A legality and analysis of the Tourcoin and cryptocurrency Industry

LEGALIZATION

Tourcoin discussion with experts in Financial Industry Regulatory Authority, Inc. (FINRA) and considered forwarding the registration application for Securities and Exchange Commission.

The cryptocurrency market has evolved erratically and at unprecedented speed over the course of its short lifespan. Since the release of the pioneer anarchic cryptocurrency, Bitcoin, to the public in January 2009, more than 1359 cryptocurrencies have been developed, the majority with only a modicum of success. Research on the industry is still scarce. The majority of it is singularly focused on Bitcoin rather than a more diverse spread of cryptocurrencies and is steadily being outpaced by fluid industry developments, including new coins, technological progression, and increasing government regulation of the markets.

Though the fluidity of the industry does, admittedly, present a challenge to research, a thorough evaluation of the cryptocurrency industry write large is necessary. This paper seeks to provide a concise yet comprehensive analysis of the cryptocurrency industry with particular analysis of Bitcoin, the first decentralized cryptocurrency.

Particular attention will be given to examining theoretical economic differences between existing coins.

The cryptocurrency industry is still young and factors that impact it are changing on a daily basis, while academic work was of course consulted for this project, the majority of the information that informs this articles was derived from White Papers or synthesized using raw data.

INDUSTRY OVERVIEW-A BRIEF HISTORY

Although the concept of electronic currency dates back to the late 1980s, Bitcoin, launched in 2009 by pseudonymous (and still unidentified) developer Satoshi Nakamoto, is the first successful decentralized cryptocurrency. In short, a cryptocurrency is a virtual coinage system that functions much like a standard currency, enabling users to provide virtual payment for goods and services free of a central trusted authority. Cryptocurrencies rely on the transmission of digital information, utilizing cryptographic methods to ensure legitimate, unique transactions. Bitcoin took the digital coin market one step further, decentralizing the currency and freeing it from hierarchical power structures. Instead, individuals and businesses transact with the coin electronically on a peer-to-peer network. It caught wide attention beginning in 2011, and various altcoins — a general name for all other cryptocurrencies post-Bitcoin — soon appeared. Litecoin was released in the fall of 2011, gaining modest success and enjoying the highest cryptocurrency market cap after Bitcoin until it was overtaken by Ripple on October 4th, 2014. Litecoin modified Bitcoin’s protocol, increasing transaction speed with the idea that it would be more appropriate for day-to-day transactions. Ripple, launched in 2013, introduced an entirely unique model to that used by Bitcoin. Another notable coin in the evolutionary chain of cryptocurrency, Peercoin, employs a revolutionary technological development to secure and sustain its coinage.

Peercoin merges the PoW technology used by Bitcoin and Litecoin along with its own mechanism, proof-of-stake (PoS), to employ a hybrid network security mechanism.

IN THE BEGINNING WAS BITCOIN

Bitcoin is an open source, peer-to-peer digital currency first proposed in a 2008 white paper published under the name of Satoshi Nakamoto. Nakamoto begins his paper by stating that “Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weakness of the trust based model”. Further, the existence of a trusted intermediary increases transaction costs, “cutting off the possibility for small casual transactions.” Additionally, the trusted intermediaries are pressured to gather as much information about the parties as possible in order to control transaction costs. Hence, Nakamoto sought to create a coin that completely removed any trusted central authority and replace trust with cryptographic proof. This system would have the added benefits of having low transaction fees, low latency (time to make transactions), and pseudo-anonymity. A bitcoin, and every subsequent cryptocurrency, is merely “a chain of digital signatures” where “Each owner transfers the coin to the next by digitally signing a hash of the previous transaction and the public key of the next owner and adding these to the end of the coin” so that ownership can dynamically be programmed into the coin [2]. Further, these lines of computer code are stored in a program called a “wallet” on personal hard drives and/or via online wallets like Coinbase. Like cash or commodities, bitcoins can be lost, stolen or destroyed. One British man became famous for throwing out his hard drive, and with it his wallet containing over 7,000 BTC.

