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Crypto Currency / Virtual Currency / Digital Currency

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Financial Action Task Force (FATF), which is the global body fighting money laundering and terrorist financing has defined Virtual currency as a digital representation of value that can be digitally traded and functions as (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not generally have legal tender status (i.e., when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction. As on date, it is not issued nor guaranteed by any jurisdiction, and fulfils the above functions only by agreement within the community of users of the virtual currency.

Virtual currency is distinguished from fiat currency (a.k.a. “real currency,” “real money,” or “national currency”), which is the coin and paper money of a country that is designated as its legal tender; circulates; and is customarily used and accepted as a medium of exchange in the issuing country. It is distinct from e-money, which is a digital representation of fiat currency used to electronically transfer value denominated in fiat currency. E-money is a digital transfer mechanism for fiat currency - i.e., it electronically transfers value that has legal tender status.

Digital currency can mean a digital representation of either virtual currency (non-fiat) or e-money (fiat) and thus is often used interchangeably with the term “virtual currency”.

Cryptocurrency is a digital currency which makes use of encryption techniques to regulate the generation of units of currency and to verify the transfer of funds, operating independently of a central bank. This is a math-based, decentralised convertible virtual currency that is protected by cryptography.

 

Types of virtual currencies

Convertible (or open) virtual currency has an equivalent value in real currency and can be exchanged back-and-forth for real currency. The notion of “convertible currency” does not in any way imply an ex officio convertibility (e.g. in the case of gold standard), but rather a de facto convertibility (e.g. because a market exists). Thus, a virtual currency is “convertible” only as long as some private participants make offers and others accept them, since the “convertibility” is not guaranteed at all by law.

Non-convertible virtual currencies cannot be exchanged against fiat currency. It is specific to a particular virtual domain or world (say Amazon). It is possible that an unofficial, secondary black market may arise that provides an opportunity to exchange the “non-convertible” virtual currency for fiat currency or another virtual currency.

Centralised Virtual Currencies have a single administrating authority (administrator) - i.e., a third party that controls the system. An administrator issues the currency; establishes the rules for its use; maintains a central payment ledger; and has authority to redeem the currency (withdraw it from circulation). The exchange rate for a convertible virtual currency may be either floating - i.e., determined by market supply and demand for the virtual currency--or pegged - i.e., fixed by the administrator at a set value measured in fiat currency or another real-world store of value, such as gold or a basket of currencies. Currently, the vast majority of virtual currency payments transactions involve centralised virtual currencies.

Decentralised Virtual Currencies (a.k.a. crypto-currencies) are distributed, open-source, math-based peer-to-peer virtual currencies that have no central administrating authority, and no central monitoring or oversight. Examples: Bitcoin; liteCoin; and Ripple.

Virtual currencies are a worldwide phenomenon that have captured the imagination of millions across rungs of businesses, banks and governments. Bitcoin, launched in 2009 by Satoshi Nakamoto was the first decentralised convertible virtual currency, and the first cryptocurrency. Bitcoin's success has spawned a number of competing cryptocurrencies, such as litecoin, Namecoin, PPCoin, Ethereum, Ripple, Monero, Dash, Augur,NEM,etc. A comparative table of major virtual currencies alongwith with their market cap may be seen here.

Virtual currency exchange /exchanger is a person or entity engaged in the business of exchange of virtual currency for real currency, funds, or other forms of virtual currency and also precious metals, and vice versa, for a fee (commission). Individuals typically use exchangers to deposit and withdraw money from virtual currency accounts.

Users can obtain virtual currency in several ways. For example, they can (1) purchase virtual currency, using real money (from a virtual currency exchange or, for certain centralised virtual currencies, directly from the administrator/issuer); (2) engage in specific activities that earn virtual currency payments (e.g., respond to a promotion, complete an online survey, provide a real or virtual good or service); (3) in case of decentralised virtual currencies (e.g., Bitcoin), self-generate units of the currency by "mining" them and receive them as gifts, rewards, or as part of a free initial distribution.

