By Mohanish Verma
Cryptocurrency is a digital currency based on use of cryptography to secure transactions, control creation of additional units and also verify transfer of assets. Each “cryptocurrency” has a unique set of features and cannot be analyzed or understood by making general observations. The term is used as a generic representation of all such tokens which are generated through cryptography. In current parlance convertible, decentralized virtual currencies are referred as “cryptocurrencies”.
One estimate puts the number of cryptocurrencies at around 6700, with a total market capitalization of an astonishing 2.5 trillion USD as of Oct 25, 2021. Bitcoin, Ethereum, Binance Coin, Cardano, Solana, Ripple, Polkadot are amongst the leading names as of 2021. There is a large variation in characteristics of the cryptocurrencies which are also evolving over time due to evolution of unique features of each such instrument.
History and Background
Haber and Stornetta were the first to propose the concept of block-chain in 1991.Block-chain is a distributed ledger technology and consists of subsets of data, in the form of blocks. Each block or coin is mined on the basis of intense calculations and cryptography, through intense “work” or arriving at the matching result to be accepted in the block-chain. Mining of a new block or “coin” is therefore a very intense and arduous job and the successful miner is rewarded in terms of a new “coin”. Advanced hardware and large amounts of energy are needed to “work” and generate or “mine” a crypto currency.
The original concept of a digital currency based on cryptography as is perceived in the present form was initiated in 2008 by “Satoshi Nakamoto” through a pseudo name.
Evolution of cryptocurrencies has been facilitated by development of crypto exchanges over a period of time. A new ecosystem is in the offing through such exchanges, which if properly regulated can facilitate smooth participation of larger numbers of population in cryptocurrencies.
Cryptocurrencies are not backed by conventional assets such as gold reserves. They derive value from democratic and decentralized utility, market acceptance and belief. Many crypto “coins” or “tokens” are in fact backed by state-of-the-art block-chain projects. Ripple (XRP) has helped Europe’s 4 th largest bank, Banco Santander develop its One Pay FX service.
Advantages and Drawbacks
There are certain advantages as well as loopholes in the use of cryptocurrencies. While there are widespread apprehensions of use of cryptocurrencies for dubious activities, there may be possibilities to control and regulate this through regulated crypto exchanges and introducing KYC norms. This is by no means an easy task. However, considering that wishing away the existence of cryptocurrency does not appear to be realistic, perhaps the best way would be to develop superior regulatory norms and plug the illegal use of this new concept.
The concept of block-chain has its advantages in terms of offering true equality, i.e. each participant is equally important and there are no middlemen or Central Authorities. While anonymity or privacy is also considered an advantage, it also comes with the risk of no support or guarantee in case of any loss or hacking of the system. It might help in easier access to credit and funding at a global level even for the small and medium business persons. These are contentious policy issues which call for careful analysis for ensuring overall welfare and security of financial systems and also check misuse of technology driven financial instruments.
Currency or Asset
Cryptocurrency was initially conceived as a medium of payment. Lately, it has developed into a form of asset, whose value keeps on fluctuating as it gets traded in the markets or exchanges. There is an element of both a currency and an asset in this new financial instrument. As an asset, it also has the feature of very rapid fluctuation in a short duration. The sensitivity to any apprehension even by a handful of “owners” results in major dips or jumps in the prices of these cryptocurrencies/crypto-assets. Market information and crypto-exchanges do play a very critical role in the value of crypto-assets.
Classes of Cryptocurrencies
There are a variety of crypto instruments which have different characteristics, some as a currency and some as an asset. Cryptocurrencies have been grouped into 7 broad classes by Wolfgang et al (2019).
Transaction mechanism – eg. Bitcoin (BTC)
Distributed computation token – eg. Ethereum (ETH)
Utility token – eg. Golem (GLM)
Security token (in stocks, financial instruments) – eg.ArCoin
Fungible tokens – eg. ERC-20
Non fungible token – eg.SAND, DEGO
Stablecoins – eg.USD Tether (USDT), LBS Peg.
All cryptocurrencies cannot be put in any class. The fundamental technology of crypto is so dynamic; it is difficult to classify them into watertight compartments. They have many uses and characteristics. This emphasizes the difficulty in treating them as an asset or a currency at any one point of time. Cryptography and mathematical calculations form the basis of mining cryptocurrencies, which do have dynamic characteristics and also multiple variants over time. New crypto instruments are being generated on a real time basis.
Challenges for Economies
The threat to the monetary system, fear of misuse for dubious activities and no control over the private crypto-exchanges enabling sale purchase of cryptocurrencies are some real challenges faced by the individual countries, as the cryptocurrencies increase their presence and influence over the global economy. Another crucial aspect relates to taxing such transactions both domestically and internationally.
Cryptocurrencies are being considered in different perspectives by various countries. First are the Crypto-friendly countries like Malta and Singapore and Switzerland, which promote use of cryptocurrency.Second category of countries restrict cryptocurrencies. These include China, which has largely banned cryptocurrencies. South Korea, Bangladesh, Bolivia, Taiwan, Lebanon have also banned use of crypto currencies. The third category regulates use of cryptocurrencies. These countries seek to balance encouraging the use of cryptocurrencies and balancing the risks attached in use of cryptocurrencies, such as the USA.
There are variations in the manner cryptocurrencies are considered for various taxes like VAT, Capital gains or Property Tax. There is no dispute that fair and transparent taxation mechanism which is also robust and dynamic must be put in place by all economies of the world. Due to lack of clarity, there is possibility of tax gaps increasing in this area in the medium and long run. While there are bigger challenges in allowing crypto-instruments to be used as currency and mode of payments, perhaps treating it as some form of asset might be feasible. Capital gains taxation might yield more pragmatic solutions, with restrictions on claiming losses and establishing a regulatory authority in each economy for issuing instructions and regulations from time to time. Analysis of classes of cryptocurrency and also defining the nature of these assets can be a starting point for adapting this instrument into the financial system in a phased manner. A global consensus is however needed in view of the digital nature and the technology involved.
The top 10 cryptocurrencies based on their market capitalization as on 25 th October 2021 as reported by coinmarketcap.com are depicted in the following chart:
The importance of cryptocurrencies in the global economy has been increasing rapidly not only in terms of valuation but also in terms of holdings by the population in different countries. Cryptocurrencies are finding support from new quarters with passage of time.
The emergence and acceptance of cryptocurrencies in different parts of the world cannot be ignored or sidelined. Block-chain technology is also here to stay. Crypto instruments have their advantages and shortcomings. It poses a challenge to the financial systems in different economies and has potential to misuse with high risk of hacking and anonymity. Perhaps more transparency and clarity is possible by considering the following issues on top priority:
1. Establishing norms and rules for use of crypto instruments in countries and at a global level.
2. Capturing transactions through KYC and developing norms for taxing transactions.
3. Developing and regulating Crypto Exchanges.
4. Collecting data and conducting research to find and plug avenues for money laundering.
5. Finding out a balance between regulation and checking crypto instruments for different purposes. Using crypto as a currency is complicated but treating it as an asset could be considered.
Research on the subject is ongoing. A more active role by governments and global institutions will help in finding pragmatic and acceptable solutions. Pragmatic regulations and transparency in treatment of this newly discovered instrument will certainly benefit in the long run.
(The author is an IRS Officer and also an ex- Visiting Researcher at Georgetown University, USA. The views are strictly personal and do not reflect the official position or policy of Financial Express Online. Reproducing this content without permission is prohibited).)