Cryptocurrencies are best thought of as fiat currencies without a country backing them.   A fiat currency is one in which the money is not based on a valuable commodity like gold or silver but on something of little or no intrinsic value such as paper money or coins made with base metal.  It is made legal tender by law.  Its market worth is based on confidence, both domestic and international.   That confidence is a reflection both of how the currency actually performs,  the regulatory regime which governs the currency and the general standing of the issuing authority which is normally a nation-state. Cryptocurrencies have no national or supranational body  (such as the EU’s  ECB) which can be held to account if things go wrong because they are created by private individuals or corporations and are as yet largely unregulated by governments.  Consequently, they lack the reassurance which a stable and well run advanced country can bring.

Cryptocurrencies are created in various ways. The most famous,  Bitcoin, is supposedly based on a limit of 21 million BitCoins which can either be “mined” using complicated software,  IT expertise and serious energy usage or bought from exchanges with real-world currencies such as the Pound Sterling or the US Dollar. Other cryptocurrencies such as   XRP, which is owned by Ripple, create a set number of coins and then sells them. Fractions of currency units such as Bitcoin can be purchased.

But however a cryptocurrency is created, it has the obvious disadvantage that only those who initiated the currency truly know how it is being run or will be run in the future. They may claim that only a certain number of currency units are being created or are available to be mined but no one knows if that is so now or will be in the future.

Volatility

To these potential drawbacks can be added huge volatility. From a  $20,000 high in December, Bitcoin is now at less than $8,000.  It might be argued that gold is also volatile but the difference is that gold always has an intrinsic value. There is no chance that gold would ever become worthless or seriously cheap and consequently, even if it has its ups and downs, holding it can never be an unequivocal disaster.   Cryptocurrencies could all too easily become worthless very quickly.

The volatility is primarily driven by “bubble mania” whereby people pile into a market caught up by the frenzy of the moment, but another component is surely the number of cryptocurrencies which are appearing. Investors climb into the cryptocurrency which looks the best prospect for growth at any moment.

Cryptocurrencies are also vulnerable to fraud and theft through hacking.  The most recent admitted example affected the  Japanese exchange CoinCheck.

More banal disadvantages are the high transaction fees, long wait times and lengthy identity checks. There have also been practices which have shut out would be buyers and sellers especially at times when serious volatility occurs.

No one to make restitution if things go wrong

Potentially the greatest problem with cryptocurrencies is there is no person or institution which can be held responsible if things go wrong . They have largely operated without state interference… although that is beginning to change. The head of the Bank for International Settlements, Agustín Carstens  recently warned:

“If authorities do not act pre-emptively, cryptocurrencies could become more interconnected with the main financial system and become a threat to financial stability…”He also described Bitcoin as“little more than a   Ponzi scheme”,

This type of concern has led governments to begin taking the first faltering steps to regulate crypto currencies and banks have begun to stop the purchase of cryptocurrencies using credit cards to purchase them.

States are also moving to investigate the possibilities of running their own cryptocurrencies. These, apart from the possibility of inadvertently undermining a country’s economy in the same way that non-state cryptocurrencies might undermine it, also raises the possibility of governments indulging in widespread surveillance of any cryptocurrency transaction made.

Governments could also act to damage competitor countries.For example, China is reputedly ideally placed to undermine Bitcoin because much of the computing power required to sustain  BitCoin is within China.

More broadly there are some important questions which remain to be answered. These are :

  1. What will be the relationship between real life currencies and cryptocurrencies? The danger is that if cryptocurrencies become a competitor to real life currencies they could undermine them.
  2. How can cryptocurrencies be put under state control other than by banning them? The answer is that it cannot be done for two reasons. First,  even if the size of the issued currency is restricted, for example, the maximum number of Bitcoins, there could be no restriction on what the value of a Bitcoin could reach.  Second, cryptocurrencies are designed to be universal. Whatever a government might want to do, a successful cryptocurrency will still be available because the blocking of websites relating to them is never going to be perfect.  For this reason, a cryptocurrency owned by a state would also be problematic.
  3. How would cryptocurrencies affect international finance or trade? There is obviously potential for huge amounts of money to be redirected. For example, If the Pound is used to buy cryptocurrencies, where do the Pounds go? Potentially anywhere in the world.Because it will probably be hoarded that will decrease the velocity of circulation of the money. That would hinder economies.
  4. Could a country be left with a severe deficit in real life currencies and a large hoard of cryptocurrencies and be unable to settle public debts or pay for public services because they cannot pay for those things with cryptocurrencies?  A large advanced economy would probably not be at risk of that but many small first world economies and developing economies, even  China and India, might well get into a real mess.
  5. How will cryptocurrencies fit in with fractional reserve banking? This is the normal practice of banks (at least in the West) where reserves are equal to only a fraction of its deposit liabilities. The idea is based on the assumption that the reserves will be sufficient to meet any likely demands from depositors wishing to withdraw money because only a fraction of deposits will ever be requested over a short period of time.  If the demand for cryptocurrencies continues in its seemingly insatiable way, the reserves which are now deemed sufficient could easily prove to be grossly inadequate.
  6. Will cryptocurrencies become as simple to use as a swipe card, credit card or even cash? Well, Bitcoin has been going for ten years and is still complicated to use and effectively impossible to “mine” for the vast majority of people. Nor is it of much use when it comes to making everyday purchases.  The number of opportunities to purchase with cryptocurrencies will doubtless increase but their use is unlikely to be as easy as using a card or cash for quite some time. Moreover, unless the volatility problem is overcome, living using just cryptocurrencies would be akin to living in a country with a very heavy dose of inflation. A person paid in a volatile cryptocurrency might receive the equivalent of £100 on a Friday and find it worth £60  by the following week.
  7. If states allow cryptocurrencies to trade in their territory, the question arises will governments eventually have to protect deposits of cryptocurrencies as they do deposits of real-life currencies like the  Pound?  If they do, exactly what would they be insuring? After all, a  private cryptocurrency might simply drop to zero value.  Of course, real life currencies can suffer serious devaluations but at least in the case of countries such as the UK and the USA governments and central banks have some control over the currency. With a private, that is, non-state cryptocurrency, governments and central banks would probably have no meaningful control. In such circumstances insuring bank deposits of cryptocurrencies might be impossible because of the potential cost.

The head of the Bank for International Settlements, Agustín Carstens,  was not far wrong when he likened Bitcoin to a Ponzi scheme. It is not  a Ponzi  scheme as such,  but the fact that Bitcoin is still largely unregulated and there is no nation state or supranational agency behind it means that it and the increasing number of cryptocurrency competitors are essentially resting on the same utterly  insubstantial foundations that eventually always catch up with the Ponzi scheme, the need to keep generating confidence to lure in more and more suckers.

Just on the facts, cryptocurrencies bear an uncanny likeness to snake oil. Governments need to get a grip.