Cryptocurrency is becoming more and more popular among investors all over the world. These digital coins can make you a millionaire in just a few seconds, or they can make you broke. It is not hard to see people trading cryptocurrencies in their daily life – back in the day, they were trading stocks.
But what on earth is a cryptocurrency, and why is it so risky? What can people do with it, and why is the blockchain technology behind cryptocurrency so important to us? I will explain this in this blog to you.
What is Cryptocurrency?
Around 2012, the European Central Bank gave a definition to the virtual currency: “digital money in an unregulated environment, issued and controlled by its developers and used as a payment method among members of a specific virtual community”. Cryptocurrency is one of the virtual currency families. Digital money and in-game currency all belong to the family. But cryptocurrency apparently is more impactful to the world’s economy.
The History of virtual currency
The majority of investors believe that Bitcoin is the first cryptocurrency in 2009 in the form of open-source software. However, the history of virtual currency is way longer than the existence of Bitcoin. Virtual currency is a type of intangible digital asset. It covers a wide range of online currencies, such as game currencies, cryptocurrencies and digital forms of real-world currencies. The first virtual currency should be “ecash”, created in 1983 by the American cryptographer David Chaum. In 1995, he made the early form of cryptographic electronic payments, which required user software, similarly to the Bitcoin wallet. This has made cryptocurrency transactions untraceable by any central government or bank.
In 1998, Wei Dai published a description of “b-money”, characterized as an anonymous, distributed electronic cash system. Shortly after, Nick Szabo described bit gold. Like bitcoin and other cryptocurrencies that would follow it, bit gold was an electronic currency system that required users to complete a proof-of-work function with solutions being cryptographically put together and published. These concepts constitute the overall concept of Bitcoin.
Nowadays, there are more than 6700 types of crypto-currencies in the world. Those famous ones include Bitcoin, Lifecoin, Etherum, Dogecoin, Ripples and Namecoin. The most valuable cryptocurrency is Bitcoin. One Bitcoin had a historic high market value of USD 60000 in April 2021. It is now worth USD 33163 per coin. Tesla has announced a purchase of USD 1.5 million worth of Bitcoins, and it would accept Bitcoin as a payment for its products in 2021. In June 2021, El Salvador, a country in Central America, became the first country to accept Bitcoin as legal tender.
Blockchain and Cryptocurrency
Cryptocurrencies, for example, Bitcoin, is generated by a mathematical algorithm involving some encryption and decoding processed by a computer. It is not hard to understand the concept of how tokens are generated if I bring this example to you. We have all played online games from time to time, haven’t we? When we participate in game activities such as completing quests, the system will give us some rewards, such as “money” to spend in the game. Under cryptocurrency settings, the players become computers. They are called “miners”. Computers take over the job simply because our human brains aren’t capable of solving the math question by producing a token. Technically, every computer in the world can be a “miner”. When a miner successfully generates a new token, there will be financial rewards. Also, the block where the miner previously worked will be added to the whole blockchain network.
Here, we shall introduce another concept – blockchain. You can imagine there is a shared blank Google doc. Everyone in this world has access to it. They can make changes to the document; they can copy it, download it and transfer it between each account. But after each change, there will be a record on the document, which everyone can see, of course. The more records on a document, the more valuable it is. Blockchain works the same, but it is surely more complicated. A “miner” solves one math question; it gives the miner a code. That code usually starts with 19 “0”s and is the key to one token in a block. The miner will record its discovery, add the block to a chain of blocks, and start functioning as a medium for people to make transactions.
Cryptocurrency: money or stock?
The biggest contributions from blockchain technology to cryptocurrency are anonymity and decentralisation. Because the blockchain network for a cryptocurrency is so huge, it is impossible to trace back every single transaction. Although each transaction will be recorded, the record only specifies the action of the transaction, for example, from A block to B block. You don’t need to know who transferred this token to you; it just happens immediately. It is also a hacker-free network: if you make changes to one block, you need to rewrite every block created before this changed block. The workload is huge and is impossible to complete.
There have been little to no regulations for cryptocurrency as well. It means you don’t need to pay tax for it. Any transaction you do with cryptocurrency is not legal, but not illegal. Cryptocurrency is a weirdo amongst all legal definitions – it’s not a commodity, it’s not money, it’s not a security. According to the SEC, when a cryptocurrency is decentralised enough, it becomes a commodity. However, they should still be treated as securities during the early stage of initial coin offerings (corresponding to initial public offerings).
Applications in real life
Cryptocurrency has all the functions that a real-world currency has. It is not as limited as game currency; it also has a significant impact on economies. You can use these digital tokens to make payments, trade them as if they are securities and earn some profit, store them as if they are commodities like gold, and so on. Here is a list of things you can do with cryptocurrencies:
What can you do with your digital tokens?
- Low-cost money transfers: Thanks to blockchain technology, the transaction fee of digital tokens is very low. It is definitely cheaper than what a bank charges you.
- Invest in tokens: Buying and selling digital tokens as if you are trading stocks? Yes, it is totally possible. Many secondary markets provide cryptocurrency trading functions that allow users to invest in tokens and earn a profit.
