How do cryptocurrencies affect the economy?
Cryptocurrency represents more than just a financial advancement, as it embodies social, cultural, and technological progress. Cryptocurrencies are digital assets managed through cryptographic algorithms and there are various types available, including stablecoins. While Bitcoin is probably the most well-known cryptocurrency, thousands of others have emerged. It is essential to understand that the impact of cryptocurrencies goes beyond daily price fluctuations, as their use cases and underlying blockchain technologies are being developed rapidly, with a tremendous economic impact on the global economy that transcends national boundaries.
As with any tool or technology, cryptocurrencies have their pros and cons. One of the most significant benefits is accessibility, enabling users to pay or receive payments without the involvement of third-party institutions such as banks. This accessibility can potentially encourage financial inclusion globally, particularly for the underserved and unbanked population, of which over 1.7 billion individuals do not have bank accounts. Cryptocurrencies offer a chance at financial inclusion, making them inherently beneficial for the economy.
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In what ways can cryptocurrencies act as a hedge against inflation?
Whether cryptocurrencies, specifically BTC, can protect against inflation is subject to interpretation. Some may prefer to only use stablecoins that are well-supported.
Traditionally, BTC and other cryptocurrencies have been seen as a hedge against inflation due to their decentralized nature and limited supply. However, the recent decline in cryptocurrency prices and high inflation rates may cause some to question whether BTC lives up to its reputation for financial inclusion and protection against inflation. The answer to this question may depend on whether one views BTC as a means of payment to meet the needs of a real economy or as an investment vehicle for hedging against inflation.
Additionally, the choice of alternative currencies matters. Some may opt to use stablecoins that are backed by a strong reserve. The validity of cryptocurrencies as a hedge against rising inflation also depends on whether one considers them to be true alternatives to traditional monetary policies, which some argue have not served the needs of the real economy since the end of the gold standard in 1971.
The benefits of cryptocurrency compared to fiat currency are especially significant in countries where the local currency has experienced devaluation rates of 50% or more against the U.S. dollar over the past decade, such as Venezuela, Lebanon, Turkey, Suriname, and Argentina. In these countries, individuals are more likely to consider using cryptocurrency as an alternative to traditional currency.
What are the challenges and issues associated with cryptocurrencies?
Cryptocurrencies have been subject to various narratives highlighting their negative aspects such as their use for criminal activities, potential environmental harm, and volatility. While it’s true that some criminals use cryptocurrencies, illicit activity represents only a small fraction of the total cryptocurrency transaction volume. In fact, legitimate usage far outpaces the growth of criminal usage.
Cryptocurrencies, particularly Bitcoin, have been criticized for their negative impact on the environment due to their proof of work consensus mechanism. However, studies show that Bitcoin contributes only 0.08% to global CO2 emissions. Furthermore, Bitcoin has helped foster a new sector and promote financial inclusion for millions globally.
One of the most significant disadvantages of cryptocurrencies is their inherent volatility. Their value can fluctuate rapidly, resulting in sudden losses for investors. Traditional economists may argue that cryptocurrencies are unsuitable as a means of payment due to their instability and lack of central bank involvement. Some may argue that central bank digital currencies (CBDCs) are a better solution because they are backed by a central authority.
Despite the chaos and volatility of the cryptocurrency markets, there appears to be an underlying logic at work. While the value of cryptocurrencies is not guaranteed, the logarithmic chart of Bitcoin shows that volatility and drawdowns have remained consistent over time.
Can cryptocurrencies withstand an economic downturn?
Despite the temporary crypto winter, the positive feedback loop between cryptocurrency prices, industry developments, and innovation appears to be enhancing one another. The downward pressure in the cryptocurrency markets may be correlated with slipping traditional markets and geopolitical factors, resulting in difficult times for cryptocurrency investors. High inflation has caused central banks to adjust their policies, such as raising interest rates, leading to a tighter financial market and making it more attractive to invest in bonds. Additionally, risk-aversion strategies during stock market corrections have toned down cryptocurrency investments.
The crypto winter is akin to a bear market cycle, and its effects have been felt by some crypto-related companies that have had to cut costs through layoffs. However, the correlation between cryptocurrency market capitalization and traditional markets indicates institutionalization, adoption, and acceptance, the first steps towards broader acceptance of cryptocurrencies and their underlying technological foundation.
Despite external chaos, prominent thought leaders argue that the cryptocurrency market develops in cycles with an underlying logic in which prices, industry developments, and innovation are connected in a positive feedback loop.
Good to know: What is the meaning of buyback-and-burn in the world of cryptocurrency?
How do investments in cryptocurrency impact the wider crypto economy?
Despite the positive feedback loop that appears to be driving the growth of the cryptocurrency market, it is important to remember that unexpected events can still have a significant impact on the trajectory of the ecosystem.
Although blockchain and cryptocurrencies are designed as “trustless” technologies, trust is still essential when humans interact with each other. The cryptocurrency market is not immune to the broader economy’s influence, and it can also generate significant effects by itself. The Terra case is an example of how any entity, whether a single company, venture capital firm, or project issuing an algorithmic stablecoin, can contribute to a boom or bust in the cryptocurrency markets.
Crypto-native events with systemic impacts, similar to traditional finance’s domino effects, and the resulting falls of Celsius and Three Arrows Capital, demonstrate that the crypto-economy is not invulnerable to failures. While traditional finance has institutions that are too big to fail, the crypto sector does not.
In retrospect, it is clear that the Terra project was fundamentally flawed and unsustainable. Nevertheless, its downfall had a systemic impact, exposing and heavily impacting many projects, venture capital, and standing companies. This highlights the importance of considering risks and potential rewards when investing in cryptocurrencies.
The fall and domino effect across the board indicate the lack of maturity of the sector itself. However, given the inherent connection between innovation and prices and the untapped potential of the early-stage development of the crypto-economy, the sector may continue to experience events that temporarily hinder growth.
Many in the sector maintain a “trustless” conviction that robust projects will weather temporary corrections and that the cryptocurrency winter will pave the way for a cycle of unlimited, novel disruptive innovation.
