Future’s Money

For governments and central banks, the meteoric rise of Bitcoin and other cryptocurrencies has brought them fresh difficulties. The risks associated with the experiment with digital assets have increased due to their rising popularity and strong market volatility.

Introduction

Cryptocurrencies have developed over a short period of time from digital novelties to trillion-dollar technologies that have the ability to upend the world’s financial system. In addition to being used as currencies to purchase a variety of products and services, including software, virtual property, and illegal substances, Bitcoin and hundreds of other cryptocurrencies are becoming more and more popular as investments.

Cryptocurrencies, according to their supporters, are a democratising force that are taking control of money creation away from Wall Street and central banks. However, detractors claim that the absence of regulation for cryptocurrencies encourages terrorist organisations, criminal groups, and rogue nations while the assets themselves fuel inequality, experience extreme market volatility, and use a significant amount of electricity. Around the world, laws are very different, with some governments supporting cryptocurrencies and others outlawing or restricting their use. In an effort to counteract the cryptocurrency growth, 114 nations, including the United States, are considering launching their own central bank digital currencies (CBDCs) as of February 2023.

What are cryptocurrencies?

Cryptocurrencies, so named because they use encryption to create virtual currency, are primarily traded on decentralised computer networks between users of virtual wallets. These transactions are catalogued on distributed, impenetrable ledgers for public viewing. This open-source system prevents coin duplication and does away with the necessity for a centralised organisation, like a bank, to verify transactions. The most well-known cryptocurrency by far is Bitcoin, which was developed in 2009 by the mysterious software developer Satoshi Nakamoto. Its market valuation has reached a high of over $1 trillion. Many more have emerged in recent years, including Ethereum, the second-most popular one.

. This open-source system prevents coin duplication and does away with the necessity for a centralised organisation, like a bank, to verify transactions. The most well-known cryptocurrency by far is Bitcoin, which was developed in 2009 by the mysterious software developer Satoshi Nakamoto. Its market valuation has reached a high of over $1 trillion. Many more have emerged in recent years, including Ethereum, the second-most popular one.

. This open-source system prevents coin duplication and does away with the necessity for a centralised organisation, like a bank, to verify transactions. The most well-known cryptocurrency by far is Bitcoin, which was developed in 2009 by the mysterious software developer Satoshi Nakamoto. Its market valuation has reached a high of over $1 trillion. Many more have emerged in recent years, including Ethereum, the second-most popular one.

In order to organise these blocks and validate transactions on the network, bitcoin “miners” must use a technique called “proof of work” that relies on computers to solve mathematical puzzles. However, Ethereum and certain other cryptocurrencies utilise a validation technique called “

 Every ten minutes, a new transaction block is added to the chain in the case of Bitcoin, at which point fresh Bitcoin is distributed. (The payout gets smaller and smaller over time.) Bitcoin has a twenty-one million coin limit on its total supply, but not all cryptocurrencies do.

The global supply and demand for cryptocurrencies, including Bitcoin, determines their pricing. But because they are backed by other assets, certain cryptocurrencies have fixed values and are referred to as “stablecoins.” Although these coins sometimes assert that they are pegged to traditional currencies, such as $1 per coin, many of these pegged currencies were broken during a period of instability in 2022.

What makes them so popular?

Cryptocurrencies, particularly Bitcoin, have risen to mainstream popularity and trillion-dollar valuations after being derided as a niche passion of tech fanatics. Bitcoin’s price surpassed $60,000 for the first time in November 2021. (By February 2023, it would have dropped to $23,000.) By the middle of 2022, an estimated 20% of US citizens interviewed by NBC News had invested in, traded in, or used cryptocurrencies.

Different currencies have different uses, but cryptocurrencies’ popularity is partly attributable to their decentralised nature, which enables quick and anonymous payments, even across borders, without the need for a bank that might impede or charge fees. Dissidents in authoritarian governments have utilised bitcoin to circumvent legislation, including US sanctions on Russia.

According to some analysts, digital assets serve largely as investing tools. According to CFR Senior Fellow Sebastian Mallaby, people purchase cryptocurrencies “because of a speculative belief that these tokens are going to go up in the future, because a new future is being built on the blockchain.” “As the past 12 months have shown, it’s an extremely dangerous bet.

