A REVIEW ON THE POSSIBILITY OF VIRTUAL CURRENCY,

SPECIFICALLY BITCOIN, IN TAKING OVER THE GOVERNMENT

MONOPOLY IN CURRENCY AND REPLACING IT WITH LIBERTARIAN
DECENTRALISED CURRENCY

I. ABSTRACT

Virtual currencies are a contemporary form of private money. Thanks to their technological
properties, their global transaction networks are relatively safe, transparent, and fast. This gives
them good prospects for further development. However, they remain unlikely to challenge the
dominant position of sovereign currencies and central banks, especially those in major currency
areas. As with other innovations, virtual currencies pose a challenge to financial regulators, in
particular because of their anonymity and trans-border character.

II. INTRODUCTION

There is no one agreed-upon definition of VC. For example, the European Banking Authority
(EBA) defines a VC as a “digital representation of value that is neither issued by a central bank
or public authority nor necessarily attached to a fiat (conventional) currency, but is accepted by
natural or legal persons as a means of exchange and can be transferred, stored or traded
electronically” (EBA, 2014, p. 7). The European Central Bank (ECB) defines a VC as a “type of
unregulated, digital money, which is issued and usually controlled by its developers, and used
and accepted among the members of a specific virtual community” (ECB, 2012, p. 14).
According to the definition of the Financial Action Task Force (FATF), “Virtual currency is a
digital representation of value that can be digitally traded and functions as (1) a medium of
exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender
status (i.e. when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction”.
(FATF, 2014, p. 4).
Virtual currencies (VCs) are a contemporary form of private money. Thanks to their digital form
and the use of Blockchain technology (in many, but not all, cases), the transaction networks of
VCs are relatively safe, transparent, and fast. Unlike their 18th and 19th century paper
predecessors, VCs are used globally, disregarding national borders. However, as with any money
or financial asset, investments in VCs are not without risk. VCs may be subject to fraud, the
bankruptcy of the issuer or intermediary, or speculative bubbles and bursts, among others

In April 2018, there were more than 1,500 VCs; however, only a few recorded meaningful
market turnover and capitalisation. Bitcoin, the first VC, created in 2009, remains a leader
among them. The VC business has seen continuous development in terms of number of VCs,
number of transactions, and market capitalisation. However, as long as major trading platforms
and financial intermediaries do not accept payments in VCs, their transactional role will remain
limited and they will fulfil mainly the third function of money, the store of value—that is, they
will serve as one of many investment assets.
Despite their technological advances and global reach, VCs are far from being able to challenge
the dominant position of sovereign currencies and the monetary policies of central banks,
especially in major currency areas. However, in extreme cases, such as during periods of
hyperinflation, financial crisis, political turmoil, or war, they can become a means of currency
substitution in individual economies.
Financial regulators may dislike VCs because of their anonymity or cross-border circulation.
They tend to fear that VCs will facilitate money laundering, the financing of illegal activities, tax
avoidance, the circumvention of capital controls (in countries where such controls are in place),
and fraudulent financial practices. Such concerns may be legitimate in some instances but must
not be generalised. In most cases, transactions in VCs result from the free business choices of
economic agents and, therefore, should be treated by regulators as any other financial transaction
or instrument—that is, proportionally to their market importance, complexity, and associated
risks. Given their global, trans-border character, it is recommended that regulations concerning
VCs be harmonised across jurisdictions (which is far from the case now). Investment in VCs
should be taxed similarly to investment in other financial assets.
This paper aims to analyse whether VCs would assume money role in the future by ending
government monopoly over currencies. To that end, this paper initially studies the historical
background of Bitcoin and the technical features that circumvent transactional bottlenecks to
enable a digital currency in sections IV and V respectively. Subsequently the paper enumerates
the actors involved in the VC realm with their functions and reviews macroeconomics models
that have been proposed already and their implication in section IX. Basing on the above,this
paper goes on to elucidate various advantages and disadvantages of Bitcoin in the same section.
Studying above features allows foretelling of broader interaction of VC with sovereign currency
and financial institutions.
Knowledge of historical precedents greatly aids in understanding how Bitcoin would not be able
to compete or replace these traditional sectors. At the very best, it might prove to be a
disciplinary mechanism of existing institutions.

III. KEYWORDS
IV. A HISTORICAL BACKGROUND

Bitcoin came into 2014 by winning the ‘Best Technology Achievement’ Tech Crunch award in
California.Bitcoin is an electronic peer-to-peer (i.e. with no third party being involved) payment
network and a digital currency. It started in 2009.At the heart of the creation of Bitcoin stands the
text "Bitcoin: a Peer-to-Peer Electronic Cash System" of Satoshi Nakamoto, published on the
internet in 2008. It was on the basis of this text and the ideas conveyed in it that the development
of Bitcoin accelerated. Contributory to the mystic nature of Bitcoin is that until now it remains
unclear whether Satoshi Nakamoto is a real person, a pseudonym, or perhaps even a group of
hackers. Satoshi Nakamoto in turn was inspired by the ideas of W. Dai, as set out in a text
http://www.weidai.com/bmoney.txt of 1998 titled "b-money" . The domain bitcoin.org was
registered in 2008 but the identity of the person(s) behind it is protected from being made public.
In January 2009 the first batch of bitcoins was generated (the so-called "genesis block" or "block
0" (20) The first exchange rate for bitcoin was published in October 2009 by New Liberty
Standard (21)(US$1 corresponded to 1 309 bitcoins). Public trading began in 2010, and the
recent market capitalisation (22)of Bitcoin amounts to over US$5.29 billion. On average, the
Bitcoin market encompasses(23)less than 100 million US dollars in worldwide trading activity
(24)on a daily basis (for comparison, daily trading is US$16.5 billion for Visa and US$9.8 billion
for MasterCard). Nonetheless, Bitcoin's success has resulted in other cryptocurrencies being
created .(25 )

V. TECHNOLOGICAL FEATURES

Attempts to create a virtual currency have been linked to the creation of online communities. The
Internet appears to have many advantages for the creation of a new means of payment specific to
it, and aimed at making transactions easier, safer and cheaper than traditional money. The
double-spending problem (spending the same money twice) prevented earlier attempts from
being successful.

