Bitcoin, the most dominant cryptocurrency around, is down more than 50% from an all-time high price of $68,000.
GS III- Indian Economy
Dimensions of the Article:
- What are cryptocurrencies?
- How are they different from actual currency?
- How do cryptocurrencies derive their value?
- What’s new about this phase of the cryptocurrency price fall?
- 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 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