A Cryptocurrency is a digital or virtual currency that uses cryptography for security. A Cryptocurrency is difficult to counterfeit because of this security feature. A defining feature of a Cryptocurrency, and arguably its most endearing allure, is its organic nature; it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation.
The first Cryptocurrency to capture the public imagination was Bitcoin, which was launched in 2009 by an individual or group known under the pseudonym Satoshi Nakamoto. As of May 2018, there were over 17 million Bitcoins in circulation with a total market value of over $140 billion. Bitcoin’s success has spawned a number of competing cryptocurrencies, such as Litecoin, Namecoin and PPCoin.
What is a ‘Blockchain’?
A Blockchain is a digitized, decentralized, public ledger of all Cryptocurrency transactions. Constantly growing as ‘completed’ blocks (the most recent transactions) are recorded and added to it in chronological order; it allows market participants to keep track of digital currency transactions without central recordkeeping. Each node (a computer connected to the network) gets a copy of the blockchain, which is downloaded automatically.
Originally developed as the accounting method for the virtual currency Bitcoin, blockchains – which use what’s known as distributed ledger technology (DLT) – are appearing in a variety of commercial applications today. Currently, the technology is primarily used to verify transactions, within digital currencies though it is possible to digitize code and insert practically any document into the blockchain. Doing so creates an indelible record that cannot be changed; furthermore, the record’s authenticity can be verified by the entire community using the blockchain instead of a single centralized authority.
A block is the ‘current’ part of a blockchain, which records some or all of the recent transactions. Once completed, a block goes into the blockchain as a permanent database. Each time a block gets completed, a new one is generated. There is countless number of such blocks in the blockchain, connected to each other (like links in a chain) in proper linear, chronological order. Every block contains a hash of the previous block. The blockchain has complete information about different user addresses and their balances right from the genesis block to the most recently completed block.
The blockchain was designed so these transactions are immutable, meaning they cannot be deleted. The blocks are added through cryptography, ensuring that they remain meddle-proof: The data can be distributed, but not copied. However, the ever-growing size of the blockchain is considered by some to be a problem, creating issues of storage and synchronization
The blockchain is perhaps the main technological innovation of Bitcoin. Bitcoin isn’t regulated by a central authority. Instead, its users dictate and validate transactions when one person pays another for goods or services, eliminating the need for a third party to process or store payments. The completed transaction is publicly recorded into blocks and eventually into the blockchain, where it’s verified and relayed by other Bitcoin users. On average, a new block is appended to the blockchain every 10 minutes, through mining.
What is ‘Bitcoin Mining?’
While traditional money is created through (central) banks, Bitcoins are “mined”. Bitcoin mining is the process by which transactions are verified and added to the public ledger, known as the block chain, and also the means through which new Bitcoin are released. Anyone with access to the internet and suitable hardware can participate in mining. The mining process involves compiling recent transactions into blocks and trying to solve a computationally difficult puzzle. The participant who first solves the puzzle gets to place the next block on the block chain and claim the rewards. The rewards, which incentivize mining, are both the transaction fees associated with the transactions compiled in the block as well as newly released Bitcoin.
The primary purpose of mining is to allow Bitcoin nodes to reach a secure, tamper-resistant consensus. Mining is also the mechanism used to introduce Bitcoin into the system. Miners are paid transaction fees as well as a subsidy of newly created coins, called block rewards. This both serves the purpose of disseminating new coins in a decentralized manner as well as motivating people to provide security for the system through mining.
Bitcoin is like gold in many ways. Like gold, Bitcoin cannot simply be created arbitrarily. Gold must be mined out of the ground, and Bitcoin must be mined via digital means. Linked with this process is the stipulation set forth by the founders of Bitcoin that, like gold, it have a limited and finite supply. In fact, there are only 21 million Bitcoins that can be mined in total. Once miners have unlocked this many Bitcoins, the planet’s supply will essentially be tapped out, unless Bitcoin’s protocol is changed to allow for a larger supply. Supporters of Bitcoin say that, like gold, the fixed supply of the currency means that banks are kept in check and not allowed to arbitrarily issue fiduciary media. But what will happen when the global supply of Bitcoin reaches its limit?
