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Decrypting Cryptocurrencies

The Bitcoin bubble and how cryptocurrencies are changing the monetary world

Trevor Klein

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Cryptocurrencies will forever change the way we think about our money. Bitcoin, Ripple, Ethereum, Litecoin and other competing cryptocurrencies show that we do not need the government to manage and regulate our currency.

Google defines a cryptocurrency as “a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.” As of right now, Bitcoin is the most popular of the many cryptocurrencies, or cryptos for short.

Some are calling bitcoin the “currency of the future,” but that is an overstatement as cryptocurrencies are flawed.  Cryptocurrencies lack a fundamental element of a sound currency — stability — as the price of Bitcoin has fluctuated wildly.

The cryptocurrency mania is in full swing. As of Jan. 27, at a price of $11,240, Bitcoin is up 1,158 percent in the past year. By comparison, the stock market is up about 32 percent, and this has been a good year.

Here at Sage, many students have been swept up by the cryptocurrency mania; there is even a Cryptocurrency club on campus. Many students have invested in cryptocurrencies using trading platforms like Coinbase. This $1.6-billion company has more than 13 million users, according to CNBC.

The problem is most students do not really understand the cryptocurrencies they are buying. In a survey that I conducted of individuals, mostly at Sage, 32 percent of respondents said they had bought or are planning to buy cryptocurrencies, while only 24 percent of respondents said they understood blockchain technology, which is the technology behind Bitcoin and other cryptocurrencies.

The fact that many people who are investing in cryptocurrencies do not understand how they work is a sign of mania. In the 2008 housing bubble, many investors did not understand risky Collateralized Debt Obligations (CDO’s), which eventually brought the whole world economy crashing down.

The CDO was a pool of mortgages, often extremely risky subprime mortgage bonds. CDO’s were all the rave in investing back then just like cryptocurrencies are now. The lack of understanding and the rapid increase in value suggests that the crypto market is a bubble.

The bubble may be starting to burst.  Bitcoin has already fallen 20.53 percent in the past month and over 40 percent since its high in December.  While it may rally in the short run, I predict it will fall a lot further over time.

It’s hard to say where Bitcoin’s price will end up because it has no intrinsic value. Bitcoin’s value is based on the trust of its users. One might argue that the two other major forms of currency — fiat paper money, like the dollar, and gold bullion — are also based on trust.

But, gold has intrinsic value because people value gold for reasons other than its monetary value such as its beauty, rarity and its resistance to corrosion. These properties, in addition to its divisibility and uniform quality, are what give it its value as a currency. Gold’s rarity is very important to its value as the gold supply only increases by less than 2 percent per year on average.

Fiat money, or money by government decree, like our dollar and the Euro, is supported by the nation or group of nations that issues and regulates the money. The problem is when governments need more money to pay for welfare programs and other expenses that tax revenue does not sufficiently cover, they often print the money to cover the shortfall. This waters down the value of all of the money in circulation, and devalues the currency.

According to a December 2017 JP Morgan report, the dollar has lost 81 percent of its value or purchasing power since 1970. This sharp decline was in large part caused by former President Richard Nixon breaking the United States’ long-standing promise to redeem dollars for gold in 1971, which enabled our government to create massive amounts of dollars that were not backed by the Gold Standard.

Fiat money has not been a suitable option because it does a poor job maintaining its value. In fact, Bitcoin’s founder Satoshi Nakamoto created Bitcoin because of this flaw of fiat money.

“The root problem with conventional currency is all the trust that’s required to make it work,” Nakamoto said. “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”

In America and all over the world, the central banks have debased the currencies and caused the sharp decline in their values.  In observing the history of government-managed paper money, the renowned French author and thinker Voltaire said, “Paper money eventually returns to its intrinsic value — zero.”

While Nakamoto is right in that fiat money is flawed, Bitcoin, as it is now, is not a viable solution. Bitcoin’s value is totally based on the loyalty of its users. If users decide to switch to one of the many other “altcoins,” which are cryptocurrencies other than Bitcoin, then Bitcoin would lose much of its value.

Bitcoin is limiting its supply to 21 million coins, but there are an unlimited number of other cryptocurrencies that can be created, whose quantity in total is unlimited. With innovation, there will be other cryptocurrencies that people will prefer to Bitcoin. In the end, an oversupply of all cryptocurrencies will decrease their value.

Gold bullion does the best job at maintaining value over time in comparison to both fiat money and cryptocurrencies. The problem with using bullion in today’s world is it is heavy and not easily portable.

The solution can be found in combining the best properties of cryptocurrencies and bullion. The timeless properties of gold can be married with the technological convenience of Bitcoin.  In fact, there are many companies, including one managed by the government of the Australian state Western Australia, who are offering cryptocurrencies that are redeemable in gold bullion. Gold can be transferred electronically, which enables you to hold gold in an account and to send it your friends or spend your gold at shops using a credit card. And all of this can be done on your cell phone. Since it is independent of governments, it is beyond their reach when they run short of money to cover their spending needs.

This combination of bullion and cryptocurrency may change the monetary world.  For now, cryptocurrencies have made a lot of people question the stability of our current monetary system and fiat money.  However, cryptocurrencies lack the intrinsic value to be a real alternative.  Gold-backed cryptos are grounded in a form of money that has maintained intrinsic value for centuries, and they could truly revolutionize money.

 

Write to Trevor Klein at [email protected]

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Decrypting Cryptocurrencies