What are cryptocurrencies?
A cryptocurrency is a form of digital currency. “It is a collection of binary data which is designed to be anonymous and secure. Cryptocurrency works on the model of Cryptography wherein data is converted into codes,” explains Gaurav Dahake, CEO & Founder, Bitbns, a leading cryptocurrency exchange in India.
The virtual currency is designed to work as a medium of exchange using cryptography to secure the transactions and to control the creation of additional units of currency. These are decentralised in nature, which means that no single entity owns or controls them. Moreover it does not rely on central banks, and is a collection of data, overall designed to work as a medium of exchange, using its underlying technology, the blockchain.
“It is a peer-to-peer system that allows anyone to make and receive payments from anywhere. Cryptocurrency payments exist solely as digital entries to an online database identifying specific transactions, rather than as tangible money carried around and exchanged in the real world. The transactions that you make with cryptocurrency funds are recorded in a public ledger. Digital wallets are used to store cryptocurrency,” said Kshitij Purohit, Lead Currency & Commodities at CapitalVia Global Research.
How big is the crypto market?
By 2025, the global cryptocurrency market is expected to be worth $2.73 billion. According to an HDFC report, there are currently over 8,500 cryptocurrencies in the world and increasing with market capitalisation of over $2 trillion. “This is equal to 18% of total gold holding globally.”
“The reason for the explosion of cryptocurrency is because it has a fairly low barrier to entry — when something is free and decentralized, it’s easy to replicate and copy,” says Vinay K Mayer, Marketing Research & Consulting @ Asia Research Partners LLP.
An interesting fact: The first commercial bitcoin transaction was to buy 2 pizza for 10,000 bitcoin in 2010. Today the same is worth $400 million!
There are two types of crypto assets – coins and tokens. Coins have their own blockchain network while tokens are part of projects built on top of existing blockchains.
Share in market capitalsation
The market capitalisation of the world’s top 5 crypto assets accounts for 70% of outstanding market capitalisation.
Ownership of Bitcoin and other major coins like Litecoin, Ethereum, etc. is concentrated as 2-3% of investors hold 90-95% of outstanding coins by value.
How is a crypto transaction done?
“When a person buys a cryptocurrency, the transaction is recorded on a distributed ledger known as the blockchain. However, the process is only complete when a miner confirms that the transaction is valid. After that, the transaction is permanently recorded in the blockchain for all to see, and the transaction is complete,” said Purohit.
What is the technology behind cryptos?
The technology behind cryptos is blockchain. In a blockchain network, the ledger – collection of transaction records – is distributed. On initiation of transfer request (e.g.: transfer of a bitcoin), a new block with the transaction details (e.g.: payer and payee details, transaction amount, account balance etc.) is created and broadcast to all the network participants.
How does it work?
Participants, by majority, verify the block against the ledger and approve or reject it
Distributed ledgers are then updated with the new transaction and the transaction is completed
“Blockchain technology is used to create most cryptocurrencies. The method transactions are recorded, and time stamped in is described by blockchain. A two-factor authentication method is also required for transactions. To begin a transaction, for example, you may be requested to enter a username and password. You may next be required to input an authentication code sent to your personal cell phone through text message,” explains Purohit.
How is it mined?
Cryptocurrency mining is the process of bringing new crypto coins into circulation by solving complex mathematical equations. Miners race against each other using powerful computers to solve the cryptographic problems.
“It is called mining because once these problems are solved, new coins enter into circulation. Miners are paid a fraction of the transaction fee for their effort,” said Patel.
Each time a user solves one of the problems they are rewarded with a coin. These coins are then stored in a digital wallet on their computer so that they can spend or trade the currency any time they like. The value of cryptocurrency is determined by supply and demand as indicated by what people are willing to pay and sell it for. If more people are buying cryptocurrency then it will go up in value, however if more people wish to sell it off than buy it that way then its monetary value will drop until things equal out again. The price is set by the market rather than being managed directly from an exchange meaning that you can instantly check the market yourself anywhere you like since there is less chance of manipulation occurring, explains Mayer.