Functioning of Crypto-currencies
The following concepts govern the functioning of most of the cryptocurrencies; however, they all vary in some way or the other in terms of development and implementation of the software or business rules:
- Decentralised: Majority of the fiat currencies in circulation are controlled by a government or a regulatory body, and their creation can be regulated, based on the internal calculations, forecasts or requirements of the regulatory or government backing the currency. This is different in the case of cryptocurrencies, whose creation and transactions are open source and publicly available, controlled by the software code which is again open source, and rely on “peer-to-peer” networks, rather than a centralised agency or authority. There is no single entity that can affect or manipulate or regulate any of these aspects of the Cryptocurrency.
- Digital: Cryptocurrencies are completely digital – they could be stored in digital wallets and transferred digitally to other peoples’ digital wallets or stored on a computer device, a pen drive or a hard drive. The transactions are also digital – with a public record of the transactions on the network.
- Open Source: Cryptocurrencies developed with the open source methodology have their software source code available for open review, integration, development and enhancement. Developers can create Application Programming Interfaces (APIs) with cryptocurrencies without paying a fee and they are open for everyone to use or join the network, irrespective of nationality, gender or location.
- Minersare the backbone of a Cryptocurrency. Miners pool in hardware and computing power and collectively verify the authenticity, accuracy, and security of the blockchains. As the blockchain grows, so does the complexity demanding tremendous amounts of computing power and electricity to power these computers. Every new block in the chain brings a monetary reward to the miner whose block is accepted, and this injects wealth into the Cryptocurrency system. The process of mining also generates value for the miners in the form of transaction fees, which is optional and very low as compared to traditional banking systems.
- Proof-of-workis just a small set of data which is difficult to compute but quite easy for others (peers) in the network to verify. Miners have to complete a proof-of-work on the present block of transactions, for their block to be accepted by other nodes in the network as legitimate. The difficulty of this proof-of-work adjusts based on the business rules of the software, which sets the approximate time limit to a new block. Proof-of-work difficulty is determined by a self-adjusting target, based on the average number of blocks per hour. If the blocks are being generated too fast, difficulty increases.
- Blockchain Technology: A blockchain is the electronic ledger which maintains record of all the transactions from the time the first unit of the Cryptocurrency – the seed – was mined. Blockchain can validate the integrity of all the units of currency at any given point of time. As a protocol, each new block contains the hash of the preceding blocks, and this phenomenon links the previous blocks to the new block, thus forming a chain of blocks. This process validates each block, all the way to the genesis block, integral to the security and integrity of the database.
Cryptocurrencies as a Disruptive Innovation
Professor Clayton Christensen had coined and defined the term Disruptive Innovation as a “process by which a product or service takes root initially in simple applications at the bottom of a market and then relentlessly moves up market, eventually displacing established competitors.” There have been numerous instances where disruptive technologies have displaced well-established competitors, WhatsApp displacing Short Messaging Service (SMS) being one such example. Disruptive technologies offer value to the users, in terms of cost-effectiveness, usability and simplicity. Considering cryptocurrencies in this perspective, they may well have the potential to displace the existing financial systems which enable electronic flow of money across different political boundaries. The success of cryptocurrencies could be attributed to the advantages they have, such as:
- Privacy Protection: Privacy and anonymity of the transacting parties was the prime concern of the proponents of cryptocurrencies when the idea was promulgated, and these became part of the underlying principles. The use of pseudonyms conceals the identities, information and details of the parties to the transaction – perquisites for privacy enthusiasts.
