Cryptocurrencies Part 3 — Medium of Exchange?

Cryptocurrencies vs Fiat - a look into various features of fiat and how bitcoins and altcoins fare on those metrics…

In the first and second parts of this cryptocurrency series, I delved into what bitcoins and cryptocurrencies are, how the blockchain facilitates transactions and how they fare against traditional investment-grade asset classes. Another use case of cryptocurrencies is, well, as a currency. That’s what they were designed for anyway. How viable are Bitcoins as money today? This would merit a peek into the history of money and how it originated.

I recently came across some works of the likes of Carl Menger and Armen Alchian, adumbrating the organic evolution of money as a medium of exchange from the pre-existing direct exchange system or barter. Lack of transferability and divisibility of commodities made bartering a pretty inefficient process. That’s where money stepped in.

If I want a box of green tea, I would go to the market with some product that I’d exchange to get green tea. Of all the products I can proffer for exchange, the one that grants me the highest chance of getting green tea is money. This thought ran through the minds of numerous people and more and more of them started bringing money to the markets to get the products they needed. Essentially, money emerged as the most ‘saleable’ commodity, turning it into a medium of exchange. And once it began to be used as a medium of exchange by some portion of society, it’s ‘saleability’ increased further and it’s now become the undisputed leader.

There were numerous iterations in deciding the appropriate item to be used as ‘money’. Cowrie shells, dried corn, precious metals like gold and silver, paper currencies pegged to metals…we’ve been through them all. Fiat currencies that we use today are not backed by any commodity but rely on supply and demand forces, people’s belief in them and the backing of the sovereign.

But, can bitcoins and cryptocurrencies rival the incumbent fiat? To serve as a medium of exchange, the following are some pre-requisites:

Acceptance

Of course, people should accept bitcoins and altcoins as valid media of exchange and agree to trade it for goods and services for it to rival fiat. They should believe in bitcoins and also believe that other people believe in it and so on. However, bitcoins haven’t been that lucky yet, and very few vendors accept payments in bitcoin.

Lack of understanding about crypto coins and their reputation as a medium of exchange for financing illegal activities have contributed to the dismal acceptance so far.

Cryptocurrencies are very young and encompass quite abstruse concepts. People view them as too technical or impractical concepts and a large portion is not familiar with the proposition. While exchanges, trading platforms, wallet and custody service providers can focus on educating larger groups of people about the nature and potential of this network, governments are the entities that can get things running.

However, there’s a lack of uniformity in the policies of different nations towards bitcoins. This is primarily due to the reputation of cryptocurrencies as the preferred mode for conducting illegal transactions on the darknet. Such discrepancies hinder cryptocurrencies’ ability to facilitate cross border transactions, a use case that would help in increasing acceptance.

Security

As we use currency, we do hope that transactions are secure and that our money remains safe. This isn’t always the case with fiat. People lose their cash, purses, wallets and get duped by fake transactions. Unaccounted transactions also abound.

Bitcoin transactions occur via complex blockchain networks and are extremely secure. There aren’t too many opportunities to engage in fake transactions and modify the ledger, as that requires immense effort, making it virtually impossible. One can lose one’s bitcoins though, by losing the private key, and double-spend attacks are theoretically possible. However, no bitcoin transaction can go unrecorded by the network. Further, while it’s pretty easy to counterfeit regular currencies, the complex nature of bitcoins makes it highly difficult to do so.

Though the balance theoretically tilts in bitcoins’ favour, there are quite a few issues that need to be handled. With sovereigns recognising fiat currencies as legal tender and with robust laws in place, there are recourse policies, albeit imperfect, for redress. The decentralization in the cryptocurrency ecosystem means that there are no such policy frameworks in place. If you lose your bitcoins, you cannot do anything about it…at least, for now.

Cryptocurrencies are naturally prone to cybersecurity threats, requiring more sophisticated measures in comparison to requirements in the traditional banking system. There has been a rise in malware targeting cryptocurrency platforms, bitcoin wallets and malicious mining, as reported by Kaspersky Labs in 2018. Fake exchanges and Ponzi schemes have also rattled the space.

Ease of Use

Bitcoins and digital currencies aim to bank the unbanked and simplify transactions. With a purely digital network eliminating the need to lug around physical wallets and cash and low transaction fees, bitcoins are meant to be easy to use.

Besides, the high divisibility of cryptocurrencies is advantageous. The minimum unit of a bitcoin is 1 satoshi, which is 0.00000001 bitcoin. This offers immense transactional flexibility and is also the reason why people argue that despite the upper cap on the number of bitcoins (21 million), the system can work.

However, the current system has some scaling issues. With bitcoins possessing processing capabilities of around 5–7 transactions per second and Ethereum managing ~15–20 transactions per second, the transaction process would take several minutes. In comparison, VISA can handle on average about 2000 transactions per second. Cryptocurrencies indeed have a real trilemma between scalability, security and decentralization. Some recommendations that have been proposed include lightning networks, sharding, staking, increasing block size, improving computing power amongst others.

Bitcoin ATMs (there are nearly 8500 of these in the world currently) and payment networks like Flexa are helping consumers transact easily using bitcoins, thus facilitating its mainstream entry.

