What is cryptocurrency?
A cryptocurrency is a digital or virtual currency. It is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. The cryptocurrencies are generally not issued by any central authority, so governments do not have any control on them. They remain out of the ambit of monetary policy.
Cryptocurrencies are based on cryptographic systems which enable secure online payments without the use of third-party intermediaries say banks. The word “Crypto” refers to the various encryption algorithms and cryptographic techniques that safeguard these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions.
How can a person get a crytocurrency?
Cryptocurrencies can be mined or purchased from cryptocurrency exchanges. Not all ecommerce sites allow purchases using cryptocurrencies. Mining is the process that Bitcoin and several other cryptocurrencies use to generate new coins and verify new transactions. It involves vast, decentralized networks of computers around the world that verify and secure blockchains – the virtual ledgers that document cryptocurrency transactions. In return for contributing their processing power, computers on the network are rewarded with new coins. The network holds a lottery. Every computer on the network races to be the first to guess a 64-digit hexadecimal number known as a “hash.” The faster a computer can spit out guesses, the more likely the miner is to earn the reward. For example Bitcoin mining is a lot like running a big data center. Companies purchase the mining hardware and pay for the electricity required to keep it running (and cool). For this to be profitable, the value of the earned coins has to be higher than the cost to mine those coins. Specialized computers perform the calculations required to verify and record every new bitcoin transaction and ensure that the blockchain is secure. Verifying the blockchain requires a vast amount of computing power, which is voluntarily contributed by miners.
Blockchain
Blochchain technology is central feature of cryptocurrencies on which the functionality of cryptocurrencies depend. Blockchain is essentially a set of connected blocks or an online ledger. Each block contains a set of transactions that have been independently verified by each member of the network. Every new block generated must be verified by each node before being confirmed, making it almost impossible to forge transaction histories.1The contents of the online ledger must be agreed upon by the entire network of an individual node, or computer maintaining a copy of the ledger.
Blockchain technology has the potential to serve multiple industries, such as supply chain, online voting and crowdfunding etc. Financial institutions such as JPMorgan Chase & Co. (JPM) are testing the use of blockchain technology to lower transaction costs by streamlining payment processing.
Types of Cryptocurrency
Bitcoin– An anonymous person called Satoshi Nakamoto invented (introduced 2008) the first cryptocurrency i.e. Bitcoin which is the most popular and valuable cryptocurrency. Bitcoin, which was made available to the public in 2009, remains the most widely traded and covered cryptocurrency. As of November 2021, there were over 18.8 million bitcoins in circulation with a total market cap of around $1.2 trillion. Only 21 million bitcoins will ever exist.
There are thousands of cryptocurrencies present in the market today. Each cryptocurrency claims to have a different function and specification.
Ethereum– Ethereum’s ether markets itself as gas for the underlying smart contract platform.
Ripple’s XRP is used by banks to facilitate transfers between different geographies.
Altcoins– In the wake of Bitcoin’s success, many other cryptocurrencies, known as “altcoins,” have been launched. Some of these are clones or forks of Bitcoin, while others are new currencies that were built from scratch. They include Solana, Litecoin, Ethereum, Cardano, and EOS. By November 2021, the aggregate value of all the cryptocurrencies in existence had reached over $2.1 trillion—Bitcoin represented approximately 41% of that total value.4
Are Cryptocurrencies Legal?
Cryptocurrencies have largely functioned outside most existing financial infrastructure. As of December 2021, El Salvador was the only country in the world to allow Bitcoin as legal tender for monetary transactions. In the rest of the world, cryptocurrency regulation varies by jurisdiction.
The currency which is used by people in every country is authorized by the monetary authority and “fiat” or “order” of the government of the country. So they are often called a “legal” tender. But there is no legal banking behind the cryptocurrencies. Cryptocurrencies are not backed by any public or private entities. Therefore, in the true sense of the word they cannot be described as legal. But even then they have different degrees of quasi legal status.
Japan’s Payment Services Act defines Bitcoin as legal property.6 Cryptocurrency exchanges operating in the country are subject to collect information about the customer and details relating to the wire transfer. Cryptocurrencies are legal in the European Union (EU). Derivatives and other products that use cryptocurrencies will need to qualify as “financial instruments.” in accordance with European Commission’s June 2021 Markets in Crypto-Assets (MiCA) regulation, that sets safeguards for regulation and establishes rules for companies or vendors providing financial services using cryptocurrencies. In the US crypto derivatives such as Bitcoin futures are available on the Chicago Mercantile Exchange but the Securities and Exchange Commission (SEC) does not consider Bitcoin and Ethereum as securities. on the other hand China has banned cryptocurrency exchanges and mining within its borders. India has not given it a legal status but it is considering formulating a framework for cryptocurrencies. And the FY 2021 budget has marked such a beginning.
