What are Cryptocurrencies?
Cryptocurrencies are digital tokens. They are a typeof digital currency that allows people to makepayments directly to each other through an onlinesystem. Cryptocurrencies have no legislated orintrinsic value; they are simply worth what peopleare willing to pay for them in the market. This is incontrast to national currencies, which get part oftheir value from being legislated as legal tender.There are a number of cryptocurrencies – the mostwell-known of these are Bitcoin and Ether.
Activity in cryptocurrency markets has increasedsignificantly. The fascination with these currenciesappears to have been more speculative (buyingcryptocurrencies to make a profit) than related totheir use as a new and unique system for makingpayments. Related to this, there has also beena high degree of volatility in the prices of manycryptocurrencies. For example, the price of Bitcoinincreased from about US$30,000 in mid 2021 toalmost US$70,000 toward the end of 2021 beforefalling to around US$35,000 in early 2022. Rivalcryptocurrencies like Ether have experiencedsimilar volatility. The extraordinary interest incryptocurrencies has also seen a growing amountof computing power used to solve the complexcodes that many of these systems use to helpprotect them from being corrupted. Despite theincreased level of interest in cryptocurrencies, thereis scepticism about whether they could ever replacemore traditional payment methods or nationalcurrencies.
How Does a Cryptocurrency Transaction Work?
Cryptocurrency transactions occur through electronic messages that are sent to the entirenetwork with instructions about the transaction. The instructions include information such asthe electronic addresses of the parties involved, the quantity of currency to be traded, and atime stamp.
Suppose Alice wants to transfer one unit of cryptocurrency to Bob. Alice starts the transactionby sending an electronic message with her instructions to the network, where all users cansee the message. Alice's transaction is one of a number of transactions that have recently beensent. Since the system is not instantaneous, the transaction sits with a group of other recenttransactions waiting to be compiled into a block (which is just a group of the most recenttransactions). The information from the block is turned into a cryptographic code and minerscompete to solve the code to add the new block of transactions to the blockchain.
Once a miner successfully solves the code, other users of the network check the solution andreach an agreement that it is valid. The new block of transactions is added to the end of theblockchain, and Alice's transaction is confirmed. (This confirmation is not instant as it takes timefor six blocks of transactions to be processed so that users can be certain that their transactionhas been successful.)
Alice sends instructions to transfer cryptocurrency to Bob. Anyone using the network can view the message.
Miners group the transaction together into a 'block' with other recently sent transactions.
Information from the new block is transformed into a cryptographic code.
Miners compete to find the code that will add the new block to the blockchain.
Once the code is solved, the block is added to the blockchain and the transaction is confirmed.
Bob receives thecryptocurrency.
Is Cryptocurrency Money?
A frequently asked question is whethercryptocurrency can be defined as ‘money’. Theshort answer is that cryptocurrency is not a formof money. To understand why, we can ask whetherthe characteristics of cryptocurrencies match thekey characteristics of money:
- Widely accepted means of payment –can cryptocurrencies be used to buy and sellthings? Money generally comes in the form ofa nation's currency, and is widely accepted asa means of payment. While cryptocurrenciescan be used to buy and sell things, they are notwidely accepted as a means of payment, andsurveys suggest that only a small fraction ofcryptocurrency holders use them regularly forpayments.
- Store of value –can the purchasing powerof cryptocurrencies (their ability to purchasea similar basket of goods and services) bemaintained over time? Large fluctuations in theprice of many cryptocurrencies mean that theirpurchasing power is not maintained over time,reducing their effectiveness as a store of value.
- Unit of account –are cryptocurrencies acommon way of measuring the value ofgoods and services? In Australia, the prices ofgoods and services are measured in Australiandollars. While some businesses may acceptcryptocurrencies as payment, they are notcommonly used to measure and compareprices.
So, while cryptocurrencies can be used to makepayments, currently their use as a means ofpayment is limited and they do not display the keycharacteristics of money.
However, there is one type of digital currency thatcould be considered money – digital currencyissued by a central bank.
What is Central Bank Digital Currency?
A Central Bank Digital Currency (CBDC) can mosteasily be understood as a digital form of cash. Itcan be issued by the central bank, accessible tothe general public, and used to settle transactionsbetween firms and households. The unit ofaccount would be the national currency, and itcould be exchanged at parity (i.e. one for one) withother forms of money, such as physical currencyor electronic deposits with well-regulated financialinstitutions.
What are the main differences betweencryptocurrencies and CBDCs? In other words, whatmakes a CBDC money? A central bank has theability to ensure that a digital currency it issuesexhibits the three main features of money – thatis, a CBDC could function as a widely acceptedmeans of payment, store of value and unit ofaccount.
Because it is issued by a central bank, a CBDCwould have legal tender status, making it widelyaccepted as a means of payment. A CBDC wouldalso be an equivalent store of value to other formsof money, since it could be exchanged for anequal value of physical cash or electronic deposits.Finally, the unit of account for CBDC issued by theReserve Bank would be the Australian dollar. Thismeans it could be used to measure the value ofgoods and service. These and other key featureshave been summarised in the table below.
| CHARACTERISTIC | CRYPTOCURRENCIES | CBDCs |
|---|---|---|
| Means of payment | Accepted by a small numberof retailers | Universally accepted, legal tender |
| Store of value | Tend to be volatile, dependson market price | Stable, consistent with centralbank price stability mandate |
| Unit of account | Own unit of account | Fiat currency (e.g. Australiandollars) |
| Governance | Typically decentralised, relieson consensus between largenumber of entities. | Centralised |
| Transaction verification | Typically a large number ofcompeting entities | Small number of trusted entities |
Surveys conducted by the Bank for InternationalSettlements indicate that CBDCs are an activearea of research for nearly all central banks.Despite this, only a few central banks haveactually issued digital currencies – to date no highincome country has issued a CBDC. The ReserveBank remains cautious about whether issuing aCBDC would be in the public interest. Primarily,this is because many of the benefits of CBDCshave largely already been realised by existingtechnologies. In a 2021 speech, the Head ofPayment’s said:
Reserve Bank staff have not been convinced todate that a strong policy case has emerged inAustralia for a CBDC. The primary reason has beenthat Australia’s existing electronic payments systemalready provides households and businesses witha wide range of safe, convenient and low costpayment services.
