Four Important Aspects of Cryptocurrencies Explained
By Aline Bessa on The Capital
Understanding cryptocurrencies and their main concerns may be a bit challenging for many people, including me. Technology evolves rapidly and keeping pace with all the innovations sometimes seems just impossible. Moreover, there is a lot of information and misinformation on the internet nowadays, and trying to separate the wheat from the chaff can be a daunting task. So, a few days ago I decided to put some effort into understanding once and for all what they really are and, as a result, I winded-up gathering some good material that could be useful for other people too, and perhaps even serve as a beginner guide for deciphering the main issues involving cryptocurrencies (for now). Below are the answers that I was looking for when I got started.
Are digital currencies and cryptocurrencies the same thing? Cryptocurrencies are digital currencies, and they are called “cryptocurrencies” because they make use of a technology called cryptography (a technological technique used for years now to protect sensitive and/or confidential information by transforming them into a code). Digital currencies, on the other hand, are all the money that isn’t tangible. The money deposited in your bank account and spent through debit cards (as well as the credit in your PayPal or Venmo account), also called electronic money is, in a sense, digital currency. The main differences between the two are:
(i) most digital currencies are only representations of sovereign currencies (often called simply Fiat in the tech market). Cryptocurrencies are priced in US dollars, and they fluctuate quite often. Because they have no external backing (such as a government, an economy), it is said that they have no intrinsic value. Roughly saying, their prices are based solely on people´s expectations that they will be successful as a means of payment;
(ii) most cryptocurrencies are underpinned by a distributed ledger technology (eg: Bitcoin uses Blockchain), which means that all the information related to the transactions made with that currency will be recorded in all the participants’ networks. The digital coins use a centralized network, meaning that the transactions are recorded in one specific network;
(iii) cryptocurrencies are “sort of” anonymous. To buy, send and receive bitcoin, one does not need to furnish personal information, although the electronic address used to make the transaction will be known by all the networks within the distributed ledger (which is why each transaction generates one address). Thus, if the agent´s address (or addresses, depending on how many transactions were done by the same agent) is somehow linked to his personal information, his identity can be uncovered. Conversely, transactions made with digital currencies usually require personal information to be performed; and
(iv) The transactions made with cryptocurrencies are “public”, because they are registered in the distributed ledgers existing in the network. Opposingly, transactions made with digital currencies are confidential (previous transactions are not publicly exposed. Usually, they are confidential, and only the parts involved know about them).
So, cryptocurrencies are the same as money? Well, it depends very much on what one means by money. If we consider that money is anything that is accepted as a means of exchange, then they could be considered money. But it seems like a very imprecise definition.
It is worth to remember that Fiat money matches some criteria that make it a suitable means of exchange. Cryptocurrencies, well, do not. First, cryptocurrencies are not trade facilitators. Wassily Leontief, a Nobel Prize economist, once defined currency as being “a good that serves as a universal equivalent to all types of goods”, which cryptocurrencies are definitely not. They are still very little accepted as a medium of payment. In 2017, a report published by an analyst at Morgan Stanley indicated that only 3 of the top 500 online merchants accepted Bitcoin as a payment method — not to mention other cryptocurrencies. Therefore, if all your money is invested in Bitcoin, it is almost guaranteed that you will have to exchange it for some type of Fiat in order to purchase something.
Another important characteristic that makes cryptocurrencies unsuitable as a means of payment is their extreme volatility. Take Bitcoin as an example. Since it was first created, its price has deviated insanely. In July 2010, a bitcoin was worth US$ 0.08. In December 2017, it reached US$ 17.900,00. In February 2018, it plunged to US$ 6.200,00. So, one may or may not have made money with Bitcoin, it depends on the time he bought it — and that is exactly the point: people still buy cryptocurrencies with the sole intention of speculating and making money out of that speculation.
What is important though is that, in spite of being popularly called “coins” and “currencies”, cryptocurrencies are not considered legal tender, which is the case with the official currencies around the world, such as the US dollar in the United States, the Euro in some European countries and the Real, in Brazil. Sovereign currencies are considered legal tender because its acceptance as a means to discharge debts and purchase goods is mandatory, because the government rules them as such (usually through a legal norm).
Given all these facts, cryptocurrencies could be more comparable to assets. In fact, many monetary regulatory authorities, such as the SEC of the United States, the European Central Bank and the CVM of Brazil consider cryptocurrencies to be assets (neither money nor securities).
