BACKGROUND TO CRYPTOCURRENCIES
Cryptocurrencies are a subset ofvirtual currencies. Virtual currency may be defined
as a “digital representation ofvalue that can be digitally traded and
functions as :
(1) a medium ofexchange;
(2) a unit ofaccount;
(3) a store ofvalue, but does not have legal tender status.. . in any
jurisdiction”.
In other words, virtual currencies are digital objects that hold
economic value and are functionally similar to fiat currencies that are
issued by governments, but are not issued as such and are instead
created pursuant to, and governed by, private agreement among a
community or users and other network participants.
Cryptocurrencies are decentralized (i.e., issued without a central administering authority) and cryptography-based virtual currencies that are distributed and open source, and thereby function on a peer-to-peer. Cryptocurrencies are also by definition convertible virtual currencies, meaning that they have an equivalent value in real fiat currency and can be exchanged for such fiat currency. In contrast, nonconvertible virtual currencies, such as World ofWarcraft gold or airline miles, are specific to a particular domain or virtual world under particular rules governing their use and cannot be exchanged for fiat currency.
The combination of these features allows cryptocurrencies to function both as currency and as a peer-to-peer payments platform. Understanding these features is crucial to the design offacilitative regulation that accords appropriate space for innovative potential of cryptocurrencies and their many commercial applications.
Bitcoin is in many ways the archetype cryptocurrency. It was the first ofits kind when it was introduced in 2009, and the technology has spawned many imitators since. Bitcoin is also today the most widely adopted cryptocurrency, with the most obvious potential for commercial and business application to real-world goods and services. Much has been written about Bitcoin, and it provides a useful case study for understanding what cryptocurrencies are and how they work.
Unlike traditional currencies, Bitcoins are not issued or backed by any government or central bank, and their value does not derive from precious metals or other similarly tangible proxies of value. Instead, like all cryptocurrencies, Bitcoins are essentially digital units ofaccount that are composed ofunique strings ofcharacters and that can be traded electronically via a cryptography system that verifies and records transactions. They are intangible, exist only digitally, and have no intrinsic value.
Instead ofa central administrator, the Bitcoin system is run by a decentralized network consisting ofover 20,000 independent computers (or nodes) around the world running Bitcoin software and operating the protocol for administering Bitcoin transactions. Bitcoins are issued to nodes in the network that succeed at being the first to solve a difficult mathematical problem that requires a tedious amount of computation. Not unlike precious metals, the supply ofBitcoin increases at a predetermined rate that gets progressively slower over time, with total supply capped at 21 million Bitcoins.
The decentralized network validates and verifies transactions using a math-based proof-of-work scheme. Whenever a new block of transactions is created, it is added to the “blockchain” where it will be verified by competing nodes in the network through a process that involves solving a mathematical problem that is difficult to solve but easy to verify. The first node in the network that succeeds in solving the problem receives a reward in Bitcoins, and the solution is broadcasted throughout the network; this solution is then quickly verified by a majority of other nodes in the network.
The use of a proof-of-work concept to generate and administer digital money has been rightly recognized as a technological breakthrough. Because of the competition for mining Bitcoins, and the scarcity ofcomputational resources, proofofwork ensures that decentralized, independent agents collaborate to maintain the integrity ofthe system and builds in incentives for honest users within the network to protect the system from attack by potentially malicious participants.2 There is thus no need for a central administrator or issuer in such a system. Cryptocurrencies other than Bitcoin (also referred to as Altcoins) use different distributed proof systems, including proof-of-stake algorithms, which require validation of transactions not through mathematical computations, but through proof of ownership.
As a payments’ platform, the Bitcoin protocol is capable oftransferring value between users on a peer-to-peer basis, thus requiring no middleman between sender and receiver or between buyer and seller. Transfers can be done almost instantaneously and either for free or for a low transaction fee in exchange for additional functionality. Transactions are secured by a dual-key system. All users have a Bitcoin address that has both a cryptographic public key and a matching private key known only to the user. When a transaction is initiated, all nodes in the network will be notified of the transfer from the sender’s public key to the recipient’s public key. The private keys are then used to sign the transaction through a cryptographic process. These processes are handled invisibly, and are not noticeable by the end users, for whom the direct peer-to-peer transaction proceeds almost instantly and in a frictionless manner.
