The Benefits and Challenges of Cryptocurrencies

Before diving into the characteristics, benefits, challenges, and applications of cryptocurrencies, you need to understand what a cryptocurrency actually is, and how blockchain works. When I use terms like “distributed ledger” or “proof of work,” you should know what they mean. For those of you needing to get up to date, I suggest the following video, https://www.youtube.com/watch?v=bBC-nXj3Ng4, which does an excellent job of explaining how cryptocurrencies work at a level anyone can understand. For those who already have a basic understanding of the technology and want to understand it at a higher level, I suggest the following article: http://www.michaelnielsen.org/ddi/how-the-bitcoin-protocol-actually-works/.

 

With that out of the way, let’s begin with why cryptocurrencies are so exciting for many people. Cryptocurrencies present both an investment opportunity–one which many prominent figures are skeptical of, including Warren Buffett, Bill Gates, and Nobel-Prize winning economist Robert Shiller–and a new method for making payments. We will mostly be focusing on the challenges and benefits of using cryptocurrencies as a novel payment method; it is difficult to evaluate as an investment due to its extreme volatility.

 

The following content pulls a lot of information from the excellent article by Jerry Brito and Andrea Castillo titled Bitcoin: A Primer for Policymakers. They go into more detail about the benefits and challenges of bitcoin, as well as legal implications. Highly recommended for additional reading. The article can be found here: https://www.mercatus.org/system/files/Brito_BitcoinPrimer.pdf

 

• Benefits: why use cryptocurrency instead of cash?
  • Reduced transaction costs: Cryptocurrencies like Bitcoin require no third-party intermediary to conduct transactions, therefore transactions are substantially cheaper and quicker. This seemingly small difference has substantial implications for cryptocurrencies.
    • It makes cryptocurrencies more attractive to small businesses, cutting the costs of authorization fees, transaction fees, statement fees, interchange fees, and customer-service fees, among other charges made to credit card companies.
    • Cryptocurrencies present a method of achieving low-cost remittances. In 2012, $401 billion in remittances were wire transferred from immigrants in developed countries to their relatives living in less developed countries. These transfers may take several days to process and are traditionally done by companies charging steep fees, such as Western Union. In 2013, the global average remittance fee was 9.05%, compared to the 1% transaction fee of bitcoin transactions.
  • Combating poverty: Because of the expenses of supplying traditional financial services to poor rural areas in less developed countries, many are turning to mobile banking services for their financial needs. The low transaction costs associated with cryptocurrencies present an opportunity in developing countries, allowing the world’s poorest to access financial services inexpensively. Several companies are already implementing mobile financial services in poverty-stricken nations using blockchain technology, such as Mojaloop. Additionally, because cryptocurrencies are often capped (e.g. the number of bitcoins that can be mined has a limit so no more than 21 million bitcoins can ever exist), they represent an alternative currency for people to use in countries with devalued or frozen capital markets. As an example of this, Argentina’s inflation crisis has caused bitcoin use in the country to surge.
  • Privacy: The privacy and anonymity aspect of cryptocurrencies is a double-edged sword. People who require financial privacy, such as spouses fleeing abusive partners or people seeking controversial health services, may need a way to spend money discreetly. On the flipside, criminals also value the anonymity offered by cryptocurrencies, making them an increasingly popular platform for money laundering, trafficking of illegal goods, and terrorism financing.
  • No intermediary: Cryptocurrencies do not require a central intermediary–like a bank–to act as a trusted service provider to facilitate exchanges. Because of this, cryptocurrencies can be used by producers to make sales directly to consumers. For example, a homeowner could make their utility payments directly to the suppliers, without the need for a financial intermediary.

 

• Challenges: why use cash instead of cryptocurrency?
  • Volatility: The volatility of bitcoin is well documented. The fluctuating value of cryptocurrencies is a concern, especially in cases where they are used only as stores of value. When used as a unit-of-exchange, however, fluctuating prices are less of an issue as merchants can price their products based on traditional currencies and accept cryptocurrencies at the going exchange rate. Customers using bitcoins as a medium-of-exchange do not care about its value, they are simply buying and using the currency to make a one-time purchase and take advantage of the reduced transaction fees. It is a real possibility that cryptocurrency values will become stable as mechanisms to counteract volatility are introduced and once the current stress-testing period is over.
  • Security breaches: Because cryptocurrencies are digital, there is a potential for digital attacks on the currencies, most notably a 51% attack: when a user has a majority stake in the computing power for mining a cryptocurrency and can therefore manipulate blocks in the blockchain. This is an unlikely and difficult-to-achieve occurrence, but it has occurred in the past with several cryptocurrencies. Additionally, advanced digital criminals are finding clever ways to access a person’s cryptocurrency wallet and stealing funds out of those wallets.
  • Criminal uses: The anonymity offered by the digital marketplace and pseudonymity offered by cryptocurrencies makes them a breeding ground for criminal activities such as illicit trading, money laundering, and terrorist funding. These activities are commonly done using an anonymizing software called Tor, and access to the dark web, which is far less regulated than the surface-level internet most people use. This presents a significant challenge to policymakers, who seek to regulate illicit activity without compromising the benefits of cryptocurrency for legitimate users.
  • Regulation: How does one regulate a decentralized system that was built with the purpose of being resistant to regulation? The birth of bitcoin and other digital currencies has led to many legal questions, such as whether private currency is legal, how money-transmission laws apply to cryptocurrency (money transmitters are subject to state and federal laws in the USA), and how to crack down on darknet markets, such as the infamous Silk Road, which was a darknet market for illicit drug trade. Many of these regulatory and legal issues present significant challenges for cryptocurrencies, which are currently seen as a safe haven for illegal exchanges.