Of late, considering the global interest in digital currencies, some central banks have initiated works on introducing Digital Currencies

The Committee on Payments and Market Infrastructures and the Markets Committee of Bank of International Settlements (BIS) has in March 2018 completed a work on central bank digital currencies (CBDCs). CBDC is potentially a new form of digital central bank money that can be distinguished from reserves or settlement balances held by commercial banks at central banks. There are various design choices for a CBDC, including: access (widely vs restricted); degree of anonymity (ranging from complete to none); operational availability (ranging from current opening hours to 24 hours a day and seven days a week); and interest bearing characteristics (yes or no). A general purpose CBDC might turn out to be an alternative to cash in some situations, thereby reducing the printing and associated costs to the central banks.

 

Genesis of cryptocurrency: Satoshi Nakamoto never intended to invent a currency. In his announcement of Bitcoin in late 2008, Satoshi said he developed “a peer-to-peer electronic cash system”. It was a decentralized digital cash system like a peer-to-peer network for file sharing. Any digital cash payment network hinges upon a record of accounts, balances and transactions and aims to intercept double spending i.e. to prevent one entity from spending the same amount twice. In case of conventional payment networks, this is done by a central server which keeps record about the balances. However, cryptocurrencies’ self-reliance comes from their system of limited entries in a database that no one can change without fulfilling specific conditions.

Anyone can download the free, open-source software from a website to send, receive, and store bitcoins and monitor Bitcoin transactions. Users can also obtain Bitcoin addresses, which function like accounts, at a Bitcoin exchanger or online wallet service. Transactions (fund flows) are publicly available in a shared transaction register and identified by the Bitcoin address, a string of letters and numbers that is not systematically linked to an individual. Therefore, Bitcoin is said to be “pseudoanonymous”. The underlying technology used by bitcoin for securing the transactions is known as “block chain”. This technology has many other applications even though bitcoin may not be acceptable. Distributed ledger system or the block chain technology allows organization of any chain of records or transactions without the need of intermediaries.

 

The mechanism: A cryptocurrency consists of a network of peers where each of the peer has a record of the complete history of all transactions and thus of the balance of every account. A transaction is a file that says, “A gives x Bitcoin to B” and is signed by A’s private key. After being signed, a transaction is broadcasted in the network, sent from one peer to every other peer. This is based on the system of public-key cryptography, or asymmetric cryptography which is an encryption scheme that uses two mathematically related keys - a public key and a private key. The public key is used to encrypt and the private key is used to decrypt. Each public key is published and the corresponding private key is kept secret. In general, to send encrypted data to someone, it is encrypted with the recipient’s public key, and then the recipient decrypts the data with the corresponding private key. Public key cryptography enables the following:


When a transaction is confirmed it can’t be reversed and it becomes a part of an unalterable record of historical transactions i.e. blockchain.

 

Role of a miner: A miner is an individual or entity that participates in a decentralised virtual currency network by running special software to solve complex algorithms in a distributed proof-of-work or other distributed proof system used to validate transactions in the virtual currency system. Miners may be users, if they self-generate a convertible virtual currency solely for their own purposes, e.g., to hold for investment or to use to pay an existing obligation or to purchase goods and services. Miners may also participate in a virtual currency system as exchangers, creating the virtual currency as a business in order to sell it for fiat currency or other virtual currency.

The job of a miner in a cryptocurrency transaction is to confirm the transactions by stamping them and spreading them across the network of nodes. The nodes then have to add it to their database to make it a part of the blockchain. The exercise entails rewards for the miners in terms of the cryptocurrency itself. Since the role of a miner is crucial to ensure a fair network and prevent forged transactions, the miners have to find a hash, a product of a cryptographic function, that connects the new block with its predecessor. This is called the ‘Proof-of-Work’. A hash is a string of random-looking characters that uniquely identifies the data in question. Transactions are bundled together into what we call a block and it is the miners who have to verify that transactions within each block are legitimate. Legitimacy of the transactions is ascertained by miners by solving a mathematical puzzle known as proof-of-work problem and only subsequently the transaction is stored in the blockchain. The first miner to solve the puzzle is rewarded for verifying the transaction and in the form of a reward, the miner has the right to add a coinbase transaction that give him/her a specific number of bitcoins. This is how new bitcoins are created. Solving a cryptographic puzzle with high difficulty entails high computer power that the miner’s invest. Thus, only a limited amount of cryptocurrency can be created in a given amount of time. Further, all cryptocurrencies control the supply of the token by a schedule written in the code.