Lot of energy is wasted in mining
Some Cryptocurrencies like GRIN, ZCash, Monero, Etc are easy to mine, while the likes of Bitcoin requires a lot of energy and effort. “0.20% of all of the world’s electricity goes to powering Bitcoin farms. Do you know that many Bitcoin miners end up using 60% to 80% of what they earn from mining to cover electricity costs,” says Siddharth Jaiswal Founder and Chief Executive Officer, SportZchain.
Estimates suggest one bitcoin transfer has a carbon footprint equivalent to 2.02m Visa transactions or 152,000 hours of watching YouTube.
What is cryptocurrency used for?
Currently, the main purpose of cryptocurrency is for it to used as an asset, like stocks or precious metals. Currently, Bitcoin is one of the most lucrative investment options. “Its value appreciation is identified as supremely dynamic and can prove to be an excellent avenue for capital expansion. However, one should be mindful while investing in cryptocurrency because of its volatile nature,” cautions Dahake.
Apart from being an asset, cryptos can also be used to buy regular goods and services. Several restaurants, flights, and apps accept it as a viable payment medium. “Currently people are using crypto projects for Minting NFTs (non fungible tokens). It is also being used in DeFi (decentralized finance) basically a bank which gives loan, insurance and other banking related tasks in a decentralized peer to peer lending system,” says Varun Mayya, Founder and CEO, Scenes by Avalon.
“In a few countries, cryptocurrencies are legal, and users can buy and sell them on exchanges where their company accepts them as payment for services. In countries where cryptocurrencies are illegal, they are also used for funding terrorism, money laundering, and more. Many countries have banned bitcoins and similar currencies due to their use in black market transactions,” says Mayer.
The higher volatility in prices compared to a traditional currency makes it less likely to be used as a “store of value”. “Bitcoin is 10X more volatile compared to major currencies and hence it is becoming a speculative asset class with increasing interest from people,” according to HDFC.
Where does crypto derive its value from?
Crypto assets, just like Gold, have value because “people believe they do” and there is no scientific or logical valuation model / method to determine fair value of any crypto asset, noted HDFC.
How can we securely use cryptocurrencies?
As the value of cryptocurrency rises, so do the target for hackers. In fact, in 2021 cryptocurrency-based crime hit an new all-time high in 2021, with illicit addresses receiving $14 billion over the course of the year in digital currencies, up 79% from $7.8 billion in 2020 largely due to the rise of decentralized finance (DeFi) platforms, according to blockchain analysis firm Chainalysis.
“The most important aspect in cryptocurrency is to have control of your wallet. Now each wallet comes with your own private key (or password) which cannot be shared anywhere. Keeping a physical copy of your secret key usually works best as keeping it online you may risk the chance of getting hacked,” says Mayya. Some examples of a secure and authentic wallet include Binance, Coinbase and WazirX.
“Do not share your user ID and password with anyone. For Crypto-currency users, it is very important to have a crypto-hardware wallet, which is a physical medium through which users can transfer their coins from the online wallets to the hardware wallet. That said, due to the rise of cryptocurrency prices and classification as an intangible asset, it is generally recommended to transfer them into offline storage (e.g. encrypted paper/hard drive) after purchase as opposed to keeping them on the exchange itself,” said Mayer.
How can we ensure we don’t get scammed?
Due to lack of sufficient information, steep growth in the value of crypto and people’s eagerness to make a quick buck, hackers and scamsters are using every possible medium to bait new investors. These include online dating portals, video streaming sites such as YouTube and various whatsapp messages too. Some fishers are using virtual Ponzi schemes and Cryptocurrency criminals promote non-existent opportunities to invest in digital currencies and create the illusion of huge returns.
“Think of the way you use your bank account while doing any transaction online. We follow certain steps so that our account details do not get compromised. We need to follow the same level of caution to prevent getting scammed while doing any cryptocurrency transaction. We need to have strong passwords and should never click on any suspicious link,” said Patel.
