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  • Writer's pictureAkshay Nayak

Cryptocurrencies Decrypted

The latest instrument which is in vogue in the financial markets at the moment is cryptocurrency. A cryptocurrency is a global digital payment system which can be used without a central bank or a central administrator. It is widely publicised as an improved and more secure system of digital payment, because it is an encrypted instrument. This makes it hard for a third party to get a cut in the money involved in the transaction during the time in which the transaction is processsed. What started off being intended as a digital medium of exchange has now also become a freely tradeable digital asset across the world. This has seen these instruments become the new sensation of the financial markets, with anyone and everyone wanting to be a part of the cryptocurrency party. But do cryptocurrencies work exactly as advertised? Are they a form currency or a means of speculative investment? Are they legal in India? Is there any substance behind all the hype that surrounds them? Today's post is an attempt to break down and throw light on all these aspects.

Cryptocurrencies originally gained popularity and are now trading at such high prices because they are being touted as the future of currencies as we know them. It is also perceived that the fact that they make use of blockchain technology (explained in the graphic below) means that they will create an effective global digital payment system in the years to come.

But to my common sense, there is nothing in the present to suggest that the future for cryptocurrencies is going to pan out as is being widely believed. I am of the opinion that cryptocurrencies are not effective either as a currency or as a tradable digital asset for speculation or investment. And I will now elucidate why.

Let me start by talking about the reasons why I cannot see cryptocurrencies being able to serve as an effective currency. First, we must understand that there are two things which make an effective currency. Any effective currency is both a great store of value, and has transaction value. Let me first explain why cryptocurrencies have no transaction value. The transaction value of a currency enables us to buy and sell using the currency, sometimes in more than one region. Lets say I live in Spain. If I start the day with 1000 Euros in my pocket I will be able to buy myself everyday things like my meals, my groceries, fuel for my vehicles and so on. Moreover, I can buy them not only in Spain but in almost any major European country, because the Euro is accepted as a currency across the European Union. Now lets say I start the day with 1000 units of a cryptocurrency in my pocket (a few examples of cryptocurrencies are given in the graphic below).

I am quite sure that I would not be able to buy any of the daily essentials mentioned above using the 1000 units of any cryptocurrency I have with me. This is simply because most dealers and service providers do not accept cryptocurrencies as a medium of exchange and mode of payment. More recently, a select few platforms, dealers and corporations have begun accepting and dealing in cryptocurrencies. But even so, we must remember that at this point of time, cryptocurrency transactions are unregulated and therefore there is no regulatory authority to refer any disputes or grievances to. The Indian rupee does very well in terms of transaction value, because it is accepted anywhere within the Indian subcontinent which in itself is a sizeable geographical region.

Let me now throw more light on an effective currency being a store of value, and why the Bitcoin is not an effective store of value. When a currency is a great store of value, it means that the purchasing power of the currency is not lost over a period of time. In other words, a good currency remains largely unaffected by inflation over a period of time. Lets say I live in Japan, and I take 100 Yen and decide to keep it in my safe at home for the next one year. Lets further say, that right now, 100 Yen is enough to buy me an entire breakfast at any local restaurant in Japan. At the end of the period of one year, if I go to a restaurant, I will still be able to buy myself most of the breakfast that I could buy the previous year. This is because inflation in Japan is pretty low (an average of 2.42% for the decade ended December 2023). Therefore the majority of the purchasing power of the Yen stays intact over time. And as I proved earlier, cryptocurrencies have no purchasing power in the first place, because we can't use them to buy stuff in most cases.

I now move on to talking about why cryptocurrencies are ineffective as a financial instrument or an avenue for speculative and long term investment. Market linked financial instruments (for instance stocks, bonds, mutual funds and so on) are usually representative of one or more underlying assets. But cryptocurrencies are not representative of any underlying asset. This makes it impossible to measure the actual value of cryptocurrencies because there is nothing against which to gauge the value of a particular cryptocurrency. In fact, this just shows that the surge in cryptocurrency prices over the past few years is purely speculative and not backed by any reason or logic of note. This is quite similar to the Tulip Mania era witnessed in the Netherlands. It saw tulip prices surge to grossly unrealistic heights starting from 1634 before subsequently cashing in 1637. In fact, the governor of the Reserve bank of India, Mr Shaktikanta Das actually drew parallels between the Tulip Mania era and the current craze for cryptocurrencies in a warning he directed towards cryptocurrency investors during a meeting of the RBI's Monetary Policy Committee in February 2022.

Moreover, during the general budget announced on February 1st 2022, Union Finance Minister Ms Nirmala Sitharaman put forth a number of tax proposals that now render cryptocurrencies highly unattractive for existing and potential cryptocurrency investors. Key among them being a proposal to tax income from cryptocurrencies at a flat tax rate of 30%. Also, investors are not allowed to set off losses arising from cryptocurrency transactions with gains from any other head of income when filing their taxes. It was also made clear that the fact that cryptocurrencies are being taxed does not mean the government is legalising them. And as long as there is a question mark over cryptocurrencies with regard to something as crucial as their legality, I see no justifiable reason for us to consider cryptocurrencies as investment avenue.

So in conclusion, I can safely say that cryptocurrencies are just a fad and are nowhere close to being the future of currencies as we know them. And as far as investing in cryptocurrencies is concerned, there are plenty of better investment options available to us outside of cryptocurrencies. Of course, in 10-15 years from now, I definitely think that an online currency will find a valid existence. But it is going to take a lot more formal legislation and regulation within the sphere of cryptocurrencies before we can give them a serious look in as an option for our investment portfolios. As things stand though, I'm more than reasonably sure that cryptocurrencies in their current incarnation are not the answer to our quest for a digital substitute for paper currency, or an ideal fit for our investment portfolios.

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