How cryptocurrencies are like normal money

Last week I wrote about blockchain, the technology that underpins cryptocurrencies like Bitcoin. I’m interested in this latest development, and so is the Maltese government. Critics tell us Bitcoin is only meant for criminals, but how true is this?

Just to recap, the technology behind cryptocurrencies, a blockchain is a chain of many blocks of records. Each block is linked to the previous one in a chain. Distributed ledgers contain the chains and are many copies of the ledgers. High-level security proves your identity, and encrypts records.

Money is worth something because we agree it does, not because it has intrinsic value

Ask most people what blockchain is for and they’ll likely answer, ‘Bitcoin’. What they mean is ‘cryptocurrencies’, even though any currency can use blockchain.

Confused? Don’t be – it’s not as hard as it sounds.

I – Definitions

First, let’s look at these fancy terms. ‘Cryptocurrency’ sounds like a more advanced version of a normal ‘currency’, doesn’t it? That’s not quite correct.

Normal currencies are based on a shared understanding of money. If I have a EUR 10.00 note in my pocket, I can pop down to the shops and get myself EUR 10.00 worth of groceries. The shopkeeper will accept my Euro note. He will use it to buy more supplies or to pay his bills. We’re all happy because we accept that the EUR 10.00 note is worth ten Euros.

Here’s the catch: that EUR 10.00 note is not backed up by anything.

There used to be a time when the central bank would have a chunk of gold worth EUR 10.00 to represent my Euro note. In those days, it was safer to walk around with a slip of paper in your pocket than a chunk of gold. That piece of paper, that banknote in your pocket, was as the saying goes, as good as gold.

We can’t say that normal money is safer than a cryptocurrency

This is what economists call ‘commodity money’. The value of money comes from the commodity, which was gold in this case.

But that’s not what you have in your pocket right now.

Today, the currencies we use are not based on gold, or on any commodity. The EUR 10.00 I have in my pocket is not even worth EUR 10.00. It only costs a few cents to make a banknote. Since Euros are legal tender in the Eurozone, I can exchange my banknote for ten euros’ worth of goods or services.

This is what economists call ‘fiat money’ because the value of money comes from a government regulation. It is nothing more than the government saying ‘This piece of paper is worth EUR 10.00 because I say so.’ The central bank decides to add more banknotes or coins into the money supply, and it does so by printing, or coining, more.

This is important – the money in your pockets is worth something because we all agree it does, not because it has some intrinsic value.

What does this have to do with cryptocurrencies?

II – Defining cryptocurrencies

A cryptocurrency is a currency which is neither backed by a commodity nor by government regulation. Instead, complicated encryption techniques regulate the money supply. There is no government controlling it. Complex algorithms designed by computer programmers decide how much of a cryptocurrency there is.

That’s it.

Some people think this is dangerous. After all, without a government or central bank backing a currency, how can we be sure a cryptocurrency is valid?

The truth is that we can’t say that for a normal fiat currency either. If I buy a pair of American jeans for EUR 10.00 today, there is no telling what it will cost next week. This is because the exchange rate between the Euro and the dollar changes based on the foreign exchange market. If the jeans cost EUR 20.00 next week it’s not because the jeans are better or more special than the ones I bought today. It just reflects the value of the Euro which changed when compared to the American dollar.

In essence, the markets determine the value behind the banknotes in our pockets.

When you think about currencies this way, a cryptocurrency which is not backed by a central bank doesn’t seem so strange, does it?

So why are people fussing about cryptocurrencies?

III – Anonymity

The advantage of a cryptocurrency is that it is completely digital.

Cryptocurrency sounds like an advanced version of normal currency. That’s not true

My Euros are not digital, they’re physical. I can see and touch them. Sometimes I need to use them to buy things from a digital shop like Amazon. In that case I put them in a bank, get a suitable debit or credit card and tell Amazon to take EUR 10.00 from the bank account linked to that card. I never have electronic money. What I have is an electronic representation of physical money.

