Current Issues in the Cryptocurrency Market
The majority of Americans don’t trust the safety and reliability of cryptocurrencies, according to a 2023 Pew Research Foundation study. Even for crypto-enthusiasts, there are multiple factors that might be keeping them awake at night.
Volatility and the Crypto Crash
Many crypto tokens are volatile and vulnerable to scams, but even those advertised as stable and supposedly backed by assets to ensure their value have collapsed.
In May 2022, the digital stablecoin TerraUSD and the algorithmic stablecoin tied to it, LUNA, crashed, tanking the crypto market and causing investors to lose more than $400 billion. Then, in November of the same year, crypto exchange FTX crashed due to insufficient liquidity, mismanagement of funds, and excessive withdrawals from unnerved investors—depressing the value of its token, FTT, as well as those of numerous other cryptocurrencies, including Bitcoin and Ethereum.
Other major exchanges have also been affected by the fall of FTX: BlockFi froze withdrawals, as did Gemini’s third-party lending partner, Genesis Global Capital. Crypto.com also froze withdrawals of the stablecoins USDC and Tether (USDT), the values of which are based on the US dollar. Coinbase laid off almost 1,000 employees in connection with the fallout from the crash.
The crypto crash also brought down the NFT market. The most popular NFTs, like Bored Ape Yacht Club and CryptoPunks, saw their prices slashed by more than half in August 2022. While the collapse paralleled a decrease in cryptocurrency prices, other factors like high-profile scams and market oversaturation also played a significant role.
Well before these nosedives, the crypto market had already crashed several times, including in 2021, 2020, 2018, 2013, and earlier, largely due to investor speculation and media hype. While this demonstrates that instability is endemic to crypto, it also shows that the technology and currencies are resilient.
Criminality and Deception
In 2022 alone, some of the most revered players responsible for keeping digital currencies functioning have been charged with crimes such as fraud—including Sam Bankman-Fried of FTX; Do Kwon, head of Terraform Labs, the parent company of TerraUSD and LUNA; and Su Zhu and Kyle Davies of Three Arrows Capital.
Also in 2022, criminals generated 117,000 scam tokens, robbing investors of billions of dollars. Many initial coin offerings (ICOs) are also suspect, particularly for cryptocurrencies with speculative business models, and have been widely criticized as scams as well.
The pseudonymous and unregulated nature of blockchain and Bitcoin transactions also raises concerns when transactions need to be disputed. In a typical centralized transaction, if the good or service is defective, the transaction can be canceled and funds returned to the buyer. However, there is no central organization in the cryptocurrency ecosystem to facilitate recourse against the seller.
Security and Privacy Concerns
While the blockchain itself is extremely difficult to hack, the same can’t be said for the exchanges where cryptocurrency is traded. Computer hacking and theft have plagued the market for nearly a decade. The first major exchange hack took place in 2015, when hackers made off with up to 850,000 Bitcoin from the Tokyo-based Mt. Gox. In November 2022, when FTX declared bankruptcy, criminals hacked the exchange and made off with $600 million. The previous month, hackers stole $570 million from Binance. Other attacks occurred in 2021 and early 2022, with combined stolen funds totaling more than$1 billion.
The code that powers smart contracts can also be hacked. In one of the “largest digital heists in history,” a hacker stole $613 million from Poly Network in 2021. This decentralized finance (DeFi) platform enabled peer-to-peer (P2P) transactions—that is, direct exchanges of tokens across blockchains. The theft was possible because of a vulnerability in the smart contract that automated the transfer of tokens. Even though the hacker returned the money after a few days, claiming he just wanted to “expose the vulnerability,” the incident highlighted the significant risks that these platforms and their users face.
Also widespread are ransomware attacks in which hackers infiltrate users’ accounts, encrypt their targets’ personal information to make it inaccessible, and extort them by demanding payment in crypto.
Environmental Impact
Coins that verify consensus through proof-of-work, such as Bitcoin, use enormous amounts of energy. Proof-of-stake tokens, like Ethereum after its 2022 transition, consume much less. Ethereum says it uses 99.9% less energy than before, while Cambridge University’s Centre for Alternative Finance says that comparing Ethereum’s pre- and post-merge energy usage is like comparing the London Eye observation wheel to a raspberry.
According to a US government fact sheet, as of August 2022, crypto is believed to consume between 120 and 240 billion kilowatt-hours per year—more than the annual electricity usage of some countries. While it doesn’t top the list, it’s one of the contributors to global climate change.
Additionally, crypto mining has caused problems with the power grids of multiple nations, including Iran and Kosovo, leading to significant electricity outages.
Responsibility, Regulation, and Oversight
Because cryptocurrency technology transcends political boundaries, national regulators’ influence is limited. Global regulators Financial Stability Board and the International Monetary Fund have joined forces to create a consistent global framework for regulation, with new rules expected by September 2023.
