The cryptic world of cryptocurrencies

What are they? How do they work? And are they here to stay?

Cryptocurrency fever has gripped the internet again, with the meteoric rise of Dogecoin and a minefield of speculative crypto buying and selling fuelled by Elon Musk’s Twitter account.

For the non-believers, cryptocurrencies like Bitcoin are nothing but a fad, propped up by meme-loving Reddit users and people seeking a quick buck. But for those within the cryptocurrency scene, it’s more than just a fun and lucrative side hustle: it’s the future.

But how does Bitcoin actually work? Is it a good investment? And what on earth is Dogecoin?

What are cryptocurrencies?

Essentially, a cryptocurrency is a digital method of payment that is decentralised. This means transactions are not verified by a central bank or other centralised authority, but by a network of volunteers using cryptography (hence the name).

At the heart of most cryptocurrencies is something called blockchain technology. Blockchain was invented for Bitcoin – the first cryptocurrency – and is essentially a decentralised ledger (a record of information) of all Bitcoin transactions across a peer-to-peer network.

Unlike traditional currency (called ‘fiat’), cryptocurrencies have no central clearing authority and their supply is not determined by a central bank. They also have no intrinsic value, meaning they are not redeemable for another commodity, such as gold, and they have no physical form.

So how do they get their value?

Dr Christoph Breidbach, from the UQ Business School, reminds us that the same question applies to any form of currency.

Dr Christoph Breidbach from the UQ Business School.

“I have a €20 note in my wallet – what is it really? It’s just a piece of paper,” he says.

“Cryptocurrency is just like any money: it’s valuable because we think it’s valuable."

“If I gave you a coin from a Roman Emperor right now, you couldn’t buy a coffee – hence, it is not valuable to you. But 2000 years ago, it was really, really valuable.

“What we really need to ask ourselves is: what is money? It’s socially constructed, an illusion.”

How do you buy something with cryptocurrency?

Let’s say Jo wants to buy a couch from Wei.

In an electronic transaction with fiat currency, like $AUD, Jo would transfer Wei money from her account, and it would arrive in Wei’s account. Behind the scenes, the transaction is verified by Jo’s bank recording the money leaving her account and Wei’s bank recording the money arriving in his.

If Jo wanted to buy the couch with cryptocurrency – say, Bitcoin – the process is a little different. This is where the blockchain comes in.

As Bitcoin is decentralised, there are no banks involved. To verify a Bitcoin transaction, the request from Jo is shared to every computer in the Bitcoin network, which add her request to a shared list of recent transactions known as a block.

To verify the transactions in the block, a group of users in the Bitcoin network join a race to solve a complex mathematical equation with computing technology in what is known as the proof-of-work concept. Whoever solves it first is rewarded with new Bitcoin. This process is known as mining.

Their record of the ‘block’ (which includes Jo’s transaction) then becomes the official record, and it is added to the rest of the blocks to create a chain.

Once it has been verified, the Bitcoin can be sent to Wei, and the transaction is complete.

Because so many different computers are competing to verify the equation (proof-of-work), it makes the Bitcoin blockchain very secure, as rewriting the blockchain would require the attacker to control 51 per cent of the network – something essentially impossible for such a big coin.

Smaller coins, however, have been victim to these attacks.

Dr Christoph Breidbach from UQ’s School of Business

Dr Christoph Breidbach from the UQ Business School.

Dr Christoph Breidbach from the UQ Business School.

The risks to be aware of in cryptocurrency investing

The spectacular growth of cryptocurrencies like Dogecoin can make it tempting to jump on the bandwagon. But, like any investment, it’s important to understand the risks associated with investing in cryptocurrency markets.

According to Head of Currency at Queensland Investment Corporation (QIC) Stuart Simmons, there are several significant deterrents for institutional investors to keep in mind when considering investing in cryptocurrencies like Bitcoin.

“There’s extremely high volatility, which is a massive deterrent, and of course, it’s a speculative instrument,” Simmons says.

“Then there’s the lack of a valuation anchor. So, because you don’t have cashflows and a traditional element of fair value, cryptocurrencies can go to zero; there’s no anchor to gauge whether it’s particularly cheap or expensive, the price simply is what it is.

“There’s also unquantifiable risks associated with it, such as fraud or theft, which is magnified by the lack of regulation and a safety net for these risks.”

Simmons also points to the direct (and very significant) influence powerful investors can have in cryptocurrency markets.

Elon Musk sitting facing towards the right against a black background.

Elon Musk, founder and chief engineer of SpaceX speaks at the 2020 Satellite Conference and Exhibition. (Image credit: Win McNamee/Getty Images)

Elon Musk, founder and chief engineer of SpaceX speaks at the 2020 Satellite Conference and Exhibition. (Image credit: Win McNamee/Getty Images)

“Another big deterrent is the potential for manipulation, where big investors might actively try to influence the direction of the market,” he says.

