What is Cryptocurrency?

  • A cryptocurrency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it.
  • It is an alternative form of payment created using encryption algorithms.
  • Some examples of cryptocurrencies include Bitcoin, Ethereum, Cardana, and Litecoin.
  • Cryptocurrency does not exist in physical form (like paper money) and is typically not issued by a central authority.
  • Cryptocurrencies typically use decentralized control as opposed to a central bank digital currency (CBDC).
  • The first cryptocurrency was Bitcoin, which was first released as open-source software in 2009.

How Does Cryptocurrency Work?

  • Transactions with cryptocurrency are recorded on a public digital ledger called blockchain, which is a computerized database using strong cryptography to secure transaction records, control the creation of additional coins, and verify the transfer of coin ownership.
    • This ledger is maintained by a network of computers around the world, and each new transaction is verified and added to the blockchain by these computers.
    • This decentralization and use of cryptography make it difficult for anyone to manipulate the currency or the transactions recorded on the blockchain.
  • To use cryptocurrency, individuals or businesses must first acquire a digital wallet, which is a software program that stores the user’s public and private keys.
    • These keys are used to send and receive cryptocurrency, and they are also used to verify transactions on the blockchain.
    • These wallets can be software that is a cloud-based service or is stored on your computer or on your mobile device.
      • The wallets are the tool through which you store your encryption keys that confirm your identity and link to your cryptocurrency.
  • Users can acquire cryptocurrency through a process called “mining” which involves using computer power to solve complex mathematical equations, which validate and record transactions on the blockchain, in return for a certain amount of cryptocurrency.
    • Some crypto schemes use validators to maintain the cryptocurrency. In a proof-of-stake model, owners put up their tokens as collateral. In return, they get authority over the token in proportion to the amount they stake. Generally, these token stakers get additional ownership in the token over time via network fees, newly minted tokens, or other such reward mechanisms.

Some Examples of Cryptocurrencies:

  • Bitcoin (BTC):
    • It is the first and most well-known cryptocurrency, created in 2009.
    • Bitcoin was invented by an unknown person or group of people using the name Satoshi Nakamoto and was released as open-source software in 2009. It is considered the first decentralized cryptocurrency.
    • Bitcoin has no single administrator, and the currency can be sent electronically from user to user on the peer-to-peer bitcoin network without the need for intermediaries.
    • Transactions are verified by network nodes through cryptography and recorded in a public distributed ledger called a blockchain.
  • Ethereum (ETH):
    • Ethereum (ETH) is a decentralized, opensource blockchain platform that enables the creation of smart contracts and decentralized applications (dApps).
    • It uses its own cryptocurrency, Ether, as a means of payment for transaction fees and services on the Ethereum network.
    • It also has a built-in programming language that enables developers to create and deploy their own decentralized applications on the Ethereum network.
  • Litecoin (LTC):
    • Litecoin (LTC) is a peer-to-peer cryptocurrency and open-source software project.
    • It is inspired by and nearly identical to Bitcoin (BTC) but with faster transaction confirmation times and a different hashing algorithm.
    • It is designed to process small transactions faster and more efficiently than Bitcoin.
  • Ripple (XRP):
    • Ripple (XRP) is a digital asset and cryptocurrency that is designed to facilitate fast and inexpensive international money transfers.
    • It is built on the Ripple Protocol, a decentralized open-source protocol for facilitating cross-border payments.
    • Ripple can be used to transfer any currency, including USD, EUR, and Bitcoin, and it can also be traded on digital currency exchanges.
  • Bitcoin Cash (BCH):
    • Bitcoin Cash (BCH) is a cryptocurrency that was created as a result of a hard fork from Bitcoin in 2017.
    • It has a larger block size limit (8MB) compared to Bitcoin (1MB), allowing for faster and cheaper transactions.
    • It is considered by some to be a “purer” version of Bitcoin, as it adheres more closely to the original vision of Bitcoin as a peer-to-peer electronic cash system.

