Cryptocurrency: The Rise of Decentralized Finance
The Idea of Money
When we hear the word money, we picture it like a coin, a dollar bill, or maybe a bag full of cash, but that is not a complete representation of it. Money, like language, is a social device – closer to a concept than a thing. Money is an intangible asset that only has a numerical value and fulfils certain social functions like facilitating commerce. People generally use both the terms money and ‘currency’ interchangeably and think of them as synonyms, but currency is the tangible form of money that has no intrinsic value of its own.
So what are these coins and notes that we use in our daily lives? They are called fiat currencies or simply currencies. A fiat currency can be exchanged for goods and services, but in the end, it has no inherent value, whereas when we see the broader picture, money has an intrinsic value for the simple fact that everyone knows that it will be accepted as a form of payment. However, throughout history, both the usage and the form of money have evolved.
The concept of money has been with us for almost three thousand years now. Before that, people used to trade using a barter system, where they used to exchange goods and services with each other directly. The system of coincidence of wants, also known as double coincidence of wants, was the foundation of the barter system. The coincidence of wants is an economic phenomenon where two parties each hold an item the other desires, so they exchange these items directly without any monetary medium. However, it was eventually replaced by money as the medium of exchange because there’s always a risk of an altercation between the two parties regarding what they want at a particular time. Therefore, under the current system, money has replaced double coincidence of wants.
The 21st century has introduced us to two novel forms of currency: digital payments and virtual currency. Mobile payments are being widely used nowadays in almost every part of the world, whereas virtual currencies like Cryptocurrency (Eg. Bitcoin) have been gaining prominence in recent times, with some people seeing them as an alternative to existing fiat currencies and also a passive source of income.
An Overview of Cryptocurrencies
Back in 2008, the world saw a financial crisis driving various economies into recession. The main reasons behind this crisis were banks giving out bad loans and the collapse of the U.S. housing bubble that peaked in 2006-2007. At this juncture, a person with the pseudonym Satoshi Nakamoto came up with a decentralized monetary system that no third party could control.
That was how Bitcoin, the first decentralized cryptocurrency, came into being. According to many experts and researchers, there was a dire need for a decentralized monetary system for various reasons. Firstly, till the 1970s, money was backed by gold, and central authorities could not print as much money as they wanted. After the 1970s, however, this was no more the case, meaning that governments could print excess money as per their needs which could devalue the existing money. For instance, due to the COVID-19 pandemic, the U.S. government printed trillions of dollars (compared to India’s total GDP) in excess to increase the country’s cash flow, which led to the devaluation of the U.S. Dollar.
Secondly, fiat currencies can be devalued by external factors such as some countries manipulating currencies that can directly affect another country’s currency. Furthermore, fiat currencies are driven and regulated by humans, making them prone to errors since politics, beliefs, and greed can influence humans.
Cryptocurrency is a virtual currency that is secured by cryptography- a method of protecting information and communications through the use of codes and algorithms so that only those for whom the information is intended can read and process it. Most Cryptocurrencies are based on a peer-to-peer network known as Blockchain, a ledger-based decentralized system. Using this technology, participants can confirm transactions without a need for a central clearing authority.
There are estimated to be more than 4,000 Cryptocurrencies in this world. Recently, the total market cap of Cryptocurrencies crossed the $2 trillion mark and has also gained much popularity after the covid pandemic because of its recent high returns and a need for passive income among people.
Fig. Market Share of Various Cryptocurrencies
The Relevance and Purpose of Cryptocurrencies
As of September 2021, the individual proportion relative to the market capitalization of bitcoin is nearly about 41.5%, and that of ethereum is 20%. Other cryptocurrencies including but not limited to Cardano, Dogecoin and Binance coin comprise 38.5% of the remaining market capitalization of the crypto market.
We can see that bitcoin has been dominating the crypto market as the most significant individual coin as it was the first asset in the crypto world and has the first-mover advantage, but there has been a recent downfall in bitcoin holdings and an increase in the overall ethereum holdings. A similar trend was seen in 2017-2018 when individual holdings of BTC and ETH came nearest to each other till now.