What Are Some of the PublicPolicy Implications?
Some of the technology behind cryptocurrenciesraises a number of considerations for publicpolicymakers. Given the anonymity provided bycryptocurrency systems, and their worldwidereach, there are questions about how tolimit the use of digital currencies for criminalactivities. In addition, the current fascinationwith cryptocurrencies has potentially added tothe speculative nature of these markets, and hasraised concerns around consumer protection. Ifcryptocurrencies were to be more widely adopted,they could also present some challenges for therole of the banking sector and raise additionalfinancial stability concerns in a crisis. Furthermore,the vast amounts of electricity used in themining of cryptocurrency raise concerns aboutthe allocation of resources and environmentalconsequences of these payment systems.
For more information about the risks involved withcryptocurrencies, see ASIC’s MoneySmart website.
In contrast, a CBDC could potentially support anumber of public policy objectives, includingsafeguarding public trust in money and promotingefficiency, safety, resilience and innovation in thepayment system. The Reserve Bank is continuing toclosely examine the case for a CBDC and workingwith other central banks on this issue. The ReserveBank is considering the relevant technical issues, aswell as the broader policy implications.
While the Reserve Bank has not yet made adecision on whether to issue a CBDC, the Governornoted in his 2021 speech ‘Payments: The Future?’that:
… the RBA is open to this possibility. To date,though, we have not seen a strong publicpolicy case to move in this direction, especiallygiven Australia's efficient, fast and convenientelectronic payments system. It is possible, however,that the public policy case could emerge quitequickly as technology evolves and consumerpreferences change. It is also possible that thesetokens could offer a lower-cost solution for sometypes of payments than provided by the existingtechnologies.
For more information on the Reserve Bank’sresearch, see: Central Bank Digital Currency.
Features of the Bitcoin System
The most well known cryptocurrency is Bitcoin. Bitcoin was launched in 2009, a year after areport that described the Bitcoin system was released under the name Satoshi Nakamoto. Thesystem was designed to electronically mimic features of a cash transaction. It was designed toallow peer-to-peer (or person-to-person) transactions, without the need to know or trust theother person in the transaction, and to occur without the need for a central party (such as abank). Unlike conventional national currencies such as Australian dollars, which get part of theirvalue from being legislated as legal tender, Bitcoin and other cryptocurrencies do not haveany legislated or intrinsic value. Instead, the value of Bitcoin is determined by what people arewilling to pay for it in the market (and, in theory, its value could fall to zero at any time).
One feature of the Bitcoin system is that the supply of Bitcoins increases at a pre-determinedrate and is capped at around 21 million (with each bitcoin able to be subdivided into 100million satoshis or 0.00000001 bitcoins). Because of this, the supply of Bitcoins has beencommonly compared to the supply of a scarce commodity, such as gold.
The Bitcoin system allows transactions to occur directly from person to person withoutrequiring a central party (such as a bank) to verify or record the transactions. This is unlike mostconventional payment methods, such as electronic bank transfers, which rely on a central partyto keep and update records of transactions. For example, commercial banks maintain a recordof their customers' account balances, deposits and withdrawals.
Instead, the Bitcoin system uses ‘blockchain’ technology to record transactions and theownership of bitcoins. This is essentially technology that connects groups of transactions(‘blocks’) together over time (in a ‘chain’). Each time a transaction occurs, it forms part of a newblock that is added to the chain. As a result, the blockchain provides a record (or database) ofevery bitcoin transaction that has ever occurred, and it is available for anyone to access andupdate on a public network (this is often referred to as a ‘distributed ledger’). The integrity ofthe Bitcoin system is protected by ‘cryptography’, which is a method of verifying and securingdata using complex mathematical algorithms (or codes). This makes the system very difficult tocorrupt.
Bitcoin transactions are verified by other users of the network, and the process of compiling,verifying and confirming transactions is often referred to as ‘mining’. In particular, complexcodes need to be solved to confirm transactions and make sure the system is not corrupted.The Bitcoin system increases the complexity of these codes as more computing power isused to solve them. A new block of transactions is compiled approximately every ten minutes.‘Miners’ want to solve the codes and process transactions because they are rewarded with newbitcoins (currently 6.25 new Bitcoins per block).
The increase in competition between miners for new Bitcoins has seen large increases in theamount of computing power and electricity required (which is often used for air conditioningto cool computer systems). While it is difficult to calculate with precision, some estimatessuggest that the annual energy consumption of the Bitcoin system is roughly equal to thecountry of Thailand.
This explainer is provided to facilitate the conceptual understanding of cryptocurrencies.It does not constitute advice, or a recommendation, to buy, trade or invest in Bitcoin or any othercryptocurrency. If you decide to trade or use cryptocurrencies you may be taking on riskfor which there is no recourse.
For more information about these risks see ASIC’s MoneySmart website.
References
Lowe, Philip (2021), ‘Payments: The Future?’, Address to the 2021 Australian Payments NetworkSummit, 9 December 2021.
Richards, Tony (2021), ‘Future of Payments: Cryptocurrencies, Stablecoins or Central Bank DigitalCurrencies?’, Address to the Australian Corporate Treasury Association, 18 November.
