Are Cryptocurrencies the Future of Money?
From barter, to the appearance of the Mesopotamian shekel 5,000 years ago, to gold coins, to the paper dollar, what constitutes money has evolved. Is the next step in that evolution the replacement of coins, paper bills and electronic accounts at commercial banks by cryptocurrencies like Bitcoin, Ethereum, Libra and Dogecoin? There are ongoing concerns about the volatility of the price of cryptocurrencies, their use for illegal and illicit transactions, their environmental impact, and the potential they pose for disrupting financial systems. What do we know about the actual and potential benefits and costs of cryptocurrencies to their users, and to society at large?
The volatility of cryptocurrencies have made them thus far a poor medium of exchange. Their main attraction is as a speculative asset.
- Interest in Bitcoin took off in the wake of the financial crisis when trust in governments, central banks, and in big private banks was very low. The cryptocurrency "revolution" began in 2008 with a link to a nine-page proposal that laid out the details on Bitcoin in a cryptography mailing list. Bitcoin promised to provide a medium of exchange that would allow two parties to conduct financial transactions just using anonymized digital identities without using central bank cash or using a trusted financial intermediary like a bank or credit card company. Bitcoin tries to replace trust in a public institution with trust that is created through a public consensus mechanism; all transactions are posted on public ledgers that are maintained on multiple computers and visible to the entire community of Bitcoin users who can agree that a transaction is valid and if not reject it.
- Cryptocurrencies exist outside of government control and operate outside of traditional financial institutions. Conventional currencies are no longer backed by precious metals, but governments support their use by accepting them for payment of taxes. These currencies need not be physical bills or coins – recently, there has been interest in Central Bank Digital Currencies (CBDCs), a digital replacement for physical currency notes and coins. To date, five countries have introduced or commenced trials of CBDCs and 81 countries are exploring the possibility. A key distinction between CBDCs and cryptocurrencies is that the former is issued by a central bank and it is backed by the full faith and credit of the government while cryptocurrencies are not backed by any government but are set up and managed by an algorithm. Ultimately, the viability of a currency depends upon trust – people trust that others will accept it for payment, a situation that requires that the currency does not lose value quickly (as would happen in a hyperinflation). Whereas the trust in the viability of a conventional currency or a CBDC comes through the backing of a government, the trust in the viability of the cryptocurrency comes through its publicly observable distributed ledger that shows the history of its transactions.
- An important role of any money is to serve as a means to purchase things – a medium of exchange. Cryptocurrencies are proving to be a very poor medium of exchange. A currency will not be an attractive medium of exchange if its value is volatile since that means the number of units of currency needed to purchase a given item varies a lot. The original 2008 blog post that introduced cryptocurrencies by someone using the name Satoshi Nakamoto focused on the medium of exchange role, stating “I've been working on a new electronic cash system that's fully peer to peer with no trusted third party.” But cryptocurrency prices have shown great volatility (see chart). The sharp swings can be more dramatic than apparent from looking at the price swings in Bitcoin overt the course of a year: On a single day in May 2021, for instance, the price of Bitcoin plummeted 30% and recovered to be down 12% at the end of the day. These large price movements make cryptocurrencies an undesirable way to pay for goods or services. Additionally, cryptocurrencies are expensive and cumbersome to use, and transactions are slow to be validated.
- Cryptocurrencies like Bitcoin and Ethereum have been an attractive way to purchase illegal or illicit goods and services but are becoming less so. The main attraction for the use of cryptocurrencies in illegal or illicit transactions is the anonymity they afford the buyer and seller who can use pseudonyms. But it is possible to uncover the identity of people who use Bitcoin or Ethereum for many transactions or for transactions involving real goods and services. Some new cryptocurrencies like Monero and Zcash are trying to offer more anonymity with more sophisticated masking technologies but these are difficult to use because they have complex user interfaces.
- Currently, the main legal attraction of cryptocurrencies is as a speculative asset, but, as such, there are concerns about systemic effects on financial stability. People who gamble on Bitcoin likely know the risks, given that its volatility is widely known. It is possible that if these people lose money there may be no effects throughout the financial system. But there are concerns about price manipulation of cryptocurrencies, which raises the issue of fraud. There are also concerns that a collapse of the market for all cryptocurrencies, which now have a market value of well over $2 trillion, could spill over to the conventional financial system.
- The way in which Bitcoin is set up demands huge amounts of electricity, giving rise to adverse environmental consequences. People earn newly-minted cryptocurrencies through “mining” which involves competing with many other miners and using brute force computing power to be the first one to solve complex computational math problems. Validating a single Bitcoin transaction is estimated to be equivalent to the power consumption of an average U.S. household for a month. Bitcoin alone accounts for 0.4% of the world’s total electricity consumption and 60-70% of all cryptocurrency costs are electricity costs. While some claim that Bitcoin is more renewable-driven than other large-scale industries, a 2020 report from the University of Cambridge refutes this, stating that only 39% of energy consumed by mining facilities comes from renewable sources. There are other cryptocurrencies like Ethereum that are moving towards different consensus mechanisms, which are the ways in which the network of computers validate transactions. These new mechanisms will allow transactions to be processed more efficiently without the associated environmental problem.
What this Means:
Cryptocurrencies have captured the public imagination, but perhaps not in the way intended. In their present form, they are not viable mediums of exchange. The anonymity they ostensibly provide make them attractive for illegal and illicit transactions, but this is not a desirable end from a societal perspective. Currently, the main attraction of cryptocurrencies is as a speculative asset, although one that exhibits a great deal of volatility. There are also concerns about the environmental consequences due to the huge electrical demands of the mining of cryptocurrencies as currently configured. While technological improvements may improve the ease of using central bank digital currencies for both domestic and international payments – and there is a lot of demand for better, cheaper, and lower cost services, especially for those without a credit or debit card or a bank account – it is less clear that privately-issued cryptocurrencies could fill a useful role as a medium of exchange.