Learning Series: Cryptocurrency

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In addition to Covid-19 pandemic and lockdowns, 2020 will also be the year when cyptocurrencies became a force to reckon with. Yes, it was in existence much before 2020, but it started to get widely accepted in 2020. Hedge funds and pension funds started investing in it, and recently Tesla, the brainchild of Elon Musk, also invested a huge amount into bitcoins. This only served to increase the popularity of cryptocurrencies and the bluechip of cryptocurrencies, Bitcoin, touched an all-time high of Rs.41 Lakhs / bitcoin. Yes, Rs.41 Lakhs or around $58000 per bitcoin from $5000 in March 2020, during the stock market crash.

Cryptocurrency was explained very simply in an article. We have all seen movies of how in prisons, the main medium of exchange could be a product that would be in demand there. Cigarettes for example. You could buy things, return favors by dealing in cigarettes directly with another person. You pay cash to buy cigarettes from outside, and these would have a value as currency only inside the prison. However, this medium of exchange would have no importance outside of the prison, where you have an official currency. Currently, Cryptocurrency in crypto exchanges is like those cigarettes in prison. So let’s understand cryptocurrencies in general.

Cryptocurrency

A cryptocurrency is a purely digital or virtual form of cash, which uses encryption techniques to control the transactions. These are peer to peer currencies (user to user like P2P networks). Bitcoin is the best example of a cryptocurrency. There are thousands of lesser known currencies, the biggest of which are currencies like Ethereum, Tether, Binance Coin, Cardano, Polkadot, XRP etc.

The basis of cryptocurrency’s creation, and most virtual currencies that have since followed, was to fix what some people thought of as flaws with the current monetary transactions and the way money is transmitted from one party to another. For example, how long it can take for a bank to settle a cross-border payment, or how financial institutions have been acting as a third-party mediator during transactions. Cryptocurrencies work around the traditional financial system through the use of blockchain technology.

Blockchain technology

Blockchain is the technology that enables the existence of cryptocurrency. Blockchain is a decentralized ledger of all transactions across a peer-to-peer network. Using this technology, participants can confirm transactions without a need for a central clearing authority, which is one of the key differentiators for cryptocurrency.  If you buy bitcoin or sell bitcoin or use your bitcoin to buy any product etc. it will be recorded, in an encrypted format, in this digital ledger.

Data from this digital ledger is stored on hard drives and servers all over the globe. This methodology serves multiple purposes. It ensures that no one person or company will have central authority over any virtual currency, and it also acts as a safeguard against cyberattacks, so that criminals are not able to gain control of a cryptocurrency and exploit its users. Since there is no middleman with blockchain technology and no intermediate is needed to oversee these transactions, the thought is that transaction fees might be lower than what would be normally incurred.

Also, transactions on blockchain networks may be settled considerably faster than traditional networks. The conventional setup of financial institutions, with its working hours and transaction timings will not be a  limitation here. There will also not be any restrictions on cross-border transactions, which otherwise may take days, while funds are verified in a conventional banking setup. With blockchain, this verification of transactions is always ongoing, which means there is an opportunity to settle transactions much more quickly. So in a nutshell Blockchain technology increases transparency of transactions, has a permanent ledger, reduces costs and speed of transactions.

How it works

· A user requests a transaction

· The requested transaction is broadcast to a P2P network, consisting of computers called as Nodes

· Network verifies the transaction and user status using algorithms and records the transaction

· This information / transaction is combined with other transactions and gets added as a new “block” of data on the existing blockchain.

· Transaction is approved and completed

Cryptocurrency transactions are verified in a process called mining. The users who check the transaction to see whether its valid or not are known as miners. Mining cryptocurrency uses a lot of computer power, so miners are rewarded for the work they do. On the Bitcoin network, miners who confirm new blocks of   information are rewarded with new Bitcoins. This is why it’s called mining. Instead of mining for gold or coal, miners are digging for new Bitcoin.

Users access their cryptocurrency using codes called public and private keys. Just like sending emails. If you want someone to send you an email, you tell them your email address. In the same way, if you want someone to send you cryptocurrency, you tell them your public key. Now, if you want to read your emails or send an email, you need to enter your email password. This is how private keys work. Private keys are like passwords for cryptocurrency.

Because cryptocurrencies operate independently and in a decentralized manner, without a bank or a central authority, new units can be added only after certain conditions are met. For example, with Bitcoin, only after a block has been added to the blockchain will the miner be rewarded with bitcoins, and this is the only way new bitcoins can be generated. The limit for bitcoins is 21 million; after this, no more bitcoins will be produced.