Many individual countries have decided not to wait, however. Due to concerns about the environment and/or crime, a handful of nations—including China, Egypt, Iraq, Morocco, Algeria, and Tunisia—have forbidden the issuance or holding of the tokens, while 42 more have implemented restrictions that prohibit crypto exchanges or impose limitations on how banks can engage with the currencies. Yet other countries have tried to entice companies to create markets for these assets.
Japan, Switzerland, and the United Arab Emirates have changed laws or introduced new ones between September 2022 and January 2023. PwC has called the Swiss framework one of the most mature to date and reported that the UAE has created the first authority in the world solely dedicated to virtual currencies. Other nations, like Canada, the UK, and Australia, are still drafting legislation, with the EU close to enacting these regulations.
In the US, Congress has begun monitoring cryptocurrency more closely in recent years, and events like the fall of FTX will likely trigger additional scrutiny.
However, since cryptocurrencies were conceived specifically to avoid governmental controls, it’s uncertain whether regulation efforts will be successful.
Why Do Investors Choose Cryptocurrency?
While the concerns around cryptocurrency are many, it still holds a lot of appeal for certain investors for a number of reasons. Many are attracted to the speculative element inherent in crypto’s shifting prices, which entices investors looking to profit from market value changes.
Other investors like cryptocurrencies for the unique qualities they offer, such as decentralization, security, and anonymity, that traditional currencies do not provide. These perceived advantages are largely theoretical at the moment, but crypto enthusiasts believe faster and cheaper transactions, improved security and privacy, and greater financial inclusion are coming, and will bring more mainstream adoption.
Protection Against Political Crises
Many invest in cryptocurrencies as a geopolitical hedge. During times of political uncertainty, the prices of these currencies tend to increase. As political and economic uncertainty in Brazil grew in 2015, for example, Bitcoin exchange trade increased by 322% while wallet adoption expanded by 461%. Bitcoin prices have also increased in response to destabilizing political events such as Brexit.
Pseudonymity (Near Anonymity)
A common misconception is that cryptocurrencies guarantee entirely anonymous transactions. They don’t. Instead, they offer pseudonymity, a near-anonymous state allowing consumers to complete purchases without providing personal information to merchants. However, these transactions may still be subject to anti-money laundering (AML) regulations and the trading platform may require customers to provide proof of identity such as a legal form of ID (referred to as “know your customer” or KYC). AML and KYC information could be used by law enforcement to trace transactions back to a person or entity.
Programmable “Smart” Capabilities
Smart capabilities are features that provide some level of programmability or advanced functionality within a blockchain or cryptocurrency protocol. Certain cryptocurrencies can provide other benefits to holders, including limited ownership and “stockholder” voting rights in their software code.
One well-known example is non-fungible tokens (NFTs). These digital assets represent ownership of a specific item or piece of digital content, such as artwork, collectibles, or virtual real estate, using blockchain technology for authentication and provenance. Digital tokens could also include fractional ownership interests in physical assets like art or real estate.
There are also mechanisms to lock out a transaction or an account until a predetermined time is reached or condition is met. Some cryptocurrencies implement advanced “smart” privacy features like stealth addresses, ring signatures, or zero-knowledge proofs. These allow users to transact privately by obscuring transaction details, such as the sender, recipient, and amount.
But the most popular applications of this feature are smart contracts, self-executing agreements with the contract terms written into the code. These contracts automatically enforce the conditions specified in the agreement without the need for intermediaries.
Take, for example, supply chain management. Let’s say a clothing company enters into a smart contract with its cotton supplier that stipulates the quality, quantity, and delivery date of the cotton, as well as the agreed-upon price. Once the supplier fulfills these conditions, the smart contract automatically releases the payment to the supplier without the need for manual intervention or third-party verification. Next, the cotton is sent to the factory, and the smart contract records the receipt of the raw materials. As manufacturing begins, the smart contract logs each production stage, such as dyeing, weaving, and cutting. This provides an accurate and tamper-proof record of the entire manufacturing process, ensuring traceability and quality control.
Peer-to-Peer Purchasing
One of the most significant benefits of cryptocurrencies is that they allow P2P. P2P transactions reduce the risk of hacking or regulatory shutdowns that impact trades on centralized exchanges because they don’t collect user and transaction information or require users to hold their cryptocurrency in the exchange’s proprietary wallet. As long as the users keep their information secure, P2P transactions offer greater privacy, lower fees, and a wider range of payment methods than conventional transactions funneled through centralized authorities.
