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Bitcoin, cryptocurrencies — how do they work?

December 6, 2017

Cryptocurrencies have grabbed a lot of attention in recent days as the value of bitcoin skyrocketed to hit record highs and Venezuela announced plans to create a digital currency called "petro."

Image: picture-alliance/dpa/J. Kalaene

Cryptocurrencies promote themselves as being nothing short of a cutting-edge digital technology that aims to fundamentally reshape the way the global financial industry operates.  

They intend to do it by eliminating the need for banks and other financial intermediaries in managing exchanges of currency and assets. The technology is decentralized, with no government, company or person controlling it.

This is in sharp contrast to what the world is currently used to. At present, most financial transactions are done in currencies like the US dollar or the euro that are issued by central banks and backed by governments. And the complex and interconnected global economy is dependent on banks for financial intermediation.

The appeal of digital currencies lies in their promise to circumvent this financial architecture. They do it by relying on clever mathematics and taking the ledger-keeping function away from financial institutions and handing it over to a network of autonomous computers.

Disruptive technology

These currencies use blockchain, which records transactions that are updated in real time on an online ledger, and transactions happen when heavily encrypted codes are passed across a computer network.

By eliminating financial intermediaries and their fees, cryptocurrency promises to reduce the costs of doing business for individuals and companies and free the world of their dependence on banks and other financial institutions.

The first of their kind, Bitcoin, was created in 2009, but its origins remain cloaked in mystery. The person credited with its introduction is known as "Satoshi Nakamoto," but its real identity remains a source of considerable speculation.

Read more: Bitcoin inventor search shifts to Sydney

Bitcoins are stored in digital bank accounts or "wallets" that can be set up at home by anyone with internet access. Setting up an account doesn't require going to a bank or sharing personal identification details and bitcoin doesn't even know the user's name or gender.

The potentially highly disruptive nature of the cryptocurrency technology has inspired volumes of debate between its proponents and opponents.

Fans of Bitcoin argue that it is a groundbreaking digital technology with the potential to radically change the way we conduct banking and commerce. 

Read more: Why bitcoin is valued in Zimbabwe

Skeptics, though, dismiss its significance. While JP Morgan Chase's CEO Jamie Dimon labeled it "a terrible store of value," legendary US investor Warren Buffett recommended people to, "Stay away from it. It's a mirage basically."

Bubble fears

Bitcoin also tends to attract a lot of negative coverage in the press, as a currency that allegedly facilitates nefarious activities like money laundering or terrorism financing. Moreover, few businesses, online or otherwise, accept it for payment.

While the value of bitcoins can swing sharply, it has witnessed a sharp spike so far this year. From a valuation of about $700 (€589) per bitcoin at the start of 2017, it has soared to record levels to cross the $12,000 barrier for the first time Wednesday, December 6.

Bitcoin is now the largest cryptocurrency, with a total market value currently estimated at over $100 billion, making it worth more than many US companies.

Analysts believe the latest jump in the value of bitcoin is being driven by growing interest about the digital currency among investors and other stakeholders.

US regulators last week cleared the way for bitcoin futures to trade on major exchanges, including the world's biggest futures center the Chicago Mercantile Exchange (CME).

"The fact that CME, the biggest kid on the block, is moving early into cryptocurrency, will force other major exchanges to follow suit in the fear of not missing out," Shane Chanel, from Sydney-based ASR Wealth Advisers, was quoted by AFP news agency as saying in a note this week.

But France's central bank last week issued a strong warning against further speculation on Bitcoin, with the Bank of France governor Francois Villeroy de Galhau terming it as a "speculative asset" whose value and volatility have "no economic basis."

Varying attitudes

Still, research conducted by Cambridge University concluded in May this year that there are over 3 million people (three times previous estimates) actively using cryptocurrencies. 

Although Bitcoin is the most prominent of cryptocurrencies worldwide, it's hardly the only one. It's estimated that there are now over 1,000 digital currencies available over the internet, like Ethereum, Litecoin, Zcash, Dash and Ripple.

And a new cryptocurrency can be created at any time. Even Venezuelan President Nicolas Maduro recently looked to digital currency to circumvent US-led financial sanctions, by announcing last week the launch of the "petro" backed by the Latin American nation's oil, gas, gold and diamond reserves.

Despite the proliferation of these currencies, governmental attitudes toward them vary across the world. Research carried out by Thomson Reuters showed that some countries have become global advocates, while others have actively banned cryptocurrencies completely, with some lying somewhere in between the two ends.

While Japan is at one end of the spectrum, passing a law accepting bitcoin as legal tender, Bangladesh represents the other extreme, with a law passed in 2014 mandating imprisonment for anyone caught using the virtual cash.

The foundational premise of cryptocurrency that financial systems do not require a central government and a central bank also poses a challenge for governments to accept their widespread usage.

Control of a currency is one of the most powerful tools of a government and cryptocurrencies may undermine it. They attempt to take some of that power away from governments, which could reduce authorities' capacity to control a nation's monetary system.

"While these digital currencies may not pose major concerns at their current levels of use, more serious financial stability issues may result if they achieve wide-scale usage," US central bank Federal Reserve's Vice Chairman for Supervision, Randal Quarles, recently warned.

Srinivas Mazumdaru Editor and reporter focusing on business and Asia