Is crypto currency?
This article explores the question of when an asset can be called money, particularly in the context of cryptocurrencies. It further goes on to explain supply and demand and its role on the price and volatility of cryptocurrencies. To conclude it briefly touches upon a relatively new form of cryptocurrency that attempts to address the volatility problem.
Historically, money has taken various forms like cocoa beans, cowrie shells, metal coins, playing cards etc. With the Bitcoin experiment, the 21st century saw the emergence of a new form of money “cryptocurrency” that uses cryptography to control its creation and transactions, rather than a central authority. Bitcoin — the most popular cryptocurrency, provides various benefits to its users. These include:
User-autonomy: Users control how they spend their money without having to go through an intermediate authority like a bank or government
Discretion: Since Bitcoin uses pseudonymous identities it is much harder to link a user’s transactions to their real world identity.
Peer-to-Peer focus: Users are able to transact with any one in the world without having to get special approvals from any external authority or having to pay exchange fees.
Despite their numerous advantages, cryptocurrencies like Bitcoin and Ethereum still have trouble fitting in as “money”. By definition, an asset is considered as “money” if it can serve as a unit of account, a store of value and a medium of exchange.
To be a medium of exchange people must be willing to accept the asset in exchange for goods and services. Elon Musk recently announced that Tesla now accepts Bitcoin as a mode of payment. This sort of news enhances Bitcoin’s credibility as a medium of exchange. A payment using Bitcoin is however costly in both time(needs about 60 minutes for a transaction to be considered irreversible) and money (transaction fees are 12.84 USD/transaction as of today). Its also difficult to use it as a medium of exchange if it’s value can quickly shift over time. For instance the Bitcoin price of a Tesla car could change day to day.
For a currency to serve as a unit of account, sellers should be able to reliably price their goods and services using that currency. Even though a lot of merchants accept Bitcoin as payment, hardly any price their products using its unit of measure i.e. BTC.
To be a store of value means that the asset holds value over time. Imagine you find an old forgotten ₹1000 note in the pages of a book. You would be delighted if it still has value. The stability of an asset’s value is also important. While Bitcoin’s value has grown dramatically over the years, it has also seen sudden plunges. This price volatility undermines Bitcoin’s ability as a store of value.
But what indeed causes the price of an asset to move up or down?
Supply and demand
Simply put, the law of supply and demand states that when an item is scarce, but more people want it, its price will increase. Conversely if there is larger supply of an item than consumers warrant, its price will decrease. Supply and demand rise and fall until they achieve balance.
Supply and demand can be affected by numerous factors. Take for example the effects of the Covid-19 pandemic on the demand for hand sanitizer and Bitcoin, as represented in Randall Monroe’s 2280th issue of XKCD. The comic shows a conversation about Bitcoin and hand-sanitizer between Whitehat who lives in 2010 and Cueball who lives in 2020. White Hat is curious about life in 2020 and is particularly interested in how Bitcoin has caught on as a currency. But its apparent that Whitehat does not initially understand what Cueball was trying to convey because the former is oblivious to the supply and demand conditions of the future and their effect on the prices of these two commodities of interest.
At the time when the comic was released, COVID-19 had begun spreading around the world, causing scores of people to die and billions to panic. This increased the demand for hygiene products, including hand sanitizers, and therefore their price increased. It also triggered a panic on financial markets, including severe devaluation of the infamously volatile bitcoin.
Bitcoin, like gold has a limited supply. It’s supply increases at a fixed rate every 10 minutes until it reaches the limit of 21 million BTC. Because the total supply of Bitcoin is fixed by an algorithm, changes in the demand for it cause the price to fluctuate accordingly. This supply cannot expand or contract to compensate for the changes in demand. Could price of a crypto currency be stabilized if supply could be adjusted to match changes in demand?
Stablecoins
Stablecoins are cryptocurrencies that peg to a traditional currency (typically USD) or other assets. The price of a stablecoin is maintained relative to its peg by automatically allowing its users to expand and contract the money supply of the stablecoin. Stablecoins have gained traction in recent years as they attempt to offer the best of both worlds — the instant processing and security or privacy of payments of cryptocurrencies, and the volatility-free stable valuations of fiat currencies. There are three types of stablecoins based on their stability mechanism:
Fiat backed stablecoins: Stablecoins that are backed by reserves of a fiat currency such as the U.S Dollar. e.g. USDC, TrueUSD
Crypto backed stablecoins: Stablecoins that are backed by a crypto currency or a basket of crypto currencies. E.g. MakerDao’s Dai
Algorithmic stablecoins: Stablecoins that do not hold any reserves but use a mechanism like that of central banks to regulate its value relative to the peg. E.g. Frax, Ampleforth
In this post we had a look at what requirements an asset needs to meet to be considered as money, tried to understand the effects of supply and demand on cryptocurrency and scratched the surface of the stablecoins world. In future posts, I will dig deeper into stablecoins and explain how they work. Stay tuned!
