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Bitcoin, the original cryptocurrency, has been on a wild ride since its inception in 2009. Earlier this year, the price of one Bitcoin soared to over $ 60,000, an eight-fold increase in 12 months. Then it fell to half that value in just a few weeks. The values of other cryptocurrencies such as Dogecoin have risen and fallen even more sharply, often solely based on Elon Musks’ tweets. Even after the recent drop in their prices, the total market value of all cryptocurrencies now exceeds $ 1.5 trillion, a staggering amount for virtual items that are nothing more than computer code.
Are cryptocurrencies the wave of the future and should you use and invest in them? And the massive fluctuations in their prices, were nearly $ 1 trillion wiped out of their total value in May, do they portend problems for the financial system?
Bitcoin was created (by a person or group that remains unidentified to this day) as a way to conduct transactions without the intervention of a trusted third party, such as a central bank or financial institution. Its emergence in the midst of the global financial crisis, which shook confidence in banks and even governments, was perfectly timely. Bitcoin has enabled transactions using only digital identities, granting users a certain degree of anonymity. This has made Bitcoin the preferred currency for illicit activity, including recent ransomware attacks. It has fueled the obscure darknet of illegal online commerce, just as PayPal has helped the rise of eBay by making payments easier.
As its popularity has grown, Bitcoin has become cumbersome, slow, and expensive to use. It takes around 10 minutes to complete most transactions using cryptocurrency, and transaction fees have hit a median of around $ 20 this year. The volatile value of Bitcoins has also made it an unsustainable medium of exchange. It’s like your $ 10 bill could buy you a beer one day and a bottle of fine wine another.
Additionally, it has become clear that Bitcoin does not offer true anonymity. The government’s success in tracking and recovering part of the Bitcoin ransom paid to hacking collective DarkSide in the Colonial Pipeline ransomware attack has heightened doubts about the security and non-traceability of Bitcoin transactions.
While Bitcoin has failed in its stated goals, it has become a speculative investment. It’s confusing. It has no intrinsic value and is not backed by anything. Bitcoin enthusiasts will tell you that, like gold, its value comes from its scarcity. The Bitcoin computer algorithm imposes a fixed cap of 21 million digital coins (nearly 19 million have been created so far). But scarcity in itself can hardly be a source of value. Bitcoin investors seem to rely on the Biggest Fool’s Theory. All you need to make money from an investment is to find someone willing to buy the asset at an even higher price.
Despite their high valuations on paper, a collapse in Bitcoin and other cryptocurrencies is unlikely to rock the financial system. The banks have for the most part remained on the sidelines. As with any speculative bubble, naive investors who arrive late to the party run the greatest risk of loss. The government should certainly warn individual investors that, just like in the GameStop saga, they act at their own risk. Securities that allow Bitcoin price speculation are already regulated, but there isn’t much more the government can or should do.
Bitcoin is not trivial. Transactions are processed by miners using massive amounts of computing power in exchange for rewards in the form of Bitcoin. By some estimates, the Bitcoin network consumes as much energy as entire countries like Argentina and Norway, not to mention mountains of e-waste from specialized machines used for such mining operations which are running out quickly.
Whatever the eventual fate of Bitcoins, its blockchain technology is truly ingenious and revolutionary. Bitcoin has shown how programs running on computer networks can be exploited to make payments securely, within and between countries, without relying on stingy financial institutions charging high fees. For migrant workers who send remittances to their home country, for example, these fees are a major burden. Technologies that make payments cheaper, faster and easier to follow would benefit consumers and businesses, facilitating domestic and international trade.
Technology is not without its risks. Facebook plans to issue its own cryptocurrency called Diem intended to facilitate digital payments. Unlike Bitcoin, Diem would be fully backed by reserves of US dollars or other major currencies, ensuring stable value. But, as with its other ostensibly noble initiatives, Facebook can hardly be trusted to put the well-being of the public ahead of its own. The prospect of multinational corporations ever issuing their own unsecured cryptocurrencies around the world is deeply disturbing. Such currencies will not threaten the US dollar, but could wipe out the currencies of smaller and less developed countries.
Variants of Bitcoin technology also make many financial products and services available to the masses at low cost, directly connecting savers and borrowers. These developments and the possibilities created by new technologies have prompted central banks to consider issuing digital versions of their own currencies. China, Japan and Sweden are already testing their digital currencies.
Ironically, instead of truly democratizing finance, some of these innovations can exacerbate inequalities. Uneven financial literacy and digital access could result in sophisticated investors reaping rewards while the less well off, dazzled by new technologies, take risks they do not fully understand. Computer algorithms could aggravate racial and other biases rooted in credit scoring and financial decisions, rather than reduce them. The ubiquity of digital payments could also destroy any vestiges of privacy that remain in our everyday lives.
While the Bitcoin roller coaster prices attract attention, the monetary and financial revolution it has sparked is far bigger and will ultimately affect all of us, for better or for worse.
Eswar Prasad is Professor at Cornell University and Principal Investigator at the Brookings Institution. His new book, The Future of Money: How the Digital Revolution is Transforming Currencies and Finance, will be released in September.
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