10 min read.Updated: 19 Nov 2021, 12:50 AM ISTVivek Kaul
Right now, when it comes to cryptocurrencies, many people are suffering from FOMO, or the fear of missing out
A few days ago, my 66-year-old maternal aunt asked me a very simple question: “Beta (son), what is crypto?" Much before her, my mother had asked the same. This is a question I often get asked these days, especially from the middle-aged and the senior citizens.
Other forms of the same question are: Is crypto really a currency? Can I use it to buy stuff from my neighbourhood kiranawalla? If it’s a currency, why are people buying and selling it?
Honestly, it’s extremely difficult to explain the technical aspects of crypto to a layperson. One is because technical aspects are, well, technical. And two, because the middle-aged and the senior citizens already have a certain visualization of money in their minds, which is very physical.
Take something as simple as cash. You keep paper notes in your pocket and as and when required, spend it. Even digital forms of money have a certain physicality attached to them. Take the case of a debit card. When one spends money using it, one is not actually paying out cash. Nonetheless, the debit card in itself is a physical thing. Also, the money spent using a debit card has been earned and deposited in a bank account.
Or take the case of all the payment apps. They are linked to a bank account, ultimately. And a bank is a physical thing, at least in the minds of people, even though a lot of banking these days happens digitally.
So, here’s an attempt to demystify and explain cryptocurrencies to the layperson, in particular, people who are senior citizens, such as my aunt and my mother. But before we get into the nitty-gritty, it is important to understand how all this first started.
From 2000 to 2006, a huge real estate bubble built up in the US and much of the Western world. This bubble became so big that when it burst in late 2007 and all through 2008, it threatened to pull down some of the biggest financial institutions in the world along with it, and a few it did. Lehman Brothers, the fourth largest investment bank on Wall Street, went bankrupt in mid-September 2008.
The weak state of financial institutions in the aftermath of the crash led to a situation where Western economies were staring at an economic depression. To prevent this, the central banks led by the Federal Reserve of the US started printing a lot of money. Between early September and end of December 2008, the Federal Reserve printed more than $1.3 trillion. Other central banks like the European Central Bank and the Bank of England soon joined the money printing party. The Bank of Japan came in a few years later.
The idea was to flood the system with money, drive down interest rates and hope that people and corporates would borrow and spend more and, in the process, drive economic growth.
Historically, paper money has almost always been backed by some commodity. Up until 1913, before the First World War broke out, most paper money was backed by silver and gold, which basically meant that citizens could exchange paper money for a certain weight of silver and/or gold. Hence, the ability of governments and central banks to create money out of thin air by printing it was largely limited, simply because people could convert their paper money into gold and/or silver. And there was only so much gold and silver going around.
Many countries in Europe suspended this convertibility when they had to fight the First World War, in order to finance high expenditure by simply printing money. Before the Second World War ended, 730 delegates from 44 countries met at Bretton Woods in the state of New Hampshire in the US to discuss and put in place a new global money system.
The system that emerged had the US dollar at the heart of it and it was backed by gold. Other countries had the option of converting their dollar hoards into gold by presenting those dollars to the American Federal Reserve. However, in 1971, Richard Nixon, the then American president, put an end to this.
What evolved out of this was the pure paper money or the fiat money system. Essentially, the money of today is not backed by anything but a guarantee by the government.
If any government prints too much money, economic theory suggests that it is likely to lead to high inflation. The point being that while the supply of money has gone up quickly, the supply of goods and services that it can buy hasn’t. In this scenario, the only way for the economic system to adjust is for the prices of goods and services to rise, and that is inflation.
With the Western central banks printing as much money as they did post September 2008, there was a great fear of inflation eroding the value of money.
Enter Satoshi Nakamoto
Satoshi Nakamoto invented the first cryptocurrency, bitcoin. It is not known who he, she or they are. As Jacob Goldstein writes in Money–The True Story of a Made-Up Thing: “Satoshi Nakamoto could be a cypherpunk living in an underground bunker in New Zealand or an executive at a bank in London. She might be a priest or he might be a criminal or they might be a cabal scheming to take over the world."
Nakamoto did not like the privilege that is reserved for government-backed central banks, which can create money out of thin air. As Nakamoto put it in a blog post: “The root problem with conventional currency is all the… central banks must be trusted not to debase the currency."
To counter this, Nakamoto invented bitcoin, a new form of money based on cryptographic techniques with “a piece of software… written in the programming language C++."
As Eswar Prasad writes in The Future of Money: “Cryptography, or secret writing, typically involves the encryption of a sender’s message and the decryption of the message by the recipient." The idea was to create a form of decentralized money which could get around the government-controlled paper money system. The first block of bitcoin was created on 3 January 2009—just a few months after massive money printing was unleashed on the world.
