A: What are Cryptocurrencies?
- Like traditional or ‘fiat’ currencies, cryptocurrencies can function as a means of payment for goods and services. The most recognised cryptocurrencies are Bitcoin and Ether.
- They differ from traditional currencies in that they:
- are generally not issued by central banks, and
- can be transferred electronically between users without the involvement of intermediaries (i.e. private banks) or the oversight of a central authority (i.e. a central bank).
- Instead, holdings of cryptocurrency are typically stored on a publicly-visible, decentralised electronic ledger, known as blockchain, and transactions are verified through consensus among users.
- Cryptocurrencies may also be viewed exclusively as a form of investment rather than a means of payment. When seen in this way, they are considered an asset rather than a currency.
B: What is Blockchain Technology and How Does it Work?
- In its simplest form, a blockchain is a chain of electronic/cryptographic blocks that contain information which are stored on a distributed ledger.
- A cryptocurrency block shall contain:
- information about the transaction (such as the sender and receiver);
- a hash – which is a unique identifier of the block; and
- the hash of the previous block,
this creates a ‘chain’ of blocks.
- If any block is tampered with and something is changed within it, the hash will also change. This will impact all blocks after it in the chain as the hash from the previous block will no longer match, invalidating the chain.
- To illustrate the difference between the way that blockchain technology and traditional systems work when transacting money, it is necessary to consider the technical processes that run ‘behind the scenes’ when a transaction takes place.
- In the case of traditional e-money services such as PayPal, where user A clicks a button wishing to send funds to user B, the clicking of that button causes a command to be sent to PayPal requesting that a transaction be made. When that request is received by PayPal, its software will check that user A has the necessary funds present in its account, that user B exists and has an account into which the relevant funds may be received and, both tests returning affirmative responses, will then update its central ledger of assets and transactions by (i) recording the fact that the transaction has taken place and (ii) reducing the value of user A’s account and increasing user B’s account by an equivalent amount. The same logic may also be applied where you do not use Paypal and make payments online directly between banks. The banks act as an intermediary between you and the party you wish to pay and will record payments made in the same fashion.
- In blockchain based systems, the underlying software is designed so as to remove the need for a central ledger-keeper altogether, with transactions taking place directly between the two users involved and there being no need for a centralised authority to determine whether individual transactions are valid and may take place. That possibility is achieved by delegating the work usually performed by the central ledger-keeper to the collective users of the relevant system, who between them (or more accurately their computers) perform the verification and settlement process usually performed by the centralised ‘owner’ of the software system – allowing the cryptocurrencies enabled by them to transfer directly between users (the digital equivalent of the way that individuals might pass hard currency, such as coins or bank notes, directly from one to another).
C: How are Cryptocurrencies stored and exchanged?
- Cryptocurrencies are kept in individual digital accounts known as ‘wallets’. However, cryptocurrencies themselves are not actually ‘stored’ in a wallet. Instead, a private key (secure digital code known only to the owner and his/her wallet) is stored that proves ownership of a public key (a public digital code connected to a certain amount of currency). So a ‘wallet’ stores a person’s private and public keys which connects that person to the cryptocurrency he/she owns, allows the person to send and receive coins, and also acts as a personal ledger of executed transactions.
- Individual wallets can be made subject to security measures in the same way as accounts on traditional electronic transaction systems. The simplest types of security measures are passwords, which function in much the same way as for traditional software accounts, but there are other, more complex, security measures which can be put in place.
- Cryptocurrencies may be exchanged either for ‘fiat’ money or other forms of cryptocurrencies via a number of trading platforms. Bitcoin, Ether and other well established cryptocurrencies may be exchanged directly for ‘fiat’ money. Others will typically be exchanged for other cryptocurrencies such as Bitcoin and Ether which can then be converted into traditional ‘fiat’ money.
E: What are the Advantages of Cryptocurrencies?
- There are at least three advantages of owning cryptocurrencies and using “a purely peer-to-peer version of electronic cash that allows online payments to be sent directly from on party to another without going through a financial institution” (Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System).
- One of the advantages of there being no intermediary is that there are no hefty transaction fees from central banks. The benefit of this is that transacting will cost less and the users will get more value out of their money.
- Another advantage is that the user is in possession and has complete control of his/her cryptocurrencies, rather than a bank. Cryptocurrencies are immune from debasement or misuse by private banks. A user can exchange the cryptocurrency for other cryptocurrencies or more traditional currencies at any point (subject to limitations at paragraph 15).
- Lastly, due to the systems infrastructure and verification procedure i.e. use of hashing to connect the blocks and verification by consensus of members of the blockchain network (described in more detail at paragraphs 9 and 12) using blockchain is generally very secure.
F: What are the Disadvantages of Cryptocurrencies?
- Cryptocurrencies, at present, are volatile to be a reliable store of value or means of exchange. This means that anyone holding these cryptocurrencies could lose or gain large amounts (for example the value of the Bitcoin has increased significantly since its inception, although its value has declined substantially from the peaks achieved in December 2017). Additionally, although an increasing amount of stores and retailers are beginning to accept major cryptocurrencies as a form of payment, cryptocurrencies are too volatile and not established enough within society to be used by employers to pay wages or as consideration in most contracts.
- Due to the infrastructure of the blockchain, its capacity to handle transactions is not as high as more traditional forms of online payment methods. According to the Bank of England, “every day in the UK, more than 30 million electronic payments are made through Bacs and Faster Payments [payment systems]. In contrast, Bitcoin’s global peak capacity is around 0.6 million transactions per day.”
For further information, please contact Simon Halberstam at Simon.Halberstam@smab.co.uk