It is safe to say that 2017 will be the biggest yet for Bitcoin and other cryptocurrencies. Bitcoin achieved the milestone of 1000 BTM (ATM machines for bitcoins) worldwide in 2016 and surpassed the US$2,700 threshold in Early 2017. These have garnered renewed focus on Bitcoin and cryptocurrencies in general. The market for Cryptocurrencies has gained traction in light of the formal recognition for Bitcoin and other Cryptocurrencies by Japan in April 2017.
Many of us still wonder what Bitcoin actually is? A lot of data is out there, and most of them are written in ‘tech language’. You and me, we both know that it is a language that uses words and alphabets from English, but sounds as alien as Greek and Tolkien, when it comes to conveying the message. Any talk about Bitcoins will bring in a lot of buzzwords. They are fun to talk but cause a lot of confusion to the unsuspecting mind. I will try to loosely define what they represent before we move on to the fun part.
Bitcoin is a cryptocurrency. It is the most popular cryptocurrency in circulation. Some other popular cryptocurrencies are Ether, Ripple and Dogecoin.
Cryptocurrency is a type of digital currency that is not issued by any Central Bank. It uses a type of encryption to regulate the generation of the currency. It is as real as the money in your credit card. You can’t get currency notes for the cryptocurrency since it is not printed out by any Central Bank. You can exchange them for USD, Euro or any other major currencies at Bitcoin exchanges. The value of cryptocurrencies is not backed by ‘real assets’. The value of Bitcoin is in the eyes of the buyer – it’s a perceived value.
Transaction of bitcoins (and other cryptocurrencies) are called blocks. Each block represents a set of transactions in chronological order. These are maintained in decentralised ledgers called blockchains.
The blocks are added to the blockchain after they are verified using certain mathematical puzzles or codes. These are called ‘Proof of Work’ or PoW. PoW involves a lot of computation, this computation is the ‘work’ and is currently beyond the capacity of individual home laptops*. Ether and Bitcoin are two cryptocurrencies that rely on Proof of Work.
Some others use ‘Proof of Stake’ or PoS, which is a different type of verification which involves similar amounts of computation.
Doing these computations with the help of a pool of computers or specific mining hardware (a high spec computer designed to specifically solve these PoW) is called Bitcoin mining. The miners are rewarded with bitcoins for each block mined (verified using PoW). This is one of the direct ways to earn a bitcoin.
Bitcoin algorithm is programmed to generate and release a specific number of bitcoins for each block mined, which is the mining reward. The payout was initially 50 bitcoins for each block mined. The bitcoin mining reward is halved at every 210,000 blocks. In the second half of 2016, the payout was 12.5 bitcoins for each block mined.
While the price of Bitcoin is interesting, mining is not free of cost; it incurs some costs. Electricity charges and bandwidth charges are two of the direct costs that make mining costly. Mining hardware or ‘miners’ are computers that consume a lot of power (electricity) and generate a lot of heat. The computational process and transaction verification should be done online, which requires internet bandwidth. There is a lot of competition from other miners. You get the reward only if you can verify the transaction within a specified time. The speed with which the transaction need be verified (mined) is analogous to the computational power out there (you and competition together).
Imagine a scenario where your laptop is playing chess against a supercomputer. Even though both are computers, the supercomputer has a higher configuration and hence an advantage over yours. Similarly, if your competition is using a miner with high efficiency, chances are that they do the mining faster than you and get the blocks allocated to them. The computational power of miners of the bitcoin network is called the hashrate. It measures the processing power of the bitcoin network in each second. For example, when the network reaches a hashrate of 10 Th/s, it means it can make 10 trillion calculations per second.
As we discussed earlier in this article, the bitcoin network relies on mathematical computations for transactions and security. So the speed with which these can happen is as important as the reliability of the network. Crypto currencies like bitcoins and Ether are still in their infancy, and hence are likely to be volatile. However, when considered in the wider context, its price has consistently increased since 2014, as its volume and market size has grown. These currencies offer an alternative monetary network that is safe from the clutches of governments, and are hence considered a safe choice for keeping personal assets secure.
