The Lowdown on Cryptocurrency with Prof. Pierangelo De Pace

Prof. Pierangelo De Pace and fiunancial graph

Cryptocurrency keeps garnering headlines for all the wrong reasons. What exactly is crypto—how is it "mined" and what determines its value? Is crypto collapsing? With the latest news of FTX’s demise, what likely is in store for cryptocurrencies?

In this Q&A, Pierangelo De Pace, chair of the Department of Economics at Pomona, sheds light on the fundamentals of cryptocurrencies, their regulation and their major challenges.

What is cryptocurrency?

A cryptocurrency is a digital asset designed to work as a medium of exchange. Cryptocurrencies use a sophisticated mathematical framework called cryptography to secure transactions. Cryptography is also a tool to control the creation of additional units of cryptocurrencies, verify the transfer of assets and validate transactions.

Bitcoin was created and launched in 2009 and was the first decentralized cryptocurrency. Several thousand other cryptocurrencies have been introduced since then. Bitcoin and its derivatives work on decentralized systems instead of traditional currencies' centralized banking and payment systems.

How does blockchain fit in?

A blockchain is a digital ledger of all cryptocurrency transactions. It constantly grows as "completed" blocks are added. Each block contains a cryptographic hash of the previous block, a timestamp and transaction data. Cryptocurrency nodes use the blockchain to differentiate legitimate cryptocurrency transactions from attempts to double-spend coins. There is no need for a central authority or bank in this system.

How is cryptocurrency created?

We create cryptocurrencies through a process called "mining." Crypto miners use computers and special software to solve complex mathematical equations. A new block of currency is created when an equation is solved, and the miner is rewarded with a small amount of cryptocurrency.

The mining process can be quite energy intensive and requires significant computing power. As more and more miners mine cryptocurrencies, the difficulty of solving equations increases. For some cryptocurrencies, there is only a limited supply. At some point, miners have to compete against each other to be the first to solve an equation or mathematical problem and earn a reward. The more computing power a miner has (which requires energy), the more likely they will solve a problem first and thus be awarded some amount of cryptocurrency. This has led to concerns about the environmental impact of crypto mining.

Does crypto have any inherent value?

Cryptocurrencies have no fundamental value, and their price should be zero. There is no underlying real economic or financial activity that justifies the price levels that we currently see in these markets, which may be unsustainable in the long run.

High volatility is unavoidable in crypto markets. We have some evidence that a substantial portion of the fluctuations in demand for cryptocurrencies is caused by herd behavior. Most crypto investors are not specialized nor knowledgeable of the differences between cryptocurrencies. Crypto markets are very vulnerable to the investment decisions of a few large investors who keep large amounts of cryptocurrencies in their portfolios.

What was behind the government of El Salvador's grand experiment with crypto?

In mid-2021, El Salvador became the first country to adopt Bitcoin as legal tender. The government argued that Bitcoin could free their indebted nation from the hold of the traditional global financial system. They also believed adopting Bitcoin would bring more citizens, about 70 percent of whom do not have bank accounts, into the formal economy.

More than a year later, the country still faces plummeting economic growth and a high deficit, and it has lost around $60 million on its Bitcoin bet.

Any currency must have three critical functions: It must be a medium of exchange; it must be a unit of account; and it must be a store of value. Bitcoin clearly can be used as a medium of exchange and a unit of account. However, when it comes to being a store of value, its high price volatility and instability cast doubts about its use as legal tender.

Will governments start regulating cryptocurrencies?

That’s difficult to say. Cryptocurrencies are often used for illegal activities, such as money laundering and drug trafficking. If the government regulated cryptocurrencies, it would be easier to track these activities and prosecute those involved. Regulating cryptocurrencies would give governments and monetary authorities more control over the economy and the money supply and could help stabilize prices.

While the blockchain technology remains an interesting opportunity for governments, central banks and financial institutions to make their payment systems safer, more decentralized, more efficient, faster and less expensive, it is unlikely that governments will try to regulate cryptocurrencies anytime soon. In the meantime, central banks and governments will monitor crypto market developments. Even though they appear to be separate from traditional financial markets and the real economy, episodes of contagion and instability transmission from these unregulated markets are always a possibility, one that authorities will undoubtedly want to prevent.

What does the FTX situation mean for other cryptocurrencies?

Over the years, FTX had become a popular trading source for many cryptocurrency investors. It was a centralized cryptocurrency exchange, the world’s third largest in July 2021, and used to operate as an exchange for a significant number of digital tokens. Large fluctuations in the price of any digital token listed on this platform had the potential to affect other cryptocurrencies in terms of pricing and market capitalization. Declines in FTX users because of negative publicity or problems with their platform could push investors towards rival platforms and lead to short‐term fluctuations across cryptocurrencies. Many digital currencies have seen varying levels of success. However, they have not reached the reliability investors look for. When one cryptocurrency falters, it raises questions about whether we can trust other cryptocurrencies for significant investments and long‐term commitments.

Early in November 2022, FTX was temporarily suspended from trading due to concern over its financial security and activities by key figures at the company. This situation caused investors to pause their activities until more information became available about FTX’s operations and future. FTX filed for bankruptcy protection on November 11, 2022. It was a swift fall from grace. The company’s valuation plunged to that status from $32 billion in just a few days. While this incident was concerning for those involved with FTX, it also underscores some broader considerations for other cryptocurrencies.

FTX’s collapse shook an already volatile crypto market, which had lost billions in value between 2021 and 2022. The consequences of FTX’s rapid decline and collapse will probably affect cryptocurrencies well into the future and could even drag down broader markets.