Welcome back to Peoria Magazine’s Econ Corner, a recurring feature in which we pose questions to experts about various economic issues and how they affect our lives and careers here in central Illinois. Doing this month’s Q&A is Jake Kinsey, director of the Illinois Business Consulting program at the University of Illinois’ Gies College of Business, the nation’s largest professionally managed, student-run consulting organization. He has long worked in the realm of emerging technologies. This conversation has been edited for length.
Peoria Magazine (PM): Many people are familiar with the term “cryptocurrency” but aren’t precisely sure what it is or how it works. Can you explain cryptocurrency, the blockchain technology behind it, and what gives this particular currency value? Can you buy things with cryptocurrency?
Jake Kinsey (JK): Cryptocurrency is a technology that can be described as a form of digital money that does not require bank or government backing. The “crypto” refers to cryptography, a form of encryption that uses “value/key pairs” to communicate. Other examples of value/key pairs we use in everyday life include usernames and passwords, and bank account numbers and signatures.
In cryptocurrency, the value/key pair is called a “public key” and “private key.” The public key is like a … routing number that helps others transfer money to an account. The private key is an internal string of characters that acts as a digital signature, like on a check. When the public key and private key are encrypted together and sent to the blockchain, the blockchain can validate the transaction is authentic, kind of like a banker validating a check based on the signature …
Blockchain is a decentralized digital ledger that records all account balances and transactions of cryptocurrencies and digital assets. The decentralization of the digital ledger means that a copy of the ledger is kept on each computer that participates in the blockchain network. To participate in the network, each computer must follow a set of rules that helps to ensure transactions added to the network are legitimate …
In general, blockchain and cryptocurrencies create value by providing digital scarcity, which is dependent on the security of the network. This means you cannot spend the same digital currency twice because the rules and regulations of the blockchain will not allow it. There also may be a limit in supply on the number of available currencies in the network … There are many blockchains and each blockchain has many cryptocurrencies that all derive value differently.
Third-party financial service providers have cryptocurrency-based credit cards that can allow for purchases of goods within the current financial system for practically any item.
PM: Many Americans may be wary of the whole cryptocurrency phenomenon, given its opaque origins. For example, Bitcoin was founded by a Satoshi Nakamoto, evidently a pseudonym for some Oz-like character whose real identity remains unknown. Given that, can cryptocurrency be trusted?
MANY AMERICANS MAY BE
WARY … CAN CRYPTOCURRENCY
K: The ethos in the cryptocurrency community is “code is law,” where code means computer code. While Satoshi Nakamoto created Bitcoin in 2008, by 2010 he stepped away … and handed control of the source code repository to Gavin Andreasen, who in turn created the nonprofit Bitcoin Foundation in 2012 to help maintain the codebase. Due to the technical ability required to audit the Bitcoin codebase, many of the initial adopters have been software developers who see the promise of the technology. Many blockchain enthusiasts trust the distributed nature of the network and the process of open-source code creation more than currencies backed by central governments.
Different blockchains are secured in different ways. Some consensus mechanisms, rules and regulations … can be manipulated if 51% of the computers on the network are controlled by a single malicious actor … There are enough computers participating in the Bitcoin network that it would be difficult for a single nation to control more than 51% … Other blockchains can be defeated if 33% of the assets that secure the blockchain are controlled by a single malicious actor.
The Ethereum network is moving to this type of mechanism where a user would have to control over $10 billion worth of the network assets. Most other blockchains are controlled by only a few hundred computers or nodes and require some level of trust from the network participants.
The success of cryptocurrencies largely depends on consumer demand. Benefits of cryptocurrency technology include:
- Faster cross-border asset transfers (from half a day to seconds);
- Lower transaction fees than credit cards (can be fractions of a cent);
- Access to money at any time (the internet never sleeps);
- No limits on withdraws or purchases;
- Accounts cannot be frozen by the government.
