How does Cryptocurrency Work?
A lot of people jump right into trading, but if we had to ask them something about cryptocurrency, they would only know a few basic concepts. Here is a run-down of all that you need to know about this digital currency. How does cryptocurrency work? What is cryptocurrency? How does it become more valuable with time? Here is all you need to know.
What are Cryptocurrencies?
Cryptocurrencies are digital tokens. They are a type of digital currency that allows people to make payments directly to each other through an online system. Cryptocurrencies have no legislated or intrinsic value; they are worth what people are willing to pay for them in the market. This is in contrast to national currencies, which get part of their value from being legislated as legal tender. There are several cryptocurrencies, the most well-known of which are Bitcoin and Ether.
Recent Trends in Cryptocurrency Activity
Over the past few years, there has been a notable surge in activity within cryptocurrency markets. The intrigue surrounding these digital currencies has been primarily driven by speculative motives, with individuals purchasing cryptocurrencies to turn a profit rather than utilize them as a novel payment system. This heightened interest has been accompanied by considerable price volatility across various cryptocurrencies. For instance, Bitcoin’s price soared from approximately US$30,000 in mid-2021 to nearly US$70,000 by the end of the same year, only to plummet to around US$35,000 in early 2022. Similar fluctuations have been observed with rival cryptocurrencies such as Ether.
Moreover, the unprecedented fascination with cryptocurrencies has led to a significant increase in the utilization of computational power for solving the intricate codes that underpin many of these systems, thereby safeguarding them against potential corruption. Despite the surge in interest, there remains to be skepticism regarding the ability of cryptocurrencies to supplant traditional payment methods or national currencies in the foreseeable future.
How Does a Cryptocurrency Transaction Function?
Cryptocurrency transactions are executed through electronic messages disseminated across the entire network, containing instructions regarding the transaction. These instructions typically include details such as the electronic addresses of the parties involved, the amount of currency to be exchanged, and a timestamp.
Let’s consider a scenario where Alice intends to transfer one unit of cryptocurrency to Bob. Alice initiates the transaction by dispatching an electronic message with her instructions to the network, visible to all users. This transaction joins a queue of recently transmitted transactions awaiting compilation into a block, which essentially represents a grouping of the most recent transactions. Due to the non-instantaneous nature of the system, the transaction remains pending until it is incorporated into a block.
The information within the block is then encrypted into a cryptographic code, prompting miners to compete in solving the code to append the new block of transactions to the blockchain. Once a miner successfully decrypts the code, other network users verify the solution and collectively agree on its validity. Subsequently, the new block of transactions is appended to the end of the blockchain, thereby confirming Alice’s transaction. However, it’s important to note that this confirmation process is not immediate, as it requires time for six consecutive blocks of transactions to be processed. This delay ensures that users can be confident in the success of their transactions.
Does Cryptocurrency Qualify as Money?
A common inquiry revolves around whether cryptocurrency fits the definition of ‘money’. The concise answer is that cryptocurrency does not align with the concept of money. To elaborate, we can assess whether cryptocurrencies possess the essential characteristics of money:
Universally Accepted Medium of Exchange: Can cryptocurrencies facilitate buying and selling transactions? Money typically takes the form of a nation’s currency and enjoys widespread acceptance for transactions. While cryptocurrencies can be utilized for transactions, their acceptance as a medium of exchange remains limited. Surveys indicate that only a small percentage of cryptocurrency holders use them regularly for transactions.
Store of Value: Can cryptocurrencies maintain their purchasing power over time? The significant price fluctuations experienced by many cryptocurrencies undermine their ability to preserve value, thus diminishing their effectiveness as a store of value.
Unit of Account: Are cryptocurrencies commonly used to measure the value of goods and services? In Australia, prices are typically denoted in Australian dollars. While some businesses may accept cryptocurrencies as payment, they are not widely employed for price comparison and measurement.
Therefore, while cryptocurrencies can facilitate payments, their current usage as a medium of exchange is restricted, and they do not exhibit the fundamental attributes of money. However, there exists a form of digital currency that could potentially fulfill the criteria of cash — digital currency issued by a central bank.
What is Central Bank Digital Currency?
A Central Bank Digital Currency (CBDC) can be best described as a digital representation of physical cash. The central bank issues it, accessible to the general public, and utilized for conducting transactions among businesses and individuals. The denomination of CBDC is based on the national currency. It can be exchanged at parity (i.e., one-to-one) with other forms of currency, including physical cash or electronic deposits held by regulated financial institutions.
What are the primary distinctions between cryptocurrencies and CBDCs? In essence, what qualifies a CBDC as currency? A central bank possesses the authority to ensure that a digital currency it issues embodies the three fundamental attributes of money — namely, a CBDC could serve as a universally recognized medium of exchange, a store of value, and a unit of account.
Given its issuance by a central bank, a CBDC would hold legal tender status, thus garnering widespread acceptance as a medium of payment. Furthermore, a CBDC would maintain equivalent value to other monetary forms, as it could be converted into physical cash or electronic deposits of equal worth. Finally, the denomination of CBDC issued by the Reserve Bank would be in Australian dollars, facilitating its use in assessing the value of goods and services.
Surveys conducted by the Bank for International Settlements reveal that central bank digital currencies (CBDCs) are under active research by almost all central banks. However, despite this widespread interest, only a few central banks have issued digital currencies, and as of now, no high-income country has introduced a CBDC. The Reserve Bank remains cautious regarding the potential issuance of a CBDC, primarily because many of the advantages offered by CBDCs are already available through existing technologies. In a speech delivered in 2021, the Head of Payments at the Reserve Bank stated, “Reserve Bank staff have yet to be convinced that a compelling policy case exists in Australia for implementing a CBDC. This skepticism stems from the fact that Australia’s current electronic payments system already furnishes households and businesses with a diverse array of secure, convenient, and cost-effective payment services.”