 

Bouquets and brickbats: FATF identifies the following advantages for virtual currencies.

It needs to be seen whether the claimed cost advantages will remain, if virtual currency becomes subject to regulatory requirements similar to those that apply to other payments methods, and/or if exchange fees for cashing out into fiat currency are factored in, and whether volatility, consumer protection and other factors limit their potential for financial inclusion.

Cryptocurrencies are being touted as digital gold that seem promising enough to increase their value overtime. Further, they are a fast and comfortable means of payment with a worldwide scope. Cryptocurrencies have given birth to an expanding and dynamic market for investors and speculators. Springing up of crowd funding projects and cryptocurrency exchanges have lent depth to the cryptocurrency market. Recently futures contracts were introduced by Chicago Mercantile Exchange over bitcoin.

However, the world of cryptocurrencies is marred by clouds of doubt. While cryptocurrencies are being used for payment, their use as a means of store of value and speculation, with volatility imbued, dwarfs their potential of being used as a medium of exchange. The innate anonymity associated with cryptocurrencies make them highly susceptible to be used as a means of payment in black markets, darknet markets and illegitimate activities. FATF has identified many potential money laundering and terrorist financing risks associated with virtual currency’s global reach. There is no central oversight body, and no anti-money laundering software currently available to monitor and identify suspicious transaction patterns. Law enforcement cannot target one central location or entity (administrator) for investigative or asset seizure purposes (although authorities can target individual exchangers for client information that the exchanger may collect). Customer and transaction records may be held by different entities, often in different jurisdictions, making it more difficult for law enforcement and regulators to access them.

FATF has issued a risk based approach in its guidance on virtual currency payment products and services.

The markets for cryptocurrencies is fast expanding and is continuously taking increasing number of people in its fold. But, whether cryptocurrency is here to stay or not, only time will tell.

 

India’s Stance:

Central banks across the world are exploring the option of introducing fiat digital currencies due to the rapid strides being made by online payments technology and rising cost of maintaining fiat paper/metallic currency. Also, technological innovations, including those underlying virtual currencies, have the potential to improve the efficiency and inclusiveness of the financial system. In view of the same, Reserve Bank of India has set up an interdepartmental group to recommend the feasibility of introducing a digital currency. The Report is due to be submitted by June 2018.

Notwithstanding, RBI has always been wary of the concerns related to consumer protection, market integrity and money laundering, among others. Reserve Bank has repeatedly through its public notices on December 24, 2013, February 01, 2017 and December 05, 2017, cautioned users, holders and traders of virtual currencies, including Bitcoins, regarding various risks associated in dealing with such virtual currencies.

In the Union Budget 2018-19, in para 112, Hon’ble Finance Minister stated that the Government does not consider crypto-currencies as legal tender or coin and will take all measures to eliminate use of these cryptoassets in financing illegitimate activities or as part of the payment system. However, the Government promised to explore the use of block chain technology proactively for ushering in digital economy.

Subsequently on 6 April 2018, RBI issued a circular stating that entities regulated by the Reserve Bank shall not deal in virtual currencies (VCs) or provide services for facilitating any person or entity in dealing with or settling VCs. Such services include maintaining accounts, registering, trading, settling, clearing, giving loans against virtual tokens, accepting them as collateral, opening accounts of exchanges dealing with them and transfer / receipt of money in accounts relating to purchase/ sale of VCs. Regulated entities which already provide such services were asked to exit the relationship within three months from the date of the circular.

The RBI notification means that crypto exchanges /exchangers operating within the country would be left without banking support and payment gateways which are regulated by RBI. Crypto-exchanges will therefore need to work independently of the banking support which means that mode of transaction will have to be tweaked from fiat-crypto to crypto-crypto i.e. exchanging cryptos for each other without any role for fiat currency. This has been done by RBI to steer clear the banking system of the risks associated with cryptocurrencies. .

Regulatory approaches of some major countries are outlined in the FATF Guidance Note.



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