Cryptocurrencies: what they are and what risks they run
The new technologies, favored by the advances of cryptography – that is, the application of methods that serve to make a message understandable / intelligible only to people authorized to read it – and by the evolution of the Internet, are causing a radical change in the global economy, with particular reference to the financial sector, in terms of the methods of exchange of goods, services and all financial activities.
Among the most significant applications of digital technology to the financial sector stands out the birth and spread of “cryptocurrencies” (or “virtual currencies”), the best known of which is bitcoin.
What is a cryptocurrency
The term consists of two words: crypto and currency. It is therefore a ‘hidden’ currency, in the sense that it is visible / usable only by knowing a certain computer code (the so-called public and private ‘access keys’, in even more technical language).
Cryptocurrency does not exist in physical form (also for this reason it is called ‘virtual’), but is generated and exchanged exclusively electronically. It is therefore not possible to find bitcoins in paper or metal format in circulation.
Some concepts traditionally used for legal tender coins, such as that of ‘wallet’, have also been adapted to the context of virtual currencies, where we talk about ‘digital/electronic wallet’ (or digital/electronic wallet or simply e-wallet).
The cryptocurrency, where there is consensus among the participants in the relevant transaction, can be exchanged in peer-to-peer mode (ie between two devices directly, without the need for intermediaries) to purchase goods and services (as if it were legal tender in all respects).
Another classification in use involves the subdivision between ‘closed’, ‘unidirectional’ and ‘bidirectional’ virtual currency. The difference between the three cases lies in the possibility or not of being able to exchange the cryptocurrency for legal tender (or ‘official’ currency or ‘fiat money’, according to other common denominations) and in the type of goods / services that can be purchased. Bitcoin, for example, is a bi-ideological virtual currency as it can be easily converted with major official currencies and vice versa.
• virtual currencies are not legal tender in almost any corner of the planet and therefore acceptance as a means of payment is on a voluntary basis;
• virtual currencies are not regulated by central government bodies, but are generally issued and controlled by the issuing body according to its own rules, to which the members of the reference community agree to join;
• there are States that have decided to experiment, under their control, the use of virtual currency in their countries (eg Uruguay with the e-peso) or have announced their use without having more information about it (eg Venezuela with the Petro) or, again, that have initiatives in the pipeline in this regard (eg Estonia and Sweden).
BOX 1 – Do Money and Cryptocurrency Have the Same Functions?
We know that legal tender coins are usually recognized as a unit of account, a commonly accepted means of payment and a deposit of value (click on the link for more information). Can a cryptocurrency perform the same functions? The high volatility of cryptocurrencies certainly does not allow the proper performance of the ‘unit of account’ function: the prices of the main cryptocurrencies are subject to very large fluctuations, even within the same days. So it is highly inefficient, not to say impossible, to price goods and services in units of cryptocurrencies. As for the function of a store of value, it must be considered that, as they were designed, the more they will be used for the payment of goods and services, the more they will increase in value. This is because the number of cryptocurrency units that can be produced is limited (the creation of new cryptocurrency is contained and reduces over time); it follows that the more transactions are settled in cryptocurrencies, the higher their value will be. Finally, they are not a commodity currency, that is, they do not also have a function of use, such as gold. Instead, they could increasingly perform an exchange function in the near future.
The main features
Cryptocurrencies have peculiar characteristics that distinguish them. The following are the constituent elements:
– a set of rules (called “protocol”), that is, a computer code that specifies the way in which participants can carry out transactions;
– a sort of “ledger” (distributed ledger or blockchain) that preserves the history of transactions unchangeably;
– a decentralized network of participants who update, store and consult the distributed ledger of transactions, according to the rules of the protocol.
BOX 2 – What are a “distributed ledger”, a “blockchain” and the Bitcoin Blockchain?
A distributed ledger or blockchain (the latter name is usually united to the use of bitcoin and in Italian literally translates to ‘chain of blocks’) is an open and distributed ledger that can store transactions between two parties in a secure, verifiable and permanent way. Participants in the system are referred to as ‘nodes’ and are connected to each other in a distributed manner.
In essence, it is an ever-growing list of records, called blocks, that are linked together and secured through the use of encryption. The data in a block are by their nature immutable (they cannot be retroactively altered without all the blocks following it being modified; to do this, given the nature of the protocol and the validation scheme, the consent of the majority of the network would be needed). The distributed nature and the cooperative model make the validation process particularly safe and stable, although it must resort to non-negligible times and costs, largely referable to the price of electricity necessary to carry out the validation of the blocks (this in the case of the bitcoin Blockchain) and to the computational capacity necessary to solve complex algorithmic calculations (an activity that is commonly referred to as ‘mining’). Authentication takes place through mass collaboration and is fueled by community interests. The Blockchain is a public ledger of Bitcoin transactions in chronological order. It is used to permanently store Bitcoin transactions and to prevent the phenomenon of so-called “double spending” (to prevent bitcoins from spending more than once at the same time). As already noted, the Blockchain is a set of linked blocks: each block is identified by a code, contains the information of a series of transactions, and contains the code of the previous block, so that it is possible to retrace the chain backwards, up to the original block (a sort of DNA of Bitcoin transactions). All nodes of the network store all the blocks and therefore all the Blockchain.
Anyone can create a digital currency; so at any given time there can be hundreds or even thousands of cryptocurrencies in circulation. To create/distribute cryptocurrencies you can resort to a so-called “initial coin offering” (ICO). The first ICOs were launched to raise funds for new cryptocurrencies, while later the main purpose became to directly finance business ideas.
BOX 3 – Initial coin offerings (ICOs)