“An institutional investor doesn’t want to be caught out with their board having bought cryptocurrencies and tried to justify it on the basis of capital growth, and someone’s just put out a tweet so it’s dropped 30 per cent.

“Traditional investments can’t be easily manipulated in this way.”

UQ graduate (Doctor of Philosophy ’13) and Honorary Senior Fellow at UQ’s School of Business, Dr Rand Low, believes in the potential of blockchain technology, but warns individual investors of going all-or-nothing in the crypto markets.

“Cryptocurrency prices are unpredictable and volatile,” he says.

“I would advise against anyone investing a substantial stake of their savings or income in cryptocurrency.

“However, I would encourage people to own some cryptocurrencies to understand the technology and the scale of disruption that can occur if they become adopted as a payment system globally.”

A brief history of cryptocurrencies infographic.
A brief history of cryptocurrencies infographic.
A brief history of cryptocurrencies infographic.
A brief history of cryptocurrencies infographic.
A brief history of cryptocurrencies infographic.
A brief history of cryptocurrencies infographic.
A brief history of cryptocurrencies infographic.
A brief history of cryptocurrencies infographic.

Are cryptocurrencies bad for the environment?

In February 2021, Tesla announced it had purchased US$1.5 billion of Bitcoin, with plans to endorse it as a method of payment by customers.

In May, a Tweet from CEO Elon Musk flipped this decision, announcing Tesla was suspending vehicle purchasing using Bitcoin due to concerns of its snowballing fossil-fuel usage.

So how can an electronic currency be so bad for the environment?

Unlike fiat currency, where money supply is technically infinite and controlled by a central bank, the total supply of Bitcoin is limited to 21 million. As of February 2021, 18.638 million bitcoins had been mined, leaving 2.362 million yet to be introduced.

New bitcoins are introduced into circulation when a block is added to the chain, which occurs every 10 minutes. The first person to solve the equation and add that block is rewarded with newly minted Bitcoin.

However, the number of Bitcoins released with each new block is halved every four years, meaning Bitcoin mining is becoming harder and consuming much more energy.

In 2011, the average laptop could solve equations and mine Bitcoin; today, mining is an operation requiring a warehouse filled with specialised hardware called Application Specific Integrated Circuits (ASIC). From these alone, redundant units contribute 11,500 kilotons of hazardous electronic waste each year (comparable to the annual e-waste of Luxembourg).

In terms of how much energy mining uses, estimates vary wildly between months and even days. The Cambridge Bitcoin Electricity Consumption Index (which Musk referenced in his May tweet) places Bitcoin’s energy consumption at its peak on 13 May as 151.16TWh, which surpasses Egypt's annual energy consumption of 150.579TWh (by 26 May, Bitcoin's estimated annual energy consumption had sunk to 112.57TWh).

A report from Cambridge University found 39 per cent of proof-of-work mining (like Bitcoin) is powered by renewable energy. While this is a positive step forward, it also means 61 per cent is still powered by fossil fuels.

However, not all cryptocurrencies are as energy inefficient as Bitcoin. The ‘proof-of-stake’ protocol, used by DASH for its blockchain and which Ethereum (the second most valuable coin) is moving towards, requires less than one per cent of the energy proof-of-work blockchains like Bitcoin use.

Equipment to mine cryptocurrency with a bitcoin laying against it.

Image: Dr StClaire/Pixabay

Image: Dr StClaire/Pixabay

Are cryptocurrencies mostly used on the black market? Can you buy everyday items with them?

Bitcoin’s drawcards of decentralisation and anonymity have also encouraged the popular narrative that it is used predominantly on the black market.

However, Dr Low says that while Bitcoin may have found initial popularity in the darker parts of the internet, transactions today are largely by traders and not for illicit activity.

“Bitcoin was initially used as a medium of exchange on the Silk Road, which was an online marketplace on the 'dark web', where illicit goods and activities could be traded without government interference,” he says.

“However, there were only around 150,000 buyers and about 4000 vendors with sales of around US$183 million in 2015.

“Today, most Bitcoin transactions are due to cryptocurrency traders as opposed to funding illegal activity or facilitating illicit transactions.”

Image: Dr StClaire/Pixabay

While the use of Bitcoin on dark net markets reached an all-time-high of $601 million in late 2019, it’s also important to note that illicit activity only accounted for one per cent of all Bitcoin transactions at the time.

It’s also not true that you can’t buy everyday items with Bitcoin. While cryptocurrencies are not currently listed as legal tender in Australia (meaning business are not obligated to accept them), some local businesses and global companies like Spotify and Microsoft will accept them.

Queensland even has its own ‘cryptocurrency town’ – Agnes Waters – where more than 30 local businesses now accept cryptocurrency as payment.