The Bitcoin transaction process uses cryptography to verify transactions, process payments, and
control the supply of bitcoins (Badev and Chen, 2014, Badev, Anton, and Matthew Chen (2014):
“Bitcoin: Technical Background and Data Analysis”. Finance and Economics Discussion Series.
No. 2014-104, 07 October. Federal Reserve Board, Washington D.C.). Cryptography has been
used since antiquity to secure information; but in this particular case, it serves to create and
control the supply of units of currency. The concept behind cryptography is that a message is
encrypted using a certain algorithm in order to make it unreadable for anybody who does not
have a key necessary to decipher this message. A Bitcoin transaction is basically such an
encrypted message that facilitates a transfer of bitcoins from the sender’s electronic address to
the recipient’s electronic address.
Bitcoin employs two cryptographic schemes: digital signatures and cryptographic hash functions.
Digital signatures ensure that: (1) the recipient can verify that the message came from a
particular sender, (2) the sender cannot deny sending a message, and (3) the message has not
been tampered with. Cryptographic hash functions enforce discipline in writing transaction
records in the public ledger. Both of these schemes existed before the creation of Bitcoin and
were widely used to secure commercial and government communications
The Bitcoin system functions according to a set of rules known as the Bitcoin Protocol. When
person A wants to pay a certain amount of bitcoins to person B, payment instruction is placed in
the system, along with other payment instructions

To be specific each owner transfers the coin to the next by digitally signing a hash of the
previous transaction and the public key, which is a passcode, of the next owner and adding -these
to the end of the coin. Afterwards a so-called payee can verify the signatures to verify the chain
of ownership. We need a way for the payee to know that the previous owners did not sign any
earlier transactions and the only way to confirm the absence of one is to be aware of all
transactions. To accomplish this without a trusted party, transactions must be publicly
announced.

Miners validate payments and record them in a newly created block by solving a computationally
demanding mathematical problem that is created and specified by the Bitcoin Protocol. Miners
get compensation for their services in two forms: fees and freshly minted bitcoins that are
created in the process of validating the transactions. Miners compete with each other, as the
compensation is paid to the first miner that solves the problem, meaning that the system favours
miners with the strongest computational power.

Fees are voluntary, but as they attract miners to particular transactions, users can compete for
miners’ computational power and speed up the validation of transactions by offering higher fees.
In addition to fees, miners receive bitcoins that are created in the process of the validation of
transactions. The system is constructed in such a way that the amount of newly created bitcoins
is constantly decreasing, meaning that the relative importance of this form of compensation will
fall and fees need to increase over time.
The creators of Bitcoin set the maximum number of bitcoins to 21,000,000. When this number is
reached, no more bitcoins will be created and the only remuneration that miners will receive will
be the fees. When the transaction is validated by the miners, it is added to a new block that later
is added to the Blockchain (public ledger). Figure 1 depicts the structure of a Bitcoin transaction
 VI. LITERATURE REVIEW

Previous research in this emerging area has focused on providing an overview of Bitcoin and its
operations (Yermack 2013, B¨ohme, Christin, Edelman, and Moore 2015, Narayanan, Bonneau,
Felten, Miller, and Goldfeder 2016); has combined theory and data to explain the velocity of
Bitcoin and its use across countries as an investment vehicle, for gambling and illegal online
markets (Athey, Parashkevov, Sarukkai, and Xia 2016); and has studied the role early adopters
play in the diffusion and use of Bitcoin within a large-scale, field experiment (Catalini and
Tucker 2017). Researchers have also examined competition between alternative cryptocurrencies
and their differences (Gandal and Halaburda 2014, Gans and Halaburda 2015, Dwyer 2015,
Halaburda and Sarvary 2016); the changes they entail for trading behavior (Malinova and Park
2016); their integration with fiat-based currencies and direct use for providing citizens with
central bank money (Raskin and Yermack 2016, Seretakis 2017, Bordo and Levin 2017) and
alternative payment systems (Beck, Czepluch, Lollike, and Malone 2016, Rysman and Schuh
2017); implications for regulation and governance (Wright and De Filippi 2015, Davidson, De
Filippi, and Potts 2016, Kiviat 2015, Walport 2016); and the privacy trade-offs cryptocurrencies
and digital wallets introduce for consumers (Athey, Catalini, and Tucker 2017). From a business
perspective, scholars have compared the transformation brought about by blockchain to the
introduction of communication protocols such as TCP/IP (Iansiti and Lakhani 2017, Ito, Narula,
and Ali 2017), and have explored applications to digital platforms beyond finance and
implications for the boundaries of the firm (Catalini 2017a, Catalini 2017b).
 VII. RESEARCH OBJECTIVE
Given the above background, this paper tries to review the realm of VC, specifically Bitcoin and
its possibility of being the future money by comparing it with fiat currency.

VIII. DATA SOURCE AND METHODOLOGY

I have used secondary data and published reports and articles as well as government
official websites as my data source. I have tried to analyze as many articles as were available to
me.
Since this is a review paper, it is mainly depended on the findings of other reports and
research works and have reviewed them analytically.

IX. ANALYSIS OF THE PAPER

 Who are the players involved?