Bitcoins can only be sent or received by logging the transaction on the public ledger, also known as the “blockchain.” Bitcoins lack intrinsic value; rather, Bitcoin’s value is purely a function of supply and demand. Unlike paper “fiat currency” that derives value from a government, is neither created by, nor backed by, any government. protocol seeks to solve the double-spending problem (essentially, spending the same coin more than once) inherent in non-cash payment systems resulting in the need for a trusted third party (such as a bank or credit card company) to verify the integrity of the transaction. Double-spending occurs when an asset is duplicated, and thus can be spent multiple times. This problem does not exist in physical currencies, since transactions involve changing possession of property. However, a digital file has the potential to be copied. The security of cryptocurrency, however, and its ability to safeguard against such digital copying, is inherent in its blockchain or public ledger systems. These systems keep records of ownership and transaction timestamps, eliminating the possibility of digital copying and, thus, double-spending.

In the case of Bitcoin, a transaction is only complete and added to the blockchain once a required amount of computational power is used so as to satisfy the proof-of-work. The transaction at this point is considered complete, and ownership of the coin has been absolutely transferred, without fear of double-spending, because the entire network becomes informed of which wallet the coin currently resides in.

CRYPTOCURRENCIES

According to coinmarketcap.com, there are over 1359 distinct cryptocurrencies currently. Thus, the cryptocurrency industry includes much more than just Bitcoin, although Bitcoin has a market capitalization of approximately $ 189 billion compared to the total market capitalization of the cryptocurrency industry of $ 340 billion. This section seeks to analyse how competition in the cryptocurrency industry has evolved since the inception of Bitcoin in 2009. Specifically, it explores the evolution of network security protocols and changing trends in coin economics.

NETWORK SECURITY PROTOCOL

Perhaps Bitcoin’s greatest technological achievement (and the sine qua none of every altcoin) is building a peer-to-peer transaction system that relies on “cryptographic proof rather than trust”.

However, replacing a central authority presents a unique problem with a solution that is not obvious. First, the coin needs to be able to change ownership. Transactions are recorded by combining the digital signatures of each party and a timestamp, so that the transaction date is recorded. This new code represents the coin and its path through the network. This code is then broadcasted to all nodes (computers connected to and running the cryptocurrency network software) on the network. However, it is necessary that the majority of the nodes agree on transactions that have occurred, otherwise double-spending and denial-of-service (DoS) attacks can occur. The mechanism used to reach consensus among nodes puts integrity in the system by verifying that the transaction is indeed legitimate. Hence, transactions are verified, and the system made secure, by implementing certain mechanisms that make it too costly to violate the integrity of the system. Larry Ren, developer of Reddcoin, notes, “The underlying principle of such a mechanism is the necessity of expending resources when confirming transactions”.

Various cryptocurrencies have developed novel resources to use as a means of network security. The resource can be a combination of electricity, time, or temporary surrender of coinage, and represents the cost to secure the network. Miners — those who own the underlying resource, and thus expend it — secure the network, and are compensated for their work in the form of either transaction fees or newly minted coins. The mechanism used to secure the network determines the resource chosen and the method used to pay the miners. Thus, the underlying network security mechanism of each coin has a significant impact on the underlying economics of the coin.

PROOF-OF-WORK

First proposed by Cynthia Dwork and Moni Naor in 1993, “A Proof-of-Work (PoW) is a piece of data which is costly to produce so as to satisfy certain requirements but is trivial to verify”. That is, PoW adds an economic cost to perform a given function. In the case of cryptocurrencies, transactions are not considered verified until a certain amount of energy has been expended. Most altcoins that use the PoW mechanism are direct copies of, or are very similar to, Bitcoin’s protocol.