Bitcoin technology records all transactions occurring in the system in a “blockchain,”
which functions as a kind of universal public ledger, with each new block of transactions linked to a preceding block. Every Bitcoin transaction ever made can be observed by following this chain backward. Because the blockchain makes available to all a record ofevery single Bitcoin transaction, attempts to spend the same Bitcoin after it has already been transferred can be easily detected by the network. Bitcoin transactions are irreversible the same way that cash transactions are irreversible.
A sizable and vibrant cryptocurrency ecosystem has developed over time in several leading jurisdictions—including Singapore—with a number of prominent venture capital firms having invested, and continuing to invest, in various cryptocurrency start-ups and businesses. This ecosystem broadly comprises participants such as miners, users, exchangers, and transaction service providers and software developers, among many other stakeholders:
Other participants in the cryptocurrency ecosystem include market information and chart providers and merchants
that accept cryptocurrencies in exchange for real goods and real
services. Indeed, an increasing number of merchants also now accept
Bitcoin as payment, including a number ofestablished household names
across the spectrum such as Dell, Target, Expedia, Bloomberg, PayPal,
and Tesla Motors. Several food and drink establishments in the United
States, Europe, and Singapore also now accept Bitcoin as
payment.
Complex cryptocurrency-based financial products are also emerging in themarket, particularly with more established cryptocurrencies such as Bitcoin. Trading in cryptocurrency futures is now possible with derivatives exchanges or trading platforms such as ICBIT and OKCoin. As recently as September 2014, TeraExchange, a Bitcoin derivatives exchange, announced that it had received approval from the US Commodity Futures Trading Commission to trade dollar-denominated Bitcoin currency swaps—the first ever Bitcoin swap approved in theUnited States. Proposals for a Bitcoin exchange-traded fund (ETF) are currently being considered by US regulators. Some businesses have also introduced interestbearing cryptocurrency accounts and cryptocurrency-based peer-to-peer lending services. These developments will likely boost liquidity in cryptocurrencies and potentially reduce volatility in cryptocurrency prices. They also increasingly blur the line between the cryptocurrencies and the traditional financial system.
Much ofthe discussion about cryptocurrency regulation has tended to focus on the dangers posed by cryptocurrencies. It is true that these risks exist, and there is a need for targeted regulation to address potential harms that flow from this. However, it is equally important not to overemphasize these risks and lose sight of the substantial benefits, economic or otherwise, that may be gained through legitimate applications of the technology.
To begin with, cryptocurrencies can significantly reduce the costs of fund transfers across international borders. The capability for direct peer-to-peer transfers, without the need for an intermediary, can eliminate or substantially reduce transaction costs and time lag. This technology has the potential to disrupt existing payment systems that involve intermediaries and associated agency costs, such as debit or credit card networks, by providing a platform for more efficient or frictionless mobile or electronic transfers in the future. Even ifcryptocurrency payments do not become widespread and ubiquitous, competition with existing payment systems and intercryptocurrency competition are likely to bring down costs or improve the quality of payment services. Efficient and secure payment systems are vital to any well-functioning economy.
A frictionless mode of international money transfer is also particularly valuable in poorer developing countries, where remittance transaction costs tend to be the highest. Cryptocurrencies could potentially revolutionize the existing $600 million annual global remittance market. By way ofexample, Africa’s diaspora pays around 12% in fees to send $200 in funds. The use ofBitcoin or other cryptocurrencies could significantly cut both the time and costs of such remittances. This would in turn raise the quality of life for migrant workers and their families and have a positive effect on the world’s poorest countries.
Cryptocurrencies also make micropayments easy and viable, where such payments would previously have not been cost-effective because of prohibitive transaction costs. This would allow businesses to extract value from low-cost goods or services on the Internet through calibrated and targeted pricing policies that use micropayments, such as one-time article downloads from newspapers or one-time game or music downloads. Cryptocurrency may support financial inclusion through new cryptocurrency-based products that serve the unbanked and can also facilitate crowdfunding for small and medium enterprises.