1. Crypto currency users

A first, and very important, player is the “crypto currency user”. A crypto currency user is a
natural person or legal entity who obtains coins to use them
(i) to purchase real or virtual goods or services (from a set of specific merchants),
(ii) to make P2P payments, or
(iii) to hold them for investment purposes (i.e. in a speculative manner)
Without trying to be exhaustive, a cryptocurrency user can obtain his coins in a number of ways
(1)

• He can simply buy his coins on a cryptocurrency exchange using fiat money or another
cryptocurrency or directly from another cryptocurrency user (i.e. through a trading platform –
this form of exchange is often referred to as a “P2P exchange”);
• If a cryptocurrency is based on a PoW consensus mechanism, he can mine a new coin (i.e.
participate in the validation of transactions by solving of a “cryptographic puzzle” and be
rewarded a new coin);
• In some cases he can obtain his coins directly from the coin offeror, either as part of a free
initial offering of coins (e.g. on the Stellar network Lumens (XLM) are being given away for free
https://www.stellar.org/lumens/) or in the framework of a crowd sale set-up by the coin offeror
(e.g. a large bulk of ether (cf. Ethereum) was sold in a crowdsale to cover certain development
costs83);
• Finally, he can receive coins as a gift or donation from another cryptocurrency.

2. Miners

A second player is the “miner” who participates in validating transactions on the blockchain by
solving a “cryptographic puzzle”. As explained above, the process of mining relates to
cryptocurrencies that are based on a PoW consensus mechanism. A miner supports the network
by harnessing computing power to validate transactions and is rewarded with newly mined coins
(i.e. through an automatic decentralized new issuance). Miners can be cryptocurrency users, or,
more commonly, parties who have made a new business out of mining coins to sell them for fiat
currency (such as US dollar or Euro) or for other cryptocurrencies. (2)

3. Cryptocurrency exchange

A third group of key players are the so-called “cryptocurrency exchanges”. Cryptocurrency
exchanges are persons or entities who offer exchange services to cryptocurrency users, usually
against payment of a certain fee (i.e. a commission). They allow cryptocurrency users to sell
their coins for fiat currency or buy new coins with fiat currency. They usually function both as a
bourse and as a form of exchange office. Examples of well-known cryptocurrency exchanges
are: Bitfinex, HitBTC, Kraken and Coinbase GDAX. It is important to note that some exchanges
are pure cryptocurrency exchanges, which means that they only accept payments in other
cryptocurrencies, usually Bitcoin (for example Binance), whilst others also accept payments in
fiat currencies such as US dollar or Euro (for example Coinbase).

4. Trading Platforms

In addition to cryptocurrency exchanges, so-called “trading platforms” also play an important

role in the exchange of cryptocurrencies (and, most notably, allow cryptocurrency users to buy
coins with cash). Trading platforms are market places that bring together different
cryptocurrency users that are either looking to buy or sell coins, providing them with a platform
on which they can directly trade with each other (i.e. an “eBay” for cryptocurrencies). Trading
platforms are sometimes referred to as “P2P exchanges” or “decentralized exchanges”.

5. Coin inventors

There are also those players who are referred to as “coin inventors”. Coin inventors are
individuals or organizations who have developed the technical foundations of a cryptocurrency
and set the initial rules for its use. In some cases their identity is known (e.g. Ripple, Litecoin,
Cardano), but ever so often they remain unidentified (eg. Bitcoin, Monero). Some remain
involved in maintaining and improving the cryptocurrency’s code and underlying algorithm (in
principle without administrator’s powers), whilst others simply disappear (e.g. Bitcoin).

6. Coin offerrors

A final group of key players to be distinguished are the “coin offerors”. Coin offerors are
individuals or organizations that offer coins to cryptocurrency users upon the coin’s
initial release, either against payment (i.e. through a crowdsale) or at no charge (i.e. in the
framework of a specific (sign-up) program (e.g. Stellar – see below)), normally to fund
the coin’s further development or boost its initial popularity. The coins these coin offerors
offer to cryptocurrency users are created or pre-mined prior to the coin’s official release /
the coin’s inception.
 Taxonomy of cryptocurrency
 Coin timeline
  Macroecnomoics of Bitcoin

Austrian School of economics

This is an economic school of thought that has its origin in Vienna in the late 19th century from
the works of Carl Menger. The topic of interest to Bitcoin is the theory of the business cycle,
which was discovered and set forth by the economist Ludwig von Mises who at the time was a
professor at the University of Vienna (Rothbard, M. (2009) Economic Depressions: Their Cause
and Cure. )

The definition for business cycles from an economist’s point of view consists on fluctuations in
aggregate economic activity that an economy experiences over a period of time, which might last
from a year to longer than a decade.According to the Austrian theory, business cycles are the
inevitable consequence of monetary interventions in the market, whereby an excessive expansion
of bank credit causes an increase in the supply of money through the money creation process in a
fractional-reserve banking system, which in turn leads to artificially low interest rates. When that
happens, the entrepreneurs, guided by deformed interest rate signals, enter on overly ambitious
investment projects that do not match the consumers’ preferences at that time (their decisions
regarding near-term and future consumption). Sooner or later, this instability can no longer be
sustained and leads to a recession, during which firms need to liquidate any failed investment
projects and readapt (restructure) their production structures in line with consumers’ preferences
at that point in time. As a result, many Austrian School economists call for this process to be
abandoned by getting rid of the fractional-reserve banking system and returning to money based
on the gold standard, which cannot be easily manipulated by any authority.

