Interest in cryptoassets has risen sharply in a short space of time. A fundamental concept of cryptoassets is the desire to create a decentralised financial system without the involvement of governments, central banks and financial intermediaries such as banks. Instead, control should lie with the participants through decentralised networks, with everyone able to transfer money to anyone anywhere in the world with no party able to limit it and without having to have a bank account for example.
Unbacked digital assets
Cryptoassets are a kind of digital asset. Many cryptoassets are unbacked (i.e. do not have any underlying collateral) and do not have a central issuer governing how many new cryptoassets should be issued or what their price should be. Neither is there any party to turn to if something goes wrong (see the section Cryptoassets have low consumer and investor protection). Instead, it is a set of rules – a protocol – that clarifies how new cryptoassets are created and how participants can interact and conduct transactions. All events such as transactions are registered in a ledger, such as a blockchain, that everyone can read. Cryptoassets also have a decentralised network of participants in which the participants update, store and read the blockchain. Cryptocurrencies: looking beyond the hype. Chapter in BIS Annual Economic Report, June 2018, Bank for International Settlements.
Illustration 1. The components of cryptoassets
Note. The figure is based on information from Cryptocurrencies: looking beyond the hype. Chapter in BIS Annual Economic Report, June 2018, Bank for International Settlements.
The cryptoassets Bitcoin and Ethereum are examples of unbacked cryptoassets without central issuers (in this staff memo called “unbacked cryptoassets”). Ethereum is actually the name of a decentralised blockchain. The Ethereum blockchain has its own cryptoasset called Ether, which is often called Ethereum. In this staff memo, the name Ethereum is used both for the blockchain and the cryptoasset.
The price of Bitcoin and Ethereum is determined by expectations that someone else will be willing to pay at least as much as the buyer has paid to buy them. There is thus no guarantee that they will hold their value. Neither is it certain that they will be exchangeable for another asset, such as a national currency. The factor that gives most cryptoassets their value is rather the hope that they will maintain or increase their value. It might also be the case that the decentralised characteristics of cryptoassets are valued.
Crypto wallets are a kind of storage place for cryptoassets. For more information on digital wallets, see for example B. Nibley (2021), “What is a crypto wallet? Understanding the software that allows you to store and transfer crypto securely”, 28 October 2021, Business Insider. The wallet does not contain the actual cryptoassets, but rather serves as a way of accessing them. A crypto wallet has a private key and a public key. The private key works in a similar way to a password, and the owner of the cryptoassets uses it to access their cryptoassets. The public key serves as the wallet's address, which the owner can provide to have cryptoassets sent to them.Although the wallet's address is public, the information concerning the wallet’s holder is concealed. This is why it is said that Bitcoin and other cryptoassets have a relatively high degree of anonymity, unlike a bank account, as banks are under strict requirements in terms of sound customer due diligence.
Transactions in Bitcoin and many other cryptoassets are based on a method called ‘proof of work’ (PoW). A general description of how this works is provided in the fact box below. For more detailed information on the process for a Bitcoin transaction, see B. Segendorf (2014), “What is Bitcoin?”, Economic Review, 2014:2, Sveriges Riksbank.
Facts - What is the proof of work (PoW) process?
To enable carrying out, for example, a Bitcoin transaction between two digital wallets, it must be confirmed by the network. The transaction is merged with other proposed transactions in a “block”. This takes place automatically every ten minutes. Those who confirm the block of proposed transactions are called “miners”, which anyone can become. This is the case of an open blockchain, also known as a permissionless blockchain. There can also be blockchains that only certain parties are able to update, known as a permissioned blockchain. Miners compete to confirm the transaction by being the fastest one to solve a mathematical problem. The solution to the problem must thereafter be confirmed by other miners through a majority decision. The more computing power a miner provides to the Bitcoin network, the more voting power that miner will have. When the block of transactions has been verified, they are added to the chain of blocks of previously completed transactions.
Miners have incentives to verify transactions because the miner who solved the mathematical problem fastest receives a reward in the form of newly created Bitcoins. The miner also receives reward in the form of a transaction fee. Transactions with no or a small transaction fee might need to wait longer for confirmation and completion. The degree of difficulty of the mathematical problem and the number of new Bitcoin created are governed by the Bitcoin protocol. When the price of Bitcoin increases, it will be more attractive to compete for and confirm transactions and hence be awarded newly created Bitcoin. If more computers participate in the network, the degree of difficulty of the problem increases. A more difficult problem requires more computing power.
Since all Bitcoin transactions need to be confirmed by the network and this is done at ten-minute intervals, it can take up to ten minutes for the transaction to be verified. Also, there is a rule of thumb that one should wait for a number of rounds to be sure that the transaction really has been completed and is registered on the blockchain.
There are also other methods for confirming transactions on blockchains. One of the best known is “proof of stake” which requires less computing power than PoW. Proof of stake (PoS), in short, entails that those who hold a sufficient volume of the cryptoassets concerned can be entrusted with verifying transactions. The cryptoasset and blockchain Ethereum will switch to PoS instead of PoW.
