Leducate Explains: Cryptocurrency
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This Leducate Explains article will introduce the key aspects of cryptocurrency, the rules surrounding their use, their controversies, and coming developments for cryptocurrency.
Introduction
Money and wealth are complicated concepts, and cryptocurrency is simply the latest iteration. Money has three primary functions:
that it represents a unit of account;
it acts as a medium of exchange; and
it is a store of value.
A currency is simply a recognised system of money, formally known as ‘legal tender’. There are 180 national currencies recognised as legal tender in the United Nations, though only a handful are used for international transactions widely.
Cryptocurrency is different from conventional money systems in that no nation state, or, more precisely, no central bank, issues it. Though representing less than 1% of the global financial market, cryptocurrencies are rapidly growing in fame and notoriety - depending on your perspective.
Given its recent development, confusion and misunderstandings surrounding cryptocurrency are common. This article aims to introduce its key aspects, the rules of use, and controversies and developments.
What is cryptocurrency?
Cryptocurrency is an umbrella term for a variety of decentralised currencies; they are not issued by the central bank of a nation state. The first cryptocurrencies appeared in 2009 following Satoshi Nakamoto’s white paper appearing in 2008.(1) Notable examples of cryptocurrency are Bitcoin, Stablecoins and Ethereum.
This form of decentralised finance has three key elements: first, a set of rules or “protocols” that specify how participants transact; second a ‘ledger’ which stores the history of cryptocurrency transactions known as ‘blockchain’; and third, a decentralised network of participants, updating and storing ledger of transactions.(2)
Image: Nodes representing a decentralised network, by GuerrillaBuzz via Unsplash
(i) Protocols
The protocols for cryptocurrencies are digitised systems agreed without the input of a central bank. These rules, using a computer code, specifies how the participants can transact and when a transaction is deemed to have occurred. The cryptocurrency Ethereum uses a protocol known as a ‘smart contract’, executing a transaction automatically when the criteria are met. Bitcoin uses a model known as ‘proof-of-work’. These cryptographic algorithms are put in place so that cryptocurrency participants are assured that money has not already been spent.
(ii) Ledger or Blockchain
Cryptocurrencies maintain a system of decentralised record keeping, formally known as ‘distributed ledger’. There are two groups of participants: “miners” who act as bookkeepers, and “users”, who transact in cryptocurrency. The ledger is updated when groups of transactions form a chain, hence the term “blockchain”. Miners can update the ledger, but both miners and users verify all ledger updates. This makes it difficult to forge counterfeit cryptocurrency - both miners and users have an incentive to self-regulate.
(iii) Participants
The users and miners comprise a decentralised network of individuals who update, store and read the ledger of transactions, and follow the rules of the protocol. Unlike conventional currencies, the participants do not bear any liability; the value of the cryptocurrency derives only from the activity of the participants and their market expectations.
Image: by Traxer via Unsplash
What are the rules governing their use?
As a mode of decentralised finance, cryptocurrencies are largely unregulated. The legal domicile of cryptocurrencies is often offshore or impossible to establish. The lack of regulation means that cryptocurrency, generally, bypasses the legal framework and taxes, non-competitive fees in the financial industry, and central bank oversight.
Why are they controversial?
The pioneers of cryptocurrency, its users, and miners have developed cryptocurrency as an alternative to mainstream finance and have developed a new asset class.
Cryptocurrencies are, thus far, limited in their ‘real-economy’ use. Unlike conventional currencies, cryptocurrency cannot be used for day-to-day transactions. There are also fluctuations in the value of cryptocurrencies as they rely on the behaviour of speculators, investors and asset managers.
Governments, financial regulators and central banks have taken a cautious regulatory approach; they have distanced themselves from the cryptoassets, eschewing them from participation in the ‘mainstream’ financial system.
Image: by Ayadi Ghaith via Unsplash
What’s next for cryptocurrencies?
Globally, there is a trend to encourage investment into cryptocurrencies and to normalise their presence in the financial system. For instance, in January 2024, the US Securities and Exchange Commission Group approved Bitcoin and Ethereum exchange-traded funds (ETFs) in these cryptocurrencies.(3) In September 2024, the Swiss stock exchange operator SIX launched a project for a crypto exchange to open.(4) In the UK, the Property (Digital Assets etc) Bill was introduced to Parliament in September 2024 which will recognise digital assets including cryptocurrency as a type of personal property.(5)
Conclusion
Views differ on cryptocurrency, but its prominence will continue growing and it is likely that it will become an important component of the financial system in future. You should now have a general understanding of what cryptocurrencies are, what the rules are surrounding their use, and their controversies.
Written by Nicholas Haddad
Glossary Box
Asset class - a group of investments that have similar characteristics. Examples of asset classes include stocks, real estate, cash and commodities.
Blockchain - a decentralised digital ledger that stores records of transactions across many computers so that the information can’t be tampered with. Each ‘block’ has data which is then linked to other blocks, forming a ‘chain’.
Central bank - a public institution that is responsible for managing currency and ensuring circulation.
Counterfeit cryptocurrency - fake cryptocurrency that is designed to look like legitimate ones.
Cryptocurrency - an umbrella term that describes decentralised currency that is not issued by the central bank.
Currency - A recognised system of money, also known as ‘legal tender’.
Decentralised currencies - currency not controlled by a single institution, such as a central bank. The control of the money supply is spread out across multiple computers and networks.
Distributed ledger - a digital system that records transactions across multiple computers.
Exchange-traded funds (ETFs) - a bundle of investments (such as stocks or bonds).
Satoshi Nakamoto - the name used by the individual (or group) who developed Bitcoin, and authored the Bitcoin white paper.