Here are some ideologies that are generally shared by Bitcoin supporters:
– They see Bitcoin as a good starting point or a solution to end the monopoly central banks have
in issuing money.
– They are strongly against the current fractional-reserve banking system through which banks
can extend their credit supply above their actual reserves and, simultaneously, depositors can
withdraw their funds in their current accounts at any time.
– The Bitcoin scheme takes inspiration by the former gold standard

Since so many currencies have been created and adopted since Nakamoto’s paper in 2008 it is
clear that the Hayekian model of competing currencies has been produced from Bitcoin.
However, what Hayek was unlikely to anticipate, is that these currencies would exist in
distributed networks. This is significant, since distributed crypto-currencies have the benefits of
difficult centralised manipulability but also are checked by the competition between them.

 Pros and Cons of Bitcoin

Pros:

● Decentralised – A currency is sad to be decentralised when no centralised authority is

involved in issuing the currency. By having a fixed creation rate of bitcoins, the inventors
aim to avoid speculations on the system, which can occur by corrupted actors within
banks or central banks. A fixed creation rate in theory makes it impossible for the
currency to inflate, however it would theoretically start to deflate when the issuing will
stop
 ● Lower transaction fees - Bitcoin offers three main advantages to its users. The first is
lower transaction costs, as there is no third-party intermediary charging users. To date
there is no comprehensive research on the actual size of Bitcoin's transaction cost
advantage. Some however state that the average transaction fees are between 0 and 1
percent. Taking into account that traditional online payment systems charge fees of 2 to 3
per cent per transaction, it is likely that Bitcoin is cheaper to use even when swapping it
for conventional fiat money, which has a fee of about 1 per cent. These benefits may
however be offset by Bitcoin’s high volatility

● Open source – As Ludvig and Tristan from Safello said, everyone who knows
programing can review the code of Bitcoin and check what it does. This gives a sort of
transparency to everyone who wants to learn more about how these virtual coins are
generated

● Accounts cannot be frozen – Making it impossible to freeze someone’s account,

eliminates any subjective judgement regarding an individual's actions and activity. It is
free of political influences.

● Does not cost to start accepting Bitcoin – Makes it attractive for businesses to try it out
as a way of payment and draw in customers that prefer using bitcoins.

● Easy to set up – The scale of difficulty is very subjective. It is determined by the level of
skills and information an individual who want to start using bitcoins has. However, there
are accessible guidelines that make it easy to get started.

● Anonymous online transactions – Anonymity does not necessarily mean something

negative. Not everyone who wants to be anonymous has bad intentions. Being
anonymous gives some kind of privacy and “minding its own business” king of behav

Cons:
● Anonymity – Makes its easier for those who want to use bitcoins to buy drugs and do
other illegal things, or finance illegal businesses.

● Volatility – Bitcoin is sensible to other potential new cryptocurrencies. Who knows what
can happen if within some months there is another new cryptocurrency in circulation that
has better protocol and security solutions than Bitcoin and therefore attracts more users?
This could bring to those who have invested and bought bitcoin great loses. In other
words, it depends on its popularity.

Bitcoin's price has been subject to high volatility since its creation, with 2013 bringing
record high appreciations and precipitous depreciations in value (see Annex A). For
example, it rose more than 20 times in value between September and December 2013, but
then lost about 60% of its value over the next three months. Almost half of bitcoins are
owned by less than 1 000 people (47 own almost one-third). Some say that this may
create a cartel-like effect on pricing, especially when there is a shortage of bitcoins on the
market. Media coverage and regulatory stances, speculation on exchanges, hacking and
shutting down of exchange platforms, one-off events such as closure of banks in Cyprus
(and apparent loss of trust in traditional fiat currency) have all had significant effects on
the price of bitcoins. The volatility of Bitcoin is likely to discourage many potential
buyers. Falling prices may deter selling by hoarders of bitcoins who expect higher returns
in the future, or it may cause them to panic and sell. In fact, there seems to be consensus
among observers that the recent instability in prices is one of the main hurdles to the
wider use of Bitcoin as a medium of exchange. Its adoption for day-today use is directly
related to price stability, needed by consumers and businesses for planning their
consumption and savings decisions
(3.i,3.ii,3.iii,3.iv,3.v,3.vi)
● Security threats - Even though counterfeiting bitcoins is supposedly not feasible as they
all have a unique identity, many problems have been reported concerning other aspects of
the currency, such as security of the exchange platforms and wallets. Cybercrime is on
the rise with bitcoins also attracting more attention, while there have also been problems
signalled with Bitcoin-based Ponzi schemes. Bitcoin's main security focus is on
preventing the same unit being spent twice, whereas it cannot validate whether the true
owner of a key signed the transaction. Empirical research on Bitcoin exchanges showed
that the less popular ones are more likely to suffer a security breach and be closed due to
theft of bitcoins. Fundamentally, since Bitcoin is outside the banking system and not
backed by any central body, in most cases users cannot recover any of their losses since
they are not covered by deposit insurance. (4.i,4.ii,4.iii,4.iv,4.v)

● Immaturity and risks- Bitcoin is a currency in a nascent stage which has various risks
involved. Firstly, it is not yet widely accepted as a payment method by merchants. In fact,
current uses of Bitcoin are mostly speculative in nature (keeping bitcoins in the hope of
price increases), as in the retail and commercial sectors it remains a niche phenomenon.
And as speculation fuels volatility, the commercial world is ever more reluctant to accept
Bitcoin widely. Furthermore, Bitcoin's security and operational robustness may be
 exposed to unforeseen challenges in the future as Bitcoin matures and handles larger
transaction volumes. An unforeseen flaw might have a detrimental effect on the whole
system. (6)

