have become a reality, and their acceptance is increasing. The price of one Bitcoin, for example, has risen from 6 cents seven years ago to almost $ 10,000–an unprecedented rise in asset value. Why would anyone pay such a high amount for an imaginary currency that has no physical face and exists only as entries in digital ledgers?
Is this the monetary future, or just a fad?
First a brief history of cryptocurrencies. In 2008, in the wake of the global financial crisis when government money was failing, a person acting under the pseudonym Satoshi Nakamoto published a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” With that was created a system to transfer money digitally between willing participants without the need of a trusted third party. The developer of the Bitcoin system cleverly restricted the algorithm to supply only 21 million bitcoins by the year 2140. Out of this total supply, 16.7 million bitcoins have already been released into the system and 1,800 new Bitcoins are currently released every day–a number that keeps dropping by the day. Since over 80% of the total available supply of Bitcoins will have been released by 2018, the other 20% will be released over the next 122 years. This will ensure that the supply of new Bitcoins keeps shrinking over time, while its demand keeps increasing, creating an upward pressure on its speculative value. Some of the upward pressure on the price of Bitcoins will come from this speculative momentum and this pressure is likely to build over time as more investors jump on the cryptocurrency bandwagon.
Until now cryptocurrencies have been trading in unregulated markets. As a result, most large institutional investors have abstained from trading these currencies. But that is about to change. Two of the largest exchanges in the world, the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) will soon start trading Bitcoin futures. Trading on these regulated exchanges will impose price discipline and make Bitcoins more attractive to mainstream investors. This will further enhance their acceptability both as an investment and a medium of exchange. The cryptocurrency boom may be just starting.
Critics point to the fact that new cryptocurrencies are being created every day. Currently, there are over 1300 such currencies and savvy entrepreneurs, lured by the attractive returns, are offering attractive substitutes to Bitcoins. There appear to be few barriers to entry, and this is the major risk involved with these digital currencies. In the end, however, only a few will survive. For investors, the vexing issue will be which ones.
Supporters of cryptocurrencies argue that the current market capitalisation of all these digital currencies is around $280 billion which is only a tiny fraction of the $ 200 trillion global market for traditional financial assets. Even if digital currencies eventually garner only 5% of the total financial market, they promise an enormous upside.
But apart from their speculative value, cryptocurrencies also have a real value which comes from their acceptance as a medium of exchange. If I can buy a car as easily with Bitcoins as I can with Rupees, I am indifferent between these two currencies. Ever since countries abandoned the gold standard in 1971, fiat currencies like the Rupee can’t be exchanged for gold (or silver) and therefore like digital currencies, they are valuable only because they provide ease of transaction and because people have faith in their acceptability as a medium of exchange.( A fiat currency is money that is not backed by anything–all currencies today are fiat currencies).
A fiat currency, like the Rupee, gets legitimacy because it is backed by the Government of India–although after demonetization one has to wonder about the credibility of that backing. But because it is controlled by the government it is minted with impunity and continually loses its value due to inflation. Additionally, its acceptability is not universal. People in other countries may not want it. The Bitcoin, on the other hand, is backed only by the faith that people have in its ability to be exchanged for things of value. Since it is not controlled by any government, it is not subject to the whims of central banks and politicians. Its price is not tied to any other currency and is subject only to human valuation in an open market. And it can be used to transact anonymously anywhere in the world.
The more willing people are to use cryptocurrencies in exchange for real goods and services the higher the acceptability and the higher their value will go. The future demand for cryptocurrencies, and hence their value, will be dependent entirely on a trust-based system.
To see how this would work consider the following example. Arun sells his car to Deepak for 10 Bitcoins. In a typical transaction involving Rupees, people trust the bank to maintain each person’s account ledger. But with cryptocurrencies, there is no third party. So who manages the ledger which records an increase of 10 Bitcoins in Arun’s balance and a decrease of 10 in Deepak’s. Surprisingly, it is the people themselves. Everyone can see everyone else’s balances ( although the real system uses numbers instead of names to maintain anonymity), so the system is self-policing. Arun makes sure that Deepak’s account has been debited by 10 Bitcoins and Deepak ensures that no more than 10 Bitcoins have been credited to Arun. Every transaction appears on every ledger on every computer in the network through a technology called ‘blockchains.’ All transactions are authenticated using digital signatures which are mathematical algorithms that are linked to the 64 digit hexadecimal account number. Since these signatures are unique to each transaction, they cannot be copied or reused later. So hacking an account is a virtual impossibility. And anyone can audit this system–in fact, auditors are called miners, and they get rewarded with Bitcoins for every successful audit they conduct. And it is these rewarded Bitcoins that add to their existing supply.
The real value of cryptocurrencies, therefore, comes from two things: transactional anonymity, and universal acceptance as a medium of exchange. Their value will go up as more and more people are able to use them to buy real goods and services. Hundreds of companies including global giants like Microsoft and eBay now accept Bitcoins as payment, and several countries, including most recently Japan, have legalized the use of Bitcoins. The acceptance of cryptocurrencies as a medium of exchange is growing rapidly.
So are cryptocurrencies a fad or the future of money? Governments worldwide are increasingly being threatened by these digital currencies because they see their power to control money being eroded. And while there will be attempts at cracking down on their use, there is very little any government can do to stop the proliferation of these virtual currencies. The horse is already out of the barn. And with people increasingly getting weary of government scrutiny of their financial activities and the growing tax coercion, the freedom and anonymity offered by cryptocurrencies is being embraced wholeheartedly.
We are in a unique period in economic history where many are starting to question what money is and who should control its value. Governments the world over have an awful track record of managing currencies. Every single currency in the world has lost value over time–that this was happening at a time when global economies were expanding rapidly is an economic aberration that can only be explained by the reckless printing of new money by governments. The Zimbabwean Dollar, for example, lost over a Billion percent in value in one month. Cryptocurrencies represent a new chapter in the global monetary order –currencies with no borders, no exchange rates, and open and transparent valuation. Hopefully, soon a country’s wealth will depend on the productivity of its people instead of how fast its government can print money. The days of centralized government control over currencies appears to be coming to an end. And hopefully, it will also be the start of the end of big governments everywhere.
Welcome to the future of money: Peer-to-peer electronic cash.