More generally, cryptocurrencies—and related blockchain technologies—have the potential to be enablers of innovation on a much larger scale, just like other computer protocols such as TCP/IP and HTML. They can provide a platform for further financial or technical innovation and enable a wide variety ofdifferent uses—even ones that have not yet been conceived of—transforming entire industries and markets just as the Internet did. As some commentators have written, because cryptocurrencies are protocols for exchanging values over the Internet without an intermediary, these protocols can be adapted to potentially transform any transaction that has traditionally required an intermediary or third-party validation, including:
Cryptocurrencies are decentralized (i.e., issued without a central administering authority) and cryptography-based virtual currencies that are distributed and open source, and thereby function on a peer-to-peer. Cryptocurrencies are also by definition convertible virtual currencies, meaning that they have an equivalent value in real fiat currency and can be exchanged for such fiat currency. In contrast, nonconvertible virtual currencies, such as World ofWarcraft gold or airline miles, are specific to a particular domain or virtual world under particular rules governing their use and cannot be exchanged for fiat currency.
The combination of these features allows cryptocurrencies to function both as currency and as a peer-to-peer payments platform. Understanding these features is crucial to the design offacilitative regulation that accords appropriate space for innovative potential of cryptocurrencies and their many commercial applications.
Bitcoin
Bitcoin is in many ways the archetype cryptocurrency. It was the first ofits kind when it was introduced in 2009, and the technology has spawned many imitators since. Bitcoin is also today the most widely adopted cryptocurrency, with the most obvious potential for commercial and business application to real-world goods and services. Much has been written about Bitcoin, and it provides a useful case study for understanding what cryptocurrencies are and how they work.
Unlike traditional currencies, Bitcoins are not issued or backed by any government or central bank, and their value does not derive from precious metals or other similarly tangible proxies of value. Instead, like all cryptocurrencies, Bitcoins are essentially digital units ofaccount that are composed ofunique strings ofcharacters and that can be traded electronically via a cryptography system that verifies and records transactions. They are intangible, exist only digitally, and have no intrinsic value.
Instead ofa central administrator, the Bitcoin system is run by a decentralized network consisting ofover 20,000 independent computers (or nodes) around the world running Bitcoin software and operating the protocol for administering Bitcoin transactions. Bitcoins are issued to nodes in the network that succeed at being the first to solve a difficult mathematical problem that requires a tedious amount of computation. Not unlike precious metals, the supply ofBitcoin increases at a predetermined rate that gets progressively slower over time, with total supply capped at 21 million Bitcoins.
The decentralized network validates and verifies transactions using a math-based proof-of-work scheme. Whenever a new block of transactions is created, it is added to the “blockchain” where it will be verified by competing nodes in the network through a process that involves solving a mathematical problem that is difficult to solve but easy to verify. The first node in the network that succeeds in solving the problem receives a reward in Bitcoins, and the solution is broadcasted throughout the network; this solution is then quickly verified by a majority of other nodes in the network.
The use of a proof-of-work concept to generate and administer digital money has been rightly recognized as a technological breakthrough. Because of the competition for mining Bitcoins, and the scarcity ofcomputational resources, proofofwork ensures that decentralized, independent agents collaborate to maintain the integrity ofthe system and builds in incentives for honest users within the network to protect the system from attack by potentially malicious participants.2 There is thus no need for a central administrator or issuer in such a system. Cryptocurrencies other than Bitcoin (also referred to as Altcoins) use different distributed proof systems, including proof-of-stake algorithms, which require validation of transactions not through mathematical computations, but through proof of ownership.
As a payments’ platform, the Bitcoin protocol is capable oftransferring value between users on a peer-to-peer basis, thus requiring no middleman between sender and receiver or between buyer and seller. Transfers can be done almost instantaneously and either for free or for a low transaction fee in exchange for additional functionality. Transactions are secured by a dual-key system. All users have a Bitcoin address that has both a cryptographic public key and a matching private key known only to the user. When a transaction is initiated, all nodes in the network will be notified of the transfer from the sender’s public key to the recipient’s public key. The private keys are then used to sign the transaction through a cryptographic process. These processes are handled invisibly, and are not noticeable by the end users, for whom the direct peer-to-peer transaction proceeds almost instantly and in a frictionless manner.
Bitcoin technology records all transactions occurring in the system in a “blockchain,”
which functions as a kind of universal public ledger, with each new block of transactions linked to a preceding block. Every Bitcoin transaction ever made can be observed by following this chain backward. Because the blockchain makes available to all a record ofevery single Bitcoin transaction, attempts to spend the same Bitcoin after it has already been transferred can be easily detected by the network. Bitcoin transactions are irreversible the same way that cash transactions are irreversible.
