“Thank you. Since we decided a few weeks ago to adopt the leaf as legal tender, we have, of course, all become immensely rich.”
- Douglas Adams, The Ultimate Hitchhiker's Guide to the Galaxy
Historically, anything can serve as money: cigarettes in the prisoner of war camps, gasoline in Europe post World War II or token currencies during the Tughlaq dynasty in the 14th century. Paper currencies as we use them today were never the order of the day. While the very first banknote can be traced back to 7th century China, paper currency only gained prominence in the 17th century in Europe and slowly spread to the rest of the world over time. And just like many other forms of currency before it, paper currency could also perish one day, giving way to a new system of money. If the rise in the usage of digital payments is any indication, the expiry date for paper currencies may be fast approaching.
Anything can function as money as long as everyone accepts it as one. Cigarettes started functioning as money when people (prisoners in war camps mainly) were willing to trade goods and services in exchange for them. This function is known as a medium of exchange. To be considered as money, cigarettes also need to act as a unit of account. If everyone accepts that a book costs 5 cigarettes and a TV costs 100 cigarettes, then cigarettes can be considered a common unit of account. Finally, cigarettes can be called money if they remain valuable over time. If it can be used, not only today but also a year from now to purchase goods and services then they act as a store of value. Thus, according to economists, anything can serve as money as long as it serves these three functions of medium of exchange, unit of account and store of value.
Is Bitcoin the new money?
While switching to net banking and digital wallets has been hard enough for most people to wrap their heads around, cryptocurrencies, a form of digital asset that can be used for speculative investment purposes and as a medium of exchange to purchase goods, have recently gained popularity. While Bitcoin, introduced in 2008, has particularly gained prominence in the headlines in recent years, it is only one of many cryptocurrencies available in the world today. Albeit, being the most famous one, others like ethereum, dogecoin, Litecoin, etc. are also being widely adopted today.
“The root problem with conventional currency 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.”
- Satoshi Nakamoto, the pseudonymous developer of Bitcoin
How do Bitcoins work?
Bitcoins are not a part of the (traditional) banking system. It is a decentralised system of money which is made up of a network of Bitcoin users. It is a peer-to-peer payment system in which the holders of Bitcoins send and receive Bitcoins from/to the wallet software stored in personal computers, mobile or online applications. This innovative payment system, like NEFT, IMPS, RTGS (current electronic money system), also needs to validate transactions. In other words, it needs to ensure that the owners of Bitcoins are able to use the Bitcoins in their wallet only once; so that the problem of double spending (of the same Bitcoins) doesn’t arise. In Bitcoins, this problem is resolved by a process called “mining”.
In this process, decentralised networks of users (holed up in any corner of the world, associated with no unified organisation) called “miners” solve laborious mathematical algorithms to verify the integrity of transactions. The process is called mining because the miners get rewarded in Bitcoins (that is they mine new Bitcoins out of the system) for solving the algorithms. Thus, mining leads to both, creation of new Bitcoins and verification of transactions. The compensation made to miners in Bitcoins enables them to charge a minimal (almost negligible) transaction fee for the verification process as opposed to other payment services (like PayPal) which charge a heavy fee for the same activity.
Another point to note here is that there is no central monetary authority in the system. An important consequence is that there is no way for a central bank to increase the supply of Bitcoins and debase the value of those already in circulation. The mathematical algorithm is designed in a way that as more Bitcoins enter the economy their rate of creation decreases progressively till it reaches its limit of 21 million coins.
Bitcoins have become attractive since they offer anonymous, cheap and efficient transactions that do not require any dependence on a centralised system such as a Central Bank (like the Federal Reserve in the U.S or the RBI in India). You can even buy a Subway sandwich with bitcoins today so if this isn’t good evidence of bitcoins’ worth as a unit of account and medium of exchange, we don’t know what is! Bitcoins users firmly believe that the digital currency has the potential to completely replace the traditional currencies (fiat currency) in the near future. However, many investors and economists worry that the anonymity associated with cryptocurrency transactions could facilitate illegal activities like tax evasion, money laundering and dealings in drugs.
The value of cryptocurrencies has also been growing recently because of investors who consider them a great speculative investment. In fact this year alone, bitcoins have grown over 96% to reach a high of US $57,000 on February 21 2021, spurred on by Tesla’s 1.5 billion dollar Bitcoin purchase, among many others. But the real danger of bitcoin lies in its volatility. Arguments about its real fundamental value and whether there is a bubble in the cryptocurrency market has been inconclusive. For comparison, Warren Buffet, the legendary investor has never bought a cryptocurrency and calls them worthless while Elon Musk, the CEO of Tesla, embraces them wholeheartedly.
But a word of caution on the volatility of bitcoins (and cryptocurrencies) has to be made here. The number of people who have lost their life savings by investing in bitcoins is no small number. If you had invested in bitcoin on February 21, 2021 because bitcoins had been growing consistently for months, and forgotten to check the value for two days, by the time you wake up on February 23, 2021 you would have seen your investment lose 15% of its total value. Even worse is when a small mistake, such as forgetting your password or entering the wrong address can decimate your entire bitcoin savings.
Due to bitcoin’s potential to satisfy the three functions of money, bitcoin users expect them to replace paper currency in the long run. However, all of the above may be some of the reasons why Central banks and monetary authorities have been worried about the increasing adoption of Cryptocurrency around the world. Moreover, economists have been worried about how cryptocurrencies could transform the role of Central banks.