Decrypting the crypto conundrum

When Satoshi Nakamoto first put forth his white paper ‘Peer to Peer Electronic cash system,’ little did he know that it would revolutionize the way payment systems function globally.

Launched in 2009, Bitcoin was created as a decentralized currency beyond the control of any single government or country and which could not be tampered with. The technology underlying this, i.e., Blockchain, is a distributed database that has evolved over time and has found large-scale applications in banking, property ownership, digital ID’s and healthcare. 

The total number of bitcoins is finite (21 million), out of which ~19 million have been mined thus far. Miners solve complex mathematical algorithms (in a process called mining) to mine out new Bitcoins and get rewarded in Bitcoins itself.

In February 2021, Bitcoins’ market cap crossed USD 1 trillion as Tesla announced its USD 1.5 billion investment in Bitcoins. Ease of transfer, minimal processing costs, divisibility and immutability, enhances the cryptocurrency’s ability to act as a medium of exchange. Companies like PayPal, Microsoft and Burger King have started accepting Bitcoins as a means of payment, while countries such as Finland, Japan, Canada and Germany have legalized cryptocurrencies.

If everything appears to be hunky-dory, why hasn’t the Reserve Bank of India legalized it as a legal tender and why are many investors skeptical of this asset class? The devil to that lies in the details, as always. 

The immutability of cryptos means that it is highly improbable to manipulate or hack the blockchain technology on which Bitcoin relies. However, it also becomes impossible to establish the ownership of Bitcoins if it has been purchased anonymously (not through a crypto exchange). This anonymity of ownership implies that Bitcoins can be used for illegal activities like money laundering, tax evasion and terrorist financing.

Since the transfer of Bitcoins is outside the scope of the formal banking system, the transactions escape the eyes of the regulators. For anything to be accepted as a currency, it must act as a medium of exchange.

The volatility (as measured by annualized standard deviation) of Bitcoins since 2010 has been more than 200%, 15 times that of S&P 5001. Bitcoin fell by ~15% on 22nd February 2021 after Elon Musk tweeted that Bitcoin might be overvalued. Such wide fluctuations create uncertainty between buyers and sellers and threaten to destabilize the economy. Imagine a product costing 100x today, and when you wake up tomorrow, it costs 115x, simply because the value of the currency has depreciated ~15% overnight.

Another pre-requisite for a currency is that it must act as a unit of account. Accepting payments in Bitcoins subjects the buyers and sellers to additional costs like exchange rate depreciation (in the case of international trade) and indirect costs due to the wide fluctuations in the value of Bitcoins.

Bitcoins are not (yet) accepted widely, which limits quantifying goods in terms of Bitcoins. This problem is exacerbated in a country like Bharat, where rural illiteracy and technological backwardness inhibit the use of digital currency, let alone cryptocurrency. Thus, cryptocurrencies do not fulfill the two main functions of a currency and cannot be used as pure currency.

Further, a currency must be backed by an underlying asset (like gold) or by a sovereign guarantee, neither of which is the case with cryptocurrencies. These currencies operate outside the ambit of the formal financial system, thereby becoming immune to the policies of the Central Bank governing the money supply. This can create severe problems for financial stability and may lead to acute corporate stress that impacts the banking system adversely. 

The question arises: Can cryptos be legalized as an asset class but be banned as a legal tender?  

The value of Bitcoin has risen by a whooping ~200% CAGR in the last ten years to give a mindboggling 52,00,000% return. The round the clock tradability of Bitcoins ensures high liquidity and acts as a perfect inflation hedge. However, an investor may lose all his Bitcoin holdings in case of hard drive crashes or if the virus corrupts the Bitcoin wallet or if the holder forgets the password to his crypto account.

Uncertainty around the market regulator’s stance on the asset and on the taxability of capital gains further inhibits the investor community from investing in Bitcoins as an asset class. Since there are no underlying assets (or earnings therefrom), the value of Bitcoin fluctuates solely based on the market forces of demand and supply. Thus, what role does Bitcoin plays as an asset in a diversified portfolio is unclear.

Extreme volatility, lack of underlying and the unregulated nature of the asset class create investor skepticism. Despite this cynicism, noteworthy investors and multi-national conglomerates have invested in Bitcoins for fear of missing out on the next big thing. 

The way forward for cryptos is obscure and uncertain. While governments are welcome to the distributed ledger technology (popularly known as DLT or Blockchain), they have been hesitant to adopt cryptocurrency as a mainstream medium of exchange. The solution to this lies somewhere in-between: treating cryptos as an asset class and regulating it.

High-powered artificial intelligence can be deployed to track the movement of cryptos across users (and across markets), which will ensure that we derive the good without the bad. An outright ban on private cryptocurrencies might not be in the best interest of the users, exchanges, businesses and the economy. Once the use of Bitcoins is legalized (as an asset class) and regulated, the country can benefit from the underlying blockchain technology.

The Blockchain stands capable of solving a multitude of problems facing the economy like digitizing property records, efficiency in banking operations and revolutionizing healthcare. The Government stands to gain revenues in the form of GST on the services provided by the crypto exchanges and capital gains tax on the realized capital gains (since it’s an asset class). 

The cryptocurrency landscape in Bharat has seen tumultuous times in the last few years, with the RBI banning cryptocurrency in 2018 and the Supreme Court overturning the ban in 2020. However, it is now very likely that Bharat embraces this new technology, puts in place the necessary safeguards and reaps the benefits that the blockchain offers (which also means legalizing cryptos); because nothing is more powerful than an idea whose time has come.

Reference:

  1. The Economic Times, 15th February 2021. 

Note: The words Cryptos/Cryptocurrency and Bitcoins have been used interchangeably, given the specific context. Bitcoin alone accounts for ~70% of global cryptocurrency market capitalization.


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About the Author

Nishit Vyas
Nishit Vyas is a Chartered Accountant by profession and a Level III candidate in the CFA program. Currently with a Global Investment Bank in the economic research domain, he has authored various publications on macroeconomic policies, investment advisory, capital markets and sports.