Section II
An Introduction to Cryptocurrcncy
What is cryptocurrency? The technical definition according to the Oxford
Dictionary is "a digital currency in which encryption techniques are used to regulate the
generation of units of currency and verify the transfer of funds, operating independently
of a central bank." What exactly does this mean though? It means that cryptocurrency is
online money that, because of a mathematic algorithm, cannot be inflated or tampered with from any single institution like a central bank. In fact, cryptocurrencies are not
backed by any government or central bank in the world. They are an alternative private
currency developed out of the free market and new digital technologies.
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This is what Nobel laureate F.A Hayek theorized in his famous pamphlet
Denationalization of Money (1978). He argues that if government removed itself as an
obstacle from the free market, individuals and monetary entrepreneurs would provide the
optimal quantity and variety of monetary products.
If the forces of competition can make
virtually all other products and services into better quality products and for a lower price,
why not have that work for the monetary industry as well? What kind of benefits can
come from alternative currencies according to Hayek. More stable purchasing power,
increased difficulty (and sometime the impossibility) of counterfeiting, and increased
divisibility because it's possible to have more denomination options. All of these benefits
and more have come to fruition in the fonn of cryptocurrencies.
Here is an example to help better illustrate what an alternative currency would be
like in real life. A private finn could digitally encrypt one million monetary units. The
encryption would make them extremely hard for someone else to produce additional units
because the mathematics behind the encryption would make it impossible to counterfeit.
For this example they will be called Freedom Coins.
The finn then contractually pledges
to redeem each Freedom Coin at any time, for either $20 US dollars or 100 Russian
rubles (any currency can be used but for the sake of example we'll US dollars and
rubles). Assuming that the firm has enough capital to back their promise and that THE EFFECTS OF CRYPTOCURRENCIES ON THE BANKING INDUSTRY AND MONETARY POLICY
everyone is fully confident of their redeemability, the Freedom Coins at auction will sell
for somewhat more than $20, helping the private firm gain initial profit. The Freedom
Coins will be auctioned above $20 because they will always be worth at least $20, but
they might be worth more in the future if the relative value of the currency increases.
This speculation is what will motivate customers to bid for the new currency. For
example, the value of Freedom Coins could increase if and when the Russian government
lets the ruble appreciate against the dollar. In this case, investors could redeem each
Freedom Coin for I 00 rubles,
which would exchange for more than $20 US dollars.
An easier way to think about the Freedom Coins in the above example is to think
of them as a derivative asset. So how can the private firm get the public to treat the
Freedom Coin as money too? The ideal way to do this, as Hayek writes, is for the firm to
specify a commodity basket (consisting of whatever they considered was relevant to
consumers: milk, gold, cotton, oil) that costs $100 US dollars. The finn would declare a
non-binding pledge along of the line of "We will use our assets to adjust the outstanding
supply of Freedom Coins so that 5 Freedom Coins will always have the purchasing power
to buy this specific commodity basket." This creates a real measure of purchasing power
so that people can better compare the power of different currencies over time. If the firm
is using inflation-proof mathematical algorithms to ensure that Freedom Coins retain
their real purchasing power, then this goal requires vitally no adjusting or managing and
will simply happen naturally.
What would happen is that the US dollar and Russian ruble would depreciate, due
to inflationary practices of their governments and central banks, via real goods and
services over time. So the price of that commodity basket would increase in US dollars
and Russian rubles. If the private firm stuck to their word and kept the value of Freedom
Coins stable, which using the mathematical algorithm mentioned above would force them
to do so, then the monetary market would see Freedom Coins as being the more stable
currency that retains value and start to use it more often, making it the dominant
currency. Even if the firm was capable of devaluing the Freedom Coins, because they
made the contractual agreement to always exchange Freedom Coins for the set amount of
fiat currencies, they have every incentive to keep the value of Freedom Coins as high as
possible compared to the two currencies to keep and gain real comparative value. Also, If
they break this contract the firm opens themselves up to massive lawsuits, which is
another economic incentive to keep their promise. Over time, the exchange rates would
change (because governments inflate their currencies) and suddenly one Freedom Coin
might be worth 1 50 Russian rubles instead of 1 00 or be worth $30 US dollars instead of
$20. Making the Freedom Coins a stronger, more stable, and more desirable currency for
consumers in the market to hold and use. The above example would continue with
different firms and different currencies in a way so that only the best currency comes out
on top.
Some critics point out that this competition amongst currencies would defeat the
original purpose of money; using money as a convenient medium of exchange. If
individuals are too busy trying to figure out what the value of one private currency is over another and trying to manage different accounts full of different currencies then this
information burden can really drag down an economy. Digital currency however can
conquer this issue with easy. A real life example is a website called CryptoCompare.com
that lists the up to the minute prices of competitive cryptocurrencies and their relative
exchange rates for free online. This dramatically reduces confusion amongst businesses
and consumers on the value of one currency over another without adding any costs. Also,
programs already exist that will automatically convert one currency into another currency
after making a purchase so that businesses don't need to keep accounts of dozens of
different currencies. In fact, websites like Coinbase.com are already providing this
service and are currently being used by both big and small companies around the world
such as Intuit, Overstock.com, Virgin Airlines, Expedia, Dell, Google and hundreds
more.
Another fear that some individuals might hold is that of a nefarious and fraudulent
private currency provider trying to take advantage of people. Inflation is overall harmful
to an economy but it does benefit the first initial people who get the newly created money
before the market prices adjust.
A private company could create a currency, attach it to a
basket of goods, then hyper-inflate the currency to buy as many commodity assets as
possible. Leaving the sellers of those commodities without their goods and holding
nothing but a now worthless currency, essentially theft. However this fear is conquered
by the fact that, in our example, the Freedom Coins are always legally redeemable for
$20 US dollars or l 00 Russian rubles. Similar to how the US dollar use to be legally
backed by and redeemable in a set amount of gold.
The difference is that governments can change laws to suit their needs but companies entering contracts with customers
cannot do this unjust act without exposing themselves to massive legal liabilities. So
contract laws would make this a virtually non-existent threat.
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Cryptocurrency doesn't need to rely on private organizations either though. In
fact, the world's most powerful, valuable, and popular cryptocurrency, called bitcoin, was
invented for free by a still unknown creator. It's a self-regulating, peer-to-peer system
that is not backed by any bank, firm, institution, or government. Although a few
companies have been created that involve bitcoin (companies help people buy, sell, and
trade bitcoin), none of them control bitcoin itself. But if bitcoin isn't owned or managed
by anyone or any single entity like every other currency, then what is bitcoin and what
does it mean in the world of cryptocurrency, banking, and monetary policy?