● Lack of supply elasticity -Bitcoin emission is capped, which means it has an inherent
deflationary bias. On average, the supply of Bitcoins will increase by 0.6 per cent a year.
If the Bitcoin economy expands faster than this, the currency will become scarce and the
price of bitcoins will rise. At the same time, the price of goods expressed in bitcoins will
fall, causing a deflationary effect. Furthermore, the pace of issue of bitcoins will most
likely be slower than that of physical currencies, which is likely to lead to its exchange
rate increasing significantly (this theory can be tempered by looking at the reality of
volumes in current use). This lack of supply elasticity makes Bitcoin's issuance
independent of general economic activity and its possible wider acceptance as a means of
payment (and therefore of increased demand). This may encourage its use as a
speculative instrument – in view of its expected future rise in value – rather than as a
means of payment. (6)

● Money laundering, speculative investments – Research on money laundering and tax

fraud via Bitcoin is limited due to difficulties in obtaining data. One landmark paper
suggests that Bitcoin (and other cryptocurrencies) is reasonably likely to replace tax
havens as a choice for tax evaders. As earnings are not subject to taxation, the identity of
traders remains anonymous, no bank account is needed and there are no third parties with
reporting obligations involved, Bitcoin has high potential for tax evasion. For the same
reasons some researchers believe that Bitcoin use will be maintained by hackers, online
gamblers, drug dealers, smugglers, and anarchists, since the features of the system make
it a very practical tool to purchase illegal items or support illegitimate activities.
However, the scale of tax evasion at present is not likely to be very high, as the number
of bitcoins available is simply not large enough and its volatility in value too high. The
European Banking Authority, European Central Bank and the FBI have all recognised
that Bitcoin may be used for money-laundering purposes. The potential comes mainly
from the anonymity and lack of regulation. Money laundering may for example take
 place by converting illegal gains to bitcoins, spreading them through several wallets and
then using several services to receive other legitimate bitcoins for a commission.
Technically proficient criminals may take additional steps to cover their traces and some
security experts argue that international drug cartels have indeed migrated online to
launder their illegal profits. The US introduced anti-money laundering guidelines
applicable to Bitcoin in 2013, and the first arrest of a prominent Bitcoin figure on money
laundering charges occurred there in January 2014. On the other hand, some analysts
state that laundering money through Bitcoin is more of a theoretical possibility than an
actual one. They argue that the small number of Bitcoin exchanges (which allegedly
started offering aid to relevant investigating agencies in 2011) and the public nature of the
Bitcoin ledger make the currency currently unattractive for high-volume money
laundering activities. (7)

● Legal frame

● Pricing – As Segendorf mentioned during the interview, the pricing for Bitcoin is not
something easily definable. For example, buying cheap goods and services becomes
suddenly very complicated, as you have to divide a bitcoin in multiple decimals. Neither
is regarded to be a practical currency when it come to the physical usage.

● Exposed Digital wallets – Something frightening with digital wallets is that they can be
hacked. Or in case of losing either private or public key, which are to different passwords
needed in order to gain access of your digital wallet, will make it impossible to log into
your digital wallet, therefore lose the bitcoins in it. There are no central agencies or units
that keep track of these keys or issue replacement ones.20

● Relying on an exchange platform – Having to trust something you do not completely

comprehend, like very complicated algorithms, makes many be sceptical and holds them
back from trading with bitcoins. Relaying on exchange platform means that one has to
except their exchange rate as best at the moment
  Regulations worldwide

VCs are a relatively new invention and have only recently begun to attract the attention of
financial regulators. Individual countries have different attitudes towards VCs. For example,
China explicitly or implicitly bans them while others, like Switzerland, are trying to attract VC
scheme investors and operators. Some others (e.g. Venezuela) even plan to issue their own
national VCs.In most countries, especially in major jurisdictions, authorities have adopted the
“wait and see” attitude, while closely monitoring developments in VC markets. Several
financial authorities (for example, in Germany,13 Poland,14 the UK,15 the US,16
Singapore,17 and the EBA18) have issued informal warnings to the general public, advising
of the dangers of involvement in VCs. Many representatives of monetary and financial
authorities and international financial organisations emphasise the need for the supervision and
regulation of VCs. For example, Christine Lagarde, the Managing Director of the IMF,
highlighted VCs’ potential as a vehicle for money laundering and the financing of terrorism
and called for “…policies that ensure financial integrity and protect consumers in the crypto
world just as we have for the traditional financial sector” (Lagarde, 2018). During the G20
meeting in March 2018 in Argentina, ministers of finance and governors of central banks agreed
to keep a watchful eye on cryptocurrencies. On the one hand, France and Germany proposed
banning deposits and loans in VCs as well as the marketing of investments based on them to the
general public (Canepa, 2018). On the other hand, Mark Carney, the Chair of the Financial
Stability Board (FSB) and the governor of the Bank of England, wrote in a letter to the G20
that “…FSB’s initial assessment is that crypto-assets do not pose risks to global financial
stability at this time” due to their limited use.19 Public authorities seem to be the most
concise and decisive when it comes to tax-related issues. In many countries, VCs are recognised
as some form of financial asset or property by the tax authorities. Consequently, tax authorities
demand payment of capital gains tax on profits made on the trading of VCs. Such decisions were
made, for example, in Australia, Germany, Israel, Norway, Poland, Singapore, Sweden, and the
US (McKenna, 2017). Some countries introduce measures aimed to deal with the problem of
increased anonymity and related money-laundering issues. For example, on 7 December 2017,
the Australian Parliament passed amendments to the Anti-Money Laundering and Counter-
Terrorism Financing Act of 2006 (McKenna, 2017). In many other countries, authorities are
currently working on similar laws and one should expect the introduction of such regulations in
those countries in the foreseeable future. Some countries are considering the issuance of their
own VCs based on Blockchain technology. Venezuela was the first country in the world that
issued a sovereign virtual currency—the “petro”, which was widely interpreted as an attempt to
circumvent the economic sanctions imposed by the US (Fanusie and Frai, 2018). In response to
the plans of the Venezuelan government to issue the petro, the President of the United States,
Donald J. Trump, issued an executive order banning any transactions related to any VC
issued by or on the behalf of Venezuelan government.20 As we can see, attitudes towards VCs
vary significantly from country to country and there is no clear trend in regulations. Below we
summarise the regulatory approaches of three major jurisdictions (the US, Switzerland, and
China) as of April 2018
The EU has not adopted any specific regulation on Bitcoin. A 2012 report of the European
Central Bank states that Bitcoin falls outside the scope of both the Electronic Money Directive
and the Payment Services Directive. The report notes that cryptocurrencies may pose challenges
to authorities "given their legal uncertainty ... as they can be used by criminals, fraudsters and
money launderers". Observers noted in March 2014 the first attempt to put Bitcoin on the
European agenda. Risk experts suggest that rather than specific legislation, adapting the existing
payment and electronic money framework and anti-money laundering laws will be sufficient.
Others argue that the multitude of approaches at Member State level may mean that
harmonization at EU level will be needed. A January 2014 survey of 40 jurisdictions pointed out
that very few countries have Bitcoin-specific regulations and that the debate on how to deal with
it is still in its infancy. It also reported widespread concern about the potential impact of Bitcoin
on national currencies, taxation, and its potential for criminal misuse. The main issue with
regulating Bitcoin seems to be that it is considered neither to be legal tender nor a security or
similar financial instrument but a "hybrid product". Financial analysts argue that Bitcoin has both
currency and commodity features. Ambiguity about its status is reflected in recent developments:
Japan decided to treat Bitcoin as a commodity, guidelines from US authorities describe
Bitcoin as property, but in Germany it is recognised as private money. There is a consensus
among commentators that as Bitcoin gains in prominence it will become more regulated.
Currently, the most restrictive approach is in countries with strong capital controls (such as
China). Authorities in the few other countries pioneering regulation have focused mostly on
taxing Bitcoin trade and preventing its use for money laundering or involvement in illicit
activities , giving a nascent industry time to grow and possibly create public benefits. Recently
Japan called for international regulation of Bitcoin to avoid exploitation of loopholes. The least
developed field of regulation seems to be that of consumer protection. One of the rare
instances, the US guidelines, makes losses on Bitcoin trading tax deductible. (9)

