Crypto - fit or unfit for the current financial system?

 

Read Time: 4 mins

As Warren Buffet said, when you invest in a business you know it will reap returns or when you invest in a farm you can sell/consume the vegetables grown, but when you invest in non-productive assets like Bitcoin, you are investing in the sentiments of how excited the next person is in buying it who is further investing in the same sentiment of another person.  

We all know that cryptocurrency is the new form of currency that does not need a centralized bank for the transaction to be processed. It has a common ledger maintained where transactions are recorded with the help of unique digital signatures which comprises of a public and a private key. Some miners mine the cryptographic references for connecting one block of the ledger to the other and the ledger with the longest chain of blocks is considered legitimate.

Although it may be too technical for people to understand how the mining of bitcoin is done and how the proof of work is generated, just like it is not easy for everyone to understand the intricacies that go behind every transaction in the current banking system. But when we talk about cryptocurrency mainly bitcoin replacing the fiat currency and organizations like Tesla investing $1.5bn in Bitcoin and accepting it for the purchase of goods and services, we need to be aware of the real value of the asset, volatility in prices, the threat of hackers, and the effect of the cryptocurrencies on the environment.

Value and Volatility  

Just like the real value of fiat currency of any country is zero if public confidence in the currency is lost, the real value of cryptocurrency is also zero. The proponents of cryptocurrency, mainly Bitcoin, believe that it is going to be the next gold because unlike fiat currency which can be printed by the central banks whenever deemed fit, Bitcoins are limited in number like gold is. For example, only 21mn of Bitcoins can be mined as per the whitepaper by Santoshi Nakamoto.

With the government printing money because of the downturn in the economy due to Covid-19, as per the theory of monetary policies, there are chances of increased inflation. This is where the proponents of Bitcoin who consider it as a natural hedge against inflation, because of its limited availability, come in. Having said that, not all cryptocurrencies are deflationary, the likes of Dogecoin which is one of the cryptocurrencies for which the price rocketed 800% in 24 hours after a tweet from Elon Musk.

Market Price of Bitcoin over the years

This shows how volatile a cryptocurrency can be as it is not centrally controlled. A single Tweet from an influential person or an investment made by a Tech giant could cause a rise in price by more than 6%, and single scam news like that of PlusToken the South Korean cryptocurrency which did a Ponzi scheme of $2,25bn could make it go bust.

Threat of hackers  

This decentralized cryptocurrency system may reduce the costs of transactions in terms of third-party involvement and move the power of currency supply from the hands of the central banks to the public in general. One needs to think about how trustworthy the cryptocurrency bubble is. The system is built around the miners adding blocks to the ledger and there is less chance that a particular group of hackers will increase in number from that of legitimate miners and will be able to enter one block after the other for the transactions to be considered legitimate. But even if they are successful in doing so, they are expected not to devalue the cryptosystem as with the reduction in the value of the crypto as the value of their assets will fall since they are also paid in the form of that same crypto.

Environmental impact  

In term of the energy consumption in mining cryptocurrencies, since mining is a reward-based concept where the miner is paid in crypto for every proof of work generated, this gives an incentive to mine more proof of works, and the load on electricity consumption increases with an increase in the volume of crypto in the market. For bitcoin, there is a new proof of work generated every 10 minutes and this time is even lesser for the other cryptocurrencies like Ethereum and Dogecoin. As the number of transactions increases, it becomes more lucrative for new miners to join the race. This will lead to bigger and more complex demand for computing power, which will require more energy consumption.   

Currently, bitcoin has an annualized power consumption of 77.78 TWh, comparable to that of Chile and Ethereum has an annualized power consumption comparable to that of Ireland at 19.49 TWh electrical energy consumed. Looking at this in the light of the world moving towards cleaner energy and especially for the likes of Tesla which is a leader in the battery-powered electric vehicle it is important to know how the Bitcoin investment made by such an organisation affects its carbon footprint.     

Having said all the above it is crucial to know all the aspects of any currency before investing in one. Whether the fiat money will be replaced by Bitcoin or any other cryptocurrency is a matter of debate for another time, but retail investors should be aware of the intricacies that go behind the rise of meme stocks like Dogecoin. Also, when one looks at the payment for goods and services in terms of Bitcoin, one needs to understand that the 5-10% daily volatility range of the cryptocurrency makes it unfit for the current financial system.