Hendrix Vachon | Senior Economist | Desjardins Group
Your brother-in-law brags that he's going to make a fortune from bitcoin. Every week, we see news reports about crypto "farms." Governments are thinking about regulating bitcoin. Mining, volatility, blockchain... Stop! How about taking 5 minutes to understand the basics?
Cryptocurrency is 100% digital currency. Transactions are carried out through a decentralized computer network instead of a financial institution. Information in all the "digital wallets" is recorded in a huge public ledger known as the blockchain.
The innovation lies in the fact that the ledger doesn't require any human verification; transactions are validated by an army of network-connected computers.
The people who own these powerful computers are called "miners" who generate revenue from transaction fees as well as the monetary expansion, also called "mining."
To date, there are over 1,500 cryptocurrencies in circulation. However, bitcoin is still the one that is getting the most media attention and attracting the most users.
The lure of money is enticing many people to try their luck in this new market. But what is cryptocurrency, exactly?
Myth: You can become a millionaire from bitcoin
Fact: Its value goes up and down like a roller coaster.
Cryptocurrencies are very volatile:
- Since 2009, bitcoin has seen many periods of strong growth, followed by major corrections.
- In 2017, it skyrocketed in value from US$1,000 to close to US$20,000.
- One bitcoin is now worth about US$8,000.
Why is it so volatile? Unlike traditional (fiat) currency, supply of cryptocurrency does not adjust to changing demand.
If demand increases faster than supply, the value of cryptocurrencies goes up, but major corrections occur when demand slows.
Fiat currencies (e.g., Canadian dollar)
- Issued by a central bank.
- The amount of currency in circulation is determined by changing demand, based on market conditions.
- This limits fluctuations in the currency's value.
- Most central banks target an annual inflation rate of around 2%.
Cryptocurrencies (e.g., bitcoin)
- Not issued by a central bank.
- The quantity issued is predetermined by a computer program.
- In the case of bitcoin, 12.5 bitcoins are automatically issued every 10 minutes.
- This rate of issue decreases over time, and no more than 21 million total bitcoins are expected to be created.
Myth: Cryptocurrency is very secure
Fact: Potential investors are essentially left to their own devices.
There is currently very little regulation. Although the technology seems secure, the fact remains that:
- Bitcoin deposits are not guaranteed by deposit insurance.
- If transactions are carried out without your knowledge (e.g., in the case of hacking), they cannot be reversed, and you will not be compensated.
- Cryptocurrencies are sometimes used for illicit activities like organized crime and tax evasion.
Myth: Cryptocurrency is efficient
Fact: Calculating transactions and blocks eats up a lot of electricity.
Cryptocurrency is completely digital, so there's no need to print bills or mint coins, and it doesn't require financial institutions to manage it through electronic processes or transactions. That's why it's often considered more "convenient and efficient" than fiat currencies.
However, a new issue has emerged with the high demand for electricity for the computers that support cryptocurrency networks. The Bitcoin network is said to be especially energy-intensive with consumption estimated at 1,000 kWh per transaction.
Myth: Bitcoin is the currency of the future
Fact: Bitcoin doesn't have the characteristics of a good currency.
A good currency cannot keep going up in value. This would mean that the price of goods and services expressed in that currency would constantly decline. It would be the same with salaries and home values.
In other words, this type of currency would lead the economy into deflation, discouraging consumption and investment.
We might even question if cryptocurrency is "real money," because we can't really say that it behaves as a true currency does.
Normally, a currency must be used as a unit of account, a store of value and a medium of exchange.
- Cryptocurrency's high volatility reduces its usefulness as a unit of account, because the prices expressed in these currencies fluctuate too much.
- Because of their high volatility, they cannot be considered as a store of value.
So, how do we define them? In a talk he gave last December, the Governor of the Bank of Canada compared cryptocurrencies to gambling. Some people will compare them to gold; others to art. Cryptocurrencies are also issued for crowdfunding and others are more akin to securities, so it's hard to lump them all together.