The Financial Crimes Enforcement Network of the US Department of the Treasury (FinCEN)
does not recognise VCs as a “real currency” (a legal tender), but recognises the administrators
and exchangers of VCs that are convertible into sovereign currencies as “money services
businesses” (MSBs), which means that they are subject to FinCEN’s registration, reporting, and
record keeping regulations for MSBs (FinCEN, 2013). The US Securities and Exchange
Commission (SEC) issued a public statement21 saying that VCs meet the definition of securities
as specified in federal securities laws and therefore platforms that offer trading of such “digital
assets” must register with the SEC as a national securities exchange or be exempt from
registration. The Internal Revenue Service (IRS) issued a notice stating that for federal tax
purposes VCs are treated as property and general tax principles applicable to property
transactions apply to transactions using VCs (IRS, 2014). The notice outlines the rules applying
to transactions using VCs with respect to federal taxes. For example, “mining” VCs is considered
to be self-employment and income from “mining” is subject to self-employment tax. The federal
authorities are working on stricter laws regarding potential money laundering and tax evasion
issues. Steven Mnuchin, the US Treasury Secretary, said that he will work with the G20 to
prevent VCs “from becoming the digital equivalent of an anonymous Swiss bank account”
(Mohsin, 2018)

Switzerland is considered to be one of the countries with the friendliest attitude when it
comes to VCs. As a result, according to a PwC Report, Switzerland has emerged as a hub for
several successful Initial Coin Offerings (ICOs) (Diemers, 2017). The Swiss Financial Market
Supervisory Authority (FINMA) even issued guidelines for ICOs.22 Companies issuing VCs are
required to obtain a license from FINMA, which recently closed down a company issuing a “fake
cryptocurrency E-Coin” for not having such a license.23 2.5.3.
The People’s Republic of China- Chinese authorities have taken an entirely opposite attitude
towards VCs. Seven government agencies, including the People's Bank of China, the China
Securities Regulatory Commission, the China Banking Regulatory Commission, and the China
Insurance Regulatory Commission issued a joint statement where they essentially banned
VCs.24 The statement declares that offering tokens such as bitcoins or ethers is “…an illegal
public financing without approval”. According to (Nelson, 2018), China appears to have the
most stringent cryptocurrency regulations among large economies. This is motivated by
authorities’ desire to fight capital outflow and corruption.
  Risk towards financial institution with the proliferation of crypto
currency:

