Regulations, Potentials and Risks of Cryptocurrencies


Academic Paper, 2019

23 Pages, Grade: 1,0


Excerpt

Table of Contents

Table of Contents

Table of Figures

1. Introduction

2. Cryptomarket Overview

3. Current Financial System

4. Cryptocurrencies and Regulations
4.1 Distributed Ledger Technologies
4.2 Cryptocurrencies
4.3 Regulation of Cryptocurrencies

5. Potentials of Cryptocurrencies
5.1 Initial Coin Offerings
5.2 Instant Payments via Blockchain
5.3 Central Bank Cryptocurrencies
5.4 Cryptocurrencies in Emerging Markets

6. Risks of Cryptocurrencies
6.1 Security and Transaction Risk
6.2 Forking Risk
6.3 Cyber-crime Risk
6.4 Market Risk
6.5 Credit Risk

7. Conclusion and Outlook

Table of Literature

Table of Figures

Figure 1: Own Illustration of a Centralized and Decentralized Ledger

Figure 2: Own Illustration of an Instant Payment System via Blockchain

Introduction

Cryptocurrencies are a phenomenon which has recently conquered the financial market. While Digitization processes are continuously disrupting the sector, Cryptocurrencies are the latest evolvement. During their presence of the last ten years, they remained generally uncontrolled and unregulated by financial authorities. They do not have any company or government issuing them and rather serve as an independent, peer-to-peer medium of exchange. They are virtual tokens which are stored and distributed on a so-called Distributed Ledger, the Blockchain, on which every participant of the network obtains the latest version in an encrypted format. (c.f. HSBC, 2018)

The market of Cryptocurrencies has witnessed high fluctuations and the appearance of new currencies, reaching its ultimate peak at the beginning of 2018. Since traditional measures do not work and these coins, since they are privately created and do not have an underlying asset, it is hard for financial authorities to regulate or even predict the movement of Cryptocurrencies. However, various potentials exist, which may change the financial system by the regulated implementation and acceptance of virtual coins. (c.f. Burnie, 2018)

It is the objective of this paper to elaborate on what Cryptocurrencies are and which potentials they bear. At first, an overview of the current Cryptocurrency market is given before the current financial system is explained, in order to understand the different nature of Cryptocurrencies. This is followed by the analysis of regulations of virtual coins in the United States, Europe, and China. Moreover, four main potentials of Cryptocurrencies will be examined before general risks will be explained. To end, a conclusion and an outlook of the Cryptocurrency environment is given.

1. Cryptomarket Overview

The market for Cryptocurrencies appears to be highly volatile. As of today, besides Bitcoin, more than 1,500 Cryptocurrencies exist, having a total market capitalization of USD 160bn. Bitcoin, the first popular Cryptocurrency represents the largest market share with over 50%, since their creation. As of today, more than 300,000 transfers are operated daily. (c.f. Burnie, 2018)

Other popular virtual currencies are Ethereum and Ripple counting for USD 17bn and USD 13bn respectively. Therefore, the big three players in the market make up more than 70% of the total market capitalization. The total market growth within five years was over 200%. Howsoever, the market is witnessing volatile phases of high price fluctuations. In early 2018, the coin price of Bitcoin went up to USD 19,000, while its last was at approximately USD 5,100 as of April 2019. Before 2015, no significant movement in the market was recognized with having merely Bitcoin as the only large share in the market counting for more than 95% of total shares. (c.f. Coindesk, 2019)

The market itself is not completely regulated yet. Cryptocurrencies are generally traded on digital Exchange Houses which are not completely controlled by financial authorities. These Houses rather serve as a platform to exchange coins than representing an approved and regulated marketplace. Financial authorities undertook started first approaches to supervise such financial intermediaries but did not come up with a consistent framework yet. As of today, the Cryptomarket lacks clear standards and regulatory approval. Because of the missing oversight, uncertainty about virtual coins is not yet removed from investors and financial institutions. (c.f. Brainard, 2018)

2. Current Financial System

In order to understand the difficulties why Cryptocurrencies are not yet regulated and controlled to that extent of physical currencies, the following explains the Global Banking System and the Global Payment System.