Regulation and taxation
Cryptocurrencies offer a form of anonymity in that you do not need a government issued ID or social security number to own, hold or transact in these. They offer an alternative monetary network and hence are considered a safe choice for keeping personal assets secure, away from the clutches of governments. However, the rise of cryptocurrencies has brought them under the scrutiny of at least some national governments and regulators. Many countries are actively looking at their regulations and taxation structures to include cryptocurrencies and other digital currencies within their jurisdictional framework. While Bitcoin may be the test case, any other currency with hopes of being adopted as part of the mainstream would need to be prepared to come under this framework.
Currency exchanges are institutions where you can trade one currency for another. You may recall that the last time you wanted to visit India, you changed some of your dollars and euros for Indian Rupees. You would have done it at places like Western Union or at airports. All these places that exchange one currency for another is a currency exchange. The cryptocurrencies are also traded for national currencies at some exchanges. That’s how you purchase bitcoin for US dollar or vice versa. And that is how we realise the value of a bitcoin (or other cryptocurrencies) from a common man’s point of view. Any currency, real or digital, would have value only if there are buyers and sellers. They do not have any intrinsic value.
Now imagine a scenario where you can not trade your bitcoins for US dollar or Indian Rupee or whichever currency you want to trade it with. What if no one can sell you dollar in exchange of bitcoin? The value of a currency is what the public endorse on it. Or in simpler words, what you can buy with it. If you can’t exchange it for real currency or real goods, then it is as good as leprechaun gold or monopoly money. This makes currency exchanges as the prime bottlenecks as governments put up barriers to exchanging national currencies to either deter users or to make the cost onerous.
It seems only logical to start the regulation of Bitcoins, Ether, Litecoins, Dogecoins and other cryptocurrencies with the exchanges. To cite an example, in February 2016, China announced that two of its major exchanges would be suspending Bitcoin and Litecoin withdrawals for one month. Though this suspension was claimed to be to enhance security procedures in respect of their anti-money laundering capabilities and other legal risks, the price of Bitcoin and other cryptocurrencies dropped sharply, following this announcement.
Another possible perspective to bring in regulation would be by treating cryptocurrencies as intangible property rather than foreign currency. This would bring them under the purview of capital gain tax, similar to what Israeli authorities are considering. Some governments have opted not to make cryptocurrencies subject to sales tax, for example, The UK Exchequer and the New York State Department of Taxation. Meanwhile, Australia has considered applying such a tax to all digital currency purchases.
Bitcoins and other digital currencies are used in many gray market and black market transactions. These include procuring weapons, money laundering, drug trafficking and smuggling. In the US, such illegal activities have attracted the attention regulatory authorities and other government agencies such as the SEC, and even the FBI. In March 2013, the US Department of Homeland Security (DHS) froze the largest Bitcoin exchange that was held at Wells Fargo. It was alleged that it broke anti-money laundering laws. In August 2013, New York’s Department of Financial Services issued subpoenas to 22 emerging payment companies, many of which handled Bitcoin, asking about their measures to prevent money laundering and ensure consumer protection.
According to Christian Kourtis of Gowling WLG, “Attempts by national governments to constrict Bitcoin and other mainstream cryptocurrency growth must be approached with caution. Over-regulation or taxation of the mainstream cryptocurrencies may see the benefits of these digital currencies stripped away, risking their abandonment by users in favour of newer cryptocurrencies that are truer to the original concept. In this way, cutting the head of this hydra may create more rather than fewer problems”.
Taxation and regulation will be an important area to monitor, as interest in cryptocurrencies gain momentum. It would be fun to see the mysteries unravel, as we all watch whether regulations bring in newer cryptocurrencies and more problems rather than curtail the existing problems.