The first installment in a Global Finance series that explains the ins and outs of cryptocurrencies.
In the shadow of the financial crisis of 2007 and 2008, the world saw the launch of Bitcoin trading in 2010. A 2009 document posted online by the mysterious creator of the cryptocurrency, using the pseudonym Satoshi Nakamoto, argued that it was A new “peer-to-peer electronic cash system” is needed explicitly designed for Internet commerce that would not require reliable intermediaries such as banks to function.
Nakamoto argued that the bank-led trust model made Internet commerce transactions more expensive than he believed necessary, particularly when payments were «reversible» or disputed, requiring bank mediation. Rather than relying on trust, Bitcoin uses a «cryptographic proof of work», hence the term «cryptocurrency».
The term ‘cryptography’ actually refers to the cryptographic keys used to secure or encrypt each Bitcoin transaction. Nakamoto argued that the cryptographic proof-of-work and irreversible nature of Bitcoin transactions provide an additional layer of protection for internet sellers or merchants against fraud and avoid the additional costs and disputes associated with the trusted third-party model. However, whoever owns the cryptographic keys also has complete control of the cryptocurrency they represent, similar to a bearer instrument.
Other characteristics, such as the distributed and open nature of the cryptocurrency ledgers (or blockchains) in which transactions are recorded, distinguish cryptocurrencies from other digital currencies or forms of electronic money, including digital currencies issued by the central bank (CBDC).
Are cryptocurrencies securities, commodities, or currencies?
Like a fiat currency, cryptocurrencies can be used to pay for things, but they are not a widely used unit of exchange. Nor are they a great store of value, given their volatility. However, in an economic crisis or in an environment where low or negative interest rates persist, some argue that cryptocurrencies provide a reliable store of value.
The volatility of most cryptocurrencies can be attributed to their limited supply. Additionally, the big players who buy and sell cryptocurrencies like bitcoin have market-making powers, contributing to their volatile prices.
So if cryptocurrencies don’t meet the criteria for a coin, what are they?
Investors, traders and users often refer to cryptocurrencies as commodities or digital assets, as their volatility makes them the perfect vehicles for speculative investments that do not correlate with other financial markets.
However, regulators have expressed divergent views on whether they should classify cryptocurrencies as commodities; securities, which are more regulated; or coins.
The US Securities and Exchange Commission (SEC) considers some cryptocurrencies, such as Ripple’s XRP, as an investment contract and therefore a security, as Ripple Labs developed, distributed and sold XRP, which Meets the definition of value set forth by the US Supreme Court Howey Test. However, Ripple maintains that XRP is a commodity.
Financial professionals should pay close attention to how different regulators classify cryptocurrencies, particularly if they are investing or trading with them. National regulators can take different approaches and sometimes many in the same jurisdiction. For example, the US Internal Revenue Service treats cryptocurrencies as property in its tax guide; while the US Financial Intelligence Unit (FinCEN) regulates them as currencies. Meanwhile; the US Commodity Futures Trading Commission; which regulates much of the derivatives markets; treats Bitcoin and Ether as commodities.
However, financial regulators and tax authorities may have to redefine how they treat Bitcoin in light of El Salvador’s adoption of Bitcoin as a secondary legal currency on June 8. Some market watchers argue that El Salvador’s actions; which other countries could copy, mean that there is a strong justification for classifying Bitcoin as a currency.