Introduction and Regulation of Cryptocurrency

Cryptocurrency, generally referred to as “digital currency” or “virtual currency”, is a mode of financial exchange that enables users to virtually pay for goods and services without the presence of a central regulatory authority. It is characterized by peer to peer (P2P) transactions. Cryptocurrency is backed primarily by user consensus. Bitcoin can only be sent or received by logging the exchange on the public ledger, also called the “blockchain”. The entire network has to collectively agree on the contents of the ledger or blockchain, instead of a central authority maintaining the accounts. This mandates the consensus of users for the information to be noted in the blockchain. Cryptocurrencies provide privacy and lower transaction costs but there are certain risks also that come along with the usage. This paper will discuss the ramifications of using cryptocurrency. The work is divided into two articles. The first one introduces cryptocurrencies and examines the benefits as well as deficiencies associated with the usage of bitcoins. The subsequent article will deliberate on the illicit uses and talk about the suggestions for having in place a regulatory framework for bitcoins.

Introduction

Bitcoin was introduced in 2009 by an anonymous developer who goes by the pseudonym, Satoshi Nakamoto. In his paper on the introduction of bitcoins, Satoshi conveyed his desire to create a coin that would eliminate the presence of a central authority and replace it with cryptographic evidence. Cryptocurrencies work as a series of electronic signatures where every holder transfers the coin to the subsequent one by digitally signing an assortment of the previous transaction and the public key of the next holder and adding these to the end of the coin[1]. The signatures can be verified by a payee to verify the chain of ownership. The transactions take place through a complex process of solving algorithms, known as “mining” [2]. The customers have to create a virtual “wallet” to indulge in the selling and buying of cryptocurrencies. Bitcoins do not have any intrinsic value. Their value is derived from their demand and supply [3]. It is a non-fiat currency. A fiat currency derives value from the government. Bitcoins are not regulated by the government or any central authority for that matter.

Bitcoin provides various benefits apart from low transaction fee and reducing the time taken to complete transactions. However, just like normal currency, bitcoins are vulnerable to theft, being lost or destroyed. These concerns are discussed further in the paper.

Benefits and Drawbacks of Bitcoins

Some of the benefits associated with bitcoins are:

  • Transparency– Since all transactions regarding bitcoins are stored in blockchains, which are publicly available, it provides a high level of transparency and verification by other consumers. This element is not present in the current currency system.
  • Anonymity– Bitcoin purchases enjoy anonymity and privacy. Cryptocurrency transactions don’t carry personal information at all, unlike the debit and ATM cards that require name, address and other unique personal information. Until a user voluntarily publishes their information, the purchases will not be related to them individually.
  • No third party interference– Since there is no regulating authority governing bitcoins, they enjoy freedom from intervention by government, banks or other financial institutions. It works on a peer to peer basis.
  • Low transaction costs Lack of any governing authority reduces the cost of exchange. Bitcoin boasts of low transaction fee compared to other modes of online payment like PayPal, that charges two to four percent [4]. Another benefit is that the transactions complete quickly, eliminating the inconvenience of authorization and long waiting periods by cutting out the middleman, thus saving costs.
  • Solves the issue of Double Spending – Bitcoin solves the problem of “Double Spending” (using the same coin more than once) that is apparent in non-cash payments by informing the entire network of the wallet that contains the coins.

Some of the drawbacks associated with bitcoins are:

  • Instability – Bitcoin suffers from instability in its prices since it is a non-fiat currency and its value is solely determined by demand and supply forces. Fiat money’s value can be stabilized through various fiscal policy decisions like changing interest rates, revaluing or devaluing currency, which is done by government, banks and other financial intermediaries. Lack of central authority, even though benefits bitcoin in some ways, compromises the stability of value. The fiat money’s value is kept stable by central banks and governments but since there is absence of a central regulatory authority governing bitcoins, there is no authority to ensure the stability of value.
  • Irreplaceability – Most bitcoins exist as a wallet file which is used to connect to the private key which keeps the money safe. If there is theft, the bitcoins will be lost forever. Although the public key can be used, the wallet can only be accessed through the private key. The public key remains but it is only accessible by the private key. Once the private key is lost, the money cannot be recovered. There have been instances in the past where people lost tremendous amounts of money because they either deleted or lost their private key. The defenders of bitcoins counter-argue that the risk of money being lost could also be encountered when dealing with real money. Although it is true that real money can also get misplaced, it is highly unlikely that a person would stock up all their money in one place. So, the loss due to misplacement will be lesser.
  • Deflation – Bitcoins are limited in number. The idea behind having a limited number was that the scarcity would lead to an upward valuation of currency. The decentralized character of bitcoin makes it incompatible for banking [5], which further promotes hoarding by individuals. Hoarding can lead to deflation. Hoarding defeats the purpose of the currency because it cannot fulfill the basic agenda of buying and selling goods and services [6]. Deflation is quite awful for a currency as it does not serve the purpose of exchange.
  • Computational inefficiency – A less ventured drawback of bitcoin is that it uses energy inefficiently. Bitcoin requires the participants on the network to use the computing power to verify transactions. This gives rise to two problems: computational power required for mining of bitcoins and size of the blockchain [7]. The computational power has been increasing over time. Bitcoin uses an astonishing amount of energy to operate. The size of the blockchain also poses a problem. Although the bitcoin is considered to have a high speed in verifying transactions, the size of the blockchain is growing to an extent that the transaction verification speed is slowing down.

Illegal uses of Cryptocurrency

Although the cryptocurrency provides certain benefits and comes along with certain drawbacks, there is a malignant side to it as well. Cryptocurrencies are being used for nefarious purposes like hacking, money laundering, obtaining illegal goods and services and other fraudulent activities.

The next half of the paper will elaborate on the illegal uses and the framework for their regulation.

List of citations and references 

  1. Satoshi Nakamoto. (2008) Bitcoin: A Peer-to-Peer Electronic Cash System. [Online]. https://bitcoin.org/bitcoin.pdf
  2. http://www.anser.org/docs/reports/RP14-01.03.03-02_Cryptocurrencies%20508_31Dec2014.pdf
  3. MARC ANDREESSEN. (2014, January) The New York Times. [Online]. http://dealbook.nytimes.com/2014/01/21/why-bitcoin- matters/
  4. R. Wu, 2014. “Why we accept Bitcoin,” Forbes (12 February) http://www.forbes.com/sites/groupthink/2014/02/13/why-we-accept-bitcoin/#402efae4130b
  5. B.P. Hanley, 2013. “The false premises and promises of Bitcoin”
  6. I. Fisher, 1933. “The debt-deflation theory of great depressions,” Econometrica, volume 1, number 4, pp. 337–357
  7. Andres Guadamuz and Chris Marsden, Blockchains and Bitcoin: Regulatory responses to cryptocurrencies, Volume 20, Number 12 – 7 December 2015,

 

Mitali Arora is a third year law student in Jindal Global University.

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