The legal status of cryptocurrencies has implications for their use in daily transactions and trading. In June 2019, the Financial Action Task Force (FATF) recommended that wire transfers of cryptocurrencies should be subject to the requirements of its Travel Rule, which requires AML compliance.
Advantages and Disadvantages of Cryptocurrency
Cryptocurrencies were introduced with the intent to revolutionize financial infrastructure. As with every revolution, however, there are tradeoffs involved. At the current stage of development for cryptocurrencies, there are many differences between the theoretical ideal of a decentralized system with cryptocurrencies and its practical implementation.
Some advantages and disadvantages of cryptocurrencies are as follows.
Advantages
Avert the possibility of a single point of failure: Cryptocurrencies represent a new, decentralized paradigm for money. In this system, centralized intermediaries, such as banks and monetary institutions, are not necessary to enforce trust and police transactions between two parties. Thus, a system with cryptocurrencies eliminates the possibility of a single point of failure, such as a large bank, setting off a cascade of crises around the world, such as the one that was triggered in 2008 by the failure of institutions in the United States.
Easier to transfer funds– Cryptocurrencies promise to make it easier to transfer funds directly between two parties, without the need for a trusted third party like a bank or a credit card company. Such decentralized transfers are secured by the use of public keys and private keys and different forms of incentive systems, such as proof of work or proof of stake.
Faster transfers– Because they do not use third-party intermediaries, cryptocurrency transfers between two transacting parties are faster as compared to standard money transfers. Flash loans in decentralized finance are a good example of such decentralized transfers. These loans, which are processed without backing collateral, can be executed within seconds and are used in trading.
Generation of profits– Cryptocurrency investments can generate profits. Cryptocurrency markets have skyrocketed in value over the past decade, at one point reaching almost $2 trillion. As of Dec. 20, 2021, Bitcoin was valued at more than $862 billion in crypto markets.
Cross border transfer- Cryptocurrencies such as Bitcoin serve as intermediate currencies to streamline money transfers across borders.
Cryptocurrency can be converted– A fiat currency is converted to Bitcoin (or another cryptocurrency), transferred across borders and, subsequently, converted to the destination fiat currency. This method streamlines the money transfer process and makes it cheaper.
Disadvantages
Cryptocurrencies are pseudonymous-Though they claim to be an anonymous form of transaction, cryptocurrencies are actually pseudonymous.
Cryptocurrencies leave a digital trail -They leave a digital trail that government agencies can decipher. This opens up possibilities of governments and their agencies tracking the financial transactions of ordinary citizens.
Cryptocurrencies vunerable to be used by criminals– Cryptocurrencies have become a popular tool with criminals for nefarious activities such as money laundering and illicit purchases. The case of Dread Pirate Roberts, who ran a marketplace to sell drugs on the dark web, is already well known.
Use of ransomware on cryptocurrencies by hackers– Cryptocurrencies have also become a favorite of hackers who use them for ransomware activities. Though cryptocurrency blockchains are highly secure, other crypto repositories, such as exchanges and wallets, can be hacked. Many cryptocurrency exchanges and wallets have been hacked over the years, sometimes resulting in millions of dollars worth of “coins” stolen.
Cryptocurrencies lead to concentration of wealth– In theory, cryptocurrencies are meant to be decentralized, their wealth distributed between many parties on a blockchain. In reality, ownership is highly concentrated. For example, an MIT study found that just 11,000 investors held roughly 45% of Bitcoin’s surging value.16
Mining of cryptocurrencies involve huge amount of power consumption– One of the conceits of cryptocurrencies is that anyone can mine them using a computer with an Internet connection. However, mining popular cryptocurrencies requires considerable energy, sometimes as much energy as entire countries consume. The expensive energy costs coupled with the unpredictability of mining have concentrated mining among large firms whose revenues running into the billions of dollars. According to an MIT study, 10% of miners account for 90% of its mining capacity.
Cryptocurrencies are prone to price volatility– Cryptocurrencies traded in public markets suffer from price volatility. Bitcoin has experienced rapid surges and crashes.