What is cryptocurrency? All you need to know

Over the past few weeks, cryptocurrencies have made headlines in India as the government and the Reserve Bank of India expressed concerns over the virtual currency space. A Parliamentary committee on finance also held consultations with stakeholders and spoke of regulations and not an outright ban as the government had earlier proposed. However, hours after the government announced that it would introduce the cryptocurrency bill in the Parliament's winter session, there was speculation that it was seeking to prohibit all private cryptocurrencies in the country, all crypto prices crashed by 15 per cent and more.

The Union government has listed the Cryptocurrency and Regulation of Official Digital Currency Bill for introduction during the winter session of Parliament. The Bill will seek to “prohibit all private cryptocurrencies” but provide for certain exceptions “to promote the underlying technology” and “its uses”.

The Bill will also aim to put in place a framework for the Reserve Bank of India to create an official digital currency. RBI has been pushing for a ban on cryptocurrency, arguing that it can be used for illegal purposes in addition to limiting the central bank’s ability to manage inflation, foreign exchange and the overall economy.

A recent report suggested that the country has more than 10 crore crypto owners while homegrown crypto exchange platforms have maintained that around 2 crore Indians have invested in cryptocurrencies.

This brings us to the question ‘What is cryptocurrency?’ Here we try to explain it in as simple terms as possible.

What is cryptocurrency?

Cryptocurrency is a digital or virtual currency that can be used to buy goods and services, but it uses an online ledger with strong cryptography to secure online transactions. This makes it difficult to counterfeit or double-spend. You could consider them as you would mall tokens or casino chips. You’ll need to exchange real currency for the cryptocurrency to access the good or service. In simple terms, you are spending money, to get your hands on a few computer codes.

Many cryptocurrencies are decentralised networks based on blockchain technology. A blockchain is a public digital ledger of transactions maintained by a network of computers in a way that makes it difficult to hack or alter. The technology offers a secure way for individuals to deal directly with each other, without an intermediary like a government, bank or another third party. One part of the appeal of this technology is its security. This decentralised structure allows them to exist outside the control of governments and central authorities. This was the aim and idea behind cryptocurrency.

The growing list of records, called blocks, is linked together using cryptography. Each transaction is independently verified by peer-to-peer computer networks, time-stamped and added to a growing chain of data. Once recorded, the data cannot be altered.

Cryptocurrencies hold the promise of making it easier to transfer funds directly between two parties, without the need for a trusted third party like a bank or credit card company.

These transfers are instead secured by the use of public keys and private keys and different forms of incentive systems, like Proof of Work or Proof of Stake.

A public key is a cryptographic code that allows users to receive cryptocurrencies into their accounts. The private key is known to the user alone and serves as the user’s digital ID. Proof of work (PoW) is a decentralised consensus mechanism that requires members of a network to expend effort solving an arbitrary mathematical puzzle to prevent anybody from gaming the system. The consensus algorithm requires each node in the network to solve a problem. The first node that solves the problem is granted permission to add a new block. The nodes are the administrative body of the blockchain and verify the legitimacy of the transactions in each block.

No government agency issues or controls bitcoin and other cryptocurrencies. This also means that the ability of anyone government or agency to determine the fate of a public blockchain is eliminated. The lack of intermediaries reduces cost, as the fees associated with third-party transactions also are eliminated. Another byproduct of how blockchain works is time efficiency — the blockchain is open for business 24 hours a day, 365 days a year, unlike banks and other intermediaries.

Are there many cryptocurrencies in the world?

There are more than 14,500 different cryptocurrencies trading publicly, according to CoinMarketCap.com, a market research website. The total value of all cryptocurrencies as of November 19, 2021, was more than $2.5 trillion, which was a drop from the all-time high above $2.9 trillion a few days earlier.

The most popular cryptocurrency is bitcoin, followed by Ethereum, Binance Coin, Tether, Solana, Cardano, XRP, Polka Dot, USD Coin and Dodgecoin.

