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Fall In Cryptocurrency Price

Context:

Bitcoin, the most dominant cryptocurrency around, is down more than 50% from an all-time high price of $68,000.

Relevance:

GS III- Indian Economy

Dimensions of the Article:

  1. What are cryptocurrencies?
  2. How are they different from actual currency?
  3. How do cryptocurrencies derive their value?
  4. What’s new about this phase of the cryptocurrency price fall?
  5. What vulnerability was revealed during this crash?

What are cryptocurrencies?

  • Cryptocurrencies are e-currencies that are based on decentralized technology and operate on a distributed public ledger called the blockchain.
  • Blockchain records all transactions updated and held by currency holders.
  • The technology allows people to make payments and store money digitally without having to use their names or a financial intermediary such as banks.
  • Cryptocurrency units such as Bitcoin are created through a ‘mining’ process which involves using a computer to solve numerical problems that generate coins.
  • Bitcoin was one of the first cryptocurrencies to be launched and was created in 2009.

How are they different from actual currency?

  • The Main difference is that unlike actual currencies cryptocurrencies are not issued by Governments.
  • Actual money is created or printed by the government which has a monopoly in terms of issuing currency. Central banks across the world issue paper notes and therefore create money and assign paper notes their value.
  • Money created through this process derives its value via government fiat, which is why the paper currency is also called fiat currency.
  • In the case of cryptocurrencies, the process of creating the currency is not monopolized as anyone can create it through the mining process.

How do cryptocurrencies derive their value?

  • Any currency has its value if it can be exchanged for goods or services and if it is a store of value (it can maintain purchasing power over time).
  • Cryptocurrencies, in contrast to fiat currencies, derive their value from exchanges.
  • The extent of involvement of the community in terms of demand and supply of cryptocurrencies helps determine their value.

What’s new about this phase of the cryptocurrency price fall?

  • This big sell-off phase has come about at a time when the war in Ukraine and the subsequent disruptions to the global supply chain have resulted in record-high inflation throughout the world.
    • Inflation in the U.K., for instance, is at its highest levels in 40 years.
  • To tackle such conditions, many central banks have gone in for interest rate hikes.
    • Early this month, the U.S. Federal Reserve increased its benchmark interest rate by half a percentage point, the biggest hike in 22 years.
  • Cryptocurrencies, which are perceived amongst the riskier investments, are weighed down in such an environment where investors want safety more than anything else.
  • Cryptocurrencies, interestingly, were promoted as those that could weather these storms.
  •  Vulnerability in the cryptocurrency ecosystem also played its part in the recent price crash.

What vulnerability was revealed during this crash?

The Bitcoin value also got impacted by what’s essentially a sub-story in the entire episode — the fate of a stablecoin called TerraUSD.

Stablecoins:
  • Stablecoins are a type of cryptocurrency that seek to hold their value steady, even if the Bitcoins of the world have a rocky journey. This, they do by pegging to a currency such as the dollar.
  • TerraUSD’s idea was to maintain a value of $1.
  • The way it maintains its peg is through an algorithmic solution, wherein if it drops below $1, a trader is encouraged to receive a ‘sister’ token called Luna at a discounted price in exchange.
  • The TerraUSD, for which Luna was exchanged, then goes out of circulation.
  • The supply falls, and the peg to $1 is achieved again.
  • That’s how it works in theory. What happened in reality is that the peg was lost, and the investors began to pull out, and both the stablecoins had a free fall.

Bitcoin value slide

  • Recently, TerraUSD was trading below seven cents . Luna was trading at $0.0002044, very close to zero.
  • The Luna Foundation Guard, which backs the Terra ecosystem, had tried selling its Bitcoin reserves to keep its cryptocurrency peg intact.
  • That, among other things, could also have played a part in the Bitcoin value slide.

-Source: The Hindu

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August 2022
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