What to Know Before Investing in Cryptocurrency
Cryptocurrency can be difficult to understand, because it’s not simply digital money. This can leave investors open to a number of risks, as many NFT owners learned the hard way in 2021 when they saw how little control they retained over the use of the art they had purchased. So it’s important to fully understand what you’re buying if you want to avoid any expensive surprises down the road.
What Is Cryptocurrency?
A cryptocurrency is a digital asset that uses cryptography, an encryption technique, for security. Cryptocurrencies are primarily used to buy and sell goods and services, though some have additional smart capabilities. Most cryptocurrencies are not backed by another commodity, such as gold, and are typically not considered legal tender. They are also generally issued by private organizations.
However, this is not universally the case. Recent years have seen the development of stablecoins—coins pegged to another asset, like the dollar, gold, or another cryptocurrency—as well as the issuance of digital currencies from the central banks of a few countries including Nigeria and the Bahamas.
Sometimes firms raise cash to develop new blockchain and cryptocurrency technologies through ICOs. Instead of offering shares of ownership, they offer digital tokens. Investors benefit by gaining early access to the cryptocurrency and any associated smart capabilities. Blockchain-related projects have raised billions of dollars via ICOs.
As of 2023, estimates indicate around 420 million people worldwide own cryptocurrencies.
Types of Cryptocurrencies
There are two major categories of cryptocurrencies: coin-only currencies like Bitcoin, utilized for purchasing goods and services, and tokens like Ethereum. Tokens also support other digital records like NFTs and smart contracts.
Bitcoin
Released in 2009 by someone under the alias Satoshi Nakamoto, Bitcoin is the most popular cryptocurrency, with a market share of roughly 45%. In a transaction, the buyer and seller utilize mobile wallets to send and receive payments. The list of merchants accepting Bitcoin has expanded in recent years, although some, including Microsoft and Twitch, have temporarily stopped taking it at times due to excessive volatility.
Bitcoin has its shortcomings. For example, it can process only seven transactions a second, whereas Visa handles thousands. The currency’s functionality is also limited: Since it was developed primarily as a tradeable coin, it doesn’t support smart contracts and decentralized applications. Bitcoin’s price has fluctuated dramatically over the years, crashing in response to 2018 developments like tougher regulation from China and India, the SEC’s announcement of a crackdown on crypto exchanges, and the reported hacking of the Binance crypto exchange. Bitcoin recovered and boomed again in 2021 as institutional investors began to take the cryptocurrency more seriously—and then crashed once more in 2022 following the FTX fraud case.
Ethereum and Ether
Ethereum is a blockchain that allows for the relatively easy creation of smart contracts, while Ether is a token used to enter into transactions on the Ethereum blockchain. Ether and other currencies based on the Ethereum blockchain have become increasingly popular. As of May 2023, Ethereum’s market capitalization was around $218 billion. The currency has seen its share of volatility over the last several years, partly due to issues with its technology, though its market share of about 19% is a few points higher than it was two years ago.
Though Bitcoin and Ethereum account for most of the market share, the last decade or so has seen the emergence and rapid growth of many new digital coins and tokens, including Litecoin, Zcash, Dash, and Dogecoin. Nearly 23,000 different cryptocurrencies exist today.
How Does Cryptocurrency Work?
Blockchain technology underlies Bitcoin and most other cryptocurrencies. It relies on continuously updated public or private ledgers that record all transactions. The blockchain is decentralized, processing and verifying transactions without a central authority like a bank, government, or payments company involved. (This is called a trustless system.)
Instead, the blockchain utilizes consensus mechanisms to verify transactions, which are then recorded in multiple nodes. A node is a computer connected to the blockchain network that automatically downloads a copy of the blockchain upon joining said network. For a transaction to be valid, all nodes must be in agreement.
For any transaction, both buyer and seller need to approve and verify it in order for it to be added to the chain. A third user—called a “miner” or “validator,” depending on the validation method—secures the chain. The transaction information can’t be altered unless all parties agree. There are two major mechanisms for consensus verification (proof-of-work and proof-of-stake) and the process varies, depending on which one a particular blockchain uses.
Many cryptocurrencies, including Bitcoin, the juggernaut, use proof-of-work. The process of confirming transactions and minting new units of currency for proof-of-work systems is called mining. Miners must solve an extremely difficult cryptographic puzzle in order to verify the transaction. Whoever solves it first is rewarded in cryptocurrency.
Anyone with sufficient computing power can mine in a proof-of-work system, but the overhead can be considerable, as an individual computer simply isn’t powerful enough to mine cryptocurrencies profitably. Instead, miners typically use multiple computers and often join pools to increase collective computing power, competing with other pools to verify pending transactions and reap the profits.
