A spectre is haunting global capitalism: the spectre of cryptocurrencies. Three distinct forces of our modern age have come together to breathe life into this strange and wondrous monetary artifice. One, the rise of computational power that allows algorithms to programmatically issue currencies; two, a distrust towards governments that can idiosyncratically debase currency or even demonetise at will; and three, a scarcity of safe assets to store wealth over the long term. The birth of the first cryptocurrency — bitcoin — was announced to the world in 2008 by still unidentified inventor(s) who goes by the name ‘Satoshi Nakamoto’.
If you have never heard of bitcoin or cryptocurrencies, one way to think of it is as tokens sold by temples — for special rituals or prasadam — in exchange for cash. These temple tokens, typically, can only be used within the premises. They are often exchangeable between individuals without the permission of any supervening authority. And if you lose the token or forget to use it, it is as good as losing money. This analogy is useful, but it can only go so far. Unlike tokens in a temple which are controlled by authorities, cryptocurrencies are generated by a network of computers that run a software called ‘blockchain’.
Most networks — be it, businesses or families — rely on trust to build consensus. What happens to consensus formation if there is no trust in families or businesses?
A network that uses ‘blockchain’ transcends this requirement of trust among members to form consensus. It is does this by relying on two fundamental ideas: the near-impossibility of reverse engineering a mathematical algorithm (‘SHA-256 hash function’) and human self-interest. In a blockchain (think of units of information arranged as separate blocks which are concatenated to form a chain), when a new piece of information arrives, it is appended to a previous block to create a new block. This new block is arranged in a specific architecture (‘the Merkle tree’) and the ‘header’ of this new block is passed through the hash function. This function spits out transformed output. We check if this output has specific preset properties. If not, then the block header is incremented by a random number (‘nonce’) and this new set is passed through the hash function again.
Finally, after many trials, when we find the appropriate nonce, the ‘miner’ announces this random number to the rest of his peers in the Bitcoin network. They check using this nonce if adding this information produces an output with specific properties, including an untampered old block. If verified, then this new block is deemed valid. The new public ledger with updated information is now deemed as the new consensus. Thus we have a cleverly-engineered consensus via a system that doesn’t rely on trust but rather on a ‘proof of work’.
Known unknowns
A natural question: why would anyone bother to mine for this random number? This is the part of the system that relies on human self-interest. For every verified number that is ‘mined’, the Bitcoin network allocates 12.5 bitcoins [~ $30,000] to the miner. When more people (as of 2015, nearly 1,00,000 merchants) accept bitcoin or other cryptocurrencies for goods and services, their value increases.
The real, and perhaps unanswerable, question is what is their true value— i.e. how many rupees is any given cryptocurrency worth? The real answer is: no one knows. Unlike fiat currencies, whose long-term relative values are driven by differentials in purchasing power, we do not have a good understanding of what determines the long-term relative value of these cryptocurrencies. But this has not stopped investors from betting on the increased acceptance of various versions of blockchain technology and its currency units.
Since 2014, the American tax authorities have treated cryptocurrencies as ‘property’ subject to appropriate capital gains tax rate. On April 1 this year, Japan deemed bitcoin as a legitimate payment method; on July 1, Australia will follow suit. Chinese authorities have aggressively stepped in, when needed, to ensure cryptocurrency exchanges function well.
However, over the past seven years, successive Indian governments have ignored cryptocurrencies. Finally, on April 12 this year, the Indian government constituted an inter-disciplinary committee to study regulatory frameworks for cryptocurrencies. It has sought public comments. However, prominent voices like the BJP parliamentarian Kirit Somaiyya have called for an outright ban citing some understandable (what happens to the monopoly of rupee in India as medium of exchange?) and many absurd fears (drugs, money laundering, Ponzi schemes).
What the Indian government ought to do instead is follow, learn, and innovate based on what China, South Korea, and Japan have done: enshrine minimum capital requirements, force segregation of customer accounts, and make potential criminal activity difficult. The Indian state can either help structure the growth of cryptocurrencies or drive the whole enterprise underground beyond its control. As a wise Finance Minister, quoting Victor Hugo, said during his 1991 budget speech: “no power on earth can stop an idea whose time has come”.
Keerthik Sasidharan is a writer and is on Twitter @KS1729