To understand what kind of challenges VCs can create for central banks concerning their
supposed monopoly on money issuance and the monetary policies conducted by them, it is worth
taking a brief look back at the history of private money. Despite their technological novelty,
VCs are a contemporary form of private money.
Private money (or currency) is a liability issued by a private business entity such as a private
bank or other financial institution, non-financial corporation, non-profit private institution, or
individual, which is accepted as a means of payment by other economic agents.
Since the middle of the 19th century, country after country established central banks and
gradually granted them regulatory powers over private commercial banks, the role of a lender of
last resort and the central monetary authority with dominant or even exclusive rights to issue
national currencies
It seems that there were two major advantages of sovereign currencies: network externalities and
the potential ability to address the problems of information asymmetry and adverse selection.
Network externality means that a given currency is broadly accepted by other economic agents
on a given market and performs all functions of money.
Unfortunately, this was not possible in the environment where several private currencies
circulated in parallel and competed with each other. The multiplicity of private currencies
meant higher transaction costs for all economic agents on a given territory. Even if they
were denominated at the same currency unit (for example, pound or dollar), they were traded at
various discount rates depending on the reputation and reliability of their issuers—that is, there
were de facto exchange rates between them, sometimes volatile and unpredictable ex ante.
Sovereign currencies eliminated this multiplicity (not entirely because of the use of foreign
currencies and helped to create single domestic markets for goods and services in individual
monetary jurisdictions. This was an important network externality for all economic agents—
using the same currency as your purchasers, suppliers, creditors, debtors, and tax authorities,
among others. The problem of information asymmetry (i.e. the information advantage of the
provider of financial services over its clients and the inability of the latter to fully assess the
quality of the purchased product, including private currency) is inherently present in financial
intermediation. This creates the potential for taking excessive risk at the cost of clients and even
the risk of the intentional abuse of rules or fraud. Furthermore, opposite to the arguments of
Smith (2005) [Smith, Adam (2005): An Inquiry into the Nature and Causes of the Wealth of
Nations. Pennsylvania State University, An Electronic Classics Series Publication. and Hayek
(1990)Hayek, Friedrich A. (1990): “Denationalisation] (10), free banking competition does not
always lead to the selection of the best products (in this case, private money) and the best
providers. Hence, the necessity to address the problem of information asymmetry and adverse
selection serves as the main argument in favour of the government regulation of financial
services. The same argument has been often used in favour of the government monopoly on
issuing money, even if history offers a large number of abuses of such monopolies, mainly for
fiscal reasons (see Reinhart and Rogoff, 2009 Reinhart, Carmen M., and Kenneth S. Rogoff
(2009): This Time Is Different. Eight Centuries of Financial Folly, Princeton University Press. ).
Eventually, the importance of having stable and trusted money for the proper functioning of the
market economy forced most countries to adopt the gold standard in the second half of the 19th
century, which largely eliminated the discretionary monetary power of governments. After
several modifications of the gold standard in the first half of the 20th century and its definite
demise in the early 1970s (see Eichengreen, 1998 Eichengreen, Barry (1998): Globalizing
Capital. A History of the International Monetary System. Princeton University Press, Princeton,
NJ) and short period of higher inflation, the role of the stabilisation mechanism was taken by
central bank independence and publicly declared monetary policy rules such as inflation
targeting.

Looking at the technological characteristics of VCs at least some of them (like Bitcoin) offer
the chance to eliminate at least part of the above-mentioned disadvantages of private
money. The transparency of their functioning and the predetermined algorithm of their creation
reduce information asymmetry and the risk of over-issuance. However, their exclusively digital
form, the quite complicated and labour-intensive mechanism of their creation, and the lack
of political willingness to accept them as official legal tender in any jurisdiction (at least in
the near future) will limit their circulation and use and make them unlikely competitors to
sovereign money.
The cryptocurrencies available today are not performing the functions of money very well.
As a result, they can only be considered as speculative assets, which are expected to yield returns
only as a result of capital gains.

 The first reason is the inherent volatility of the values of today’s main
cryptocurrencies, which are by-products of their supply protocols. In the case of bitcoin,
the quantity supplied is fixed at an upper limit (21 million), which is approached
following a predictable, near-predetermined path. Importantly, the supply does not match
the quantity demanded.
The inelastic nature of the supply embedded in the protocol rules (which for bitcoin looks
like a rule derived from the gold standard) results in volatility, which prevents these
currencies from functioning as good stores of value. This, in turn, also limits their
adoption and keeps the network of users relatively small, thus reducing their role as
mediums of exchange and as units of account.

These two problems reinforce each other because the high volatility of today’s cryptocurrencies
is also partly the result of their limited use and the fact that the networks of users consist mainly
of speculators.

Figure shows that given its volatility, bitcoin cannot perform well the basic function expected
from a currency. With inflation (and deflation) rates closer to those observed in Venezuela than
those observed in the euro area, bitcoin is clearly not a good store of value. This also means that
most retailers who accept bitcoin do not want to take the exchange rate risk and thus update their
prices in bitcoin frequently and exchange bitcoins just after the transactions (highlighting
bitcoin’s limitation as a unit of account)
 The second reason why cryptocurrencies are not a good medium of exchange is the
cost of the transactions and the time they take to be recorded in the decentralised
ledger. Despite the absence of the fixed cost associated with building a centralised
network, the amount of computing power needed to validate cryptocurrency transactions
in order to avoid any falsification of the ledger is energy inefficient and represents a
significant waste of resources. The borderless nature of today’s main cryptocurrencies
could also be a major issue: price stability means that the basket of goods and services
included in the CPI of a particular (homogenous) jurisdiction has a stable price. But
current cryptocurrencies are global and not attached to a particular country or region.
From a monetary policy perspective, a global cryptocurrency area is unlikely to be an
optimal currency area, as this would lead to an inability to adjust exchange rates within
the ‘area’. The result would thus be a crypto-monetary policy (ie its supply protocol) that
would be consistently too tight and too accommodative for different countries at different
times.
  Interaction between central bank and cryptocurency

The interaction between cryptocurrencies and central bank monetary policy is treated in detail by
Fernandes-Villaverde and Sanches [(2018) Fernandes-Villaverde, J. and D. R. Sanches (2018)
‘On the Economics of Digital Currencies’, Working Papers 18-7, Federal Reserve Bank of
Philadelphia.]. Their theoretical model predicts that the coexistence of central bank and
private money depends on the type of monetary policy the former follows. In particular,
privately-issued currencies would be used if the official currencies do not ensure price stability,
but would lose their value as a medium of exchange when the central bank credibly guarantees
the real value of money balances.

