A cryptocurrency is a digital or virtual currency (computer generated currency). It is based on the principle of cryptography. 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. Bitcoin’s success has spawned a number of competing cryptocurrencies, such as Litecoin, Namecoin and PPCoin.
How These Works?
Let us take the example of Bitcoin. To start dealing in bitcoin, one needs acquire a bitcoin wallet and then transfer funds (from bank) into that wallet to buy bitcoins. Bitcoins can be used to buy products and services from various websites. Bitcoins are created through a process known as mining. New coins are created when an individual solves a complex algorithm.The newly created bitcoins are added to a public ledger known as blockchain. All the transactions since the beginning of the cryptocurrency are stored in this ledger.
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.
Factors responsible for growth of cryptocurrencies
1. The rise of computational power that allows algorithms to programmatically issue currencies
2. Distrust towards governments that can idiosyncratically debase currency or even demonetise at will.
3. Scarcity of safe assets to store wealth over the long term.
Benefits of cryptocurrency:
1. Privacy Protection: The use of pseudonyms conceals the identities, information and details of the parties to the transaction.
2. 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. 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.
3. Lower Entry Barriers: Possessing a bank account or a debit/credit card for international usage requires documented proofs for income, address or identification. 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.
4. 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
5. Open Source Methodology and Public Participation: They have their own consensus based decision making, built-in quality control and self-policing mechanisms for building frameworks, practices, protocols and processes.
6. 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.
Risks involved in cryptocurrencies:
1. Key/Wallet/Exchange Security: In the entire chain of security, wallets and exchanges are found to be the weakest link, and that is where the attacks are commonly aimed at. In 2014, hackers stole about 480 million USD in Bitcoins from Tokyo’s Mt. Gox exchange
2. Hijacking/Routing Attacks/Distributed Denial of Service (DDoS) attacks on Cryptocurrency System: Cryptocurrency systems are open and are vulnerable to hijacking or Internet routing attacks to which cryptocurrency systems19 are vulnerable to. Additionally, cryptocurrency platforms have also been found to be prone to DDoS attacks, targeted at the exchanges might slow down services or render the platform completely inaccessible. Indian exchange Coinsecure had faced DDoS attacks in 2016,
3. Uncertain Regulatory Environment: The future and further success of cryptocurrencies depends upon the way regulatory frameworks are devised. Different countries have approached this innovation in different ways, and therefore the regulatory environment remains uncertain.
4. Lack of Liquidity and Lower Acceptability: Cryptocurrencies function outside banking systems, beyond the regulations or controls of the regulatory agencies. Although online exchanges facilitate exchange of cryptocurrencies with fiat currencies, but generally, this is restricted to the more popular cryptocurrencies only.
5. Price Volatility: Cryptocurrencies are known to be extremely prone to price fluctuations. Cryptocurrencies do not yet have an accepted vulnerability index, which other financial instruments such as fiat currencies and gold have.
6. Uncertainty over Consumer Protection and Dispute Settlement Mechanisms: Cryptocurrencies are decentralised, that means, there is no single authority for mediation or dispute redressal. The miners are not responsible for any arbitration of disputes between the parties. The transactions are also irreversible.
7. Potential use for Illicit Trade and Criminal Activities: Between 2011 and 2013, the value of Bitcoins surged as criminals were purchasing Bitcoins in large volumes. In late 2015 and early 2016, Dutch police unearthed two small groups that indulged in Bitcoin-related money laundering. Cryptocurrencies are also emerging as a new funding stream for terrorist outfits. Islamic State of Iraq and Syria (ISIS) had proposed using Bitcoins to raise funds
8. 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.
What India Thinks?
RBI, in 2013, had issued a warning to individuals dealing with virtual currencies in India on the financial, legal, operational and security-related risks. It further reiterated this stand in 2017, again cautioning users, holders and traders of Virtual Currencies about the potential financial, operational, legal, customer protection and security related risks Over the years, India had ignored cryptocurrencies. Government of India has set up a committee chaired by the Special Secretary (Economic Affairs) to take stock of the present status of Virtual Currencies both in India and globally; examine the existing global regulatory and legal structures; and suggest measures (related to consumer protection, money laundering, etc).
Final Line to Say
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. 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. In terms of benefits, this could be a force multiplier in India’s quest for financial inclusion, parallel to the electronic payment modalities such a digital wallets and Adhaar Enabled Payment System.