Quoting Thomas Carper, US-Senator- “Virtual currencies, perhaps most notably Bitcoin, have captured the imagination of some, struck fear among others, and confused the heck out of the rest of us.”
After reading this article, you will be able to understand the basics of Cryptocurrency and the Blockchain Technology, a digital ledger of economic transactions.
A Cryptocurrency (most notably Bitcoin) is a digital asset designed with the purpose of decentralizing the financial system. It uses Cryptography (practice and study of techniques for secure communication) to secure its transactions and ensure that the transfer of assets has been safely done.
By decentralizing the financial system, we mean that theoretically there is no interference or manipulation done by the central authority in issuing this digital asset. Thus, the Central Bank cannot expand or shrink the supply of virtual currency in the economy.
Let us first put hands on the most hotly debated topic of Bitcoin. The technology on which this Cryptocurrency is based was created by an individual or a group known under the pseudonym Satoshi Nakamoto. The idea behind this invention was to replace the paper money printed by central banks with Bitcoin. Some economists however argue that Bitcoins have failed to fulfill even the basic purpose of its establishment. Any form of money has three main functions- a medium of exchange, a unit of account and a store of value. Because the price of Bitcoin fluctuates to a great extent, it cannot be used to make future payments. Hence, this currency cannot ensure monetary stability in the economy, which makes it difficult to use Bitcoins as a medium of exchange.
HOW BITCOIN WORKS
Bitcoins are virtual coins which have their own value and do not require a bank account for storing money or making transactions using that money. Bitcoins are traded from one personal ‘wallet’ to another. This wallet is a personal database that one stores on his/her personal computer or tablet. These Bitcoins are then used either to purchase goods and services or are left idle hoping their prices increase in the near future.
Bitcoin uses peer-to-peer technology which facilitates instant payments. The Governing body of Bitcoins, individuals or a company, does all the computing work and participates in the Bitcoin Network. This Governing body is known as ‘Miners’. It is the miners who enforce the credibility of the Bitcoin network.
Bitcoin wallets keep a secret piece of data called a private key which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet. This signature prevents the transaction from getting altered by anybody once it has been issued.
All Bitcoin transactions are stored in a public ledger known as a Blockchain. Each Blockchain is unique to every individual user and his/her personal Bitcoin wallet. This helps in ensuring authenticity and preventing fraud. In a way, the Blockchain technology helps in facilitation of these transactions and eliminates the need for an intermediary.
Each time a transaction takes place, for example one party sending Bitcoins directly to another, the details of that transaction – including its source, destination and date/time – are added to what we call as a block.
The validity of the transactions within the cryptographically-protected block is then checked and confirmed by the miners within the network.
On an individual basis, these miners are computers which are configured to solve complex mathematical problems, passing the block's data through a hashing algorithm until a solution is found. Once it has been solved, the block and all of its respective transactions are verified as legitimate. Rewards (Bitcoins) are then divided among the computers that contributed to the successful hash.
This process continues perpetually, expanding the Blockchain's contents and providing a public record that can be trusted. Apart from being constantly updated, the chain and its blocks are also distributed across the network to a large number of machines.
Thus, ensuring that the latest version of this decentralized ledger (Blockchain) exists virtually everywhere, making it almost impossible to counterfeit the same.
Having discussed about Bitcoins, it is essential to talk about a term which has off late become quite popular. Yes, Bitcoin Futures are now a reality. Certain exchanges have already launched Bitcoin Futures but their entry into the Indian markets still seems to be a distant reality. Let us take a closer look at Bitcoin Futures.
Futures are financial securities that derive their value from an underlying asset and the expectation of the future price trend. Futures are priced on the basis of the underlying security. In a Futures contract, if a person buys something, he makes a promise to pay for it at a future date. Similarly, if a person sells something, the seller has to deliver to the buyer at a future date. In both the cases the future dates are pre-decided. However, one does not actually exchange the physical product, rather settles the value of the contract against cash. Similarly, in case of Bitcoin Futures, the underlying asset is the Bitcoin and there is no actual buying and selling (no physical product).
For example: As on December 26, 2017 a Bitcoin future is valued at $12,000 for a contract ending on March 27, 2018. The value of Bitcoin, as on December 26, 2017, on the Chicago Exchange was $11,000. This shows that there is an expectation that the price of Bitcoin will go up in the near future. In general, those who buy a Futures Contract have a positive view and those sell it have a negative view of the value of the asset at the expiry of the contract. In Futures, both the buyer and the seller have an obligation to complete the contract. This, essentially makes investing in Bitcoin Futures a risky business because the price of Bitcoin is extremely volatile and can move against your expectations.
AN INVESTMENT OR A LOTTERY?
The biggest question that we now try to answer is- Is ploughing money into Cryptocurrency termed as an investment or an equivalent of Gamble?
To be able to answer this question we first understand the features of an investment. First, an investment requires logic. One has to apply his/her understanding to determine if an investment is to be made or not. It is not based on euphoria, sentiments or emotional behaviour. Second, its demand is determined by rationale, like a rise or fall in prices, fluctuations in sales etc. Thus, it can be linked to an economic theory and its features are transparent in nature. Lastly, a platform exists whereby any grievances related to the investment can be handled: A time bound mechanism to resolve the investment related grievances.
Let us try to evaluate Bitcoin as an investment on the parameters mentioned above. Majority of the people currently putting their money into Cryptocurrency neither understand on what principles does this currency work nor do they realize the reason why it was invented at the first place. It was developed to decentralize the financial system. Most of the people follow the herd behaviour, whereby nobody wishes to miss out on the quick gains that one can make by investing in such a currency. Next, huge fluctuations in the prices of these digital assets are based on sentiments which are neither linked to any logic nor to any real events. Moreover, since such currencies are not a legal tender in most countries, expecting transparency in its trading can happen only in a utopian world. Lastly, if tomorrow the price of Bitcoin falls from say, $10,000 to $100, where would the investors who haven’t been able to self off this currency at the right time go? Since there exists no redressal mechanism, there is a huge amount of risk involved in investing money in such an asset. Although, one can make huge sums of money even in a gamble, but chances are high that people who follow blind faith will lose out. It, therefore, makes investing in Cryptocurrency no better than a lottery system, which if goes your way can make you opulent, else penniless.