This week the Lawton Constitutions reported a piece of news on how cryptocurrency will be factored in the current Federal government budget discussions involving infrastructures. The Constitution readers may want to know what a cryptocurrency is if they have not already known it. Cryptocurrency is a digital currency that facilitates online transactions. Cryptocurrency is not legitimized by the government or the banking system. The currency has been in existence at least for more than a decade. The first known cryptocurrency is bitcoin which started circulating in 2009, founded by a person known as Satoshi Nakamoto.
Though cryptocurrencies may have been used informally before in certain regions of the world, Bitcoin is the first one that achieved worldwide recognition and respectability. Bitcoin is also the fastest-growing coin in the cryptocurrency market. There is a large number of cryptocurrencies that are traded in the market now, many of which are pegged to some major currencies of the world including the US dollar, British pound –sterling or Euro, or a basket of major currencies. Cryptocurrency is another example of creative destruction or disruptive technology and has the potential of transforming the financial landscape into a new, though uncertain terrain.
The 2008 Great Recession created a fertile background for cryptocurrencies with the loss of trust in the government and the banking industry to protect the value of their assets. The growing use of cellphones, internet and social media also helped the growth of cryptocurrencies. With the onslaught of the pandemic last year, the world witnessed a meteoric rise of cryptocurrencies last year. The number of cryptocurrencies listed in the CoinMarketcap, a website that lists such currencies, increased from about 6000 a year ago to 11,145 now according to The Economist magazine.
The arrival of Cryptocurrency has challenged the very concept of money as we know and are used to. We are used to thinking that money has a national origin. Modern money is composed of fiat money, which is the liability of the government and bank deposits which are liabilities of banks. The confidence in the government and the banking system makes the payment system work even though it is not backed by gold or any other commodity and maintains its stability of the payment system. All transactions involving bank deposits are maintained by the ledgers of the banking system and bank deposits are protected in the USA by FDIC insurance. While traditional money is backed by confidence in the government and the banking system, cryptocurrencies generate ‘trust’ through their complex, inimitable computer algorithms. Since there is no traditional institutional backing of cryptocurrency, its security assumes added significance. Transactions involving most cryptocurrencies are recorded on a secure online ledger protected by a strong cryptography. These transactions are recorded and connected through a network of chains and nodes called Blockchains. Blockchain technology verifies and secures each transaction using powerful computers – a process known as mining. Miners solve complex computational problems to chain a new transaction to a block of transactions or link different blocks of transactions. The miners of bitcoin are rewarded with a new bitcoin. Blockchain technology is dubbed as a revolutionary technology that takes the concept of digital transactions to a new height by “digitizing, distributing, and protecting” all online transactions.
An important question for investors is how the rate of exchange with currently available fiat currencies is determined. The currencies which have some relation with the traditional currencies are called ‘stable coins’. Richard Senner and Didier Sornette in ‘The Holy Grail of Crypto Currencies: Ready to Replace Fiat Money’, classified cryptocurrencies into 3 types:
1. Stable coins collateralized by other cryptocurrencies: Examples are BitUSD pegged to the US dollar and BitCNY pegged to the Chinese Renminbi.
2. Stable coins collateralized by fiat currencies: USDT claims to be fully backed by US dollars,
3. Stablecoins without collateral: They are pegged to a weighted basket of a fiat currency, other cryptocurrencies and some macroeconomic indicators. For example, Carbon is pegged to the US dollar but can be pegged to the CPI (Consumer Price Index) in the future.
Despite attempts by cryptocurrencies to have them legitimatized, the governments in various countries are trying to impose restrictions on trade in them, many governments are still leery of them. The U.K. and Japan regulators banned Binance, one of the biggest cryptocurrency exchanges in June, 2021. Cryptocurrencies have a particular appeal for the underground economy that includes money laundering and other black market transactions. In addition to losing tax revenue, the government is concerned about whether the wider use of cryptocurrencies causes major instabilities in the financial system. A “stress test” conducted by the Economist magazine (August 7-17th) suggests that holders of bitcoins would lose hundreds of billions of dollars in case of the collapse of the bitcoin. Tether, a stable coin tethered to the US dollar, issued $62 billion worth of tokens which are supposed to be redeemable in dollars, one dollar per token. However, the Economist reported these tokens are backed by 5% cash or treasury bills and its 50% of assets are kept in commercial paper – a risky investment. Tether ended up paying a fine of about 15 million US dollars for misleading investors about its reserves against any possible loss. The Chinese government banned mining cryptocurrencies early this summer in China which used to devote two-thirds of global energy to harvest bitcoin. The Chinese government is on the path of becoming the first country to issue its own digital currency. The US government wants to enforce rules requiring brokers of all digital agents, crypto, and non-crypto currencies to report gains to the IRS. The Federal government is planning to impose taxes on capital gains in cryptocurrencies and is expecting to raise $28 billion in revenue over 10 years which will be used to finance infrastructure spending.
Syed Ahmed is a Lawton Independent Agents Chair and Professor of Economics and Director of Bill Burgess Jr., Business Research Center.
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