Cryptocurrencies: Dawn of a new economy

Crypto currencies have captured the imagination of some, struck fear among others, and confused the rest. Essentially a “Cryptocurrency” is a digital representation of value that (i) is intended to constitute a peer-to-peer (“P2P”) alternative to government-issued legal tender, (ii) is used as a general-purpose medium of exchange (independent of any central bank), (iii) is secured by a mechanism known as cryptography and (iv) can be converted into legal tender and vice versa”. Bitcoin originated with the white paper that was published in 2008 under the pseudonym “Satoshi Nakamoto.”. Other cryptocurrencies are Ripple, Ethereum , Cardano etc.

Figure: Overview of coins ( Source: Houben, July 2018)

Cryptocurrencies and blockchain have become hot topics in the last couple of years. In simple terms, block chain is a growing list of records linked using cryptography. It is the technology behind the large variety of cryptocurrencies currently in circulation. The cryptocurrency market key players include cryptocurrency user, miner, cryptocurrency exchanges, wallet providers etc.

Let’s consider the case of Bitcoin. It has value because its supply is limited. This limit exists because the reward for the miners is halved every 210,000 blocks (approximately every four years). Because of this, the present price of the currency is determined solely by expectations about its future price.

Figure: Price of Bitcoin from 2011-2018(Source: Coindesk)

How does it work?

First of all “Coin inventors” develop the technical foundations of a cryptocurrency and set the initial rules for its use. The issue of cryptocurrencies that are based on a PoW (proof of Work) consensus mechanism takes place via a process called "Mining". Mining is the process of confirming transactions and adding them to a public ledger. A ledger records all transactions so that total visibility is provided. Miners validate transactions on the blockchain by solving a “cryptographic puzzle” and are rewarded with newly mined (or created) coins and operate their own blockchain network.

How to become a cryptocurrency user?

Some of the main ways are listed here although not exhaustive. Firstly, one can simply buy her coins on a cryptocurrency exchange using fiat money or another cryptocurrency or directly from another cryptocurrency user i.e. through a trading platform. There are also a few entities in India which are operating Bitcoin exchanges/trading platforms dealing in buying, selling, storing, using and accepting Bitcoins such as Zebpay, Unocoin and Coinsecure. Secondly, if a cryptocurrency is based on a PoW (Proof-of-work) consensus mechanism, she can mine a new coin (i.e. participate in the validation of transactions by solving of a “cryptographic puzzle” and be rewarded a new coin).

21st-century unicorn – or the money of the future?

Bitcoins are decentralized and are demanded for their low transaction costs, anonymity, and investment possibilities. Although they have a few severe disadvantages such as high price volatility, susceptibility to hacking, no protection from a central bank and no consumer protection and possibilities for use in illegal activities Moving on to its monetary properties- there is controlled supply. All cryptocurrencies control the supply of the token by a schedule written in the code. This means the monetary supply of a cryptocurrency in every given moment in the future can roughly be calculated today. Some countries are accepting the cryptocurrencies while some are not, some of them are yet to make their decision. Bitcoin’s decentralized nature represent a threat to financial stability, and other security concerns have led to countries banning the currency. On the other hand, some countries have taken a flexible view towards it and consider such transactions as barter arrangement subject to appropriate taxes depending upon the use.

Crypt currencies have been marked by massive price fluctuations, and there are severe questions about the stability of the currency.

Scope

Cryptocurrency in India

Indian Finance Minister Arun Jaitley, during the national Budget, stated that the country does not recognize Bitcoin as legal tender and steps would be taken to penalize crypto payments- sending cryptocurrency enthusiasts and investors in a tizzy. Shortly after the minister’s statement, the price of Bitcoin fell to a two-month low of less than $7,000 . No Government that imposes capital account currency controls can afford to ignore non-fiat currencies. Very few countries have legalized the use of cryptocurrencies. . Japan is one of the few exceptions – the Bank of Japan imposes stringent restrictions on use but Japan does recognise bitcoin as legal tender. South Korea also has rules for bitcoin-denominated payments and transfers.

In India bitcoins has been available since 2012 and at present in India there are 11 trading platforms and around 1 million users of bitcoin. At the moment RBI has banned the transaction of bitcoins in India. So one cannot use the cryptocurrency for the payments of good and services. There is no protection available to those using and trading them or dealing in them. The Reserve Bank of India (RBI) has been consistent in warning citizens of the risk associated with cryptocurrencies and traders of its perils. RBI has not declared dealing in virtual currencies as illegal nor has it introduced any regulatory framework governing them.

Conclusion

Crypto currencies will certainly play a major economic role in 25 years, and that role can reasonably be expected to be exponentially larger than it is now. This new form of money with its mystic operational mechanism is understandably going to face a large resistance to adoption and use. But there is no reason to think that crypto currencies will replace or push out fiat currencies. Over time, we will use currencies for what they are best suited for. Fiat currencies will continue to be issued and used for the majority of commerce and taxation, and will continue to give governments some control over the money supply and inflation. Crypto currencies will be used when ease of transaction, and anonymity of user has to be maintained- a significant part of the total transactions, but not completely uprooting fiat. There is space for both fiat, and cryptocurrencies to exist parallely, and with the advent of cryptocurrencies backed by governments the distinction between the two is bound to become less pronounced.

Author: Shuchita Jain