The number of investors in cryptocurrency has been increasing rapidly, there are more than 100 million cryptocurrency users worldwide. There has been a rapid increase in the number of individuals buying and selling crypto in South Asia and Latin America in the last 1-2 years. In India, almost 15 million cryptocurrency users are holding Rs.15,000 crore worth of digital assets as of now and the numbers are increasing day by day.
There are various concerns of Crypto’s being speculative (situation where the underlying value of an asset has no significance but people invest in it heavily resulting in an unrealistic increase in its prices) that do not have a firm footing as bitcoin today is seeing wider institutional adoption. Bitcoin has started to serve the functions of money- primarily as a ‘store of value’ and any virtual thing can do that as long as it is socially adopted which bitcoin has so far been able to do so. The sudden hike and fall in bitcoin prices can be attributed to its small market cap relative to the stock markets and a small probability of them being unsuccessful can result in price fluctuations very spontaneously. But as the market capitalization increases, volatility decreases.
A store of value is anything that preserves its value over time. Financial stores of value like equities and bonds have value because of their future growth and ability to produce cash flows. Although, yield is not a prerequisite for a store of value. Gold, wine, etc. which are non-yielding have a store of value too because apart from their materialistic use people in the past have placed a value on them in exchange for money for various reasons.
Post-WWII, gold was primarily used as a hedge against inflation. Gold has a very unique role to play in the global financial world. It is both used as a ‘store of value’ and a commodity. Till today, gold serves as an alternative fallback money instrument for adverse states of the world—when investors are unsure about the safety of conventional assets or fiat money in general (e.g. due to the risk of inflation). In foreign exchange markets, gold behaves like an “inverse currency”: its price tends to fall when the fundamentals of major currencies improve and tends to rise when the fundamentals of major currencies worsen.
In this new digital era, there is a demand for a digital store of value since a huge part of the social interactions and commerce are done online, we need gold for the digital generation. This is where Cryptocurrency comes in and the best candidate to be an alternative to gold among major Cryptocurrencies is bitcoin because of its wider social adoption.
Factors Affecting The Rising Demand of Cryptocurrency
This increase in demand and why people are so bullish about cryptocurrencies can also be attributed to some factors other than decentralization such as scarcity, divisibility, transportability, less risk of them being counterfeited, and increasing world debt.
Scarcity is one of the significant characteristics of some cryptocurrencies, maintaining a supply of money is crucial for overall economic health and growth, if the supply of money is in excess, it will cause hyperinflation, and if the supply of money is too small, it can cause economic problems whereas some cryptocurrencies like bitcoin have a protocol of limited supply (21 million for bitcoin).
Divisibility: The ability of Cryptocurrencies to be divided into much smaller units makes them a good fit for exchange and helps increase their liquidity. For eg- Bitcoin is divisible up to eight decimal points. The smallest unit, equal to 0.00000001 bitcoin, is called a Satoshi after the pseudonymous developer behind the cryptocurrency. This allows for quadrillions of individual units of Satoshis to be distributed throughout a global economy.
Transportability: It is easy to exchange Bitcoin into USD, Singapore dollars, INR or other currencies, although the commissions are high as of now.
Counterfeiting: The problem of double spending and creating a fake currency is high in fiat currencies whereas counterfeiting/double-spending cryptocurrencies are hard because of the underlying technology it is based on.
World debt: With each day passing, there is an increase in debt taken by the world governments also known as public debt, national debt, or sovereign debt. This is the money owed by the governments to the lenders. Debt can be owed internally-within the country or externally- to foreign groups or lenders. By the end of 2020, the world debt was as high as 281 trillion dollars, more than 355% of the total world GDP. Therefore, there are some speculations that there will be a time when the GDP to debt ratio of various countries will increase substantially and the bubble will burst (their GDP would no longer support countries’ debt) and there will be a financial collapse and people would lose huge amounts of money. The governments will start blaming each other, our financial system would be questioned in the media but eventually, it’s the people who are losing their hard-earned money.
Bitcoin vs Ethereum
The Cryptocurrency market is in its infancy and is a nascent field that is very dynamic and ever-changing. It remains a market that sees frequent shifts in technology and with so much to adapt, bitcoin with only its first-mover advantage might look sceptical while other coins like Ethereum bring innovative approaches and smart contracts making them more agile and futuristic.