However, many central governments see cryptocurrencies as a threat to national security … Therefore, countries are starting to consider their own digital currencies, known as Central Bank Digital Currencies (CBDCs) …
The main difference from a centralized government to a distributed system is that the centralized government would most likely retain the ability to freeze assets and track all forms of digital spending. While these differences would limit the liberties of good actors, they would also allow for additional consumer protections …
PM: Wall Street is experiencing a bear market, so many people’s investments are taking a pounding, but cryptocurrency prices have been in freefall after soaring earlier. On the risk scale, just how much of a chance are investors taking by putting their money down on, say, Bitcoin or other cryptocurrencies?
JK: Bitcoin and other cryptocurrencies are still considered risk assets. Bitcoin and Eth are the closest to “bluechips” that exist in crypto due to the size of the networks backing the currencies. Any other cryptocurrency is known as an “altcoin” or alternative coin. These altcoins carry much more risk but could also provide for greater returns.
Recently, cryptocurrencies as an asset class have been in freefall because the industry was overleveraged. Some projects in the blockchain space were promising returns of 20% or more by leveraging assets to buy more assets in a process called “yield farming.” When markets started to turn, these projects could not keep paying out top returns, and malicious actors participated in market manipulation. These projects began to become insolvent and eventually failed …
Investors are demanding more transparency and reserves of traditional currencies to underwrite riskier projects.
PM: How many cryptocurrencies are out there, and what are the differences?
JK: There are thousands of cryptocurrencies. You have come this far with me, so let’s dive further down the crypto rabbit hole … I break down cryptocurrencies into three functional buckets: (1) digital gold; (2) network coins; (3) application coins.
$5 IN BITCOIN IN 2011 WERE
WORTH $325,000 IN 2021
Digital Gold: The godfather of cryptocurrencies and the poster child for digital gold is Bitcoin … Only 21 million Bitcoins will ever be added to circulation based on Bitcoin’s source code. This helps to create digital scarcity and drives the price of Bitcoin higher …
Bitcoin can be used to buy goods and services through financial services firms that offer traditional credit cards. However, because the price of Bitcoin is considered to go up significantly … Bitcoin maximalists are more likely to hold the currency in hopes it will multiply in value. If you bought a pizza in 2011 for five Bitcoin when Bitcoin was equal to $1, those same Bitcoins would have been worth $325,000 at the peak of 2021. The acronym adopted by investors in Bitcoin is HODL: Hold On for Dear Life.
Other forms of digital gold are from projects that are supposedly tied to traditional currencies … called “stable coins.” …
Network coins: Eth is the native coin of the Ethereum blockchain. Ethereum is different from Bitcoin, as the Ethereum Network will allow collection of fees from computers in the network to run applications. This means that the value of Eth is directly related to the desire to use these applications on the Ethereum network. While Ethereum was the first blockchain to introduce compute functionality … there are now many competing networks wanting to be the next currency to power the internet.
Application coins: Another category of cryptocurrencies come from the blockchains that allow for compute. Some applications create their own cryptocurrencies … backed by the application designer. This is where we get coins like Shiba Inu. The application creator controls the supply and any uses for the coin that might drive demand. For example, the carmaker Tesla will accept payment for its vehicles with Shiba Inu coins …
PM: No one has a crystal ball, but do you foresee digital currencies replacing traditional currencies?
JK: Predicting the future is what blockchain enthusiasts love to do! The technology that financial institutions use today is outdated. Cryptocurrency provides so many more benefits than traditional currencies that it is hard to imagine a world where they do not get adopted. The big question is if the digital currency of the future are CBDCs controlled by a central government, currencies within a distributed and open network, or some combination …
Personally, I think there is room for everything. I can see a world where there are multiple cryptocurrencies … depending on the need of the individual. If you need currency that is safe and dependable, you will use the government CBDC. If you need more flexibility to innovate or simply want a reserve currency independent of government interests, you’ll use an open, distributed cryptocurrency.
Even beyond digital currencies, blockchain technology has the potential to revolutionize the way we interact with digital assets, including our personal data. Eventually, these technologies will be incorporated into the applications we use in a seamless manner that simply provides consumers with more convenient money management in the digital age.