Cryptocurrencies have become extremely popular due to the ideals of decentralization they convey, along with potentially outsized gains, but their volatility remains high and these assets carry a greater risk of losses than many traditional assets. For instance, in 2017, Bitcoin prices rose from about $1,000 to a high of more than $19,000 before dropping to around $3,000. Then, Bitcoin again rose through the end of 2020, reaching new highs of around $60,000 before dropping again to $30,000 in the summer of 2021.
- Cryptocurrencies have become extremely popular due to potentially huge gains, but their volatility also involves the risk of dramatic losses.
- Cryptocurrencies offer an easy-to-use, digital alternative to fiat currencies.
- The noncorrelated nature of the market makes cryptocurrencies a potential hedge against risk, similar to precious metals like gold.
Cryptocurrency is a digital or virtual currency designed to serve as a medium of exchange. The crypto prefix comes from the fact that cryptocurrencies use cryptography to secure and verify transactions as well as create new currency units (coins). Cryptography makes it easy to encode something that is easy to decipher with a key and difficult to decipher without a key, which means coins can be difficult to create but transactions can be easy to verify.
At their core, cryptocurrencies are entries in an immutable and pseudo-anonymous database—known as a blockchain—that no one can change (except under extreme circumstances when direct edits are made). The blockchain is a public record that is verified by many different nodes, which makes counterfeiting coins extremely difficult or impossible. It also makes it easy to trace any specific transaction between anonymous individual accounts or wallets.
Cryptocurrencies offer an easy-to-use, digital alternative to fiat currencies. Consumers from the United States or European Union may view cryptocurrencies as a novelty, but there are many countries with mismanaged domestic currencies. For example, Venezuela’s authoritarian regime has become infamous for its skyrocketing inflation, which has led to plummeting living conditions for millions of citizens without access to external currencies.
The wild swings of Bitcoin and other cryptocurrencies may seem risky to U.S. consumers, but Venezuelans may find the swings tolerable when their domestic currency has been in a sharp decline over several years with no signs of abating. In other words, many global consumers may see cryptocurrencies as a hedge against inflation since the number of cryptocurrency coins in circulation is mathematically limited over time.
Other countries have strict capital controls in place to control the flow of money and/or charge high taxes. Cryptocurrencies can be used to circumvent these capital controls and taxes—legal or not—which has led to increased demand on the part of consumers and businesses. For this reason, many countries have started cracking down on the illegal uses of cryptocurrencies for tax evasion or illegal purchases or sales abroad.
The official response to cryptocurrencies has been lukewarm at best across central banks and financial institutions. While there are some organizations that have been supportive of the cryptocurrency, many central banks remain cautious given the market’s extreme volatility. Issues with tax evasion and capital controls also have led to some widespread concerns.
- United States Federal Reserve: U.S. Federal Reserve Chairman Jerome Powell believes that technical issues remain and governance and risk management will be crucial before cryptocurrencies become part of mainstream society.
- European Central Bank: Former European Central Bank Vice President Vitor Constancio called Bitcoin a “tulip” in reference to the 17th-century bubble in the Netherlands and many other governors have expressed similar skepticism.
- People’s Bank of China: The People’s Bank of China believes that conditions are “ripe” to embrace cryptocurrencies, but the central bank wants full control, and authorities are cracking down on the cryptocurrency ecosystem in the country.
- Bank of Japan: The Bank of Japan doesn’t see a market for cryptocurrencies.
- Bank of England: The Bank of England Governor Mark Carney called cryptocurrencies part of a “revolution” in finance, making the central bank one of the few governmental proponents of the technology.
The Venezuelan government, facing capital restrictions of its own, launched its own cryptocurrency in 2018—called the petro—that’s allegedly backed by barrels of crude oil. While official sources indicate that the country raised billions of dollars, many analysts are skeptical of these figures and the United States has outlawed U.S. citizens from purchasing the cryptocurrency.
As of 2020, the petro is still struggling to become a truly functioning currency.
Impact on Global Investments
Cryptocurrencies have many benefits when it comes to frictionless transactions and inflation control, but many investors are adding these currencies as assets to their diversified portfolios. In particular, the noncorrelated nature of the market makes cryptocurrencies a potential hedge against risk, similar to precious metals like gold. Many cryptocurrency exchange-traded products (ETFs and ETNs) have arisen for this very reason.
On the other hand, some experts fear that a cryptocurrency crash could have an adverse impact on the wider market, similar to how mortgage-backed securities sparked a wider global financial crisis. It’s worth noting that the total market capitalization of all cryptocurrencies, which is between 1 and 2 trillion dollars as of now, is still less than that of some large public companies, such as Facebook or Amazon. Yet, cryptocurrencies as an asset class is a new and dynamic prospect that can go in either direction. In the end, many investors view cryptocurrencies as either a vehicle for speculation or a hedge against inflation, but the size of the market doesn't represent a systemic risk, as of 2020.