After the relentless hype about Bitcoin and other cryptocurrencies such as Ethereum, Solana, Dogecoin, and LUNA, we have witnessed their complete meltdown over the last couple of years. The hype was primarily driven by the eye-popping increase in valuations of all major cryptocurrencies. Bitcoin went from around US$ 4,000 to US$ 64,000, a sixteen-fold increase, in twenty months. Other cryptocurrencies had even more ridiculous price increases over the same time—Ethereum rose fifty-fold, Solana 500 times, and LUNA had a 1,000-time increase.
Now, these cryptocurrencies are crashing. Bitcoin has dropped 55%, Ethereum by more than 60%, Solana by 85%, and LUNA has gone all the way down to zero.
How does one make sense of these complex and mysterious things whose combined valuations grew to trillions of dollars and are touted as the future of currencies in the digital age? Are they merely highly-speculative Ponzi schemes? Or do they have legitimate use in a world of increasingly widespread digital transactions?
Let us start by examining the justification for cryptocurrencies. In theory, they are supposed to enable electronic payments with no intermediary, i.e., peer-to-peer cash transactions. The problem with transferring money electronically between two parties is how to determine the balances after the transaction. First off, the party sending the money should have the amount required. After the transaction is complete, the amount should also get deducted from the balance of the sending party and added to the balance of the receiving party. We actually have had working digital cash for decades, and they work quite well, processing hundreds of thousands of transactions per second. Debit and credit cards, wire transfers, UPI [in India[ and digital wallets all serve that function. But all these have central intermediaries, in most cases banks, to determine and adjust balances.
So, what is the problem with intermediaries? After the 2008 financial crisis, the banking sector in the West collapsed. The western central banks undertook massive money printing through quantitative easing to revive and support the banking sector and the economy. This resulted in a collapse of confidence in the big banks amongst a large section of people. Money-printing sparked the fear that the fiat currencies of the major economies would devalue. Cryptocurrency was meant to address these problems by enabling digital transactions without intermediary banks, which got rid of the need to have banks at all, at least in the minds of its proponents. The currency devaluation problem was “solved” by limiting the supply of cryptocurrencies (Bitcoin is limited to 21 million coins) and removing the role of central banks in creating money.
So how are currencies created? It was proposed they would be made purely algorithmically through a process called “digital mining”. As immediately obvious, from a political standpoint, this is a hugely problematic goal. It seeks to eliminate the sovereignty of the State over currency and its role in money supply and replace it with private entities. Further, running “digital mining” requires powerful computers and loads of electricity. Hence, people with more powerful computers and the ability to virtually purchase enormous amounts of electricity would have a monopoly over money creation, replacing the State in that role. This libertarian dream is the driving force behind cryptocurrencies, and many leading bitcoin proponents subscribe to libertarianism. Libertarianism is an extreme right-wing political philosophy that opposes the State’s role in anything except maintaining law and order and protecting private property.
Let us return to the problem of how Bitcoin and other cryptocurrencies operate without central intermediaries. They handle the problem of verifying and maintaining balances by making them public but pseudonymous. So, you are no longer “you” in the crypto world. Unlike in traditional banking systems, there is no KYC [Know Your Customer] here. Instead, you are represented by a sequence of really long computer-generated random numbers that act as your pseudonym. The numbers are randomized to ensure anonymity. A ledger of everyone’s balances is placed in the public domain but identified only by these pseudonyms. This public ledger is called the “blockchain.”
When a transaction takes place between two parties, the blockchain is examined and updated to perform the necessary credit and debit balances. However, since the blockchain is public and there are no central intermediaries, how does it ensure somebody does not fake transactions? Or simply adds money to their own balances?
This is where the notion of “mining” comes in. The transactions are verified by solving cryptographic problems (complex mathematical problems) using computers. The nature of these problems is such that they require a huge amount of computing time and resources to solve. But once solved, anybody can verify the solution. The miners are incentivized to do this by rewarding them with cryptocoins every time they solve the cryptographic verification problem—thus creating or “mining” new coins.
A massive amount of computing resources, electricity and time need to be expended to verify transactions and mine new coins. It is estimated that the Bitcoin network burns as much electricity as a mid-sized country. And it can only process between four and seven transactions per second, while credit card networks already handle tens of thousands of transactions per second. So in these times of global warming, we have supposedly built a system of the future that wastes electricity and is orders of magnitude slower than systems that have existed for decades.
Another issue is that cryptocurrency transactions made by mistake, fraud or theft through hacking attacks cannot be reversed since there are no trusted intermediaries. There are no authorities or ombudspersons to complain to!
Given these problems, cryptocurrencies are really not practically useful for doing online transactions. And, as we see, their prices fluctuate wildly, making them useless as either a store of value or medium of exchange. They don’t even act as guards against inflation. In periods of high inflation like now, forget keeping up in real terms, cryptocurrencies have dropped steeply in nominal terms. This was one of the core stated motivations behind creating cryptocurrencies in the first place—that they would guard against inflation caused by massive money-printing by central banks. There are numerous accounts of vulnerable people from countries with high inflation rates, such as Argentina, Nigeria and Pakistan, who invested their life savings in stablecoins (cryptocurrencies advertised as being pegged to the dollar) to protect against inflation, only to lose everything.
What, then, can cryptocurrencies accomplish? Due to the anonymity they provide through pseudonyms, they can be used for criminal activities such as asking for ransoms after hacking attacks—ransomware attacks—and money laundering and tax evasion.
The other category they are widely used in is Ponzi schemes. These are financial frauds which pay the initial investors high returns by taking funds from new investors. Ponzi schemes inevitably collapse once they run out of gullible new investors and, therefore, their flow of new funds. Since governments and central banks worldwide did not act quickly enough to tackle these “currencies,” they have remained outside the purview of financial, banking and securities regulations, which protect people from Ponzi and other predatory schemes. It has provided massive opportunities for all kinds of financial entities, including hedge funds and venture capitalists, to pour billions of dollars into cryptocurrencies to reap massive profits through financial speculation and Ponzi schemes.
One such scheme resulted in a couple of cryptocurrencies—LUNA and TerraUSD—run by the Terra Foundation going bust last month, evaporating more than US$ 50 billion. And yet, these schemes are being allowed to not just continue but are actively being touted by all sorts of celebrities such as Kim Kardashian and actor Matt Damon, tech billionaires such as Elon Musk, Twitter founder Jack Dorsey and other internet influencers. These influencers either get paid enormous amounts to market cryptocurrencies or gain early access and cash out once the cryptocurrencies are hyped up, and their value shoots up.
Cryptocurrencies are like cancer to financial systems. They solve no useful purpose, suck huge amounts of resources such as electricity and computing power, and enable all kinds of illegal activities. They have created a multi-trillion dollar industry that enables powerful financial entities like hedge funds to engage in predatory activities like sucking people’s life savings into Ponzi schemes. Governments all over the world need to wake up to these risks and deal with them. China has taken the lead by banning all cryptocurrency mining and transactions. The Indian government, after talking about a ban, appears to have developed cold feet. It is reportedly looking to regulate and tax them as legitimate financial instruments. This cancer should not be regulated but eliminated.
While banning cryptocurrencies, China also launched a “Central Bank Digital Currency” called the e-Yuan or Digital Yuan to address the legitimate needs of its exploding digital transaction space. Central Bank Digital Currencies (CBDC) should not be confused with cryptocurrencies. Unlike cryptocurrencies, CBDCs are very much backed by the State and have the central bank as the intermediary. They can scale to thousands of transactions per second without the need for hugely wasteful digital mining. As for cryptocurrencies, they must die!