Types of Cryptocurrencies

  • There are different types of cryptocurrencies, each with its own purpose and function.
    • Utility Tokens: These tokens, like Ripple’s XRP and Ethereum’s ether (ETH), serve specific functions on their blockchain platforms.
    • Transactional Tokens: These tokens are designed to be used as a method of payment, with Bitcoin being the most well-known example.
    • Governance Tokens: These tokens represent voting or other rights on a blockchain platform, such as Uniswap.
    • Platform Tokens: These tokens support applications built to utilize a specific blockchain, such as Solana.
    • Security Tokens: These tokens represent ownership of an asset that has been tokenized, like a stock. An example is the MS Token, which offers partial ownership of the Millenium Sapphire.

Legal Status of Cryptocurrency:

  • In India:
    • The legal status of cryptocurrency in India is currently in a state of flux.
    • The Reserve Bank of India (RBI) has issued several warnings against the use of cryptocurrencies, stating that they pose risks to investors and are not legal tender.
    • In 2018 the Supreme Court struck down a circular of Reserve Bank of India, which bans financial institutions from dealing in digital or cryptocurrencies.
      • In 2020, the Supreme Court of India had lifted the ban on cryptocurrency, which was imposed by the Reserve Bank of India.
    • In 2022, the Government of India mentioned in the Union budget 2022-23 that-the transfer of any virtual currency/cryptocurrency asset will be subject to 30% tax deduction.
      • The Govt has also set up a panel to explore the potential use of blockchain technology and the possibility of issuing a Central Bank Digital Currency (CBDC).
    • In an effort to tighten the oversight on digital assets, the government, in March 2023, imposed money laundering provisions on cryptocurrencies or virtual assets as it looks to tighten oversight of digital assets
    • At present (2024), India neither prohibits nor allows investment in the cryptocurrency market.
  • Elsewhere:
    • At present, El Salvador and the Central African Republic (CAR) are the only two countries in the world where Bitcoin functions as a legal currency.
    • However, many countries have taken steps to recognize and regulate the use of certain cryptocurrencies, such as Bitcoin.
      • Some countries, such as Japan and South Korea, have issued regulations for cryptocurrency exchanges.
      • Nations like Germany and Switzerland, have recognized Bitcoin as a “legal means of payment.”
    • Other countries, such as China and Russia, have taken a more cautious approach and have imposed restrictions on the use of cryptocurrencies.

Advantages and disadvantages of Cryptocurrency

  • Cryptocurrency has the following advantages:
    • Funds transfer between two parties will be easy without the need of third party like credit/debit cards or banks.
    • It is a cheaper alternative compared to other online transactions.
    • Payments are safe and secured and offer an unprecedented level of anonymity.
    • Modern cryptocurrency systems come with a user “wallet” or account address which is accessible only by a public key and pirate key. The private key is only know to the owner of the wallet.
    • Funds transfer are completed with minimal processing fees.
  • Cryptocurrencies have the following disadvantages:
    • The almost hidden nature of cryptocurrency transactions makes them easy to be the focus of illegal activities such as money laundering, tax-evasion and possibly even terror-financing.
    • Payments are not irreversible.
    • Cryptocurrencies are not accepted everywhere and have limited value elsewhere.
    • There is concern that cryptocurrencies like Bitcoin are not rooted in any material goods. Some research, however, has identified that the cost of producing a Bitcoin, which requires an increasingly large amount of energy, is directly related to its market price.

