Cryptocurrencies
A cryptocurrency is an alternative to conventional money. The first, biggest and most famous example is bitcoin, which was launched in 2009. Despite the name, bitcoin is not a coin. It has no physical form whatsoever but exists only as records in computer networks. There are at least 25 other major cryptocurrencies and more than four thousand smaller ones.
Why is a bitcoin worth $52,000 today? Because that is the value people are willing to pay for it. In other words, its value is purely consensual. Bitcoin has no physical meaning, no backing in gold reserves nor financial support of any sort. Is it a fiction? It is a fiction in Harari's sense, ie it is something that has value only because people believe in it. However, the same is true of other forms of money, such as banknotes, shells, beads and gold. If no-one believed in the dollar it would be worthless, just like some obsolete banknote. Except for barter or the Sumerian practice of paying with bags of barley, nearly all forms of exchange of value rely on consensual value. However, the rate of exchange between two currencies, such as the dollar and the yen, is based on objective economic factors; no objective factors come into play to set the exchange rate between bitcoin and dollars. The feeling in the market plays that role.
Cryptocurrencies are even stranger than conventional money, strange as that would be to a hunter and gatherer. Unlike conventional money, cryptocurrencies are extremely volatile. Today a bitcoin is worth $52k, a year ago it was worth only $1k. Ten years ago it was worth a dollar. In the future it may be worth $52, a million or nothing. No-one knows. It is more volatile than any stock. Unlike a stock, it is not linked to the value of something in the physical world. You could say that its value is purely psychological.
Belief in bitcoin exemplifies trust in a better future, ie one in which the value of bitcoin will continue to rise. Unlike conventional money, bitcoin is a form of investment.
There is no central authority controlling or validating cryptocurrencies and their transactions; the entire bitcoin network plays that role. Cryptocurrencies are truly international and do not depend on any government or organisation. Cryptocurrencies have generated a lot of hype, suggesting that they liberate people from the financial tyranny of governments and banks. In particular, the holder of a cryptocurrency is immune to the inflation of a conventional currency and the effects of printing money. Cryptocurrencies promise fast transaction times, low transaction fees and security. The downside is their unpredictable volatility - the value of a cryptocurrency can change drastically in a matter of hours. Also, this complex technology comes with new pitfalls and has not yet been accepted by many merchants.
The creator of bitcoin, Satoshi Nakamoto (who is worth $54 billion), stated that: "The root problem with conventional currencies is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust." The Economist describes bitcoin as "a techno-anarchist project to create an online version of cash, a way for people to transact without the possibility of interference from malicious governments or banks."
The bitcoin ledger is a blockchain, where bitcoins are registered to bitcoin addresses. To create a bitcoin address one picks a random private key and computes the corresponding bitcoin address, ie the virtual location where the bitcoins are deemed to reside. This computation can be done in a split second. The reverse, computing the private key of a given bitcoin address, is practically unfeasible. This is why they are called cryptocurrencies. Users can make public a bitcoin address without compromising its corresponding private key. If the private key is lost, so are the coins. The bitcoin address is like a bank account number and the private key is like the password that gives access to the account.
There is the danger of losing one's password, which means losing all one's bitcoins. Stefan Thomas owns 7,002 bitcoins, worth $367 million. However, he has lost his password and so cannot access his bitcoin wallet, where his private key is stored. Maybe he should invest in a few sessions of hypnotherapy! Of the existing 18.5 million bitcoin, around 20 percent — currently worth around $970 billion — appear to be in lost or otherwise stranded wallets.
The security of bitcoin transactions is guaranteed by a blockchain, a digital ledger, which is a sequence of computer records that is continually growing. A block consists of the transactions made in the last ten minutes plus a special number that has to meet a rigorous test. Finding this number is a major cryptographic challenge. It is not possible to change the records without the collusion of a majority of the entire network. However, if and when quantum computers become a reality, it may be possible to quickly generate the private key from the publicly known bitcoin address and hence cryptocurrencies such as bitcoin would be in real danger of being stolen.
