Cryptocurrencies represent a new paradigm for money that promises to streamline existing financial infrastructure by eliminating centralized intermediaries like banks and monetary institutions, enabling transacting parties to exchange value and money independently. At the same time, they bring with them a number of novel risks. To learn more, read the following explainer.
What Is Crypto?
The most well-known cryptocurrency is Bitcoin, which is used to transfer value online without the need for a middleman, and typically at near-instant speeds, 24/7, for very low fees. Bitcoin and other cryptocurrencies are based on a technology called blockchain, which is an online ledger that records transactions in a decentralized manner. The most popular cryptocurrencies share the same basic features, but many offer more, and are differentiated by their market capitalization.
Most cryptocurrencies are created by miners, who run computers that solve complicated math problems to add new Bitcoins to the global supply. As more and more computers are needed to mine, energy consumption is increasing rapidly. In fact, the total annual energy consumption by the Bitcoin network is estimated to be about the same as that of Thailand.
As with any asset class, there are a variety of ways to invest in cryptocurrencies, including buying them directly on exchanges or through brokers. Some of these investments are speculative, and can increase or decrease in value quickly and without warning. Others seek to leverage the price movements of cryptos, and are designed to provide an income stream.
The value of cryptos, both stable and volatile, is determined by a complex interplay between demand, supply, and other market forces. For example, if more people began using Bitcoin for payments, the demand for it would increase and its price in U.S. dollars would rise. This interplay can also have negative effects, such as a bubble and subsequent crash.
Regulators are grappling with how to deal with crypto, as they struggle to balance innovation with risk management. Several countries have already banned or restricted its use, but most are taking a hands-off approach until the market matures. This leaves regulators in the unenviable position of trying to craft rules that limit traditional finance risks while avoiding stifling innovation.
The most significant risks associated with cryptocurrencies revolve around regulation, volatility, and counterparty risks. The regulatory status of cryptocurrencies is unclear, and a sudden shift in policy could make it difficult to sell or buy them. Additionally, most investors rely on exchanges and other custodians to store their crypto, and the theft or loss by one of these third parties could cause a severe loss in value. These risks can be mitigated by understanding the purpose of each crypto and staying abreast of regulatory developments. Despite these concerns, the CFR’s Mallaby believes that cryptocurrencies are here to stay, and they are bringing with them a new kind of organizing principle for finance. He writes that “we can now construct a whole system of finance out of blockchain-based tokens that have advantages over the old, centralized kinds of money.” He concludes: “We need to understand this, because it is not just another way to hold our assets; it may be a much better and more efficient way to organize financial markets.”