Challenges and Risk of to using cryptocurrency:

  • Volatility: Cryptocurrency prices are highly volatile, which makes it difficult for businesses to accept it as a form of payment.
  • Regulation: There is a lack of clear regulation around cryptocurrency, which makes it difficult for businesses and individuals to know how to legally use it.
    • Since cryptocurrencies don’t need banks or any other third party to regulate them; they tend to be uninsured and are hard to convert into a form of tangible currency (such as US dollars or euros.)
  • Security: Cryptocurrency exchanges and wallets are susceptible to hacking attacks, which can result in the loss of funds.
  • Adoption: Despite its growing popularity, cryptocurrency still has low adoption rates, which makes it difficult for individuals to use it as a form of payment in everyday life.
  • Scalability: The scalability of cryptocurrencies is limited, which makes it difficult for the technology to handle a large number of transactions.
  • Energy consumption: The process of verifying transactions in a cryptocurrency network, known as mining, is energy-intensive, and contributes to climate change.
  • Throughout their existence, cryptocurrencies have been involved in criminal activities and multi-billion-dollar fraud schemes.

Way Forward

  • Clarity on the legal status of cryptocurrencies is important for their widespread adoption and use. When governments provide a clear framework for cryptocurrency, it creates a more stable environment for businesses and individuals to invest in and use them. This can also encourage innovation and growth in the industry.
    • The examples of countries like El Salvador and the Central African Republic recognizing cryptocurrencies as legal tender show that it is possible for governments to embrace this new technology and create a favorable environment for it to thrive.
  • The RBI has started a blockchain-based Central Bank Digital Currency (CBDC) pilot program. The government should take this into consideration because cryptocurrency is based on blockchain technology as well.
  • Regulation is the Solution: Launching cryptocurrency with a strong regulatory framework can ensure its proper use, prevent fraud and illegal activities, and increase consumer protection. On the other hand, a complete restriction of cryptocurrency may stifle innovation and limit its potential benefits to society.
  • Clarity on Crypto-currency definition: A legal and regulatory framework must first define crypto-currencies as securities or other financial instruments under the relevant national laws and identify the regulatory authority in charge.
    • The classification of cryptocurrencies as either goods or asset classes is still unclear and subject to change in many countries, including India. 
      • Currently, software is considered a good and can be taxed as such under Indian law. Profits and earnings from the sale of cryptocurrencies are considered taxable income, but only after the legalization of cryptocurrencies.
  • Strong KYC Norms: Instead of a complete prohibition on cryptocurrencies, the government shall rather regulate the trading of cryptocurrencies by including stringent KYC norms, reporting and taxability.
  • Ensuring Transparency: Record keeping, inspections, independent audits, investor grievance redressal and dispute resolution may also be considered to address concerns around transparency, information availability and consumer protection.
  • Igniting the Entrepreneurial Wave: Cryptocurrencies and Blockchain technology can reignite the entrepreneurial wave in India’s start up ecosystem and create job opportunities across different levels, from blockchain developers to designers, project managers, business analysts, promoters and marketers.

Central bank digital currency (CBDC)

  • CBDCs are digital currencies issued by central banks. Their value is linked to the issuing country’s official currency.
  • In other words, CBDCs are the legal tender issued by a central bank in a digital form.
    • The digital rupee (e-Rupee) is the digital currency launched by Reserve Bank of India.
  • It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency, only its form is different.
  • CBDCs are similar to—but not the same asstablecoins.
    • Stablecoins are a specific type of private, stabilized cryptocurrency pegged to another currency, commodity, or financial instrument with the goal of maintaining a relatively stable value over time.
Difference between cryptocurrency and CBDCs
  • Role of central bank
    • Cryptocurrencies and CBDCs are both blockchain-based digital currencies.
    • However, cryptocurrencies are generally run by private companies or individuals.
    • On the other hand, a CBDC is controlled and tracked by a country’s central bank and corresponds to that country’s fiat currency.
  • Volatility
    • Bitcoin’s price may vary by hundreds or even thousands of dollars in a short period of time.
    • On the other hand, a CBDC would (ideally) be worth as much as its physical counterpart.
  • Investment vehicles
    • Investors often buy large quantities of Bitcoin or other cryptocurrencies and hold them in the hope of making a profit.
    • This doesn’t make sense in the case of CBDCs as they are not meant to be investment vehicles.
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