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. 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. 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 per cent of the total available supply of Bitcoins will have been released by 2018, the other 20 per cent 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.
But how do these cryptocurrencies get their value? 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?
The value of a cryptocurrency comes principally from its 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, 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, like the Rupee, gets legitimacy because it is backed by the government of India — although after demonetisation 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 be. 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.