The Crypto Conundrum

PARIBHA VASHIST

With a Latin American country recently ‘making history’ by accepting the cryptocurrency, Bitcoin, as a legal tender for all economic transactions, cryptocurrencies have come into the limelight again. Heated debates on the long-term sustainability of bitcoins as a medium of exchange, and the cropping up of terms like ‘cryptocurrency bubble’ and ‘dollarisation’ in the mainstream news, have just served to obfuscate the common man’s understanding of the cryptocurrency phenomenon.

As the world progresses towards the inevitable reality of digitising the global economy, it becomes important to simplify the dynamics of cryptocurrency to be better positioned as a consumer and as an investor. This piece is an attempt to unravel the workings of cryptocurrency, and understand its status quo in the Indian context, along with its potential costs and benefits.

DECODING CRYPTOCURRENCY

Put simply, cryptocurrency is a form of decentralised digital, encrypted currency, or medium of exchange that works on blockchain technology. Unlike fiat money, cryptocurrencies are not regulated by any central authority. Hence, central banks do not have any control over its supply or value.

In a 2008 paper, Bitcoin: A Peer-to-Peer Electronic Cash System, the first cryptocurrency Bitcoin was described as “an electronic payment system based on cryptographic proof instead of trust.” This cryptographic proof is obtained when transactions across computers are recorded in ‘blocks’ and are then connected to a ‘chain’ of past cryptocurrency transactions, giving form to a programme called ‘blockchain.’ Blockchain enables every cryptocurrency user to have a copy of the transactions and this copy keeps getting updated with each new transaction.

Two ‘mining’ techniques, namely ‘Proof of work’ and ‘Proof of stake,’ are used to verify transactions in order to prevent any kind of fraud. In ‘Proof of work,’ each participating computer solves a mathematical problem that verifies a ‘block’ and then adds those ‘blocks’ to the blockchain ledger. The first computer to do so gets a certain amount of bitcoins as a reward. However, the winners only manage to break-even as there are considerable costs of electricity and computing resources associated with this process. In the other method, ‘Proof of stake,’ a number of transactions a person can make is restricted to the amount of bitcoins they are willing to ‘stake.’ So, based on the amount of bitcoins put on ‘stake,’ a person is chosen to verify transactions and is subsequently awarded with new cryptocurrency. Since transactions must be validated using either of the two methods, general consumer transactions using cryptocurrencies are not instantaneous and may take around ten minutes to two hours to be verified.

IMPACT ON THE ENVIRONMENT

Bitcoin ‘mining,’ which is essentially the process of generating new bitcoins by solving complex mathematical problems with the aid of computers, is dependent on a huge amount of electricity that primarily comes from fossil fuels. When the demand for cryptocurrency skyrockets in the economy, mining becomes lucrative as people now have an incentive to generate profits. However, the environmental cost associated with cryptocurrency mining is massive. Take for example, the case of China where more than 75 per cent of Bitcoin blockchain operations of the world are located.

A study using a simulation-based Bitcoin blockchain carbon emission model reveals that “without any policy interventions, the annual energy consumption of the Bitcoin blockchain in China is expected to peak in 2024 at 296.59 Terra-watt hours [Twh] and generate 130.50 million metric tons of carbon emission correspondingly.” On a global level, a University of Cambridge estimate shows that Bitcoin mining consumes over 120 Twh annually, using more electricity per year than countries like Argentina, Malaysia, or Sweden.

Thus, if the status quo remains unchanged and electricity consumption continues at this rate then the Bitcoin network would definitely undermine global efforts towards reduction of greenhouse gas emissions and promotion of sustainable development. Elon Musk, CEO of Tesla, has, as a result, decided to suspend the use of Bitcoins for the purchase of Tesla vehicles. He tweeted, “We are concerned about rapidly increasing use of fossil fuels for Bitcoin mining and transactions, especially coal, which has the worst emissions of any fuel.” This tweet, in and of itself, caused the cryptocurrency’s value to drop by as much as 17 per cent, thereby shedding light on its volatile nature. He further added that “When there’s confirmation of reasonable [~50 per cent] clean energy usage by miners with positive future trend, Tesla will resume allowing Bitcoin transactions.” This decision is a positive effort to push ‘to-be-digitised economies’ towards adopting renewable energy sources in the long-run.