But those profits are declining. As Bitcoin miners’ overhead expenses balloon, the profitability of mining has plummeted, dropping by 70% from October 2021 to May 2023. In that same period, the price of Bitcoin fell 63%. Many countries have banned mining due to the strain on power grids. And some cryptocurrencies are doing away with the anyone-can-mine approach altogether, including the second most popular cryptocurrency, Ethereum.
In September 2022, Ethereum switched to a less energy-intensive consensus mechanism called proof-of-stake. In a proof-of-stake system, users stake a portion of their own coins for the privilege of validating a transaction. In order to get their staked coins back, these validators must confirm the transaction accurately. The validator is then compensated for their work with a transaction fee. Because just one validator is chosen randomly by an algorithm, proof-of-stake avoids the race between multiple miners—or mining farms—to validate first. This dramatically reduces the electricity required to validate a transaction and significantly lowers costs and emissions.
Factors Affecting Cryptocurrency Prices
The value of traditional government-backed currencies is typically determined by several elements, including the differential in interest rates, inflation, capital flow, and money supply between two countries. However, the worth of crypto coins is subject to different forces:
Supply and Demand
The blockchain code limits the supply of Bitcoin to a maximum of 21 million, and with more than 19 million Bitcoin already mined, experts project that miners will reach this total by the year 2140. If adoption rates rise, the slowing growth in the number of available tokens would likely cause the price to increase. But not all cryptocurrencies work this way. Many have their own unique tokenomics, which define their total supply and issuance models.
Applications
Cryptocurrencies have value as a means of exchange. They can increase their appeal by improving on the Bitcoin model or, like Ether, by incorporating other capabilities, such as smart contracts, that create additional value.
Ongoing Regulatory Changes
Cryptocurrencies’ value is strongly influenced by future expectations, and increasing regulation is sure to have an impact on both. Unlike much of the world, Japan already has a strong and growing regulatory apparatus, informed in large part by the Mt. Gox and other hacks. Europe will implement new regulations as early as July 2024. How the US will regulate digital assets is unclear, but US President Joe Biden signed an executive order in 2022 authorizing increased oversight and regulation of cryptocurrencies in response to their “dramatic growth.”
Technological Developments
Cryptocurrency prices often react to changes in technology. For example Bitcoin value dropped in 2017 during a controversy about altering the underlying technology to improve transaction times. But two weeks after the change was completed, the price shot up to a record high of $1,600. Likewise, the price of Ethereum dropped more than 20% when the currency switched from the proof-of-work to proof-of-stake. News reports about crypto exchange hacking often lead to price decreases as well.
Investor Behavior (and Misbehavior)
Bubble mentalities can inflate crypto values. Those in control of these currencies drive up values by limiting the supply of tokens for trading and increasing demand through hype and speculation. Another significant cause of inflated value is fraud. Con artists capitalize on crypto hype by engaging in tactics like grift, pump-and-dump schemes, and exit scams to augment their wealth before the fall.
How Is Cryptocurrency Taxed?
Under current accounting guidelines, cryptocurrencies aren’t considered cash or cash equivalents since they lack the former’s liquidity and the latter’s stable value. However, the accounting treatment of cryptocurrencies is still uncertain as neither the International Finance Reporting Standards or the American Institute of CPAs has yet to issue official guidance.
In the US, the IRS instructs holders of digital assets to treat them as personal property and subject to the same tax obligations as property transactions. On a balance sheet, the value of cryptocurrency holdings is equal to the fair market value at the time of acquisition.
Outside the US, accounting treatment varies. In 2015, the European Court of Justice ruled that crypto should be treated like government-backed currencies, and holders shouldn’t be taxed on purchases or sales. But a new proposal from the European Parliament is including taxes on investors’ capital gains, transactions, and mining.
Similarly, in Japan in 2017, cryptocurrencies were reclassified as a “means of settlement” of transactions and exempted from the 8% consumption tax.
Cryptocurrency’s Ultimate Challenge
Five years on from its heyday in 2017 and 2018, cryptocurrency still has many people to win over, including Warren Buffet, who has called Bitcoin ingenious but ultimately “a delusion.” But other investment experts, like Bill Miller, remain bullish.
In the simplest terms, cryptocurrency is a fintech phenomenon; on a more complex level, it’s a revolutionary technology challenging the political, economic, and social underpinnings of society.
Even if cryptocurrency’s fortunes continue to wane, the blockchain technology that emerged from it has the power to transform the way we do business. Technology consulting firm CB Insights has identified how the blockchain can fundamentally change processes as diverse as banking, cybersecurity, voting, academia, and supply chain management. Financial analysts predict that by 2030, the worldwide blockchain technology market will produce revenues close to $1.24 trillion, up from $5.85 billion in 2021.
The challenge that crypto-enthusiasts must meet is advancing the technology to its full potential while building the public’s confidence in the cryptocurrency market enough to achieve mainstream adoption.