PROTOCOL

Under the protocol, all transactions during a certain time period are collected into something called a block. This block is then broadcasted to all the nodes currently connected to the network. This uses the Hashcash PoW mechanism, first proposed by Adam Back in 1997. Under this mechanism, in order to agree upon a set of broadcasted transactions, each node essentially takes the block and begins adding a piece of data to the block called a nonce, such that the (block+nonce), when put into a hashing algorithm, has a hash that meets certain requirements — in this case, it begins with a certain number of zeros. Thus, each node attempts to solve a complex mathematical computation, the result of which can be easily verified by computing a single hash. The protocol requires that nodes use the hashing function.

Once a node finds a solution to the problem, the PoW requirements are considered satisfied, and the new (block+nonce+hash) is added to the blockchain and broadcasted to all nodes. Because only one block can be verified at a time, the probability a node will solve for the correct hash increases proportionally with the amount of CPU power expended. Hence, the resources consumed in this instance are electricity and time, which are indeed scarce.

MINING

The entire process undergone by each node is called mining, because in each block that is verified, the node (now the miner) receives a payment for his service. Miners are rational profit seekers, so in order to incentivize individuals to mine, the protocol offers rewards in two forms: transaction fees and newly minted coins, called mined coins. Each block that gets verified under the protocol introduces new coins to the market, which are given to the miner as payment for the energy and time expended.

This number decreases with time so that there will never be over specified coins in existence. In this way, the protocol functions similarly to commodities like gold: “The steady addition of a constant amount of new coins is analogous to gold miners expending resources to add gold to circulation”. Hence, in the long run, transaction fees will likely have to increase to compensate miners appropriately. A major criticism of the PoW mechanism is the massive amounts of energy it consumes, with no other benefit than to verify transactions. Thus, as the mint rate slows in the network, “eventually it could put pressure on raising transaction fees to sustain a preferred level of security”.

HASHING ALGORITHMS

In addition to the network security mechanism, hashing algorithms also affect the coin. For PoW mechanisms, the hashing algorithm and the target difficulty of the hash dictate how many hashes — how much energy — is expected to be spent. Because miners are incentivized to find ever more powerful computing equipment, this has created a mining arms race. For instance, mining originally was carried out by CPU (Central Processing Unit); however, the same functions could be carried out by GPU (Graphics Processing Unit) at a much faster rate. GPUs then gave way to Application Specific Integrated Circuits (ASICs), designed to carry out PoW mining at incredible speeds — magnitudes higher than could be done through GPUs. The algorithm used in protocols and various altcoins felt the brunt of this arms race, and many coins have introduced alternative hashing algorithms that are often praised as being ASIC-resistant. However, this is not the case, as ASICs can be designed to carry out any hashing algorithm. It is expensive to do so, so until miners receive enough incentive to build ASICs for a particular hashing algorithm other than, like Script, they will likely not. There has been a dramatic increase in the number of gaga hashes per second extent on the network. Another problem with this is that economies of scale are created. In order to be decentralized, coins need to have the security distributed among many users. However, small-scale investors no longer see it as profitable to connect their home computers to the coin network, as they would then be forced to compete with much faster ASICs. Hence, this arms race has had the side effect of essentially centralizing network authority into the hands of the largest miners.

PROOF OF STAKE

An alternative to the PoW mechanism is the Proof-of-Stake (PoS) mechanism. Instead of relying on computational power as its “scarce resource,” the resource that the network security depends on is ownership of the coin itself — “proof-of-stake means a form of proof-of-ownership” — which is also scarce. Hence, in order to verify a transaction and receive the coin reward (whether new coins or transaction fees), a miner must own some coin himself. Further, the probability that he succeeds in creating a new block is a function of the amount of coin he owns, not of computational power. Hence, there are very little energy costs in this transaction. Further, in order to undermine the integrity of the system, one would have to own more than 50% of the coin currently being staked, in which case violating the coin security would be very costly. Generally, payment takes the form of an “interest” on the amount of coin staked to verify the transaction. Hence, most PoS coins do not have a capped money supply, and are thus inflationary. However, PoS systems are faced with the challenge of how to initially distribute the coin. Whereas PoW distributes the coins to the miners who add value to the network, a coin that relies purely on PoS must decide whom to distribute the coins to. This can create a host of problems. In fact, most pure PoS coins have turned out to be fraudulent, as the creator often gives himself the majority of the coins.

