Cryptocurrencies are changing the way the world thinks about money and finance. In Sri Lanka, their use is prohibited. According to the Central Bank of Sri Lanka (2023), “Cryptocurrency is a type of virtual currency that is generated by private entities and not by a monetary authority of a country. The term ‘cryptocurrency’ refers to a digital representation of value that is implemented using cryptography and Distributed Ledger Technology (DLT) or similar technology.” Sri Lanka’s stance against cryptocurrency is stern and clear: “The CBSL has already highlighted, through Press Releases issued in 2018, 2021, and 2022, the significant financial, operational, legal and security-related risks as well as customer protection concerns posed to users of cryptocurrency… As per Directions No. 03 of 2021 under the Foreign Exchange Act, No. 12 of 2017, Electronic Fund Transfer Cards (EFTCs) such as debit cards and credit cards are not permitted to be used for payments related to cryptocurrency transactions.
Cryptocurrency operates through informal channels, and therefore, it does not contribute to the national economy and can also cause a loss of valuable foreign currency to the country.” Even though digital currencies are not legalised in Sri Lanka, some individuals engage in related activities. The prospects and challenges of cryptocurrencies are vast; however, several factors hinder their adoption. This article does not argue whether cryptocurrency should be legalised. Instead, it highlights the potential economic benefits of legalising cryptocurrencies, such as boosting financial inclusion, attracting foreign investments, and creating jobs. Additionally, the article explores the psychological implications of cryptocurrency, where a person’s trust, behaviour, and perceptions shape its use. On the other hand, it delves into the challenges associated with cryptocurrency adoption.
Should we include cryptocurrency in our Investment Portfolio?
Before delving into investment potential, it is crucial to understand the context of cryptocurrency. Cryptocurrency, or virtual currency, operates as a financial market that relies on the digital bookkeeping system called blockchain. Investors often rely heavily on speculation and rumours when managing cryptocurrency assets. Due to its unpredictable price changes, it is difficult for investors to take optimal positions in trading and investing. According to Andrianto and Diputra (2018), cryptocurrency carries high risk, indicated by a standard deviation rate that can exceed 100 per cent. Nevertheless, it improves portfolio effectiveness. They found that cryptocurrency investments are most profitable over monthly periods rather than semi-annual or annual ones. This observation aligns with Modern Portfolio Theory, which explains why cryptocurrencies are included in investment portfolios. Furthermore, cryptocurrency has outperformed the S&P 500 and Dow Jones indexes. To understand cryptocurrency investments, one must examine the theory behind them. American economist Harry Markowitz introduced his pioneering theory of “Portfolio Selection,” published in the Journal of Finance in 1952. He was later awarded the Nobel Prize for his work on Modern Portfolio Theory.
Modern Portfolio Theory
A key component of this theory is diversification. Most investment portfolios consist of either high-risk, high-return assets or low-risk, low-return assets. However, Markowitz argues that investors can achieve optimal results by selecting a mix of both based on their risk tolerance. The theory assumes that investors prefer less risky portfolios and require higher compensation for taking on additional risk. Modern Portfolio Theory advocates for diversifying portfolio assets from different classes, suggesting that such diversification is less risky than holding a portfolio of similar assets. A portfolio frontier maximises expected returns for each level of risk (measured as standard deviation). Cryptocurrency investors can leverage this principle. A typical portfolio frontier is illustrated below: According to Letho, Chelwa, and Alhassan (2021), cryptocurrencies are heavily skewed, meaning that their risks increase quickly and decrease gradually. They also observed weak negative and positive relationships between cryptocurrencies.
Economic potential of cryptocurrencies in Sri Lanka
According to De Filippi (2019), technological innovation influences the entire financial services market, changing the economy in general and restricting traditional economic actions. Both individuals and corporations can benefit from these innovations due to cheaper and faster payment systems, which reduce the cost of living for the general public. Digital currency provides an efficient, low-cost means of transferring and storing money, enabling individuals to build savings.