THE EL SALVADOR EXAMPLE

In the June Bitcoin 2021 Conference, President Nayib Bukele announced that El Salvador would officially adopt Bitcoin as a legal tender, and its implementation would begin in three months’ time. The main reason behind this shift to cryptocurrency is the emergence of a fierce debate in academic and political circles about how the 2001 dollarisation of the country increased its economic dependence on the US and the urgency to have a monetary policy that is independent of the Federal Reserve or Fed [Central Bank of the United States]. Many experts in Salvador believe that the Fed solely takes into account the interest of the US economy and not that of the Latin American economies dependent on the dollar, like El Salvador, while formulating its policies. Given this context, the Bitcoins would certainly help in reducing the country’s dependence on the decisions of a foreign central bank.

Moreover, a precedent for large-scale Bitcoin adoption to promote financial inclusion was set by the Bitcoin Beach Project in El Zonte, a small coastal village in El Salvador. The project was started in 2019 with the help of some anonymous donations and the aim was to develop a sustainable environment for the use of Bitcoins. Since most people in the coastal community did not have traditional bank accounts, or credit cards, the willingness to learn how to make transactions through Bitcoins was quite high. As a reward for their enthusiasm, the residents were taught how to use Bitcoins for quotidian transactions and several families were given Bitcoins to cope with the horrors of the COVID-19 pandemic. The disruptive nature of this project brought it into the notice of Jack Mallers,the CEO of Strike, a digital wallet firm, who then came into contact with El Salvador’s government and played an instrumental role in expanding this initiative on a national scale.

The El Salvadoran government strongly believes that the digital currency would be of great help in a country where more than 70 per cent of the people do not have access to traditional banking services. The cryptocurrency would also play a fundamental role in attracting foreigners dealing in Bitcoins to invest in El Salvador.

THE INDIAN STANDPOINT

In the initial years of the introduction of cryptocurrencies in India, the government followed a cautious approach. It focused on raising awareness on the risk factors of cryptocurrencies, which included their high volatility, ability to facilitate criminal activities [tax evasion, money laundering, etc.,] and their vulnerability to hacking. The fear arising from these risks propelled the Central Bank- the Reserve Bank of India [RBI] to ban cryptocurrency trading in 2018. However, two years later, the Supreme Court annulled this ban stating that this was an extreme measure and alternate measures that curb the risks associated with cryptocurrencies could be adopted instead.

In the present scenario, the Indian government has prepared a draft ‘Cryptocurrency and Regulation of Official Digital Currency Bill, 2021,’ that is yet to be presented in the Parliament. Through this draft Bill, the government aims to criminalise all private cryptocurrencies, while simultaneously preparing a regulatory, legal framework for an RBI-backed digital currency. The reason stated for this criminalisation is the inability of regulatory bodies in India to directly regulate private cryptocurrencies owing to the lack of a proper legal framework. Though this measure may be necessary to impose regulatory constraints that ensure fair competition, classical economists in concurrence with the laissez-faire principle would argue that private individuals should be given a chance to exploit the potential of this revolutionary technology and citizens should be given the freedom of choice to test a novel means of exchange besides the traditional central bank-backed fiat currency.

COST-BENEFIT ANALYSIS

Cryptocurrency is, indeed, a form of revolutionary technology that has several benefits. Since all confirmed transactions are stored in a public ledger and the blockchain technology ensures secure digital transactions through encryption, cryptocurrency is generally fraud-proof. Additionally, over 2 billion people who have access to the Internet, and not traditional exchange systems, have been able to gain from the cryptocurrency revolution.

However, the volatility of cryptocurrencies and the unreasonable fluctuations in their value are major concerns. Generally, people purchase these currencies as a speculative investment with expectations that their value would increase in the near future. Since there’s always an anticipation that their value will increase even more, people do not use Bitcoins for regular payments.

On the opposite end of the spectrum, if the value starts dropping then people stop accepting cryptocurrencies as a form of payment as it is expected that their value would fall even more subsequently. The other reason why decentralised digital currencies like Bitcoins are ‘bad’ is because there is a lack of control by a central authority, making these currencies a favoured medium for transactions in illegal activities. In this age of cyber-attacks, cryptocurrency exchanges for payment of “ransoms” have become a common phenomenon. It’s only by analysing the pros and cons before venturing into the ‘cryptocurrency world,’ can we brace ourselves for the uncertainties of this digital epoch.