But, if it is that simple, what is all the fuss about cryptocurrencies? Perhaps just the fact that, in spite of not being considered legal tender, they are gaining big exposure among investors. This, in and of itself, is not the problem. What concerns the authorities is the fact that cryptocurrencies are not issued, controlled or regulated by a monetary authority.
Interestingly, it turns out to be one of the most attractive peculiarities of cryptocurrencies for investors. Their biggest enthusiasts even consider them to be more reliable and trustworthy than money, claiming, among other things, that cryptocurrencies: (i) are free from risks related to the soundness of the banking system (in other words, the risk of bankruptcy or banking insolvency); (ii) are unsusceptible to money debasement (decline in purchase power of a particular currency, caused by inflation); (iii) eliminate the necessity of intermediaries (role usually played by financial institutions), because of the so-called peer to peer transactions; (iv) allow gains of capital free from taxes, if you succeed in buying them without having your identity revealed (which is tax evasion btw, but it’s a reality; it was broadcasted that fewer than 7% of Americans who are estimated to own cryptocurrencies have reported their gains and losses to the authorities); (v) are confidential, because the transactions with cryptocurrencies can be done with little or no personal information.
Ps: I am not discussing the validity of these arguments, as much as some issues have already been discussed above.
Why would the fact that “cryptocurrencies are not issued, controlled or regulated by a monetary authority” be a reason for concern? Indeed, many issues related to cryptocurrencies seem to require attention. According to the US Federal Reserve, a typical cryptocurrency is not a liability of any individual or institution — in stark contrast, for example, to money, which is a liability of central banks, and deposit accounts, which are liabilities of authorized banks. In other words, it means that neither an individual nor an institution has any responsibility for cryptocurrency maintenance, security, and reliability. Here are some pragmatic examples of problems that could arise from this fact, for you and for society as a whole.
First, there is a security problem. If a hacker steals your cryptocurrencies in a virtual heist, for example, you have little or no recourse. After all, not only do they lack legal framework and strong governance, which means that their miners (people who “make” cryptocurrencies) and exchanges have no specific law or rules to abide by, little to no information about the owners in their distributed ledgers is stored, and that makes them a bearer instrument. According to the existing laws in many countries, the holder of this bearer instrument is presumed to be its owner. So, even if there were specific regulations on them, how would you claim that your cryptocurrency has been stolen if you cannot even prove that it was yours in the first place? Make no mistake, this kind of attack is recurrent. The last one happened on June 10th to a cryptocurrency exchanger in South Korea, and the losses were said to amount to about forty million US dollars — which, by the way, caused the Bitcoin’ price to plunge over 10%.
Yet, there is still the most disliked but truthful argument: the suitability of cryptocurrencies for illicit activities, such as illicit payments and money laundering. Precisely because they allow peer-to-peer transactions, with little to no information on ownership records, authorities are left with little to no recourses to hold criminals accountable. According to a research dated January 2018, 44% of Bitcoin transactions are associated with illicit activities. Of course, one can argue that cash is also anonymous (being traceable only through serial numbers), but cryptocurrencies seem more problematic because they reach the immense online the market, enabling anonymous online and cross-border transactions.
Do you still remember the cyber-attack with the malware wanna cry, that hit more than 300.000 computers in 150 nations? The hackers received more than US$ 140.000 worth of bitcoin ransom (total losses are said to have reached US$ 4 billion). It was said, at the time, that they only didn´t get more value in Bitcoin because many companies didn´t know how to pay to buy the cryptocurrency and do the transactions (sad? comic?). The identity of the attackers remains unknown.
Secondly, there is a maintenance problem. Monetary authorities are responsible for maintaining the purchasing power and stability of Fiat money. They resort to monetary policy for that. When it comes to cryptocurrencies, owners have no one working on their stability.
The reliability problem. In order to an economy to function properly, propel economic growth, promote high employment and currency stability and, therefore, achieve well-being for all its citizens, economic agents must trust institutions, trust the currency (that it will remain a good store of value, a widely accepted means of exchange, a standard of deferred payment). Governments make use of monetary policies to do it as well. They work on promoting the reliability of their money and institutions. Cryptocurrencies are not part of the game and, considering that the lack of governance is one of their main attractors for investors, it is unlikely that will ever be the case. After all, it seems fair to think that, if regulated, their prices could possibly be reduced to zero.