To buy cryptocurrencies, you’ll need a “wallet,” an online app that can hold your currency. Generally, you create an account on an exchange, and then you can transfer real money to buy cryptocurrencies such as bitcoin or Ethereum. Coinbase is a popular cryptocurrency trading exchange where you can create both a wallet and buy and sell bitcoin and other cryptocurrencies. Also, a growing number of online brokers offer cryptocurrencies.

Though the concept of blockchain technology first appeared in 1982 in an academic dissertation paper discussing “the design of a distributed computer system that can be established, maintained, and trusted by mutually suspicious groups”, it was a 2008 paper by the pseudonymous Satoshi Nakamoto titled “Bitcoin: A Peer-to-Peer Electronic Cash System” that brought an academic theory into real-world use.

Satoshi Nakamoto is the anonymous name used by the creators of the Bitcoin cryptocurrency. Although the name Satoshi Nakamoto is often synonymous with Bitcoin, the actual person or people that the name represents have never been found. Satoshi Nakamoto designed the first blockchain database.

What makes crypto stand out from regular or fiat currency?

Cryptocurrency boasts of political independence and is essentially impenetrable data security. Users of cryptocurrency enjoy benefits that are not available to users of traditional fiat currencies, such as the Rupee, and the financial systems that it supports. To cite an example, any elected government can freeze or even seize bank accounts located in its jurisdiction. But with crypto, it is very difficult for it to do the same. For funds held in cryptocurrency, even if the holder is a citizen the government cannot do much.

What are the issues with Cryptocurrencies?

They are highly volatile and can go up in value, but many investors see them as mere speculations, not real investments. Why? Just like real currencies, cryptocurrencies generate no cash flow, so for you to profit, someone has to pay more for the currency than you did. That’s what’s called “the greater fool” theory of investment.

It is important to remember that a currency needs stability so that merchants and consumers can determine what a fair price is for goods. Bitcoin and other cryptocurrencies have been anything but stable through much of their history. This price volatility creates a conundrum. If bitcoins might be worth a lot more in the future, people are less likely to spend and circulate them today, making them less viable as a currency.

Famous investor Warren Buffett compared bitcoin to paper checks: “It's a very effective way of transmitting money and you can do it anonymously and all that. A check is a way of transmitting money too. Are checks worth a whole lot of money? Just because they can transmit money?”

Can you really ban cryptocurrency?

They are legal in the United States, while China has banned all cryptocurrencies and declared all transactions of cryptocurrencies as illegal. El Salvador is the only country to have permitted it for official use.

China is one of the world's largest cryptocurrency markets. The price of Bitcoin fell by more than $2,000 (£1,460) in the wake of the Chinese announcement. Trading crypto-currency was officially banned in China in 2019 but has continued online through foreign exchanges. But, this year there has been a significant crackdown.

The technology at the core of many cryptocurrencies, including Bitcoin, relies on many distributed computers verifying and checking transactions on a giant shared ledger known as the blockchain. As a reward, new “coins” are randomly awarded to those who take part in this work - known as crypto “mining”. China, with its relatively low electricity costs and cheaper computer hardware, has long been one of the world's main centres for mining.

It might prove difficult to actually ban the tokens – which could be called an asset, a commodity, a currency, or even a security. Millions of people around the world could, theoretically, hold such a currency – which are basically pieces of code that can't be ‘banned’ – and still agree to use it as a medium of exchange, which will then lend it value.

Coming back to India, the union government has not defined what constitutes as ‘private’ cryptocurrency, it is likely that Bitcoin, Ethereum, and other crypto tokens are unlikely to be banned as they are based on public blockchain networks. Private cryptocurrency could refer to Monero and Dash.

A blanket ban would force crypto exchanges to stop operations in India. One of the world’s largest crypto exchanges, Huobi, had to do the same when China issued a blanket ban on cryptocurrencies in September. With the union government inclined to ban bitcoins, it makes it clear that there is a clear risk in investing in it.