In the early 2000s we couldn’t have electronic money for a simple reason. How can you prevent someone making a copy of the electronic banknote? Blockchain technology solves this problem which is why it is only now that we can talk about cryptocurrencies.

Since a cryptocurrency is already electronic, I don’t need to place it into a normal bank. This means  there is no way to trace the transactions online, yet. By this, I don’t mean there is no way to tell if I’ve spent all my money or not. That mechanism is there and it works well. What I mean is there is no way for the police to trace what I did with my cryptocurrency. Banks have laws forcing them to reveal information to the authorities under certain conditions.

There are no such laws for cryptocurrencies.

To use a simple example, if I use my bank’s credit card to buy a load of guns on http://www.ILoveGuns.com there is a record of this at my bank. If I use a cryptocurrency, I bypass the traditional banking system. The police don’t have the jurisdiction or know-how to find my transaction and prove it was mine.

This is why criminals are eager to use cryptocurrencies.

But there must be some way we can enjoy cryptocurrencies, right?

IV – Serious uses

There is.

No tool is either good or bad. It all depends on how we use it. For example, there is no reason a central bank can’t issue a cryptocurrency. Many central banks are already thinking along these lines:

• Last November, Reuters reported remarks made by William Dudley, the US Federal Reserve’s President. He said, “At this point it’s really premature to be talking about the Federal Reserve offering digital currencies, but it is something we are starting to think about […]”
• The Financial Times described the Reserve Bank of Australia’s thoughts on the matter. The bank is analysing the benefits and drawbacks of issuing an electronic form of the dollar. An eAUD if you will.
• The Basel-based Bank for International Settlements is sometimes called the central bankers’ bank. Last September it issued its own report on central bank cryptocurrencies. In cases like Sweden where cash use is already declining, a central bank cryptocurrency would be “an electronic form of central bank money that can be exchanged in a decentralised manner known as peer-to-peer, meaning that transactions occur directly between the payer and the payee without the need for a central intermediary.”

Cryptocurrencies are not good or bad. It’s how we use them that counts.

I find this last example especially interesting because of how I would handle my money in such a situation. Right now, I keep my money in my bank account after I get hold of it. If it’s all electronic, and if it’s all issued and backed by the central bank, then why not just have an e-account at the central bank?

Would this spell the end of retail banking?

We don’t yet know the answer to these questions.

But, for those of you with long-enough memories, what has this got to do with the situation in Malta?

V – Regulation

I’m glad you asked.

The island state also wants to authorise cryptocurrency providers⁷.

My original point about regulation applies to authorisation too. With a dodgy reputation, why would an investor trust something the Maltese state authorised?  I would argue that providers should meet international standards to give a greater sense of security. This is a smarter approach because Malta’s reputation won’t affect the companies.

But it’s more complicated than that.

There’s more to it than meets the eye.

Next week I will take a closer look at what Malta is doing, and what it should be doing instead.

Share this with someone who is still unclear about what Bitcoin and blockchain are.

References

1. As good as gold; The Phrase Finder; (Retrieved 2018-05-17) 
2. Criminals hide ‘billions’ in crypto-cash – Europol; Shiroma Silva; BBC; 2018-02-12
3. Amid bitcoin surge, Dudley says offering digital currency on Fed’s radar; Jonathan Spicer; Reuters; 2017-11-29
4. What the bitcoin bubble tells us about the economy; David Smith; The Sunday Times of London; 2017-12-03
5. Australian central bank mulls electronic banknotes; Emma Dunkley and Alice Woodhouse; The Financial Times; 2017-12-13
6. Central bank cryptocurrencies; Morten Linnemann Bech and Rodney Garratt; Bank for International Settlements; 2017-09-17
7. PS confident new Bills will appease banks concerns over blockchain, crypto companies; Helena Grech; The Malta Independent; 2018-04-24

All references were valid and correct when this article was published. Changes to referenced websites or web pages may render some references invalid. If this is the case, please leave a comment below.