02 Jun 2021 8:57 AM

The past month has seen a bumpy ride for cryptocurrencies. After values soared in recent years, the two largest cryptocurrencies Bitcoin and Ethereum have declined by 41% and 43% respectively since reaching all-time highs only a few weeks ago.

Part of the recent collapse in value is explained by the announcement that Chinese authorities have banned banks and payment firms from providing services related to cryptocurrency transactions. China’s concerns stem from fears of money laundering and claims that the volatility of cryptocurrencies is “seriously infringing on the safety of people’s property”.

Another reason for their recent weakness was a tweet from Tesla boss, Elon Musk, who reversed his decision to accept Bitcoin for vehicle purchases on environmental grounds. Bitcoin mining, the process by which new Bitcoins are generated, is an energy intensive process, involving high-powered computers solving complex mathematical problems. Cambridge University estimates that Bitcoin mining uses more electricity than the whole of Argentina.

Ever since Bitcoin was created as the first decentralized cryptocurrency in 2009, views on cryptocurrencies have remained polarised. Supporters claim cryptocurrencies represent the dawning of a new era, which will disrupt many industries, most notably financial services, by increasing economic freedom. However, sceptics have compared cryptocurrencies to Ponzi schemes. The investment guru, Warren Buffet, famously branded Bitcoin “rat poison squared” and predicted a bad ending for cryptocurrencies, arguing that they have little practical application. 

As a decentralized currency, Bitcoin uses peer-to-peer (P2P) blockchain technology, which enables currency issuance, transaction processing and verification to be carried out by the P2P network. While this decentralization means Bitcoin is free from government interference, the downside is that there is no central authority to ensure smooth operation or to support the currency’s store of value.

A currency needs to be a stable store of value that gives certainty over spending power, i.e the basket of goods one can buy today will be the same as the basket of goods one can buy tomorrow. This is not the case with Bitcoin and other cryptocurrencies as when demand for the currency falls there is no central intervention to reduce the supply of the currency and thus preserve the value of the currency. As a result spending power of the currency collapses.

Bitcoin and many other cryptocurrencies have developed into instruments of speculation. In 2010, Laszlo Hanyecz, a software developer spent 10,000 Bitcoin on two pizzas, at today’s exchange rate the pizzas would be worth an astonishing $368m! The strategy for many investors has been to buy and hold through periods of volatility.

Recently there has been discussion around potential central bank digital currencies (CBDCs).  Like other forms of cryptocurrency, CBDCs are a form of virtual money that uses an electronic record or digital token to represent cash, however their key differentiation is that they are issued and regulated by a country’s monetary authority. For example, the Bank of England has launched a taskforce to explore the idea of a digital pound. Fans of Bitcoin claim the centralised nature of CBDCs will erode financial privacy.

A cryptocurrency that is an accepted part of the mainstream financial system would have to satisfy divergent criteria.

The debate surrounding the future of cryptocurrencies continues...


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