Some experts claim that the price volatility of Bitcoin and other cryptocurrencies reduces its value as a medium of exchange. (The majority of buyers and sellers do not want to accept payment in something whose value is subject to daily fluctuations.) However, some companies do take Bitcoin. Bitcoin frequently receives compared to gold and is viewed by many investors as a speculative asset to be held over time rather than used for immediate payments. Because the supply of Bitcoin is eternally set in contrast to that of fiat currencies, which central banks can increase at any time, some people view it as a hedge against inflation. However, several analysts questioned this claim as Bitcoin crashed during market turmoil in 2022. 

 Even while many are connected to a larger initiative within the digital asset market, the valuation of other cryptocurrencies can be more difficult to understand. Some cryptocurrencies, like Dogecoin, which was designed as a joke, have held its value and attracted investment from well-known investors.

Several Latin American and African nations, as well as others with traditionally weak currencies, have seen a rise in the popularity of Bitcoin among populist politicians. El Salvador made history in 2021 when it became the first nation to recognise Bitcoin as legal cash (people can use it to pay taxes and settle debts), however the decision prompted unrest. Politicians from other regions of the region who favour the concept of making Bitcoin legal tender have done so.

Meanwhile, experts believe that stablecoins have the ability to compete with fiat currencies as the main means of payment. They may be transmitted instantaneously, without the transaction costs associated with credit cards or other international remittance services like Western Union, and their value is often steady. Stablecoins also give a chance to include millions of people who lack regular bank accounts in the financial system because they can be used by anybody with a smartphone. Regulators have raised their inspection of them, nevertheless, particularly when a number of stable coins lost value relative to their $1 pegs throughout the market turbulence of 2022.

Define “DeFi”?

Blockchain technology and cryptocurrencies have spawned a new breed of “decentralised finance” (DeFi) ventures and initiatives. DeFi, which promises to provide users with access to financial services including as borrowing, lending, and trading without the use of legacy organisations like banks and brokerages, which frequently charge exorbitant commissions and other costs, is essentially the bitcoin equivalent of Wall Street. Instead, “smart contracts” carry out transactions automatically when certain criteria are met. Tens of billions of dollars are being invested in the DeFi industry as its popularity soars.

The Ethereum blockchain is used for the majority of DeFi apps. Blockchain technology has a variety of potential applications outside of bitcoin due to its effectiveness in tracking transactions, according to experts, including facilitating real estate sales and international trade.

The use of blockchain-based tokens to create a new financial system with benefits over traditional, centralised forms of money is conceivable. It’s a new method of doing finance, and you can trust the code, the blockchain, and the decentralised ledger, according to Mallaby of CFR.

What difficulties has this brought about?

Governments now face a whole set of issues as a result of cryptocurrencies, such as worries about criminal activity, environmental damage, and consumer protection. 

Most of the world’s Bitcoin mining takes place in China, which has stepped up its efforts to stifle cryptocurrencies. The price of several cryptocurrencies immediately dropped as Chinese officials announced a broad ban on all cryptocurrency transactions and mining in September 2021. Eight other nations (Algeria, Bangladesh, Egypt, Iraq, Morocco, Nepal, Qatar, and Tunisia) have reportedly banned cryptocurrencies, while dozens more have moved to limit the adoption of digital assets, according to the U.S. Law Library of Congress. However, the majority of countries have so far adopted a quite constrained strategy.

Illicit behaviour. 

Cybercriminals have been using ransomware attacks—which include hacking into computer networks, locking them down, and then demanding payment to unlock them—more frequently in recent years.According to the most recent annual assessment by the U.S. Drug Enforcement Agency (DEA), drug cartels and money launderers are also “increasingly incorporating virtual currency” into their operations. A number of so-called darknet markets—websites where anonymous users may use bitcoin to buy and sell illegal products and services, principally drugs—have been shut down by U.S. and European authorities. As evidence, critics point to the loss of more than $1 billion in cryptocurrencies by a North Korean hacker group in 2022 as evidence that these enforcement attempts have failed.

Terrorism and circumventing sanctions. Because of the dominance of the US dollar, the US has unmatched authority to inflict severe economic penalties. But nations like Iran, North Korea, and Russia are adopting cryptocurrencies more frequently to get beyond American restrictions. Terrorist organisations that deal in cryptocurrency include the self-declared Islamic State, al-Qaeda, and the military branch of the Palestinian group Hamas.

Hazards to the environment. Bitcoin mining requires a lot of energy; now, the network uses more electricity than several nations. Concerns regarding the cryptocurrency’s role in climate change have been raised as a result. Supporters of cryptocurrency claim that this issue can be resolved using renewable energy; for instance, the president of El Salvador has promised to mine Bitcoin using volcanic energy. Ethereum reportedly switched to a proof of stake approach, which consumes less energy, because of environmental concerns.

