When cryptocurrencies fluctuate, they do not only affect investors’ wallets – they have widespread effects on the entire market, Luther Lie writes.
Over the past several months, the world has witnessed an explosion of investment in notoriously volatile cryptocurrencies, causing distortion in the financial market.
Most recently, Dogecoin, a cryptocurrency originally started as a joke – jumped 900 per cent and then plunged 30 per cent in just a month, and has risen 12,000 per cent overall this year. On the other side of the spectrum, Bitcoin recently crashed 50 per cent in just a few weeks.
Volatile returns aren’t the only risk associated with cryptocurrencies though – frauds are around too. Recently, an Istanbul-based cryptocurrency exchange, Thodex, shut down, reportedly taking with it $2 billion in investors’ money.
This begs the question: how did financial authorities allow cryptocurrencies to so suddenly make such a huge impact on the financial market?
Cryptocurrencies are a digital, private, and partially anonymous currency. Cryptocurrencies are mined by high-powered computers to solve complicated math equations, then stored and transferred as files held in an encrypted ‘wallet’. Many are stored on a decentralised network known as a blockchain. Hailed as a future medium of exchange, they are issued by private enterprises in an aim to combat central banks’ monopolies on the supply of money.
They are not pegged against any real-world currency, and users can trade peer-to-peer without intermediaries. This means the value of cryptocurrencies is heavily determined by demand and supply, making them function somewhat like a commodity, rather than being used primarily for transactions like a traditional currency.
The first cryptocurrency created was Bitcoin, established by Satoshi Nakamoto, who was inspired by an article on ‘b-money’ written back in 1998 by computer scientist Wei Dai from the University of Washington.
Dai’s idea was to create a medium of exchange in which government intervention is “not temporarily destroyed but permanently forbidden and permanently unnecessary”. Ten years later, Nakamoto actioned this idea, creating Bitcoin.
Despite being a financial product, cryptocurrencies are barely regulated. This is a contrast to the highly regulated nature of the financial markets for traditional currencies, commodities, and stocks.
Earlier this year, the President of the European Central Bank (ECB), Christine Lagarde, voiced the ECB’s intention to regulate cryptocurrencies. She also raised similar concerns as the Managing Director of the International Monetary Fund, an international institution that is responsible for regulating the currency exchange market. While there is some appetite for regulation, little progress has been made.
So, should cryptocurrencies be regulated, or would it undermine their worth?
Some have raised concerns about the regulation of cryptocurrencies, arguing that it could introduce transaction costs. Cryptocurrencies avoid these costs because they are traded peer-to-peer without the fees of intermediaries. Real-world currencies and stocks, which are regulated, carry a fee to be traded, collected by either banks or brokers.
Another concern is that the regulation of cryptocurrencies will affect their value. Unlike real-world currencies, cryptocurrencies cannot be devaluated by central banks, and some view this as one of their key assets.
These are valid concerns. However, cryptocurrencies should not be entirely left unregulated.
Cryptocurrencies are increasingly owned by retail investors – almost 20 per cent of respondents to an Australian survey said they own cryptocurrencies, and 36 per cent of institutional investors in the United States and Europe also said they own cryptocurrencies. Like for any other financial products, regulators must protect the public – who often do not have the sophisticated financial knowledge to analyse these markets and make informed decisions – from losing large amounts of money, either by false investment projections, misleading news, or personal misjudgement.
Of all those respondents who said they owned cryptocurrency in the last year, more than 20 per cent lost money on their investment.
The wave of personal bankruptcies that would follow a large number of people losing their savings in cryptocurrencies – similar to the ‘too big to fail’ phenomenon – could cripple a nation’s economy. In such an event, government bailouts would be necessary to save an economy.
The government response to the Thodex incident suggests the weakness of an unregulated cryptocurrency exchange. While the Turkish central bank has now prohibited the use of cryptocurrencies, investors’ money has been irrecoverably lost.
Amid the ban, a second Turkish cryptocurrency exchange, Vebitcoin, collapsed.
Cryptocurrencies are also highly susceptible to negative externalities. Although ostensibly difficult to mine and free from the intervention from central banks and intermediaries, the supply of cryptocurrencies is not stagnant.
Unlike real-world currencies, the production of cryptocurrencies is not controlled by a central producer. By monopolising cryptocurrencies mining resources, private enterprises that issue cryptocurrencies may be able to arbitrarily ‘control’ demand and supply to influence their value.
Considering these weaknesses of cryptocurrencies, regulation would be well worth it. The huge gains offered by cryptocurrencies may sound alluring to public investors, especially during COVID-19 pandemic, but the fact that they come from an unregulated market meant that there will always be big losers in the game, to the cost of everyone.
Governments can’t allow the financial system to be treated like a horse race, with investors embracing a ‘win big or go home’ attitude. A financial product like cryptocurrencies affects public investors’ money, and if it fails, it will not only threaten their livelihoods – it will potentially risk national economies.
The views expressed in this article are those of the author alone.