Jasiwal offers some insightful tips to ensure security with crypto investments:
•Refrain from taking any information at face value. Investigate the claims being made around any investment, especially if they seem too good to be true or promise overnight windfalls.
• Enable two-factor authentication whenever possible on whatever kind of crypto wallet and exchange you use
•Double and triple-check the website URLs. Scammers attempting a phishing scam will copy the URL of legitimate sites and swap letters and numbers
•There are investment and business opportunity scams prevalent as well. Sometimes this scam takes the form of “investment managers” who offer to help grow your assets. They will set up in what they will claim as an investment account for your crypto, but you won’t be able to access your money unless you pay them a fee.
• A scam company will launch a new cryptocurrency coin or token, claiming it solves some critical unmet need in the market. They will pitch you on their product and ask you to buy into their coin as an investment that will pay off a hundredfold later on, then vanish. The best example here is the “Squid Game” based coin.
Bitbns’ Dahake says users should never share login credentials with anyone or fall prey to any promise of big returns, including crypto exchanges. “Check the security feature offered by the exchanges before choosing any platform for investment.”
Why are governments and banks so hesitant in adopting cryptocurrencies?
In India, the central government and the Reserve Bank of India are yet to regulate cryptocurrencies. There is debate about whether they should be classified as a commodity or a virtual money. For the RBI, cryptocurrency is a threat to the rupee. Moreover investors in cryptos are vulnerable to hacking, scams, and losses due to sheer volatility. There are risks to relevance of monetary policy and its impact on economy if unregulated monetary instruments like crypto currencies gain scale in adoption.
Increasing popularity and participation in crypto assets poses risk to financial stability, if prices of such assets collapses. ” Unanticipated shifts in market sentiment can result in price swings that are both strong and rapid. It is not unusual for the value of cryptocurrencies to collapse by hundreds, if not thousands, of dollars in a matter of seconds,” said Purohit.
Moreover, lack of strong regulations around KYC, make crypto assets a preferred payment instrument for illegal and criminal activities. The Reserve Bank of India is worried that it can be used for criminal activity or money laundering since it is relatively difficult to trace and seize.
What’s my personal risk?
Significant fluctuation in prices can happen as seen in the past
” It is extremely difficult to predict the future performance of cryptos. Many of the cryptos that were among the top 20 by the beginning of 2021 are no longer in the top 100,” says Patel.
“Cryptocurrencies have caught the fancy of young investors. While some may have benefited from its meteoric rise, others have had to bear deep losses as cryptocurrencies are highly volatile and poorly understood,” says Archit Gupta, Founder and CEO – Clear(formerly Cleartax).
Susceptible to hacking / cyber theft and retrieving the same is nearly impossible
“In the traditional banking system, if something goes wrong like say you transferred money to the wrong account, the money is refunded back to you through customer care. In crypto, there is no customer care, and if you transfer the money to the wrong address you will never get your funds back. Another key risk is your wallet. It is almost impossible for someone to hack your bank account and deplete all the funds, we have safety measures like OTP and username password. But in crypto we have seen that if you lose your wallet key, you will lose all your funds and there is again no chance of recovery, warns Mayya.
Operating in the grey area
Crypto assets currently operate in a grey area in India. The absence of regulation creates uncertainty for industry players, opening them up to unforeseen liability with enforcement authorities.
“In India, crypto exchanges such as WazirX have received notices from the Enforcement Directorate, the nodal law enforcement authority for financial crime in the country, for violations of the Foreign Exchange Management Act, 1999 (FEMA).In the absence of any clarifications issued regarding how FEMA or any other law may touch upon the business of crypto asset services, it is difficult for these businesses to navigate such frameworks autonomously” argue Meghna Bal and Shweta Venkatesan in a report titled ‘Regulating Crypto Assets in India’ for the Observer Research Foundation.