Today, the Ethereum ecosystem provides users with its smart contract technology through many DeFi (decentralized finance) applications and allows developers to create new applications on its platform. Most of the DeFi apps today are based on ether’s network and most of the non-fungible tokens (NFT’s) issued today are purchased using ether.
Etherium is undergoing must faster change than bitcoin and is shifting from PoW(power of work) to PoW(power of stake) verification methods which measure its miners rewards on the basis of their ether holdings rather than how much is their processing capacity making the whole ethereum ecosystem energy-efficient than bitcoin which has energy consumption as big as Netherlands making it a difficult choice of investment through ESG perspective.
Bitcoin has one more key significance in addition to its first-mover advantage i.e scarcity or limited supply. With only 21 million bitcoin to ever exist and 83% of them being already mined and available, only 2 million bitcoins are to be mined in the future. However, all of this will have no point if bitcoin doesn’t have a real use in the Crypto world and does not upgrade its protocols.
We have seen that first-mover advantage is difficult to maintain in a fast-moving technology and a growing world. The incumbent can lose its dominant position if it doesn’t respond well to consumer’s shifting preferences and demand. The best example is Google and Yahoo, Facebook and Myspace, etc. Thus, bitcoin remains a volatile asset with market prices dropping as high as 30% in one day. Only real demand that solves an economic problem will end this volatility and usher in a new mature era for crypto—one based upon economics rather than upon speculation.
Recent Trends in Crypto Market
There has been a significant surge in total Ethereum holdings in the world especially in India, where over the last few years people have been buying mostly bitcoin but now Indians now are flocking their money to different cryptocurrencies especially Ethereum. They are now hedging their bets by investing in Ethereum after selling bitcoin. In the first half of August 2021, 70% of total money pumped in different exchanges was directed to Ethereum- the Economic times reported. According to Nischal Shetty, the CEO of WazirX’, one of the biggest Cryptocurrency exchanges in India, the platform has seen a growth of 150% in the total number of ETH orders placed in the first six months of 2021. Not that bitcoin has been a slouch- it’s risen to $52,000 from $35,000 in July whereas Ethereum has jumped from $1,300(about 1lakh) to $3,900 in the past few months.
“Long-term buyers and highly vested traders were the first ones to liquidate their positions on other assets to buy ETH, following new-age millennial and new investors,” said Shivam Thakral, CEO of BuyUcoin, a Cryptocurrency exchange.
What the Future Looks Like For Cryptocurrencies
With increasing internet penetration among the masses and rapid technological advancement, the digital world wants to run freely and smoothly, with lesser corruption and more transparency in the financial system to boost consumer confidence. Cryptocurrency promises these things. This correspondence of interests will undoubtedly make Cryptocurrencies more eligible for widespread adoption among the masses, making the Crypto market more mature and decreasing its volatility. Also, the innovation and technological agility like smart contracts, DeFi etc. provided by some cryptocurrencies like Ethereum are very captivating. Therefore, the possibility for Cryptocurrencies to find it’s mainstream use is quite high.
Progressive adoption of cryptocurrencies and a demand for a decentralized economy is paving the way for blockchain technology to be adopted more quickly and efficiently which in turn is promoting DeFi applications. These are not controlled by any central authority or a single entity, but by user-controlled decentralized autonomous organizations or DAOs. They are primarily based on the Ethereum network, laying the foundations of a decentralized economy – a projection that is far from guaranteed. But with every step taken forward in this technology, it is clear that it will be something disruptive and meaningful. A growing number of DeFi believers wants to rebuild the financial system using this technology which promises a financial system that is cheaper, transparent, efficient and not dominated by any big tech giants and other powerful central entities. DeFi also promises to make cross-border payments and transactions more cheap, efficient and credible.
Cryptocurrencies offer a lot of opportunities, optimism, and will eventually find more efficient last-mile adoption among users across the globe, where government rules and regulations will have a very critical role to play. Even today, government regulations remain sceptical and unclear in many parts of the world. Through a collaborative vision between governments and blockchain pioneers, we can improve our financial system without replacing it and be more reliable and secure. This means partnering with governments to streamline their underlying financial infrastructure to build a more inclusive financial system.