Since 2008 with the invention of Bitcoin, the cryptocurrency market has ballooned into a ~$1.4 trillion market with over 4000 digital currencies. Much of this growth occurred during the pandemic in what many are considering a cryptocurrency boom – or, according to skeptics, a bubble.
Since 2008 with the invention of Bitcoin, the cryptocurrency market has ballooned into a ~$1.4 trillion market.
Much of the recent increase in cryptocurrencies’ value is driven by large financial institutions’ newfound acceptance of the technology as a viable investment. The CEO of JP Morgan, Jamie Dimon, went from calling Bitcoin a “fraud” in 2017 to allowing clients to access Bitcoin funds in March. Legendary hedge fund manager Paul Tudor Jones has used bitcoin as a hedge against inflation, and CitiGroup claimed in a March 2021 report that Bitcoin was “at the tipping point” of going mainstream. To top it off, El Salvador made Bitcoin legal tender in June, becoming the first country to do so.
Despite this new acceptance from major finance players, the debate rages on over whether cryptocurrencies should be treated as a risky asset class or as a legitimate potential medium of exchange. Either way, there are structural issues with present-day cryptocurrency that must be resolved.
The debate rages on over whether cryptocurrencies should be treated as a risky asset class or as a legitimate potential medium of exchange.
All cryptocurrencies operate on a technology called blockchain, which is essentially a database that is run on a network of computers rather than just one. For a cryptocurrency transaction to go through, the entire list of historical transactions plus the new one must be validated by every computer in the chain. Each transaction is added to a ledger that exists simultaneously on each computer. This decentralization makes cryptocurrencies difficult to tamper with, since if one version of the ledger is altered, it will no longer match the ledger on the remainder of the network.
The first issue with the technology is how new cryptocurrency is introduced. Coins are supplied to the market in one of two ways; Proof of Work (PoW) or Proof of Stake (PoS). For PoW cryptocurrencies, like Bitcoin, new currency is introduced as computers in the network compete to solve an increasingly complicated, arbitrary mathematical equation. Through this process, the ledger is validated, and the winning computer is rewarded with coins. This process is called “mining,” and it has come under criticism from many for its excessive power usage. The University of Cambridge estimates that 0.55% of the world’s electricity goes to Bitcoin mining.
Given the unsustainability of the PoW system, many cryptocurrencies, including the second largest, Ethereum, have begun the switch to the new PoS system. Under this system, users can “stake” their coins and then mine proportionally to how many coins they own, rather than having to validate the entire ledger. This reduces the energy consumption but introduces inequality to the market, since the more coins someone has, the more they stand to gain from the system.
Second, cryptocurrencies’ volatility needs to be resolved if it is to be widely adopted. Currently, Bitcoin is trading at ~$34,000, having peaked in April 2021 at ~$64,000 and begun 2020 trading at ~$7,500. Thus, cryptocurrencies’ reputation as one of the most risky volatile asset classes is well founded. Ironically, this also makes them terrible for use as actual currency. To solve this issue, a type of cryptocurrency called “stablecoins” has emerged. To fix the volatility, the value of a stablecoin is pegged to another asset – usually a fiat currency or commodity such as the US dollar or gold. While this does succeed in stabilizing prices, it also defeats the purpose of having a cryptocurrency in the first place. If cryptocurrencies are intended as a decentralized alternative to traditional currency, what good does it do then to tie them to real money?
In the cryptocurrency world it seems as though every solution to a problem brings about equally damning ramifications. Until these issues are fixed, it is unlikely that investment banks, central banks, investors, and the like will ever adopt cryptocurrencies, either as an asset class or as tender.
Even if cryptocurrency never becomes a viable alternative to fiat currency as it was intended to, there is still hope for its underlying technology – the blockchain. Since the blockchain is merely a decentralized database, it has extensive uses beyond being a vehicle for cryptocurrency. The most important use is a software called “smart contracts” — self-executing contracts that operate on the blockchain. Smart contracts could be used to automate activities such as processing insurance claims, calculating credit risk, managing loan payments, optimizing a company’s supply chain, and much more. This is made possible through blockchain because its decentralization allows for near full security and transparency of transactions. As smart contract innovation grows, it has the potential to revolutionize the entire finance industry.
Even if cryptocurrency never becomes a viable alternative to fiat currency… there is still hope for its underlying technology – the blockchain.
The main cryptocurrency to utilize smart contracts and the blockchain itself as a selling point is Ethereum. Ethereum sells space on its blockchain for developers to run their smart contracts and charges them in Ether, Ethereum’s associated cryptocurrency. Thus, the price of Ether is tied to the success of the smart contract/blockchain technology. This is a very clever way of stamping out the volatility seen in cryptocurrencies like Bitcoin and tying the value of a cryptocurrency to something real. While this model is still being perfected, big finance institutions have already begun to notice, with Goldman Sachs calling Ethereum “the cryptocurrency with the highest real use potential”.
Time will tell whether cryptocurrencies ever gain widespread use, but as the market for them grows and they gain traction with financial institutions, the technology should no longer be brushed aside. Additionally, even though many of the criticisms of cryptocurrency are valid, particularly criticisms of its volatility, skeptics should not brush aside the potential of the blockchain to revolutionize how we conduct finance in the future.