Explainer - What are cryptocurrencies like bitcoin?

Bitcoin

Cryptocurrencies, also known as digital currencies or virtual currencies, are a form of digital money. They allow payments to be made electronically and function in a similar way to standard currencies that use physical cash. However, unlike standard currencies that can be exchanged physically using notes and coins, cryptocurrencies are only exchanged electronically using lines of computer code. Examples of well-known cryptocurrencies include bitcoin, ethereum and litecoin.

How are cryptocurrencies different from standard money?

Most paper currencies, such as the euro, have legal tender status. This means that the currency is the country’s officially recognised currency, and must be accepted as payment of a debt.

Cryptocurrencies on the other hand, do not have legal tender status. This means there is no legal obligation for them to be accepted.

Another big difference between cryptocurrencies and paper currencies is how they are structured. Official currencies are centralised and guaranteed by a central bank that controls their supply. So for example, the European Central Bank guarantees the euro and controls its supply in the euro area. Cryptocurrencies meanwhile are unregulated and decentralised. This means that no central bank guarantees them or controls their supply.

Who controls cryptocurrencies?

Cryptocurrencies are controlled using a technology known as “blockchain” or “distributed ledger technology”. A good way to understand distributed ledger technology is to think of it like one big public file – or ledger – that is shared and stored across a huge network of computers. This file contains all the transactions made using the cryptocurrency. Because it is publicly shared and its contents validated by so many different people, it makes it virtually impossible for anyone to include a fraudulent transaction on it.

Why are cryptocurrencies like bitcoin in the news?

Cryptocurrencies, but in particular bitcoin, have been in the news a lot over the past couple of years. This is due to the huge swings in their value. For example at the start of 2017, the value of bitcoin was $882 per coin. Later in the year it soared to $19,343 per coin. However, by the end of 2018 one bitcoin was worth less than $4,000.

So is bitcoin a currency?

A common question relating to bitcoin (and other cryptocurrencies) is whether it is a currency and if it can function as money. A well-functioning currency has the following three functions:

  • Store of value
  • Unit of account
  • Medium of exchange.

Bitcoin struggles to meet these criteria for the following reasons:

  • Store of value

    To be a store of value, a currency should be stable over time. As seen by the large price fluctuations, this is not the case for bitcoin.
  • Unit of account

    A unit of account means that the money should allow us to easily form an understanding of the value of goods and services, and allow us to compare them to each other. The volatility of bitcoin makes it difficult to perceive it as a unit of account.
  • Medium of exchange

    A medium of exchange means money should facilitate buyers and sellers to make transactions. In some ways, bitcoin fulfils this condition – as buyers and sellers can use it for some transactions. However, limitations such as slow transaction speeds, high transaction costs, as well as bitcoin’s unstable value make it difficult for it to properly function as a medium of exchange.

In general, bitcoin is more like a very high-risk, speculative asset than a standard currency.

Could a central bank issue a digital currency?

One recent topic of discussion is whether central banks should investigate launching their own digital currency.

The Swedish Riksbank and the Bank of England have conducted research on this topic. However, the idea of a central bank digital currency is still very speculative, and does not look likely to happen in the near future.

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