The ecosystem
A sizable and vibrant cryptocurrency ecosystem has developed over time in several leading jurisdictions—including Singapore—with a number of prominent venture capital firms having invested, and continuing to invest, in various cryptocurrency start-ups and businesses. This ecosystem broadly comprises participants such as miners, users, exchangers, and transaction service providers and software developers, among many other stakeholders:
- Miners are persons or entities that run specialized software to generate solutions to complex algorithms and verify transactions in the cryptocurrency network.
- b. Users are persons or entities that obtain cryptocurrency and use it to purchase goods or services, or to transfer value to another person, or to hold for investment purposes.
- c. Exchangers are persons or entities in the business of exchanging cryptocurrencies for real or fiat currency, such as the US dollar or the Japanese yen, or for other cryptocurrencies or virtual currencies.
- d. Transaction service providers are websites that provide transaction services, allowing individuals to store and transact Bitcoins without having to run the Bitcoin client on their own computers. This includes wallet and vault providers.
- e. Software developers are persons or entities that are involved in researching, designing, making, or testing computer software that makes use of cryptocurrencies.
Complex cryptocurrency-based financial products are also emerging in themarket, particularly with more established cryptocurrencies such as Bitcoin. Trading in cryptocurrency futures is now possible with derivatives exchanges or trading platforms such as ICBIT and OKCoin. As recently as September 2014, TeraExchange, a Bitcoin derivatives exchange, announced that it had received approval from the US Commodity Futures Trading Commission to trade dollar-denominated Bitcoin currency swaps—the first ever Bitcoin swap approved in theUnited States. Proposals for a Bitcoin exchange-traded fund (ETF) are currently being considered by US regulators. Some businesses have also introduced interestbearing cryptocurrency accounts and cryptocurrency-based peer-to-peer lending services. These developments will likely boost liquidity in cryptocurrencies and potentially reduce volatility in cryptocurrency prices. They also increasingly blur the line between the cryptocurrencies and the traditional financial system.
Benefits and future applications
Much ofthe discussion about cryptocurrency regulation has tended to focus on the dangers posed by cryptocurrencies. It is true that these risks exist, and there is a need for targeted regulation to address potential harms that flow from this. However, it is equally important not to overemphasize these risks and lose sight of the substantial benefits, economic or otherwise, that may be gained through legitimate applications of the technology.
To begin with, cryptocurrencies can significantly reduce the costs of fund transfers across international borders. The capability for direct peer-to-peer transfers, without the need for an intermediary, can eliminate or substantially reduce transaction costs and time lag. This technology has the potential to disrupt existing payment systems that involve intermediaries and associated agency costs, such as debit or credit card networks, by providing a platform for more efficient or frictionless mobile or electronic transfers in the future. Even ifcryptocurrency payments do not become widespread and ubiquitous, competition with existing payment systems and intercryptocurrency competition are likely to bring down costs or improve the quality of payment services. Efficient and secure payment systems are vital to any well-functioning economy.
A frictionless mode of international money transfer is also particularly valuable in poorer developing countries, where remittance transaction costs tend to be the highest. Cryptocurrencies could potentially revolutionize the existing $600 million annual global remittance market. By way ofexample, Africa’s diaspora pays around 12% in fees to send $200 in funds. The use ofBitcoin or other cryptocurrencies could significantly cut both the time and costs of such remittances. This would in turn raise the quality of life for migrant workers and their families and have a positive effect on the world’s poorest countries.
Cryptocurrencies also make micropayments easy and viable, where such payments would previously have not been cost-effective because of prohibitive transaction costs. This would allow businesses to extract value from low-cost goods or services on the Internet through calibrated and targeted pricing policies that use micropayments, such as one-time article downloads from newspapers or one-time game or music downloads. Cryptocurrency may support financial inclusion through new cryptocurrency-based products that serve the unbanked and can also facilitate crowdfunding for small and medium enterprises.
More generally, cryptocurrencies—and related blockchain technologies—have the potential to be enablers of innovation on a much larger scale, just like other computer protocols such as TCP/IP and HTML. They can provide a platform for further financial or technical innovation and enable a wide variety ofdifferent uses—even ones that have not yet been conceived of—transforming entire industries and markets just as the Internet did. As some commentators have written, because cryptocurrencies are protocols for exchanging values over the Internet without an intermediary, these protocols can be adapted to potentially transform any transaction that has traditionally required an intermediary or third-party validation, including:
- property transfer,
- contract execution,
- identity verification and management.
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