The ramifications are two-fold.

 First, the coexistence of government money and cryptocurrencies that are valued as
mediums of exchange is not a theoretical impossibility.
 Second, the central banks have the advantage: by choosing a specific type of monetary
policy they can prevent cryptocurrencies from being valued as a medium of exchange
(but they could still be valued for other reasons, for instance as a pure speculative asset).

From this perspective, rather than posing a threat, the coexistence of government money and
cryptocurrencies can have a positive effect by acting as a disciplining device on central banks.
This is a partial vindication of Hayek (1976), who argued in favour of breaking the state
monopoly on money as a way to ensure the stability of the official currency. Nevertheless, from a
more practical standpoint, central banks could face some risks from the emergence of
cryptocurrencies as relevant mediums of exchange with stable purchasing power.
First, the extent of the substitution by economic agents of cash and bank deposits for
cryptocurrencies will determine the effectiveness of monetary policy. Extensive substitution
of bank deposits in particular would translate to reduced control over monetary conditions,
because of the shrinking of the amount of broad money in the economy. At the extreme, the
provision of base money and the resulting influence over interest rates would be rendered
ineffective. However, as Stevens (2017)[ Stevens, A. (2017) ‘Digital currencies: Threats and
opportunities for monetary policy’, NBB Economic Review June 2017, National Bank of
Belgium] points out, as long as money issued by central banks retains the role of unit of account,
the switch to cryptocurrencies as a medium of exchange would be limited and thus the associated
threat to monetary control would also be limited.
Second, the shrinking role of central bank money creates a possible fiscal risk in the form of
reduced seigniorage revenue. The response could be higher distortionary taxes that would hurt
growth. That said, such risks appear to be exaggerated given that seigniorage revenues make up
an insignificant fraction of total government revenue.
The last, but probably most pertinent, threat does not emanate from the potential use of
cryptocurrencies as money, but from their attractiveness as investment assets. As a
speculative investment – an investment made in expectation of a return from capital gains only –
cryptocurrencies will be prone to bubbles. The collapse of a cryptocurrency bubble could
reverberate into wider financial instability if households, corporates and financial institutions
hold unhedged debt positions. Central banks would then face a double risk: first to the stability
of financial institutions they supervise, from the potentially unregulated cryptocurrency debt
markets, and, second, to price stability, from the effects on the real economy of deleveraging and
defaulting by economic agents.

 Financial stability implications

One has to ask what forces would give rise to banking in such a cryptocurrency world. In the
case of today’s fiat government currency, the possibility for users to hold and store its physical
form (ie bills and coins) is fraught with security risks and inconvenience. Full-reserve banks
(which do not provide lending for productive investments) would at least provide a solution to
this problem, by serving their clients’ needs to make payments. In a cryptocurrency world by
contrast, full-reserve banks would be irrelevant: as payments would be done directly in the
decentralised ledger, there would be no need to resort to an intermediary to complete a
payment. To sum up, it seems that in a full crypto-financial system, savers would have to choose
between holding IOUs labelled in a cryptocurrency unit of account issued by unstable banks (not
benefiting from a lender of last resort) or sticking to cryptocurrencies that stay idle in the ledger.
In that case, who would provide lending to the rest of the economy? One possibility is direct
peer-to-peer lending but this would force individuals to screen, monitor and diversify their
investments themselves, unless individuals pool their wealth (in cryptocurrencies) to share risks
and lend to other agents. However, these entities that would provide loans to the economy would
look more like investment funds than banks, as their funding sources (in cryptocurrencies) would
not be deposits but equity. Although liquidity risk would be less of a concern for the holders
of equity, they would also be more exposed to credit risk than bank depositors, because
they would not benefit from the seniority that bank depositors enjoy in case of default
compared to other creditors. This risk could thus disincentivise savers from lending and could
thus lead to a severe credit squeeze that would clearly be detrimental for the economy.

X. Conclusion

Currency management has a societal value – effectively the societal value of monetary policy.
The value and stability of money is what enables societies to function well and is not separate
from broader choices governments make when they run policy. It is therefore also a part of what
constitutes the social contract [(Collard, 2017 Collard, B. (2017) ‘Money is the Real Social
Contract’, Foundation for Economic Education Blog, 25 August) (11) ]between the principal (the
citizen) and the agent (the government). Manipulating a currency has historically been a
powerful means of enabling the sovereign to pursue certain objectives, including financing wars.
In other words, this power of controlling money can be used and abused. This is why in modern
democracies currency management goes through appropriate layers of legitimacy and
accountability. A modern authority that controls the currency will be evaluated according to how
well it sticks to the implicit social contract agreed through democratic procedures. This means
that any authority can be released for not delivering on what the social contract dictated. How
could an intelligent algorithm that is automatic and anonymous ever be held responsible
for failing to deliver agreements? The complexity of currency management implies that the
system will fail sometimes, just like financial crises periodically happen. No algorithm, no matter
how intelligent (and indeed benevolent), will remove the possibility of crisis. The automation of
monetary policy would remove it also from the system of checks and balances. This type of
‘independence’ of monetary policy effectively also makes accountability impossible, and makes
monetary policy exogenous to the process that identifies, monitors and evaluates agreements . It
is only the existence of this system of checks and balances that allows modern lenders of last
resort to create money out of nothing and provide ample liquidity in times of crisis. As soon as
this system breaks down and trust in authorities goes, the currency ceases to be an acceptable
means of payment or even unit of account. The currency is only as strong as its lender of last
resort, and the lender of last resort is only as strong as the backing it has from its constituents.
Constituents in turn, build trust depending on how well social contracts are adhered to.

XI. POLICY IMPLICATIONS:

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