HYBRID POW/POS

A hybrid PoW/PoS system uses the PoW mechanism for initial coin minting and distribution. That is, PoW allows the network to distribute new coins to miners. However, over time, the PoS mechanism phases out the PoW mechanism, creating a long-term energy efficient cryptocurrency. Peer-to-Peer Crypto-Currency with Proof-of-Stake,” are the first to propose and then implement such a hybrid PoW/PoS system. In this hybrid-design, block generation, instead of relying on one CPU per vote, relies on a concept of “coinage”. Coinage is roughly the amount of coin owned multiplied by the life of ownership by the current owner of the coin. Block generation thus goes to the block with the most coinage. Further, coins are minted according to one percent per coin-year consumed, which functions as an interest rate for staking coin. The main advantage, however, is that this system does not rely on high-energy consumption in the long run. Hence, the design is cost-competitive to that which relies on PoW and avoids the distribution problem inherent in PoS

BYZANTINE CONSENSUS

Ripple and Stellar offer an alternative security mechanism entirely, which are both implementations of the Byzantine Consensus Protocol. The infrastructure of the coins is that of a distributed network, where each server in the network is faced with the problem of deciding whether other servers in the network are sending accurate messages. The messages in this case are transactions. This system is tolerant of a class of failures known as the Byzantine Generals problem and is thus deemed Byzantine fault tolerant. In the Byzantine Generals problem, the Byzantine army is divided among multiple lieutenants who receive an order of attack or retreat from a commanding general. However, there are a number of traitors — potentially the commanding general himself — yet all loyal generals need to reach consensus despite a small number of traitors working to foil this plan. The problem is that the loyal lieutenants need to reach consensus on which order to obey by sending each other signed messages. Various algorithms have been proposed that provide solutions to the above problem. The distributed networks created by Ripple and Stellar face a problem analogous to the Byzantine Generals problem. First, individuals engaging with one of these coins would have to join a server. Each server in the network is faced with the problem of deciding whether other servers in the network are sending accurate “messages,” which in this case are transactions. Ripple’s protocol requires that entities join a server. Each server maintains a Unique Node List (UNL), whereby the server only communicates with the nodes on its UNL. This allows servers to be in contact with only trusted servers. Any server can broadcast transactions, and the servers then vote on the transactions. However, servers vote only on transactions that came from other nodes on its UNL. Every few seconds, the servers all send messages back and forth, until the algorithm terminates with consensus or failure to reach consensus. The specific algorithm used in Ripple requires that a transaction be accepted by 80 percent of the servers in order for consensus to be reached. This security mechanism is both much more energy efficient than the PoW mechanism, requires at least an 80% attack on the network in order for the network security to be violated (the algorithm terminates without consensus if there is not 80% agreement), allows for flexible trust, and offers faster transaction times.

RESULTS

The final results of the systematic review of each coin suggest that a standalone PoW or PoS system is not feasible by itself. The PoW system is not feasible long-term as it is energy intensive, typically deflationary, and tends to create economies of scale within the mining community. Similarly, PoS can be feasible in the long run, but it faces the logistical issue of how to initially distribute the coins. A hybrid system, however, is much more flexible regarding inflationary and deflationary tendencies, is energy efficient long-term, and relies on the successful PoW distribution system for initially distributing coins. The trend in the industry appears to be growing consensus of the hybrid mechanism among the cryptocurrency community, as measured by the number of successful coins introduced recently. However, alternative methods have also been proposed with noteworthy success.