The Global Banking System consists of various institutions that work together, in order to allow financial performance. Generally, the principle of money lending and money borrowing is pursued along with financial intermediaries. It involves Central Banks, such as the Federal Reserve in the United States and the European Central Bank in Europe to be the ultimate leaders and supervisors of the international system. They set interest rates and control money supply with the ulterior goal of price stability. Besides central banks, national banks exist which conduct monetary policy on a local basis. Commercial banks are yet another form that coexist in the framework. These banks work for profit and give out loans to private persons or companies, for instance. Private banks fulfill a similar task, as well as investment banks. Non-bank financial institutions can, for example, be insurances or even controlling organs. Generally, the whole system, which is accompanied by the World Bank, aims at risk prevention and economic flow. In other words, financial stability in economies and around the world is a main objective of the global banking system. (c.f. Simpson. 2018)

The global payment system, in addition to that, provides tools to operate financial transactions which are conducted and controlled through financial authorities. They enable flows of capital, the storage of value as well as increased security in the payment system. Proof of identity is an important consideration in a financial transaction. This validation of identity is fundamentally different from the principles of current Cryptocurrencies which provide security mainly through encryption and mathematical computing rather than through identity.

Federal systems consist of The Society for Worldwide Interbank Financial Telecommunication (SWIFT) system which allows financial transfers internationally. As of today, all major transactions that are operated cross-borderly, involve SWIFT, predominantly transfers between the United States and Europe. Other systems include, for instance, Fedwire, a transaction system by the Federal Reserve, Clearing House Interbank Payments System (CHIPS) which is privately conducted or Single Euro Payments Area (SEPA system) and the Trans-European Automated Real-time Gross Settlement Express Transfer System (TARGET) in the Eurozone. It is to say that all these systems are regulated and approved by the respective financial authorities as well as governments to allow a secure transfer of money. (c.f. SWIFT, 2017; ECB, 2018)

Private systems do exist in the financial world, such as VISA, Mastercard, PayPal or Western Union which allow direct financial transfer in a relatively short time. However, these private systems require approval by the financial authorities and are generally connected to a bank account that belongs to the global banking system. This is fundamentally different from current Cryptocurrencies.

One consideration when regulating Cryptocurrencies is the clear definition of money and the fulfillment of requirements which are set by central banks. As stated by the Federal Reserve as well as the European Central Bank and other central banks, a currency, to be accepted as legal money, has to fulfill three basic requirements in order to function as an approved currency. (c.f. Brainard, 2018)

1. Medium of exchange: A currency has to serve as a medium which is exchangeable in the economy.
2. Unit of account: A currency has to be measurable, in other words, it has to serve as a unit of account.
3. Store of value: A currency has to provide the ability to store value in it.

Legal money, developed from commodity money, meaning that every good could have been exchanged for another good, to representative money, money that may be exchanged for other units having value (such as gold) and finally to fiat money. Today, fiat money is characterized as such as it is not exchangeable for any fixed amount and has no intrinsic value. It can either be stored in cash, in a bank account or electronically. Fiat money represents a liability of any federal reserve in that monetary area. To be accepted as a medium, money not only has to fulfill the three requirements but also needs to be controlled and regulated by any authority in order to be legally accepted. (c.f. ECB, 2018)

3. Cryptocurrencies and Regulations

Due to the fact that Cryptocurrencies have only recently been developed they are still rather unregulated.

3.1 Distributed Ledger Technologies

Cryptocurrencies are an independent medium of exchange in the form of virtual tokens which rely on a Blockchain. A Blockchain is a subcategory of Distributed Ledger Technologies (DLT), platforms that are decentralized and stored with every participant of the network. It is a peer-to-peer environment that allows transactions in an encrypted and tamper-proof manner. In the case of current Cryptocurrencies, this decentralized system is not monitored by any government or financial authority. (cf. Herian, 2018)