Perhaps the strangest aspect of cryptocurrencies is "mining". In cryptocurrency networks, mining is the validation and registration of transactions. A transaction is validated by means of a digital signature, which only the owner of the bitcoin address can generate by means of their private key. Miners keep the blockchain consistent, complete, and unalterable by repeatedly grouping newly broadcast transactions into a block, which is then broadcast to the network and verified by recipient nodes. For this effort, a successful miner obtains 6 newly created bitcoins, which happens roughly every ten minutes. This creates new currency, hence the term 'mining'. Miners have to invest large sums of money on high performance computers and electricity. Thus the value of the currency obtained for creating a valid block often does not justify the amount of money spent. Bitcoin uses as much electricity as all of Switzerland.
The cost of mining a bitcoin has a bearing on its dollar value, however, it does not account for the wild fluctuations.
Should you buy a cryptocurrency? That depends on your appetite for high-risk investment and willingness to use a complex and novel technology, one that is still a work in progress.
I don't feel a burning urge to pay my gas bill using bitcoin. Our current payment systems work well. To replace them with something else is a major change that would require a major inducement. So far, this has not been produced. The thought of going to a lot of trouble and risk in order just to keep paying my bills is not attractive. The touted benefits of cryptocurrencies are pretty much theoretical. We might escape the predatory banks but only to fall prey to hackers, price volatility, increased complexity and new scams. Life is already too complex for comfort.
As I see it, the problem with cryptocurrencies is that they are seen by most people as an investment - analogous to a share - rather than what they were designed to be, ie a means of payment. This is problematic because a cryptocurrency has no value except the consensus on the market. As stated previously, the value of such a currency has no objective foundation. It is determined by nothing more substantial than the hopes and fears of those who buy into it.
John Naughton puts it more bluntly: "Bitcoin has been a fascinating phenomenon from the beginning, but one that morphed under the pressure of greed." Although cryptocurrencies were not set up as Ponzi schemes, this is arguably what they have become. Early investors made a killing, late ones lost money when the bubble deflated.
NB The prices given in this article were current at the time of writing. They could be very different by the time you read this.
For a more detailed and technical description of bitcoin, see wikipedia.
For a discussion of the effect of quantum computing on bitcoin look here.
PS1 Since there is no organisation running the operation of bitcoin, other than the entire network, how is the software that runs the system maintained? The answer is that a change is implemented when 95% of miners agree to it.
PS2 The FTX cryptocurrency exchange collapsed in November 2022, going from $32 billion to $1 in a single day.
William Bennett wrote, "Dubbed the ‘Lehman Brothers’ moment for crypto, last week the second-largest exchange, FTX, spectacularly imploded as investors realised putting their hard-earned money into an unregulated and highly speculative ‘asset’ probably wasn’t the wisest idea." Arwa Mahdawi wrote, "Why on earth did some of the supposedly smartest minds in venture capital give Bankman-Fried so much money and provide so little oversight? Two reasons, I think. The first is that nobody understood what on earth the guy was talking about and decided that that meant he was a genius. Secondly, they just liked his vibe. 'I don’t know how I know, I just do. Bankman-Fried is a winner,' wrote Adam Fisher, a business journalist, in a glowing profile of Bankman-Fried."
I would add that another factor was a huge dose of wishful thinking. These guys sorely wanted to believe they were onto the next big thing.
Commenting on the collapse of the crypto exchange FTX and the arrest of its CEO, Sam Bankman-Fried, David Banks wrote in The Guardian:
"Blockchain-based technologies were supposed to make finance an automated, frictionless environment where fallible humans and their corruptible institutions could be replaced by the infallible logic of code. Cryptocurrencies would finally give the little guy a chance by forcing everyone to play by the same encoded rules. But instead, these technologies appear to have supercharged the same old problems, letting a Bahamas-based 'polycule' commit international fraud to the order of billions of dollars."
"The reality is that the 21st-century crypto industry – automated or not – must follow the same capitalist market physics that were endemic to 20th-century energy markets, or 19th-century London banks: ruthless competition winnows an industry down to a few key players and then, as Marx wrote in 1847, there comes a phase 'when everybody is seized with a sort of craze for making profit without producing'."