What Are Cryptocurrencies like Bitcoin, Ethereum and Ripple?
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Bibliographic details
- Authors: VIKRAM HAKSAR, ANTOINE BOUVERET
- Published: June 1, 2018
Summary overview
- Cryptocurrencies and their underlying technologies offer benefits but also carry risks.
- Distributed ledger technology could reduce the cost of international transfers and foster financial inclusion.
- The first cryptocurrency, Bitcoin, was introduced in 2009 by a programmer (or group of programmers) using the pseudonym Satoshi Nakamoto.
- As of April 2018, there were more than 1,500 cryptocurrencies, according to coinmarketcap.com; along with Bitcoin, Ether and Ripple are the most widely used.
Uses of money (context for cryptocurrencies)
- Money serves as:
- a store of value,
- a means of exchange for goods and services,
- a unit of account that measures value.
- Historical evolution:
- Commodity monies (seashells, copper, silver, gold) preceded fiat money.
- Paper fiat money appeared in eighth century China under the Tang dynasty.
- Modern central banks seek to maintain price stability by regulating the supply of money on behalf of governments.
Bookkeeping and ledgers (centralized model)
- Financial systems required trusted intermediaries and credible accounting systems; double-entry bookkeeping was a major innovation.
- Central banks validate transactions among financial institutions in a central ledger.
- Example transaction flow in the centralized model:
- Bank A debits Mehrnaz’s account.
- The central bank moves money from bank A to bank B and records the transaction in its central ledger.
- Bank B credits Mary’s account.
- The system is based on trust in the central bank and its ability to safeguard the integrity of the central ledger and prevent double spending.
Distributed ledgers and cryptocurrency mechanics
- Many cryptocurrencies rely on distributed ledger technology, such as blockchain, maintained across a network rather than by a central agent.
- Double-spend prevention: each member of the network verifies and validates transactions using computing and cryptography; a decentralized consensus is required before a transaction is added to the ledger.
- The ledger provides a complete, permanent transaction history that cannot be manipulated by a single entity.
- Network validators (miners) are usually rewarded with newly minted cryptocurrency.
- Pseudo-anonymity: holders have two keys:
- a public key (like an account number),
- a private key required to complete a transaction.
- Transaction example in the distributed model:
- Mehrnaz (public key ABC) initiates a transfer to Mary (public key XYZ) using her private key.
- Network members verify ABC has the funds by solving a cryptography puzzle.
- Once validated, a new block is added to the blockchain and the transfer from ABC’s wallet to XYZ’s wallet is recorded.
Benefits and risks
- Limitations relative to basic functions of money:
- High price volatility limits use as a store of value and unit of account.
- Limited acceptance for payment restricts use as a medium of exchange.
- High production cost for many cryptocurrencies reflects the large amount of energy needed to power computers that solve cryptographic puzzles.
- Decentralized issuance means no entity backs the asset; acceptance depends entirely on users’ trust.
- Potential benefits:
- Distributed ledger technology could reduce the cost of international transfers, including remittances.
- Some payment services now make overseas transfers in a matter of hours, not days.
- The technology can be used to securely store important records, such as medical histories and land deeds.
- Potential to foster financial inclusion.
- Potential risks:
- Pseudo-anonymity makes cryptocurrencies vulnerable to use in money laundering and terrorism financing if no intermediary checks transaction integrity or identity.
- Cryptocurrencies could eventually present challenges for central banks if they affect control over the money supply and the conduct of monetary policy.
What Are Cryptocurrencies? VIKRAM HAKSAR, ANTOINE BOUVERET, June 2018, F&D Magazine (IMF)
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