Flexa uses an interesting and complex model to ensure that the latency issues accompanying transaction processing on the blockchain are avoided. The network pays merchants right away via cash transfers while the corresponding amount of bitcoins or altcoins are debited from the crypto wallet at the exchange rate prevalent at the transaction time. Each transaction is secured by FlexaCoins, via a staking system, to prevent malicious entities from reversing transactions after Flexa delivers payment to the merchant. GameStop, Nordstrom, Whole Foods, Caribou Coffee, Jamba Juice, and Crate and Barrel are some merchants accepting payments via the network.

Relative Stability in Purchasing Power

One essential aspect required in a medium of exchange is stability and purchasing power durability. In essence, if I can get a box of green tea today for ₹150, I wouldn’t be too happy to find out that next week I need to shell out ₹1500 for the same item. A decline in the purchasing power of money in the long-term is palpable, but in the short to medium-term, people expect money to be relatively stable.

Bitcoins have had their value undergoing wild swings. Given the relatively sparse population of the bitcoin community in comparison to that of fiat, and also taking into consideration the fact that cryptocurrencies haven’t been around for too long, such volatilities are understandable. Small markets are more susceptible to fluctuations in demand and supply. With a stable regulatory policy, greater adoption of bitcoins and enhanced security standards, the volatility might reduce.

What’s to be noted here is the reason for the volatility in bitcoins and altcoins. It’s not a macro effect tied to economic factors, but largely driven by information regarding hacks, regulations, and the size-related illiquid market. They do not face inflationary instability. Fiat currencies are most definitely not insulated from volatility. Hyperinflation can wreak havoc. Currently, Lebanon, Venezuela and Zimbabwe are witnessing extreme inflation levels. Since 2016, inflation in Venezuela reached a staggering 53,798,500%, making storage of Venezuelan currency unviable for more than a few days. And citizens are embracing cryptocurrencies as a payment option.

A Detour — Nature of Fiat and Cryptocurrencies

Bitcoins and altcoins are deflationary currencies. With just 21 million bitcoins destined to be in existence, they are extremely scarce. Fiat currencies, on the other hand, aren’t scarce at all and are inflationary currencies. A lot of governments are engaging in quantitative easing and printing quite a bit of money. This can result in inflationary pressure and reneges on scarcity.

Under an inflationary currency regime, the purchasing power of one unit of currency decreases over time. The reverse is the case under a deflationary regime, where a unit of currency has more purchasing power in the future than in the present. Broadly, under a deflationary environment, Keynesian economists warn of situations where people focus on hoarding money and abandon spending, stymying economic growth. The Austrian School of economics, however, argues that people would still have to spend on essentials and goods of need.

Gresham’s law is also quoted in this context, according to which, ‘bad money drives out the good money’. Bad money (fiat) is overvalued, so people hoard good money (bitcoins), which is undervalued, using bad money. Thus, some arguments circulate about how fiat currencies will hinder the circulation of bitcoins as people will hoard it.

Though cryptocurrencies’ scarcity can serve as a hedge against inflation, it does tend to contribute to deflationary pressure. While this attribute is good for an asset class, there are questions regarding its ability to serve as a medium of exchange. Arguments leveraging the nature of high divisibility counter this though.

Transferability

The ability to transfer one currency to another and across borders is an important requirement. While bitcoins can enable easy cross-border transactions, regulatory discrepancies between countries pose a hindrance to the same.

Regulations and Risks

Lack of robust regulation is surely a major hurdle for cryptocurrencies if they seek to rival fiat currencies. I had looked at some regulatory examples in my previous piece. Needless to say, it’s pretty diverse across countries. Warren Buffet had said in 2017, ‘It doesn’t make sense. This thing is not regulated. It’s not under control. It’s not under the supervision of any…United States Federal Reserve or any other central bank. I don’t believe in this whole thing at all. I think it’s going to implode.’

Areas of concern for governments are some of the cryptocurrencies’ salient features — decentralization and pseudo-anonymity of transactions. While all executed transactions are indeed captured on the blockchain, it’s only in terms of public addresses and digital signatures (for more details, check out my previous piece). This flags some troubles for governments as such a system can be leveraged by miscreants to finance illegal activities and money laundering.

When the dark web marketplace Silk Road was operational, bitcoins and other cryptocurrencies were used as means of transactions. Even now, transactions on the darknet and payments demanded by cyber terrorists rely heavily on crypto coins. However, there are some aspects of blockchain that work in law enforcement’s favour.

Interpol and Europol are two major bodies involved in crypto crime-fighting. By leveraging the transaction trails left by the blockchain, law enforcement focuses on deploying blockchain analytics, dark web research, open-source information, and financial or in-house data to nab parties involved in the transactions. If transactions like those done via the Silk Road were carried out using cash, it would have been impossible to trace those involved.

Conclusion

While full dislodgement of fiat currencies seems unlikely, cryptocurrencies do have the potential to serve as complementary media of exchange. Building up of proper digital and security infrastructure, spreading awareness and robust regulations must be focus areas. However, this is a difficult terrain to navigate as regulations mustn’t compromise on the decentralised nature as well. The pandemic’s acceleration of digital payment mechanisms bodes well for bitcoins and altcoins and it remains to be seen what the future holds for crypto coins.

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Swetha Srinivasan

Swetha Srinivasan

A finance and public policy enthusiast, passionate orator, keyboard player and reader who loves dreaming big, working hard and trying out new things.