- A censorship-free alternative store of wealth: Since there is no law to regulate cryptocurrency, it has become a way to manage taxation. Recently, governments are aware of this conduct when people try to escape from taxation rules. A lot of countries now require taxpayers to declare their income through token transactions.
- A way to raise funds for start-up companies: Traditionally, start-up companies use initial public offerings to raise funds by selling securities to the public. But through initial public offerings, financial market regulators will closely monitor each step. It can sometimes be troublesome. With crypto-currency, companies can raise money from initial coin offerings, without all the annoying regulations.
- Make private transactions: Usually, when people send and receive huge amounts of money through banks, they often need to answer lots of questions to prove this money is legal. But with a decentralised blockchain network, users can transfer tokens which represent huge value without supervision from a bank. And, the transaction is anonymous.
Absence of regulations
Some of the cryptocurrencies are operated in a closed system with strict limitations on transactions and are not allowed to exchange to the real national currency. But some of them, such as Bitcoin, Ethereum and Ripple, are convertible into commercial material in the real economy, like cash. Anyone can join and trade these virtual tokens online, and it is troublesome to trace a user’s real identity. Therefore, anonymity and decentralisation provide an umbrella for lots of illegal activities.
Cryptocurrency is usually a good medium for money laundering because the government cannot trace the transactions in the network. Also, it is common for scammers to use fake initial coin offerings to attract people to invest. In fact, only 10% of legit ICOs will achieve success and provide considerable profit return to investors. Over 90% of them will fail because the network is not decentralised enough. Let alone, those scam coin offerings have a 100% failure rate because they don’t even have a blockchain network.
In the US, an Australian citizen named Stefan He Qin pleaded guilty to security fraud. The 90 million cryptocurrency hedge funds in USD were fraudulent, and Qin tried to steal money from investors. Another notorious use of cryptocurrency is money laundry. Police in China have arrested over 1100 people for “using cryptocurrency to launder illegal proceeds from telephone and internet scams”. Meanwhile, with more and more people participating in cryptocurrency investment and trading, there is a strong market incentive to call for regulations.
In the US, ICOs are regulated under the FinCEN. All the ICOs that qualify as securities need to be registered with the SEC. The trading platforms need to register with the SEC, too. The SEC also sets up a page listing all the ICO companies and exchange platforms that have been disciplined under “Cyber Enforcement Actions” for alleged fraud and unregistered ICOs. The FinCEN also published the Bank Secrecy Act for anti-money laundering and terrorist financing regarding virtual currency exchanges. The approach is conservative but considering the complexity of the financial market in the US, it seems a good strategy to take it slowly and passively because of the rapid change of cryptocurrency and blockchain technology.
The European Union
Apart from the US regulation, the European Union also plays an influential role as a monetary union that has a significant impact on international financial issues, in this case, the ICOs. In the EU, ICOs are financial instruments under the scope of the EU financial rules. Those who are not financial instruments will remain unregulated unless they are recognised as “electric money” or “alternative investment fund”. Investors are therefore under the risks of ICOs and are not fully protected by the law.
The People’s Republic of China
The policies in China is probably the strictest one. In 2017, the People’s Bank of China banned all cryptocurrencies and ICOs in the financial market. This applied to all the ICOs, including foreign ICOs wanted to raise funds in China. All the exchange platforms involved in the crypto-related exchange are ordered to cease the function and stop providing service for token exchange. ICOs who have already done fundraising in China need to return the money to Chinese investors. Such an approach is very protective but is even more conservative than the US one. Considering China’s international influence, the prohibition is reckless to the overall financial market.
New Zealand approach: Regulation on cryptocurrency
One successful practice of a decentralised approach to regulating these decentralised tokens is in New Zealand. Although there is no specific law for regulating cryptocurrency, New Zealand still has these tokens under control. New Zealand adopts a leading mechanism where trading platforms acting as the guard dog for investors. The central regulator only provides general guidance on general principles. For the sake of their own reputation, the trading platforms need to select and evaluate ICOs carefully. Only those ICOs seemingly have higher success rates in the future will appear on the list for investors to choose from. The selective approach eliminates scam coin offerings.
The New Zealand crowdfunding mechanism also allows investors to take back their money if a crowdfunding scheme fails. This is very meaningful under cryptocurrency settings. As mentioned above, the cryptocurrency transaction is untraceable. Therefore, it is unlikely that you can get a refund. This is why scammers can always easily gather huge money, and people will never see them again. But with the New Zealand approach, investors have an extra safeguard – if the initial coin offerings fail to raise enough money, they can get their money back.
Although the concept of cryptocurrencies is still new to every aspect of the world, people still reach some consensus regarding their core features. Despite the literal meaning of their names, cryptocurrencies are also unregulated and decentralised. Non-government entities issue them, but they still represent certain economic value for an object or transaction. Owners of cryptocurrencies retain exclusive property rights using blockchain technology.
It is, of course, exciting to see such a huge technological revolution in our world right now, but we need to be careful. Blockchain technology still has a lot of aspects for people to explore, so as to cryptocurrency. We do need the international financial markets to impose regulations on them, but such regulation shall never be a restraint of development.