Simmons says to keep note of milestones for institutional adoption, which help give credibility to cryptocurrencies as a method of payment.

“A really big inflection point was in October 2020, when PayPal announced they were allowing customers to buy, sell and store cryptocurrencies in a PayPal digital wallet,” he says.

“From there it really ignited because of the prospect of more institutional adoption; it gives it credibility that PayPal is getting involved.

“Since then, we’ve seen MasterCard announce they’re bringing crypto onto their network, and traditional custodians like Standard Chartered, Northern Trust and Bank of New York Mellon have announced they’ll offer crypto custodian services.”

Are cryptocurrencies here to stay?

The highly speculative nature of the cryptocurrency market has led to a comparison to the dot-com bubble and its subsequent bursting in the early 2000s.

“During the early days of the internet, a huge number of internet companies popped up, and they all went public,” Dr Breidbach says.

“There were IPOs from some random company with dot-com in its name, and all of a sudden, they were worth $2 billion overnight without generating any revenue whatsoever.

“That was the dot-com boom, and then we had the crash, where most of those companies all disappeared and ceased to exist."

The crypto bubble has already burst once, in 2018, when the price of Bitcoin fell 60 per cent in February after an all-time high in December 2017. By September 2018, the MVIS CryptoCompare Digital Assets 10 Index was wiped of 80 per cent of its value, making it worse than the dot-com crash in terms of peak-to-trough decline.

A graph of Bitcoin's price hike in late 2017 where it reached a peak of around $70,000. The graph shows the steep decline in Bitcoin's value over the following year to around $20,000. The right axis indicates price, with the bottom axis indicating date.

The 2018 'cryptocurrency crash' as seen in the chart of Bitcoin's price from November 2017–November 2018.

The 2018 'cryptocurrency crash' as seen in the chart of Bitcoin's price from November 2017–November 2018.

But Dr Breidbach is confident that if (or perhaps when) this bubble bursts again, there will be survivors who will redefine the global landscape of payment systems.

“It’s important to remember that we still have Google, Amazon, Microsoft from the dot-com bubble – we are online all the time,” he says.

“In the last 20 years, we’ve seen a fundamental societal shift due to something that was an odd piece of technology 20 years ago, and this is exactly where we are right now with cryptocurrencies, in my personal opinion.

“We are in the dot-com boom of cryptocurrencies – anything that has a funny name like Dogecoin is being purchased by someone."

“Now, how many of those will make it in 20 years? Probably very few. But what will happen is that the concept, the idea of cryptocurrencies, will continue.”

UQ graduate and Managing Director, Global Liquid Strategies at QIC, Susan Buckley (Bachelor of Economics ’85, Master of Business Administration ’10), also sees similarities between the dot-com crash and the current state of the cryptocurrency markets.

“If you actually look back and compare [the current cryptocurrency trend] to the tech crash in 2000, Amazon was one of the companies that almost went under back then, and look at Amazon today,” Buckley says.

“I think this is the early, early stage of a very long cycle in terms of the cryptocurrency space, with Bitcoin and existing cryptos being the first stage of an enduring trend.

“We’ll go through various cycles; we might already be at the pointy end of the first phase, the bubble, with the speculative element that we’re seeing unfold right now with 30 or 40 per cent drops, but there is another chapter.”

Data analysing the price change cryptocurrency.

Data analysing the price change of cryptocurrency. (Image credit: ezstudiophoto/Adobe Stock).

Data analysing the price change of cryptocurrency. (Image credit: ezstudiophoto/Adobe Stock).

Like Dr Breidbach, Simmons believes a burst would likely help shed the unsustainable currencies that have surfaced among all the hype.

“The tech bubble ended up sorting out those who actually could sustain a product or a market – all those trying to get involved but didn't have a product that was sustainable, they got shaken out,” he says.

“In the end, it’s companies like Amazon that survived – but remember, Amazon dropped 95 per cent from its peak in December 1999 in less than two years.

“There are thousands of cryptocurrencies, but thousands aren't going to survive.

“There’s going to be a lot of winners and losers. Probably more losers than winners.”

However, it’s not all about the cryptocurrencies themselves. According to Dr Low, it’s also about the blockchain technology behind it and the potentials of the emerging technology for the future.

“Cryptocurrencies are definitely experiencing a price bubble, similar to Yahoo and Altavista in the 1990s,” Dr Low says.

“However, I am sure we will see Amazon or Google equivalents in the cryptocurrency space in eight to 10 years from now. 

“Blockchain technology does have several interesting and powerful use cases, and I look forward to its widespread use.”

The take-home message? Cryptocurrencies are a highly volatile investment, so probably don’t try and double your house deposit by putting it all in Dogecoin.

However, behind the funny names and unpredictable market swings, a fascinating new technology is emerging. We’ll just have to wait and see where it leads.

What do you think of cryptocurrencies? Would you invest?

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