This increased financial inclusion can enhance economic security by helping people manage their finances more effectively. However, if poorly managed, digital currencies could raise inflation or devalue existing currencies. Many Sri Lankans lack access to traditional banking systems due to factors like geography, lack of documentation, and inefficient financial infrastructure. Cryptocurrency can provide these individuals with access to financial services through the Internet and smartphones.
Additionally, traditional banking systems often charge fees for basic services like money transfers and account maintenance, increasing transaction costs. Cryptocurrency can offer low-cost or even no-cost alternatives. In developing markets, small businesses struggle to access credit or financing from traditional banks due to a lack of collateral or credit history. Decentralised lending platforms powered by cryptocurrency and blockchain technology can address these challenges. Small businesses can also accept global payments, opening up new growth opportunities. In developing economies like Sri Lanka, cryptocurrency could address weak Central Bank credibility, inefficient payment systems, and limited access to financial services.
If the Central Bank of Sri Lanka issues digital currency to strengthen macroeconomic policies and improve payment systems, it could enhance economic security and financial inclusion. The rapid growth of the crypto ecosystem presents new opportunities. Technological innovation has made payments and other financial services cheaper, faster, and more accessible. According to the IMF (2021), decentralised finance offers a more innovative, inclusive, and transparent system. With the right mechanisms in place, Sri Lanka could harness these benefits to enhance its financial and economic growth.
Psychological implications and challenges associated with cryptocurrencies
The psychological implications of cryptocurrency can also be understood through Bitcoin, which highlights similar effects. According to Faboye Michael (2024), “There is a complicated emotional dance hidden beneath the appeal of instant wealth and financial independence. The wild ride that is Bitcoin prices can be both an exciting and dangerous one, full of psychological difficulties.”
Cryptocurrencies offer financial freedom by removing the need for banks or Governments to control assets. The main factors driving investment in such currencies are wide availability and social acceptance. Bogamuwa and Fernando, in Sri Lankan Perceptions on the Future of Cryptocurrency and Blockchain Technology, state:“Despite the arguments for and against cryptocurrency and blockchain technology, they are forces that are now too large to ignore… [Cryptocurrencies have] made a global market accessible to more people, especially in developing countries that lack access to foreign equity and financial markets.” Michael also highlights that Bitcoin provides individuals with financial autonomy, potentially earning them significant profits and creating a sense of empowerment.
Crypto communities foster camaraderie by bringing together individuals with shared interests. However, this collectivist mindset can lead to herd behaviour, where decisions are influenced by social groups rather than individual analysis. The cryptocurrency market is also characterised by rapid price fluctuations, which can trigger psychological responses like the Fear Of Missing Out (FOMO). Additionally, the thrill of trading can be intoxicating, leading to addictive behaviours. Reckless investment behaviour driven by FOMO can result in widespread disillusionment during market downturns, eroding trust in the technology.
Human nature tends to seek high income with low risk. However, the reality is that high income often involves high risk, which explains the modern fascination with currencies like Bitcoin and crypto. National regulators must prioritise implementing global standards and ensuring effective supervision (IMF, 2024). In the global context, policymakers should work towards making cross-border payments faster, cheaper, and more inclusive through the G20 Cross-Border Payments Roadmap (IMF, 2024).
Conclusion
In conclusion, cryptocurrencies hold significant potential to transform an economic landscape by promoting financial inclusion, reducing transaction costs, and unlocking new opportunities for businesses and individuals. However, this potential is tempered by the need to address key challenges, including regulatory risks, psychological implications, and the volatility inherent to digital assets.
While the global crypto ecosystem evolves rapidly, Sri Lanka must tread carefully, balancing the benefits of innovation with the necessity for robust governance and financial stability. A pragmatic, well-regulated approach could enable the country to harness the advantages of cryptocurrencies while mitigating their risks, paving the way for a more inclusive and resilient economy.
(Charani L.C.M. Patabendige is a Research Assistant and an Acting Research Analyst of the Institute of National Security Studies (INSS) and the Ministry of Defence. Thisuri Jayathma is a Research (Intern) at the INSS. The opinions expressed are their own and not reflective of the Institute or the Ministry)