Abbildung in dieser Leseprobe nicht enthalten

Figure 1 : Own Illustration of a Centralized and Decentralized Ledger

A transaction is stored in this network. By the example of Blockchain, every transfer is recorded and encrypted before it is put together in a so-called Block with other transactions. For this, algorithmic computing power is required in order to validate each operation. So-called Miners use their computing power to solve mathematical problems in order to hash or encrypt a transaction. These Miners are individuals that are connected with the network. They obtain a small reward in terms of coin percentiles for every transfer that is operated by the solve of the problem. With the process of hashing, a quest exists to find the lower numerical value of the subsequent block. If this value is found by computing through Miners, a block can be finalized and stored in the Blockchain. As of today, nearly every ten minutes a Block in the Blockchain of Bitcoin is created consisting of multiple individual transactions. The Blockchain, so to say the record of the ledger, is stored at every node in the system and is automatically updated so that every participant ultimately receives the latest version of the ledger. (cf. Hameed et al., 2016; Brühl, 2017)

3.2 Cryptocurrencies

Cryptocurrencies are one of the latest phenomena during the Digitization of the financial markets. They appeared in 2009 by yet unknown individuals as a response to the disenchantment of the financial system during the Financial Crisis in 2008. Cryptocurrencies are virtual tokens that are stored and traded in a virtual environment. Taking as a basis a decentralized network, the so-called Blockchain, they are detached from financial regulations and governments. (cf. Hameed, 2016)

Cryptocurrencies are virtual tokens that are based on DLT. In order to trade Cryptocurrencies, a user requires a so-called Wallet, a software that enables access to the peer-to-peer network. With the help of algorithmic functions, a transaction is encrypted and signed to guarantee protection and anonymity of data. As stated in chapter 4.1, every transaction is then stored in the Blockchain after it was approved through the algorithmic validation from Miners. (cf. Brühl, 2017)

It is to say that as of today, various forms of Cryptocurrencies exist. Since all rely on the creation of an open-source platform, every individual may be able to create its own coin. Virtual coins are generally traded on Exchange platform. As the same with Cryptocurrencies per se, these platforms are not regulated and function as a meeting spot of buyer and seller. It is to say that since there are yet no clear frameworks by authorities and governments on how to define Cryptocurrencies and how to regulate them, the world economy remains unsure about how to value such coins. (cf. Brainard, 2018; Brühl, 2017)

3.3 Regulation of Cryptocurrencies

As of today, there are no consistent frameworks on how to regulate and control Cryptocurrencies. Since they are not backed by any government or financial authority, they cannot be seen as legally accepted by the financial system.

The Federal Reserve and the European Central Bank, for instance, do not see a fulfillment of the three requirements to match the definition of money. According to both, Cryptocurrencies may serve as a means of payment and represent a unit of account, however, they fundamentally miss the definition of a store of value. It is claimed that no institution stands behind the privately issued coins, arguing that it is not a liability of any federal reserve bank, as it is the case with the Dollar or Euro, for instance. Both banks assure that they continuously monitor the movements alongside the Cryptocurrency market, but obviously do not publish any legal classification on virtual coins. (cf. Securities and Exchange Commission, 2018)

As with U.S. and E.U. institutions, various definitions of Cryptocurrencies exist. Some authorities see them as to be money-like while others argue that virtual coins can be seen as a commodity or security. Others claim that it is a property or a non-regulative asset. China, on the other hand altogether banned Cryptocurrency activity, stating that it is illegal for individuals or companies to engage in Crypto-business. (cf. Franklin Templeton Investments, 2018)

It is apparent that there is no congruent framework in the world economy. The current situation may be titled as a wait-and-see approach since no authority yet published clear regulative standards. As long as these statues are non-existent, the issue with Cryptocurrencies remains that the economy is unsure what the future development of the Cryptocurrency environment may be.

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Excerpt out of 23 pages

Details

Title
Regulations, Potentials and Risks of Cryptocurrencies
College
Boston University
Grade
1,0
Author
Year
2019
Pages
23
Catalog Number
V904828
ISBN (eBook)
9783346224040
ISBN (Book)
9783346224057
Language
English
Keywords
Cryptocurrencies, Financial Systems, Financial Regulations, Bitcoin, Ethereum, Initial Coin Offerings, Blockchain, Distributed Ledger Technologies
Quote paper
Jaby Felix Coronel (Author), 2019, Regulations, Potentials and Risks of Cryptocurrencies, Munich, GRIN Verlag, https://www.grin.com/document/904828

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