Cryptocurrency: An unsustainable surge

The sudden surge in the value of cryptocurrencies has drawn the attention of investors and policymakers. Cryptocurrencies are convertible virtual currencies with an equivalent market value to real currency. Currently, there are around 9,271 different cryptocurrencies, the Bitcoin, Ethereum, Tether, BNB, and USD coins are the top five cryptocurrencies.

Bitcoin is the first and by far the most popular cryptocurrency introduced in 2009 as an alternative to physical money, as an electronic peer-to-peer payment system without the intervention of institutional authorities like banks and governments. The cryptocurrencies do not behave much like a currency and are, at best, unprepared to serve the same function as physical money.

Physical money provides a universal reference for value and a concise way of transferring it. The implementation of such a system requires one to possess three important attributes such as a medium of exchange, a unit of account, and a store of value. The cryptocurrencies fail miserably in fulfilling these criteria. Around the world, an insignificant proportion of online merchants accept cryptocurrencies as a form of payment and those who accept them face security issues like delays in the verification of transactions.

Secondly, as a unit of account, the cryptocurrency only works if it is valued in physical currency. With the surge in the value of cryptocurrency, particularly bitcoin, people deal in smaller units such as milli or micro bitcoins. Trading in micro-cryptocurrencies requires traders to quote the prices of retail commodities out to four or five decimal places with leading zeros, a rare impracticable phenomenon.

In addition, the crypto price varies in different exchanges, which is a clear violation of the principle of the law of one price. On the last attribute, cryptocurrency though fulfils the function as a store of wealth rather well, but its volatility makes it riskier and carries a greater threat of loss.

The cryptocurrencies lack additional characteristics that are usually associated with modern physical currencies, they cannot be deposited in a bank, and they must be held in digital wallets, which are expensive to maintain, and are vulnerable to security issues like cyber-attacks, hacking and ransomware. The supply of bitcoin is fixed; it has an absolute limit of 21 million units that can ever be mined, with no possible expansion in the supply after the year 2140.

Theoretically, to maintain stable price levels, it is imperative that the money supply should be able to grow in tandem with macroeconomic activity; if not, it can only be addressed by increasing the velocity of money or by a structural decline in prices. This may land the economy in a depression.

The artificial scarcity of bitcoin is an advantage for investors: rising demand with inelastic supply leads to a higher price. In addition, each day new cryptocurrencies have been floated if each private entity issues its own currency; it results in monetary instability. Likewise, the absence of a central regulator makes investor protection impossible and poses a broader stability risk.

The exponential growth of the cryptocurrency market may inflict greater damage to the economy, people invest in these markets assuming that, the cryptocurrencies will appreciate in future; the presumption fosters speculative activities, and a sudden change in the presumption may tumble the market hurting many naive investors.

The degree of damage to the economy depends on the interconnectedness between crypto-assets and the conventional financial sector. Economists view that the direct exposure could be transmitted from crypto assets to the financial sector and the indirect effects may spread to other asset classes. The RBI financial stability report (2021), said that the crypto assets pose long-term concerns on capital flow management, financial and macroeconomic stability and monetary policy transmission.

Governments across the world have taken differing views towards crypto-assets; China has altogether banned them, and El Salvador declared them as legal tender. In India since 2018, the Reserve Bank of India (RBI) barred financial institutions from supporting crypto transactions — but the Supreme Court overturned it in 2020. Resting the speculation on crypto assets, the finance minister in the budget announced 30% tax rate with applicable surcharges, and to track crypto footprint, 1% TDS on payment made for the transfer of virtual assets above a monetary threshold has also been announced.

The cryptocurrencies lack strong operational, governance and risk practices, the currency without intrinsic value adds no value to the market. The new taxation policy though may mop up additional revenue for the government; however, the surge in speculative investments with no value creation may inflict greater damage to the economy. The policy imposing restrictions on cryptocurrency is sooner the better for the sustainable macroeconomic health of the economy.

(The writer is an assistant professor at a college based in Bellary)