Valuation of cryptocurrencies

Considering the current skyrocketing valuations of these currencies, which are purely digital with no physical backing, the valuations are difficult to be determined.

It is dependent on a number of factors. These include:

· How quickly blockchain technology is adopted by bigger businesses;

· How quickly merchants are willing to accept virtual currencies as a form of payment;

· Whether governments around the world will accept cryptocurrencies as legal tender, or choose to ban them entirely (Like India is considering).

The current runup can be explained due to the increasing adoption of cryptocurrencies like Bitcoin, by mainstream investors. At first, only retail investors or “cyberphunks” accounted for most virtual currency    trading. Institutional investors had kept to the sidelines because either their company had restrictions / reservations to invest in cryptocurrencies, or they were simply too volatile to merit an investment. Retail investors tend to be more reliant on their emotions relative to institutional investors, leading to moves that tend to overshoot to the upside, and downside.

The second factor is regarding the nature of the investments.. Among traditional equities, like the stock market, an investor has the opportunity to buy, sell, and even bet against an equity. Money can be made if an equity moves up or down. With nearly all cryptocurrencies, except bitcoin, buying or selling is the only option. There is no way to make money if a cryptocurrency goes down, which naturally tends to incentivize buying.

There is also another theory, especially regarding the rise of Bitcoin. We read earlier on how each Bitcoin transaction is cleared by ‘miners’ on a blockchain for which the miner receives a reward which was originally set at 50 Bitcoins per block. Since the supply of Bitcoin is restricted to only 21 million coins, every four years the cryptocurrency goes through a ‘halving’ event. The first halving took place in November 2012 and the second in July 2016. The third halving took place on May 11, 2020. A miner used to get 12.5 Bitcoins for every block they mined till the latest halving, which has now reduced to 6.25 Bitcoins. The supply of bitcoins is lower and with supply vs. demand equations working favourably, the price was also impacted positively.

Is it legal?

In 2018, RBI brought out a circular banning all entities regulated by it to not deal or provide services for facilitating any person or entity in dealing with virtual currencies. However, the Supreme court struck down this circular in early 2020, which again revived the volumes in the cryptocurrency platforms. However, the industry is currently operating in a regulatory vaccum, as both the government and the RBI are silent on what form of regulation will eventually be imposed. The ongoing Budget session of Parliament is expected to consider a bill that prohibits all private cryptocurrencies in India and provides for an official digital currency to be issued by the Reserve Bank of India.

Pros and Cons

Supporters of cryptocurrencies see the features of these currencies as the main advantages; with no central authority and no reduction in value of money. Speculators are racing to buy them now, presumably before they become more valuable. They have no interest in the currencies’ long-term acceptance as a way to move money across geographies, without any restrictions.

The blockchain technology has more supporters because it is a decentralized processing and recording system and is considered as more secure than traditional payment systems. Many experts believe that blockchain and related technology will disrupt many industries, including finance and law. 

Cryptocurrencies face criticism for a number of reasons, including their use for illegal activities, exchange rate volatility, and vulnerabilities of the infrastructure underlying them. Legendary investor Warren Buffett compared Bitcoin to paper checks: “It’s a very effective way of transmitting money and you can do it anonymously and all that. A check is a way of transmitting money too. Are checks worth a whole lot of money? Just because they can transmit money?”

Just like real currencies, cryptocurrencies generate no cash flow, so for you to profit, someone has to pay more for the currency than you did. This is in contrast to investing in a well-managed business, which increases its value over time by growing the profitability and cash flow of the operation.

Interesting Facts

The inventor of Bitcoin is still unknown. The Bitcoin whitepaper was made open to the public under the pseudonym of Satoshi Nakamoto. The identity of “Satoshi” is still a mystery yet to be solve.

On January 12, 2009, Satoshi Nakamoto made the first Bitcoin transaction. They sent 10 BTC to a coder named Hal Finney.

In 2010, a programmer bought two pizzas for 10,000 BTC in one of the first real-world bitcoin transactions. Today, we can imagine the worth of10,000 BTC – a big price to pay for satisfying hunger pangs.

James Howells, an IT guy, lost 7,500 bitcoins in November 2013. While he was cleaning his desk at home, he threw away his hard disk containing the private keys of bitcoins which he had mined in 2010.

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