Aleksander Berentsen and Fabian Schär of the Federal Reserve Bank of St. Louis have recently published an article that emphasizes many of the benefits of cryptocurrencies. The article states “that cryptoassets are well suited to become an important asset class,” in addition to offering praise regarding a number of the major applications associated with cryptocurrencies.
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The piece opens by outlining many of the core motivations underpinning the development of bitcoin, stating that it was Satoshi Nakamoto’s intention to “develop a cash-like payment system that permitted electronic transactions but that also included many of the advantageous characteristics of physical cash.” The authors state that bitcoin was designed to comprise a monetary form that would allow the electronic transfer of value through the circulation of data files – allowing bitcoin to “retain the advantages of physical cash,” whilst being able to be distributed freely via “electronic networks.”
Berentsen and Schär state that “the true potential of blockchain technology will become apparent” only once distributed ledger technology attains general adoption, which the authors anticipate may take “many years, or possibly decades.” As such, the authors conclude that one cannot predict the industries in which bitcoin and blockchain technology will have the greatest impact – however, the article emphasizes the shift in economic dialectical relations may be borne through the innovations of colored coins and smart contracts.
Of colored coins, the authors state that bitcoin “can be used to produce fingerprints for all kinds of data files and then store them in a blockchain.” The article states that “public blockchains [create] the potential to monitor data files,” which may have far-reaching implications with regards to “data integrity.” It is asserted that the employment of colored coins renders “any manipulation attempt […] apparent because any change to the data file will lead to a completely different hash value,” thus creating a decentralized, untamperable record of said data that is publically available to all.
Smart contracts are described as “self-executing contracts.” The authors state that the typical function of smart-contracts is “to stipulate that a Bitcoin payment will be executed only when a certain condition is met.” In addition to such, the authors state that smart-contracts can be used to host a variety of applications, including “e-voting systems, identity management and decentralized organization, and various forms of fundraising.”
Risks Associated With Cryptocurrencies
Despite the authors’ optimism regarding cryptocurrencies, a number of risks are identified to be associated with crypto assets. Firstly, the article emphasizes that risks that forks may pose to specific cryptocurrencies, describing the emergence of Ethereum Classic and Bitcoin Cash as having occurred as a result of ideological dissent between conflicting factions within a given cryptocurrency community.
The perceived energy wastage that stems from proof-of-work mining and increasing mining difficulty is also cited as a significant risk pertaining to the cryptocurrency space. However, the authors contest the mainstream narrative surrounding such by emphasizing the energy costs associated with centralized payment systems, using the lack of research conducted into the electricity consumption required to operate a central bank as an example of such. Beyond bitcoin, the article also asserts that “many crypto assets use alternative consensus protocols, which do not (solely) rely on computational resources.”
The article also identifies the price volatility associated with cryptocurrencies as a risk which may pose a hurdle to the widespread adoption of virtual currencies. The authors state that “it is very likely that the Bitcoin unit will display much higher short-term price fluctuations than many government-run fiat currency units,” owing to the absence of a mechanism such as “the Federal Reserve System has been explicitly founded ‘to provide an elastic currency’ to mitigate the price fluctuations that arise from changes in the aggregate demand” for monetary instruments.
Whilst Berentsen and Schär state that “Price volatility and scaling issues frequently raise concerns about the suitability of Bitcoin as a payment instrument,” bitcoin is described as a “novel technology” that allows the “stor[age] and transfer [of] monetary unit[s] without the need for a central authority.”
Moving past the authors’ assessments of bitcoin as a means of payment, the article states that “As an asset, however, Bitcoin and alternative blockchain-based tokens should not be neglected,” emphasizing many unique applications made possible by cryptocurrency – such as the management and verification of the integrity of data, and the emergence of smart contracts. Said utilities, the authors write, comprise “Promising applications […] which may bring change to the world of finance and to many other sectors.”
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