Cryptocurrency – Decluttered

Cryptocurrency seems to be the fad of the day. Currently, there are more than 15 thousands of Cryptocurrencies being traded in various crypto exchanges world over with combined market capitalization running into billions of dollars. Obviously there is so much commotion about it, public is enthusiastic while governments are wary.

What is Cryptocurrency

Simply put Cryptocurrency is a digital asset that is intended to work as medium of exchange for goods and services either as part of Blockchain it belongs or otherwise. Being virtual, it does not exist in conventional note, paper or coin formats and is meant to be transacted electronically while such transactions are recorded on distributed ledger/Blockchain in encrypted format. Thus, is also perceived to be safe and tamper proof to large extent.

Cryptocurrency as a currency

Cryptocurrencies do share some common characteristics with conventional currencies in terms that they are capable of being medium of exchange, measurement of value, store of value, standard of deferred payments etc. and further like conventional currencies seem to exhibit durability, portability, divisibility, acceptability, exchangeability etc. albeit to some extent.

However, so far, Cryptocurrencies are private and unlike conventional fiat currencies, they are not issued, backed and regulated by governments or sovereigns. Further, barring few like El Salvador and Central African Republic, who have recognized Bitcoin as ‘legal tender’, they have not been accorded such recognition by other sovereigns. Nevertheless recognition by even few nations does accord at least Bitcoin status of currency.

In fact, inspired by popularity of Cryptocurrencies, many countries like India, UAE, Saudi Arabia, Australia, Sweden, Norway etc. are contemplating having ‘Central Bank Digital Currency (CBDC)’ which would be their legal tender when launched.

Cryptocurrency as a Security

Securities are negotiable financial instrument that holds some type of monetary value. This coupled with fact that the launch of many Cryptocurrencies has been through ‘Initial Coin Offering (ICO)’, a concept akin to Initial Public Offerings (IPO), wherein instead of stocks such companies raise funds through the sales of ‘Crypto Coins’ etc. especially through crowd funding route. This makes Cryptocurrencies a strong contender as security.

Ethereum way back in 2014 popularized the ICO trend collecting equivalent of $18.3 million. Telegram in 2018 and raised around $1.7 billion through two ICOs however, its TON was not so lucky as US Securities and Exchange Commission (SEC) prohibited its launch. In fact quite a few ICOs have seen similar fate.

Cryptocurrency as a Commodity

A Commodity is a useful or valuable thing that can be bought and sold. Commodity can be traded directly in the Spot or Cash Market or via Derivatives such as Futures and Options and do include financial products, such as foreign currencies. 

Further, argument that Cryptocurrency is a commodity finds strong support from fact that since 2015 U.S. Commodity Futures Trading Commission’s (CFTC) has recognized virtual currencies as commodities under the Commodity Exchange Act (CEA). Canada Revenue Authority (CRA) generally treats Cryptocurrency like a commodity for purposes of the Income Tax Act. Czech Republic, Hong Kong, Indonesia also consider them commodity.

Cryptocurrency as Virtual Asset

Many countries like Mexico, Brazil, and India simply consider Cryptocurrencies as Virtual Digital Assets and tax them accordingly.

How Cryptocurrency is created

We know conventional currencies being fiat, are printed and minted in accordance with established, recognized and time tested economic principles and strategies under monitor and control by sovereigns or their central banks.

Cryptocurrencies on other hand are mostly generated during process called ‘Mining’. They are created as means of reward for performing ‘Consensus Mechanism’ for ensuring only authentic or validated new blocks get added to Blockchains.

Mining Cryptocurrency

Mining is a process wherein a determined amount of Cryptocurrency is created to reward an entity that successfully participates in Consensus Mechanism and performs authentication or validation of new Block(s) being added to the Blockchain. Purpose is to incentivize such entities so that they have reason to invest in resources and contribute to such public Blockchains.

How Mining works - Mempools

Generally the Blockchain transactions are not directly committed and are clubbed into chunks or Blocks. These commitments go to ‘Mempool’, a waiting area for the transactions. Next based on Consensus Mechanism, an eligible Mempool participant is picked or allowed to perform the validation. On successful validation such Block is committed or added to the Blockchain and all other participants notified.

To reward this effort, some predetermined amount or fraction of Cryptocurrency is created and awarded to such successful participant. This process is more or less same across Cryptocurrencies. Though what varies is how the successful participant(s) is picked or selected or allowed to mine. 