A lack of regulation and volatility. Due to the rapid growth of cryptocurrencies and DeFi businesses, billions of dollars’ worth of transactions are now happening in an area that is comparatively unregulated, raising questions about cybersecurity, fraud, and tax evasion as well as the soundness of the overall financial system. The ability of central banks, particularly those in smaller nations, to determine monetary policy through control of the money supply may be constrained if cryptocurrencies take over as the primary method of transacting on the international stage. 

A small number of crypto enterprises were unable to repay their loans, who were mainly other crypto firms, after high volatility in 2022 reduced the value of numerous well-known coins. Numerous lenders and debtors filed for bankruptcy, including FTX, the third-largest bitcoin exchange in the world at the time. Although traditional financial firms were mostly unaffected, the failure of FTX and other companies cost investors tens of billions of dollars in damages. 

What steps are countries taking to address this?

Many governments have shied away from crypto, but its rapid growth and innovation, together with the emergence of DeFi, have compelled regulators to start drafting regulations for the new industry. Around the world, laws are very different, with some countries accepting cryptocurrencies and others outright prohibiting them. According to experts, the problem for regulators is to create regulations that minimise conventional financial dangers without inhibiting innovation.

What is a central bank digital currency?

Policymakers in the US have said they are gradually going to regulate cryptocurrencies and the developing DeFi market. But because cryptocurrencies do not cleanly fit into the current legislative structure, there is uncertainty that politicians will probably need to clear up. Gary Gensler, the chairman of the U.S. Securities and Exchange Commission (SEC), has compared the cryptocurrency industry to the Wild West and urged Congress to give the SEC more authority. Stronger regulation of stablecoins has been demanded by both Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell. Regulators have yet to provide crypto investors with the same safeguards seen in more conventional finance, such as deposit insurance.Christopher J. Waller of the Federal Reserve Board of Governors stated in 2023, “If you buy crypto-assets and the price goes to zero at some point, please don’t be surprised and don’t expect taxpayers to socialise your losses.”

Authorities have targeted exchanges where users can trade cryptocurrencies for dollars and other national currencies in order to reduce illegal activity. Major exchanges like Coinbase, Binance, and Gemini abide with “know your customer” and other anti-money laundering standards due to pressure from regulators. Meanwhile, to analyse and monitor criminal activities, law enforcement and intelligence organisations have figured out how to take advantage of the traceability of the majority of cryptocurrencies by using blockchains. For instance, the FBI later found part of the ransom money given to the Colonial Pipeline hackers. As a “threat to U.S. national security,” the Treasury Department said in August 2022 that it would tighten down on so-called bitcoin mixers, which criminals can employ to conceal their activity on the blockchain.

Many central banks, notably the U.S. Federal Reserve, are thinking about launching their own digital money, also known as a central bank digital currency (CBDC), as a means of asserting their sovereignty. CBDCs promise supporters the speed and other advantages of cryptocurrencies without the risks. Numerous nations are investigating CBDCs, representing more than 90% of the world economy as a whole. CBDCs have been fully introduced in eleven nations. Ten of them are in the Caribbean and have lower incomes; Nigeria is the eleventh. China is currently anticipated to expand its CBDC pilot programme to its population of over one billion by the end of 2023 after testing a digital yuan in 2019. There is allegedly dispute among Fed officials in the US on the necessity of a digital currency.

According to experts, interest in CBDCs increased in 2019 after Facebook stated it will launch Libra, a new digital currency that may provide its more than two billion users with a new payment option. Since then, the project has been cut back and given the name Diem. Another driving force is China: According to experts, a digital yuan may undermine the dollar’s position as the preferred international reserve currency and give Beijing even greater control over its citizens and economy.

Direct accounts with the central bank for citizens would be one option to introduce CBDCs. Governments would be given strong new tools to manage the economy in this way—for example, stimulus funds and other benefits might be credited to people directly—and the backing of the central bank would make CBDCs a secure digital asset to possess. However, their introduction could also lead to new issues because they could consolidate a tremendous amount of authority, information, and risk in one bank, thus compromising security and privacy.

According to some experts, there are hazards involved if commercial banks are replaced by CBDCs as intermediaries because they play a crucial economic function in originating and allocating credit (i.e., issuing loans). If people decided to bank with the Fed directly, the central bank would be forced to either discover new ways to pump credit or make it easier for consumers to borrow money, both of which it might not be able to achieve. These factors lead some experts to recommend private, regulated digital currencies over CBDCs.