There is an embedded halving period for how many Bitcoins are created for each added block and the size of the reward that the miner who solved the problem fastest can thus receive. After 210,000 blocks, the volume of created Bitcoins is halved. Eventually, the volume of newly created Bitcoins will therefore decrease to around zero. This means that there is a cap on how many Bitcoins can be created in total, which is 21 million. In the Middle of May 2022, the volume of Bitcoins in circulation was around 19 million. See Blockchain’s website: Blockchain Explorer – Search the Blockchain | BTC | ETH | BCH. Since miners receive fewer newly created Bitcoins when they confirm transactions, transaction fees will become a more important part of the network. In other words, transaction fees will form an increasingly important incentive for miners to verify transactions compared with currently, as they are also rewarded with newly created Bitcoins.
Cryptoassets are also called cryptocurrencies but lack the characteristics of regular currencies
It is common for the term “cryptocurrencies” to be used to describe cryptoassets. However, the Riksbank finds the term “cryptocurrency” misleading because it implies that cryptoassets are supposedly a type of money.
There are different ways of defining what money is. A common way of defining it is that an asset must fulfil three criteria to be considered money: It must act as a store of value, it must act as a means of payment and it must act as a unit of account. See for example G. Söderberg (2018), “Are Bitcoin and other cryptoassets money?”, Economic Commentaries No. 5, 2018, Sveriges Riksbank. Because Bitcoin is the largest cryptoasset so far, we take this as an example.
An asset working as a store of value means that its holder must be able to trust that it is possible to buy about as much for, let’s say, SEK 100 today as it will be tomorrow. The price of Bitcoin has been highly volatile (see Figure 4) and it is thus a relatively poor store of value. There are however cryptoassets that aim to have stable prices over time (see the section How do stablecoins differ from other cryptoassets?).
An asset working as a means of payment essentially means that it can be used for payments; that is, a buyer uses the asset to pay and a seller accepts it as payment. There is no exact figure of how many businesses accept Bitcoin as a means of payment in the purchase of goods and services. Coinmap, however, has a map service where users can add different merchants that accept Bitcoin directly for payments and also Bitcoin ATMs where Bitcoins can be bought for cash or with a credit card. As of 13 May 2022 around 29,500 merchants and ATMs worldwide had been added to the map. See Coinmap’s website: Crypto ATMs & merchants of the world | Coinmap.org. As a comparison, Visa cards are accepted by more than 60 million merchants worldwide. Visa (2022), ”Leading by example”, Visa. Accessed 25 April 2022. [online] Available at: Leading by Example | Visa. In El Salvador, Bitcoin has fairly recently been made legal tender, and has the same legal status there as cash has in Sweden. This generally means that it should be possible to use Bitcoin as a means of payment everywhere in El Salvador. In April 2022, the Central African Republic also made Bitcoin legal tender.
An asset working as a unit of account in short means that it is used to price goods and services. The other two functions have a bearing on this, because it is more difficult to price a good or service if the value of the asset fluctuates considerably or if it is not used as a means of payment. In Sweden, and other countries, prices are set in the local currency and not in Bitcoin.
Bitcoin does not generally fulfil the three functions and the conclusion can thus be drawn that Bitcoin is not money, at least not in the sense that it works like money in the traditional financial system and in society. The same can be said of many other cryptoassets.
The value of cryptoassets has risen sharply but has been highly volatile
The cryptoasset market has grown a lot since the beginning of 2018. The market value reached a record level of around SEK 25,000 billion in November 2021 but has thereafter decreased rapidly and is currently worth around SEK 12,400 billion (around USD 1,200 billion) (see Figure 2). Moreover, the market for cryptoassets is still only a small market compared with the global financial system, of which the total assets were valued at around USD 470,000 billion at the end of 2020. FSB (2021), “Global Monitoring Report on Non-Bank Financial Intermediation”, 16 December 2021, Financial Stability Board.
In total, there are around ten thousand different cryptoassets. Based on market value, Bitcoin is the largest cryptoasset, but there are also several others that have grown in size. The market value of cryptoassets is usually calculated as the price per cryptoasset multiplied by the volume in circulation. One example of such a cryptoasset is Ethereum. A major reason for the increase in the total market value of cryptoassets is that the price of various cryptoassets has risen, while the number of cryptoassets in circulation has also increased.
There are cryptoassets called memecoins because they refer to internet memes. A meme is a kind of funny image, video or GIF circulating on the internet. The meme often has a caption. For some of these, prices have risen rapidly, often after they have been hyped up in various internet forums, to then plummet. An example of this is Dogecoin. At the beginning of 2021 it was worth around 1 US cent (see Figure 3). In April and May 2021, the price increased sharply to around 68 cents per Dogecoin, to then drop in June and July by almost 74 per cent to around 18 cents.
Although the prices of many cryptoassets like Bitcoin and Ethereum have risen considerably in the past few years, they have also been highly volatile. The developments in the past few months have been a clear example of this volatility. Also compared with other assets, Bitcoin and Ethereum have been much more volatile (see Figure 4).