FACTORS THAT AFFECT GROWTH

Despite the traction that cryptocurrency has gained over the last half decade, its path has been turbulent. Many argue that the performance of anarchic cryptocurrency has been underwhelming in comparison to the hype it stirred when it publicly emerged in 2009. This section will address two of the main factors that have affected the growth of the cryptocurrency industry and will continue to influence its development and integration into the broader financial scheme well into the future: international government regulatory attempts, and ambivalent public perception in moving toward its wider adoption.

GOVERNMENT REGULATIONS

While the expanding cryptocurrency market has the potential to revolutionize the way money is exchanged, its introduction into global venues is fraught with challenges and potential pitfalls. Because virtual currencies are not universally recognized as official means of paying for goods and services, developing standardized systems for their use is critical. For the currencies to be sustainable, their legal status must be established. Regulatory systems are burgeoning, with myriad approaches being taken by various governments. Current regulatory measures are in their infancy and continue to evolve with the rapidly expanding industry. Regulations will offer greater legitimacy to a currency struggling to gain mass acceptance. They will standardize elements of the market and minimize at least some of the volatility. While governments are testing an amalgam of regulatory steps, their end goal is the same: to limit fraud, protect consumers, respect economic sanctions, and institute viable taxation methods. A brief detail of current cryptocurrency policy in various states will offer clarity and a broad overview of contemporary regulation attempts. Because of the infancy of virtual currency, available data is in flux and subject to frequent change. The United States takes a permissive, slightly neutral stance on cryptocurrencies. The current challenge faced by regulators is expanding existing laws to allow for the unique aspects and challenges of the virtual currency world. For taxation purposes, virtual currencies are handled as property rather than as currency, and transactions are subject to the same taxation norms as other types of property. At a federal level, the Financial Crimes Enforcement Network (FINCEN) has taken the forefront on implementing regulatory methods. The FINCEN’s early attempts to clarify cryptocurrencies’ place in the financial market came in 2013 with its announcement that while individual use of virtual currencies is not to be considered a money service business (MSB), exchanges and conversion of virtual currencies do fall under the definition of a money service business. As such, virtual currency transmitters must follow the government requirements already established for MSBs, including reporting techniques, record-keeping and abiding by the Bank Secrecy Act of 1970.

This is significant in that it demands a degree of accountability from virtual currency transmitters, as well as one more layer of security against fraud. Individual U.S. states also have a large role in establishing regulations for the emerging currency. 28 states and Puerto Rico have instituted licensing protocol for virtual coin operations. Currently, California has more cryptocurrency activity than any other state, and has been proactive in incorporating digital currencies into existing financial frameworks. In January of 2015, cryptocurrency gained legal status in California, leading to predictions that other states would follow suit. New York has also taken note of the emerging market, currently in the final stages of instituting its own regulatory framework. Australia, whose citizens account for roughly 25% of Bitcoin users, has not formally adopted regulations for virtual currency, but has established a system of taxation for the coinage. Trading done in the form of cryptocurrency is subject to the country’s pre-existing tax rules relating to goods and services.

In Japan the tax will cover gains from trading Altcoins and bitcoins, purchases made with Cryptocurrencies and revenues from transactions. Banks and securities firms will be prohibited from Bitcoin trades.

PUBLIC PERCEPTION

While retailers are starting to officially respond to the virtual currency market, the scope of the currency’s success is ultimately contingent on gaining public acceptance. The intrinsic value of cryptocurrency is in its number of users; without public trust, the system of virtual currency as an alternative payment method is unsustainable. This road is complicated and will require massive amounts of education and assurance to assuage a sceptical public, particularly in light of recent events indicating the volatility of cryptocurrency. This section will highlight both positive and negative factors related to public perception that have and will likely continue to affect the growth of the cryptocurrency industry. Slowly, through news stories and pioneering individuals championing its virtues, cryptocurrency is gaining a presence in the global market.

by Ronald Myers

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