Mining & Consensus Mechanism

The older Cryptocurrencies like Bitcoin, Ethereum 1.0 etc. use ‘Proof of Work’ Consensus Mechanism wherein Mempool participant who performs validation first is usually rewarded. This requires that such participants must maintain advanced computation resources to be quick so as to earn enough block rewards to cover the associated costs of mining. Proof of work is highly resource intensive, involves multiple competing parties who consume good amount of electricity and other resources, thus it is considered a Non-Green Mechanism.

The newer Cryptocurrencies like Ethereum 2.0, Cardeno, Tezo, Atmos etc. are based on ‘Proof of Stake’ Consensus Mechanism which deploys a more greener mechanism wherein the miners stake their existing Cryptocurrency to get opportunity to validated a new block and in return get additional Cryptocurrency as reward. Other factors like length of time miners have been part of such Blockchain etc. are also considered for selection and vary across Blockchain implementations.

There are some other Consensus Mechanisms like Practical Byzantine Fault Tolerance (PBFT), Istanbul Byzantine Fault Tolerance (IBFT), Delegated Proof Of Stake (DPoS) etc. but the concept remains same.  

Theoretically or technically, anyone can mine using their computer and running mining software but to mine Cryptocurrency profitably, is the challenge.

How Cryptocurrency gets its value

Per economics, value depends on demand and supply. Perhaps this is the reason why many of the Cryptocurrencies like Bitcoin have been ‘capped’ implying after reaching as specific number no further will be mined. For Bitcoin this value is 21 million Bitcoins.

However, controlling just supply side is not sufficient, demand side also must be kept rejuvenated. Factors like usage, liquidity, popularity, accessibility, acceptability, rate at which new investors or traders get attracted, availability and listing in Crypto Exchanges etc. play important role.

Further, factors more specific to Cryptocurrency valuations like scale of community involvement, performance of the corresponding Blockchain, rate at which a particular Cryptocurrency is being mined, owners sentiments, uses such Cryptocurrency can be put to, the popularity, legal recognition, etc. play vital role.

‘Production cost’ is another vital factor determining ‘Minimum Profitable Value’ of Cryptocurrency. It is the direct costs of resources (i.e. electricity cost, the mining difficulty, the block reward etc.) that have gone into the mining of the coin. Some estimates claim that production cost of 1 Bitcoin may be about a whopping $35500!

Challenges for Cryptocurrencies

Cryptocurrencies are mostly private, and have gained immense popularity. Many people based on popularity, hype, perceived valuation and in hope of profitability are attracted towards investing in them without realizing all the risks involved.

Most nations are struggling to decide on their legality and regulatory frameworks as they are concerned not just about the security of investments of their citizens but also the fact that Cryptocurrencies have high potential for creating Parallel or Black Economies and their exploitation for Money Laundering is not unheard or farfetched.

Recent international conflicts especially Ukraine-Russia conflict have shown that international sanctions are the instruments of choice. Further, given fact that, Cryptocurrencies are global and mostly private, and concept of fundamental rights and human rights are not universal while international covenants define just the bare minimum and countries and powerful private players are known to enforce their own interpretations, no country would want to lose or handover reins of their economy.

According the legal tender status or developing statutory frameworks in haste may complicate the matters. Being digital, ubiquitous, involving cross-border transactions etc., a comprehensive approach may be required.

Conclusion

We see that Cryptocurrencies display flavors of being Currency, Stock as well as Commodity. Perhaps they come out as an interesting amalgamated class. This also explains why different countries treat them differently.

They are mostly private, their present cost of production seems high and their valuation complex. Their viability strongly depends on global inter and intra-play of economic, financial, technological and legal ecosystems while success of their corresponding Blockchains remains paramount.

Nations are obliged to protect their national interests, citizens and any recognition in haste has potential, though may seem farfetched, to make them puppet in hands of not just international community but even private organizations.

Every opportunity comes with its risk and not to mention breed of parasites. It is matter of individual investor prudence and discretion before one invests in them.

Albeit, “End of Law is not to abolish or restrain, but to preserve and enlarge freedom…” - John Locke.

Hope, we have been able to add value to your understanding on Cryptocurrency, clarify some of your doubts and you enjoyed reading this article. Stay tuned for more.

- By Ravi Mohla