One of the most well-known applications of Fintech is the development and use of cryptocurrencies. The arrival of Bitcoin, and the subsequent high financial gains that were quickly made by some of those involved, generated significant media attention.

In this article we will take a look at what exactly cryptocurrencies are, the potential impact of this disruptive technology, and their application as a source of short and long-term finance.

Digital assets

Essentially, a cryptocurrency is a digital asset. While it works in a similar way to traditional currencies, it has no physical form and exists solely as digital code.

In order to be considered an asset, digital assets must offer the holder the right to use. In a cryptocurrency system, the holders of the digital code (cryptocurrency units) have the right to use or exchange that data, either for other digital assets (ie units of a different cryptocurrency) or more traditional items such as goods or services.

On the face of it, this exchange is very similar to the use of money in a traditional fiat currency system, however the way that cryptocurrencies operate is very different.

Distributed ledger

Fiat currencies operate through a central banking system. The central records are held at the central bank, transactions are carried out and authorised by the bank clearing system using manual processes, and the bank oversees and takes ultimate responsibility for that currency.

In a cryptocurrency system, there is no central bank, no central records, and no central authority. It is operated instead using a distributed ledger system.

A distributed ledger is, in effect, a huge database of which there is no single definitive version. The ledger is instead ‘distributed’ meaning that it is multiplied and held on every computer that is connected to the cryptocurrency network. When a change is made, such as a transaction taking place between two users of the cryptocurrency, the transaction will be authorised, not by a bank or other centralised authority, but by a consensus mechanism carried out by the network connected to the ledger. Once approved, every single copy of the ledger, on every single computer is updated to reflect the change.

This presents a clear advantage over the traditional banking system in which central records could be hacked and manipulated. To successfully manipulate a distributed ledger system every single copy of the ledger would need to be hacked and altered; a near impossible task.

Benefits of cryptocurrencies

The decentralised network on which cryptocurrencies operate means that cryptocurrency, unlike fiat currency, is not regulated nor reliant on a central bank (which may collapse) or government (which may become unstable). This offers several benefits:

• Reduced currency risk
• Avoidance of bank or regulator transaction fees
• Easier business transactions with wider range of domestic and international users
• Cryptocurrencies could also potentially offer a more stable currency to locations with unstable local currencies

Limitations

However, cryptocurrencies are still an emerging area and to date they remain largely unregulated.

The extent to which regulations are in place also varies significantly around the world. For example, in China cryptocurrency exchanges are illegal and regulation is harsh. Japan on the other hand has a progressive regulatory environment for cryptocurrencies and they are considered legal tender. In the United States, laws and regulations vary from state to state, meaning there is no consistent approach in the country itself.

The UK, like the majority of countries, does not class cryptocurrencies as legal tender and they are not governed by any specific laws. However, exchanges are legal, and the registration requirements of the Financial Conduct Authority (FCA) must be complied with.

This low regulatory environment, combined with the relative anonymity afforded by the blockchain technology on which cryptocurrencies are built, presents serious risks, including:

• Lack of accountability as there is no one to govern the system. Law enforcement is challenging as a result.
• The lack of a central authority also means a lack of consumer protection, for example there will be no collective deposit insurance scheme to reimburse investors who lose funds due to hacking.
• Investors may lose their funds if their password is lost. This is because users are identified in the system using keys rather than personal data. This makes it much harder, and sometimes impossible, to confirm identity.
• Increased risk of tax evasion as cryptocurrency transactions take place outside the formal banking system. The current generation of cryptocurrencies are complex and difficult to track, making cryptocurrency transactions much harder to account for, increasing the ease with which they can be omitted from taxable income reports.
• Due to the high levels of confidentiality afforded to users, along with the challenges of tracking transactions, cryptocurrencies can facilitate illicit activity, such as money laundering or illegal drug transactions

Despite these limitations, cryptocurrency use continues to rise.

Cryptocurrencies as a means of exchange
Cryptocurrencies can be used in a similar way as cash for the payment for goods and services. However, not only are they are not widely accepted by retailers they are volatile and as such an unreliable store of value.

In many locations globally, cryptocurrencies are not legal tender and considered to be neither money, nor a currency.

However, the use of cryptocurrencies as a medium of exchange offers some benefits, for example transactions can be carried out much faster, and at lower cost, due to the involvement of fewer intermediaries. The lack of a central system also means the risk of outages is greatly reduced resulting in a more stable platform for transactions.

The use of cryptocurrencies in this way is now declining as users move increasingly towards holding cryptocurrencies as an investment.

Cryptocurrency investments
At present, the biggest use of cryptocurrencies is an investment, with many attracted by the widely publicised high gains made by others, such as during the Bitcoin bubble of 2017.

Cryptocurrencies are traded on exchanges, similar to those used for trading stocks and shares and offer the possible benefit of widening access to new investment opportunities. However, the risk to which consumers may be exposed is significant, both due to the lack of regulation and the potential for loss, such as when the 2017 bubble ‘burst’ in early 2018. The relative anonymity of users also increases the risk that cryptocurrency investment will be used for money laundering or other financial crimes.

Initial coin offerings (ICOs)
Cryptocurrencies can also be used as a method of raising finance. This is achieved through the creation of a decentralised network in an ICO.

ICOs have a degree of similarity with Initial Public Offerings (IPOs) in mainstream investment. However, there are some key differences.

• Supporters, not investors: ICOs involve supporters who buy into the system. This is similar to the approach used in crowdfunding; however, while crowdfunding involves making donations, in an ICO the supporters receive a potential reward as a motivation to invest.
• There is no controlling authority to govern ICOs due to their decentralised nature.
• Unlike IPOs, ICOs are, in the most part, unregulated. This increases the potential for scam ICOs targeting under-informed investors drawn by the possibility of high returns

Supporters buy into the system, receiving tokens in the new currency in exchange. Unlike shares received in an IPO, the tokens in an ICO have no inherent value. But if the system was successful, the tokens would become valuable.

However, ICOs were banned in the Republic of China in 2017.

Written by a member of the Strategic Business Leader examining team