Cryptocurrencies like bitcoin, litecoin and ethereum are quite different from normal currency, most notably because they can’t be directly exchanged at a bank for paper dollars and metal coins. Also, unlike good old currency which is guaranteed by banks, cryptocurrencies have no intrinsic value. Using them requires specialized and often technical software, and trusting them involves understanding sophisticated cryptographic mathematical principles.
The most important — and the most difficult — concept to understand about cryptocurrency is how people get it in the first place. Once someone has some bitcoin or other cryptocurrency, they can trade for items or services, like a digital barter system. But where does it begin?
It is useful to think about digital currency as a prize won in a computer game. Many video games ask players to complete a series of puzzles or challenges, from which they earn points. More sophisticated games have in-game economies (where players can complete tasks to earn coins or tokens or credits that can be exchanged for in-game rewards, like new outfits or specialized tools.
In what might be called the crypto game, players load software on their computers to solve sequences of complicated mathematical problems. They compete with countless others around the world, and the person who owns the computer that actually solves each problem gets a prize — in the form of cryptocurrency.
Most uniquely, the players play the game anonymously, and the record of the transactions is shared by everyone in what is called the blockchain, a mechanism that guarantees integrity.
Value of Tokens
The value of the tokens in a digital game depends on several factors including the subscription price and the number of players playing the game on a regular basis. Managing the economy of digital games has parallels with real-world economies, and this includes the problem of inflation.
Globally, the value of the game market with 2.2 billion players is estimated to be about $108 billion. On a per capita basis this is small change compared to the value of cryptocurrencies. For example, Bitcoin mining user base was about 5 million in March 2017 but its market cap had reached over $300 billion by the end of the year. Many have compared the rise of these currencies to the tulip mania of the 17th century.
One allure of bitcoin is its purported anonymity. That was the reason it was used for most transactions on Silk Road, a darknet market best known for selling illegal drugs, before it was shut down by the FBI in October 2013. The total revenue at the site in the preceding two years was nearly 10 million bitcoins, which in today’s prices is about $100 billion.
Most investors don’t know how cryptocurrencies work but it has become like a digital gold rush. The ICOs (Initial Coin Offerings) are not regulated and there are enough scammers around who are ripping off naïve investors. In India, for example, scammers were able to dupe investors to the tune of nearly $350 million in the offering of a fake OneCoin cryptocurrency before it was shut down in 2017.
Cryptocurrency backers argue that they could be used for social-network based applications. The idea is that these services will be paid for by cryptocurrencies associated with the blockchains and the demand for these services will set the price for the blockchain’s token. With this pitch, the backers hope that they will not be subject to oversight by bodies like the U.S. Securities and Exchange Commission.
But not everyone is convinced that this is a viable model. Just recently, Hong Kong’s Securities and Futures Commission (SFC) said it has sent letters to seven exchanges and firms attempting to fundraise through initial coin offerings (ICOs), warning them about the legalities of selling digital tokens with the characteristics of securities.
Energy costs and morality
The digital game of cryptocurrency mining comes with ever-increasing power costs. For example, the rate at which bitcoins are created decreases by half roughly every four years, which means the computations needed to mine tokens progressively become more intensive. The current global energy consumption of the bitcoin network is estimated to be of the order of 700MW and it is going to reach order of 14GW by the year 2020, which in itself appears unsustainable. According to one view, Bitcoin is about 5,033 times more energy intensive, per transaction, than VISA, at current usage levels and the energy consumption in its mining is already greater than many medium sized countries.
The energy cost issue in itself might lead to a cry for regulation of cryptocurrencies. The argument could be that these are high levels of power consumption without redeeming public good and they come with indirect costs to the environment.
The recently passed Tax Reform Act has provisions that make it easier to tax cryptocurrency capital gains (IRS views it as property) together with taxes when one cryptocurrency is exchanged for another. This taxation is possible for Bitcoin transactions are not truly anonymous and they can be traced by special software.
It has been suggested that as current excitement about their sky-high values tapers off and it is more widely known that cryptocurrency can be traced by IRS, their values will fall to levels dictated by the same economics that governs the tokens of other digital games.
The moral case related to energy costs of mining cryptocurrency is best countered by an argument of Abhinav Gautam (Twitter: @abh1navgautam) who is not only one of the world’s most brilliant doctors but has deep understanding of societal implications of information technology. He says a lot of what is accepted by society as fair cost has no intrinsic long-term value and examples of this are people uploading their videos on the Internet (where it is stored on servers that consume a great amount of power) and much of entertainment and travel. Given that banks charge too much for their services and pass their profits to elite insider groups, cryptocurrency and blockchains are a way to a new paradigm of democratization and thus worth the attendant technology costs.
We live in a fraught age, in which jobs are disappearing due to increasing automation and AI. There is also a shifting of political and economic power from the West to Asia without clarity about how the new world will manage itself. There is loss of faith in institutions and even in the medical profession. People are turning to crypto as a hedge against all this uncertainty.
The turning to cryto is also for protection against inflation since US and other countries have printed trillions of dollars in the past few years. US has been protected somewhat from short-term price spikes since dollar serves as the world’s de facto reserve currency and it is able to siphon off much of the wealth held by the elite in the poorer countries. Nevertheless, property values in the US are shooting up greatly, especially on the two coasts.
Crypto can be viewed as a form of post-modern abstract art. Its value is a product of the integrity of the process (which is also the reason originals of paintings and art are valuable) and as long as there is a stable world order, crypto will hold its value. But just as in history there have been anti-art religious movements, many governments may ban it altogether.
It is a threat to entrenched power centers and it offers a way for people in a non-democratic system to vote disapproval. For example, bad economic policy will encourage people to invest in crypto at the expense of national currency leading to inflation and fall of the regime.
Since the US is likely to let cryptocurrencies have much free play, crypto can become one of the instruments of its foreign policy.