How cryptocurrency works

27 Mar 2020  Read 577 Views

‘Bitcoin’ became a popular term a couple of years ago. The buzz it created all over the world can be fathomed with an observation that people would rarely know about Blockchain Technology, but they knew about Bitcoin. It was as if they did not know what a mobile phone is but they know what Samsung does. However, this cannot be blamed on people. Blockchain technology came as a revolution. Started with a research paper in 1992, it came into being in 2009; and the first application of blockchain was the Bitcoin. This piece talks about Bitcoin and other cryptocurrencies like Ripple, Ethereum, and so on. The concept of functioning of all cryptocurrencies is the same.

What is Cryptocurrency?

A cryptocurrency is a blockchain-based currency. In general online transactions we have a payer and a payee. The payer authorizes its bank to pay to the payee, the bank checks the account balance of the payer and verifies the details of the payee, and then it validates the transaction. On approval of the transaction, money gets deducted from the payer account and deposited in the account of the payee.

A cryptocurrency is devoid of such intermediaries for approval. It uses blockchain technology for databases. Each person on the network with a distributed ledger can approve the transaction and add the block to the ledger. In layman terms, ordinary people on the network will be able to verify the transaction, validate that, and add to the database.  It means there is no need for the bank or any other intermediary to verify and approve. It is ‘Peer-to-Peer’ transaction. It saves time and effort.

The Bitcoin

Bitcoin was the first blockchain-based cryptocurrency. Just like 100 paise makes a rupee, one Bitcoin comprises 10 crores ‘Satoshi’. People connected on the network can see and approve the transactions on the blockchain.  In normal scenarios, the bank charges transaction fees on the payment in the form of Merchant Discount Rates or Payment Gateway charges. In the case of Bitcoin, those who approved the transaction would get transaction fees in the form of Bitcoins. This approving the transaction and adding it to the blockchain is called the ‘Bitcoin mining’.

The Popularity

The benefits of Bitcoin were plenty. It has the power to eliminate an entire industry. Moreover, the transaction was secured and out of any surveillance. This lack of monitoring made it even popular. On one hand, it was the flag bearer of the free markets; on the other side, it could be easily used to pay for drugs, arms, and other forbidden and illegal stuff. Resultantly, the popularity of Bitcoin soared. The advantages of Bitcoin gave way to the rise of other cryptocurrencies.

The Bubble

The laws of demand and supply govern any commodity, including currencies. For instance, globally countries use the US Dollar to buy Crude oil. Now assume if someday the oil-producing countries say they will not accept the US Dollar. In that case, demand for dollars will fall and the price of dollars will also fall.

In a reverse case, the demand for Bitcoin started increasing and so did its price. People all over the world started buying Bitcoin. Even in India, people without the basic knowledge of finance started buying Bitcoin because everyone else was buying. People thought it was a gamble they were sure to win. For example, people would buy luxury items thinking that they will repay once they sell their Bitcoin in the next couple of weeks. Such situations are dangerous. It is a classic example of what investors should be wary of. 

The bubble started creating. Bitcoin was worthy, that is true; but the way people were buying Bitcoins was as if they were ready to pay one crore rupees for a Hyundai i10. The car is good, but not worthy of a crore rupees! The bubble was not limited to just Bitcoin. It spread well enough to Litecoin, Ethereum, Ripple, and the entire cryptocurrency market.

The Burst of the Bubble

Then the worst came. A plethora of countries including India denounced any move to accept cryptocurrencies as a legal tender. It means any transaction using these currencies was illegal. The financially literate crowd understood what it meant and pulled their money. The demand for Bitcoin fell; its price fell harder. Those gambling their fortune on the currency were in deep shit. Bitcoin now deals at a price much lower than its peak. They learned the lessons of speculation the harder way. This is why Finology strives to make everyone financially literate and aware.

The Criticisms

Bitcoin and other cryptocurrencies have several advantages over the current monetary system. The bubble and its burst was not its fault. It is the speculators and uninformed ‘gamblers’ to be blamed. Yet, Bitcoin has its fair share of issues. It is beyond any national interest to let its currency go out of its control. The currency can be manipulated by artificially pumping the price, and then dumping it; just like ‘Pump and Dump’ frauds of the stock market. The central banks like RBI prevent any such speculative attack on the currency.

Moreover, Bitcoin promised to limit its number to 21 million. It is also important from the point that one cannot issue endless currency. However, later Bitcoin too came up with other variants like Bitcoin Gold and Bitcoin Cash. These currencies acted nothing more than an alternative to Bitcoin. In a way, they artificially increased the number of cryptocurrencies in the market. They can issue any number of currencies in this manner. This is dangerous for an economy.

The Supreme Court Judgement

March 4, 2020 was the day of reckoning for the future of cryptocurrencies in India. Earlier the government and The Reserve Bank of India refused to recognize it. Circulars were issued regarding cautions and the risks dealing in cryptocurrencies. RBI in its circular issued on April 6, 2019 clearly stated that no entity should deal in cryptocurrency or provide any service to those who facilitate its trading or settlement of transactions.

They went after the ‘coin exchanges’. Coin Exchanges are just like stock exchanges, just that here cryptocurrencies are traded instead of stocks. Although there was no formal ban, RBI banned any banking channel to such exchanges and ultimately led to the closing down of these exchanges. In the court, the Government defended every move taken to prevent the integrity of the banking system. However, due to the absence of any law regarding this, the Honourable Supreme Court struck down any curbing on the trade of cryptocurrencies. The trading no longer remains illegal.

Winding Down

Cryptocurrencies are an application of blockchain technology. These currencies have shown us a way to what the future currency may look like. However, using them in their current form is problematic. With no central authority to control, the currencies have proved to be vulnerable to speculative attacks. Their use in drug and arms dealings can compromise global security. Excessive use of energy for Bitcoin mining is another concern. Perhaps with better norms, improved Blockchain technology, and better economics around this, cryptocurrencies will prove to be the currency for the future.

About the Author: Vivek Tiwari | 66 Post(s)

Vivek Tiwari is a Software Engineer and a Data Scientist who hopelessly fell for Economics. His plans to move to Management might now save mankind from his IITJEE selection story.

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