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When people became civilized and there was a division of labor, people began to exchange the goods they produced for the goods they needed in the system of barter. However, an exchange system is the most inefficient as it requires negotiation for every trade made. After that, empires began issuing some type of currency in the form of seals, coins, etc. These were tied to a certain value and were valued at their established “face value” as they had the support of the ruler.
Precious metals, especially gold, later became the preferred mode of transaction. However, because of the weight of gold, gold-backed receipts became popular where the people who held the gold would issue those receipts and anyone who had a receipt could go to the issuer and request physical gold by submitting the receipt. This has been called the “gold standard”.
After the Second World War, 44 countries formed an international currency exchange system in which each currency was pegged to the US dollar, which in turn was pegged to the global gold reserves. However, that system collapsed in 1971 and since then countries have been free to conduct their own monetary policies and their currencies devalue and devalue against other international currencies based on that country’s policies.
Currency has two roles to play. First, it’s a store of value (which was even more evident when it was a gold standard) and, second, it’s a medium of exchange. It stores value for the person who owns it and acts as a medium of exchange when a transaction is made with it.
What is changing with cryptocurrencies
So what’s different with cryptocurrencies and why is there such a hype about the same thing. First, there is absolutely no connection between the created cryptocurrencies and gold or any other asset. Even if the banknotes may not be backed 1: 1 with gold today, there are indeed gold reserves and the cover is provided by the government through the central bank. In the case of crypto, there is no asset correlation or government to support it.
The “store of value” function was artificially determined by listing these currencies on stock exchanges. The fact that someone is willing to buy the currency at a certain price was the basis for the currency’s valuation. However, is there anyone willing to buy the entire range for this price, or just a few pieces? As we have seen in the stock markets, most of the times the stock price does not accurately reflect the fundamental value of the company.
What we have is just supply and demand, and that is what determines the price today. The offer is created through a complex process of mining coins. The process was controlled by a system of checks and balances, but for most of us this is a mystery. Hypothetically, it is possible that the process will get a lot easier, or a lot more people will start mining and suddenly the supply will go up. That would lead to a drop in prices.
Now we have a store of value that is outside of the regulated and government-set system. If this were to gain popularity, the government would eventually lose control of the monetary system as the amount and supply of crypto would play a crucial role in the financial system and the exchange rate. It is therefore not surprising that governments are cautious about this system. Cryptocurrencies are so widespread that governments are not banning them out of hand, but they must control them in order to continue to dominate the financial system.
In the other role as a medium of exchange, the unregulated character of cryptocurrencies means that they can be transferred from one person to another without data and MIS being made available to the authorities. This is a major concern as it is believed that cryptocurrencies have become a dominant medium for illegal or prohibited transactions. It is therefore of the utmost importance that the government work together to find a way to get a grip on all cryptocurrencies and their movements immediately.
As a crypto investor, you only see the tip of the iceberg. No information is available about the current and future provision of the currency. The rise in prices has always attracted more people and it is now fashionable to talk about and own cryptocurrencies, but we saw similar trends at the height of the stock market bull runs. People paint the most optimistic pictures and drive prices up until one day the markets collapse.
One could conclude from this that investments in cryptocurrencies are speculative in nature. They just hope the price will go up without having a basis for it.
(Pankaj Chopra is the founder of Five Rivers Portfolio Managers)
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