- Cost-effectiveness: Electronic transactions attract fees and charges, which is on the higher side when the transactions are transnational and undergo currency conversion, or attract processing fee levied by the banks, third party clearing houses or gateways. Debit or credit card transactions also attract a processing or transaction fee when used overseas, which is somewhere of the order of 1% to 3%, while electronic transfers could exceed to 10% or 15%. Cryptocurrencies solve this problem, as they have single valuation globally, and the transaction fee is extremely low, being as low as 1% of the transaction amount. Cryptocurrencies eliminate third party clearing houses or gateways, cutting down the costs and time delay. All the transactions over Cryptocurrency platforms, whether domestic or international, are equal.
Another facet, which brings the cost down considerably low, is inbuilt security and fraud prevention mechanism, which accounts for 40% of the costs of payment processing gateways.
- Lower Entry Barriers: Possessing a bank account or a debit/credit card for international usage requires documented proofs for income, address or identification. Banks or financial institutions might have their own set of eligibility criteria for these facilities. Cryptocurrencies lower these entry barriers, they are free to join, high on usability and the users do not require any disclosure or proof for income, address or identity.
- Alternative to Banking Systems and Fiat Currencies: Governments have a tight control and regulation over banking systems, international money transfers and their national currencies or monetary policies. Cryptocurrencies offer the user a reliable and secure means of exchange of money outside the direct control of national or private banking systems.
- Open Source Methodology and Public Participation: A majority of the cryptocurrencies is based on open source methodology; their software source code is publicly available for review, further development, enhancement and scrutiny. The ecosystem of cryptocurrencies is primarily participation based, as software development, bug reporting and fixing, testing etc. are driven by the wider user base, rather than a closed set of individuals or an institution. They have their own consensus based decision making, built-in quality control and self-policing mechanisms for building frameworks, practices, protocols and processes.
- Immunity to Government led Financial Retribution: Governments have the authority and means to freeze or seize a bank account, but it is infeasible to do so in the case of cryptocurrencies. For citizens in repressive countries, where governments can easily freeze or seize the bank accounts, cryptocurrencies are immune to any such seizure by the state.
Despite these numerous advantages and user friendly processes, cryptocurrencies have their own set of associated risks in the form of volatility in valuation, lack of liquidity, security and many more. Cryptocurrencies are being denounced in many countries because of their use in grey and black markets. There are two sets of interconnected risks; one being to the growth and expansion of these platforms in the uncertain policy environment, and the other being the risks these platforms pose to the users and the security of the state.
Risks from Cryptocurrencies
- Potential use for Illicit Trade and Criminal Activities: The perpetrators of Wannacry ransom-ware – which created havoc across 150 countries in May 2017 – demanded ransom of 300-600 USD through Bitcoins. Cryptocurrencies are virtual and decentralised, well beyond the control or authority of the state. Probably, this has made their absorption quicker into grey and black markets, ransom-wares and a host of other illicit activities of crime and money laundering.
- Potential use for Terror Financing: In the aftermath of the attack on World Trade Centre on September 11, 2001, rigorous vigilance and regulatory controls were imposed on global financial systems to crack down on terror financing. This moved terror outfits towards money laundering and hawala networks, but owing to the similar reasons as stated above, cryptocurrencies are also emerging as a new funding stream for terrorist outfits.
- Potential for Tax Evasion: Cryptocurrencies are not regulated or controlled by governments, making them a lucrative option for tax evasion. Sales made or salaries paid in the form of cryptocurrencies could be used to avoid income tax liability. Taxation rules and regulations may vary from state to state, and many countries do not yet have policies in place for cryptocurrencies.
Move to ban cryptocurrency
The draft Banning of Cryptocurrencies and Regulation of Official Digital Currencies Bill 2019 has proposed a 10-year prison sentence for persons who mine, generate, hold, sell, transfer, dispose, issue or deal in cryptocurrencies. Besides, making it completely illegal, the bill makes holding of cryptocurrencies a non-bailable offence.
Arguments in Favour of the Bill
- Sovereignty:Issuance of currency is a sovereign right. Unless, there is a conscious decision by a state to forgo this right, any currency issued by anybody else is considered as counterfeit currency. For counterfeit currency, there is already a legal provision in India of that of sentencing guilty persons for 10 years jail.