Also, unlike paper money, the total amount of bitcoin that can ever be created is limited to 21 million units. The creation of fresh units of bitcoin halves every four years. Further, modern paper money runs primarily on trust. As citizens of a country, we trust that when we use paper money to pay for something, it will be accepted. That trust stems from the government guaranteeing it.
So, where was trust supposed to come in the case of bitcoin? As Prasad writes: “Trust is created by making certain aspects of transactions transparent and visible to everyone." Goldstein puts it in a much simpler way, where he says: “The dream of bitcoin is that you don’t have to trust a government, or a bank, or Satoshi Nakamoto; you just have to trust the code."
Over the years, bitcoin caught the attention of techies and, given that no government or regulator was involved, anyone with enough technical capability could launch a system similar to bitcoin and that’s precisely what happened. As per the database Statista, the number of cryptocurrencies in the world in November 2021 stood at 7,557.
Medium of exchange
The original idea behind bitcoin and other cryptocurrencies was to create a form of money which gets around the government-based fiat money system. Hence, the word currency became attached to them. But over the years, this has turned out to be a misnomer.
Bitcoin, in particular, has been very popular when it comes to making payments in illegal commerce—everything from terrorism financing, human trafficking, and money laundering.
But bitcoin or any other cryptocurrency for that matter hasn’t managed to emerge as a medium of exchange in everyday life. It is very difficult for a whole bunch of people, including senior citizens, to visualize cryptocurrency as a form of money that they can use to make payments in everyday life. Second, all said and done, it is easy to trust the government in most countries than other entities.
Third, there is a very basic problem in the way cryptocurrencies are structured, which limits their ability to process payments at a fast pace. As William Quinn and John Turner write in Boom and Bust—A Global History of Financial Bubbles: “[Bitcoin’s] popularity exposed the inability of its system to process large numbers of transactions, resulting in long delays in transferring bitcoins and substantial transaction costs. The impossibility of reversing mistakes made it impractical." The bitcoin network can handle around seven transactions per second. Visa can handle 65,000 transactions per second. The good bit is that newer cryptocurrencies are trying to solve this problem. So, in that sense, you can’t use cryptos to carry out everyday money transactions.
Over the years, people have put their savings in bitcoin and other cryptos, and have turned it into a mode of investing and a form of speculation—by betting on its price movement. For bitcoin aficionados, bitcoin is like digital gold and a store of value.
Gold has been a popular store of value because its supply grows at a steady rate every year. There is no way that a government can suddenly increase the supply of gold, like it can with paper money. In that sense, bitcoin is like digital gold. Its supply increases only at a steady rate and is capped at the upper end.
This became the theoretical argument for owning bitcoin. Governments around the world were debasing paper money by printing more and more of it. Hence, it made sense to buy bitcoin. This sent its price soaring. Of course, after a while, like in the case of any other form of investing, the theoretical argument didn’t really matter and people invested because they had seen prices going up for a while.
The success of bitcoin rubbed on to other cryptos as well. And this is precisely where the entire argument about bitcoin being digital gold falls apart. While there is a cap to the total number of bitcoins, there is no cap to the number of other cryptos that can be launched.
As renowned investor Ray Dalio put it in a note on bitcoin: “Competition will play a role in determining bitcoin and other cryptocurrency prices. In fact, I assume that better ones will come along and displace this one because that is the way the evolution of everything works." Hence, in the years to come, while gold will still be around, we really can’t be all that sure about bitcoin.
As data from Statista shows, in July 2021, the number of cryptocurrencies stood at 6,044. In August, the number had fallen to 5,840. Investors in the cryptos which disappeared must have lost money.
Right now, when it comes to cryptos, many people are suffering from FOMO, or the fear of missing out, driven by all the advertisements promising easy money.
So, should the middle-aged and the senior citizens fall for this and enter the easy money bandwagon? Consider the period between 6 November and 13 November. As of 6 November , the price of one bitcoin was $60,163.8. On 10 November, it touched a price of $68,789.6—a 14% upward swing in just four days. By 13 November, the price was down 8% to $63,303.7. Many such examples can be offered. When it comes to many other cryptos, their volatility is even higher. So, clearly, investing in crypto is not for the weak hearted.
Also, the typical argument offered by bitcoin aficionados is that even though bitcoin prices fall rapidly, they also go back up again. While this is true, past performance is no guarantee for future performance.
In all this, do not forget the oldest cliché in investing: Don’t put all your eggs in one basket. If you are investing in cryptos, do make sure it forms a very small portion of your overall portfolio.
Further, do keep in mind that cryptos have got nothing to do with the government, as the word currency seems to suggest. And finally, there is a lack of clarity on the regulatory structure as well as the taxes that will have to be paid on the gains made by buying and selling cryptos.