- Also, current holders of bitcoin (a type of Cryptocurrency), are considered to have diluted sovereignty of the country by investing their money into that currency.
- Not a legal Tender:Cryptocurrencies such as bitcoins are not yet the legal tender of exchange in the country. Legal tender is the national currency, such as paper money and coins that is declared by law to be valid payment for debts and financial obligations.
- No Regulator:Investment in cryptocurrencies is risky as there is no one to regulate the transactions that happen through cryptocurrencies.
- Used for Wrongful Purposes:It has been reported that a lot of transactions related to human trafficking, drugs, cartels, terror funding is being done in cryptocurrencies.
- India does not have the required infrastructurefor supporting Cryptocurrency exchanges. Also, people in India yet not have enough expertise to deal with digital currencies.
- Countries like China have already banned the use of cryptocurrencies completely.
- Money Laundering:When there is a transfer of money from one legal jurisdiction to another one, that too, without having the regulatory mechanism, then such transfer falls into a grey area of money laundering.
- Full Capital Account Convertibility:As per some experts, cryptocurrencies may require India to go for full capital account convertibility.
- Presently, India is a country of partial convertibilityon the capital account.
- The capital account of the balance of paymentscomprises a summary of cross border transactions in assets. Assets in the context of international transactions mean investment assets: equity, debt, immovable property or any combination or hybrid of these.
- Thus,full capital account convertibility would mean that there is no restriction on the conversion of the domestic currency into a foreign currency to enable a resident to acquire any foreign asset. It also enables a non-resident to acquire a domestic asset on the conversion of foreign currency to the domestic currency.
Arguments against the Bill
- The Inevitable Transition:In earlier times, there used to be a barter exchange system that was prevalent in the society, then the countries shifted to paper notes and currency, now it is the time to shift to digital currencies.
- Impact on present Bitcoins holders:Presently, there are around three million bitcoins in India. It has been argued that present holders of bitcoins have purchased the Cryptocurrency by using legal tenders. If the Bill becomes an Act, anybody who is holding bitcoins would not be able to sell or transact it. Therefore, at least, a cooling off period is required for holders of bitcoins to convert their digital currency into legal tender money.
- Alt Coins:Apart from bitcoins, there are another 3,000 alt coins (other cryptocurrencies) that are available in the country.
- Russia, U.S. and many European countriesaccept cryptocurrencies as a medium of exchange. Such countries also have in place a regulatory system for the same.
- There is a concern that the decision to ban cryptocurrencies would provide leeway to people to use cryptocurrencies for wrongful purposes. Until a proper regulatory mechanism for cryptocurrencies is there in the country, the RBIcan collaborate with virtual money exchanges to ensure the proper use of cryptocurrencies.
- Not in consensus with India’s stance in the recently concluded G-20Finance Ministers’ Meeting: India at the meeting had shown consensus with the rest of the countries to regulate crypto-assets.
For developing countries like India, disruptive technologies like cryptocurrencies bring their own set of benefits and risks. At one end, traditional banking systems have their constraints regarding reach and innovation, where private enterprises fill this space up with novel ideas and innovative business solutions. At the other end, developing countries are at the lower end of technology adoption life cycle, as far as design, development or entrepreneurship in disruptive technologies is concerned. These countries are generally caught by surprise, as disruptive innovations suddenly rise up the value chain and rattle their existing policies, processes, strategies, instruments or technologies. Cryptocurrencies could be a great value proposition in this regard for India, but the prominent security threats, in form of terrorism and left wing extremism, might bring in some hesitation in the early phase of adoption or integration of this technology with the financial system.
Nevertheless, the three factors which are going to shape the likely outcomes of policy on cryptocurrencies in India are:
- The thrust of the government towards Digital economy, driven by the flagship programs of the government for financial inclusion;
- The risks of tax evasion, given the stringent regulations in the past one year for the crackdown on black and unaccounted money; and
- The present security situation and experience with terrorism or Left Wing Extremism.