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The Legitimacy of Cryptocurrencies

3486 words (14 pages) Essay in Finance

08/02/20 Finance Reference this

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Since 2008, there has been altering interest in the idea of cryptocurrencies as the public learns about the technology – primarily, what they are, how they work, and what the future will look like for them. Currently, cryptocurrencies are defined as: digital tokens used to anonymously transfer money instantly between individuals in a decentralized peer to peer network with minimal transactional fees (Nguyen et all, 109). This current definition has raised questions about their validity in the current market and if they are beneficial in facilitating market transactions. The witnessed price volatility, supply, demand, and legislation are proving to be barriers for widespread adoption. Once the barriers have been overcome, cryptocurrencies have the potential to fundamentally change how the world’s financial system works.

As the cryptocurrency market matures, there are emerging hesitations, particularly the competition of amongst hundreds of cryptocurrencies being offered on major exchanges. In understanding the competition from the top three coins and how they interact with each other, this will serve as the gateway for understanding the future of all cryptocurrencies. Currently, Bitcoin is the most widely used and accepted virtual coin as it is the original cryptocurrency. However, there are technological infrastructures that may soon hinder Bitcoin operational. In the event Bitcoin were to become unusable, would another major cryptocurrency take its place or would the entire market fall (Nguyen et all, 106)?

Previous literature has contradicted each other in answering the above and other important questions. ElBahrawy et al in “Evolutionary dynamics of the cryptocurrency market” argues that Bitcoin is growing at an exponential rate which is putting other cryptocurrencies at risk (201). However, Gandal and Halaburda in “Can We Predict the Winner in a Market with Network Effects? Competition in Cryptocurrency Market” suggests the gained popularity in Bitcoin will allow other cryptocurrencies to grow and one day exceed the usage of bitcoin (13).

This research paper’s purpose is to investigates the behaviors of the cryptocurrency market to determine their legitimacy as a financial commodity and technological tool. While previous studies provide meaningful insight, the authors only consider the price of Bitcoin rather than considering the transactional usage and speculative demand cryptocurrencies can offer (Nguen et all, 107). Cryptocurrencies have the potential to impact how the world’s financial systems work at a fundamental level because of the usage of blockchain technology, but first it needs to be able to survive market crashes, gain overall strength in the market, and become accepted by both the private and government sectors of the world.

To begin understanding why cryptocurrencies have an important impact on the world, it is important to have a brief background on the history of Bitcoin. Bitcoin was introduced in 2008 as a white paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” by Satoshi Nakamoto. It was not until 2009 where Bitcoin was launched for public use. Cryptocurrencies have no central authority, meaning the survivability of a cryptocurrency is held up by the community of users. In this peer to peer network, each user is a host and a node for the software to communicate and live at. Moreover, when a cryptocurrency or virtual coin is passed around, there is a series of cryptographic algorithms emplaced to: secure the transaction from user to user, control the number of transactions per second, and introduce supply (Tsukerman 1137).

Bitcoin and all other cryptocurrencies have an underlying protocol that they work on. After a virtual coin is sent from one user to another, it is confirmed in a “Block” where a series of blocks combine to create a “block chain.” This process can be imagined as each time a transaction happens it is written onto a piece of paper. As more transactions happen it will fill up the paper until another piece is needed. Each piece of paper is a “block” where they get organized and bound together (Tsukerman 1134). The bounding of blocks is through cryptographic chains that all rely on the previous chain. For instance, to change the value in block one when there are three blocks present, the key to unlock chain two relies on the keys to unlock chain one. In theory, this makes the block chain un-hackable.

This analogy helps in understanding why the blockchain and cryptocurrencies offer an inherent level of trust, but it is important to define the role of “miners” in the bitcoin ecosystem. Tuskerman clearly defines this by stating:

A transaction is not part of the public ledger (blockchain) until verified and included in a block through a process called mining. Mining is both the process for creating Bitcoins and the method for updating the blockchain with the most current transactions (1137)

These transactions are bundled into a block that are generated every ten minutes and requires a computationally intense process to solve/guess correctly. Once solved, it takes rather little effort to prove the work. This type of “proof-of-work” solution has been engineered into Bitcoin and other cryptocurrencies and it requires quadrillions of computations per second (Tuskerman 1138).

 The promise of the blockchain as a decentralized trustless public ledger extends beyond simply tracking Bitcoin transactions. The revolution cryptocurrencies are offering the world is the ability to have a system that can generate scarce digital pieces of property. With any piece of new property that can be exchanged, there is a market as demand and perception changes. In Lawrence White’s “The Market for Cryptocurrencies,” he introduces the concept that only having 21 million bitcoins in circulation keeps the currency from being over issued, but it leaves the currency’s value to be directly controlled by demand (391). A current major issue facing cryptocurrencies in determining their legitimacy are the overly volatile markets they experience. For instance, TerraCoin “which at its peak had a market cap of $7.1 million, is now … down to around $23,000, a decline of more than 99 percent” (White 392). Additionally, Freicoin peaked with a market cap $16.1 million and then fell 99 percent to $61,000 (White 392). When a commodity begins behaving this way, it is generally referred to as a “bubble” because it grows to a critical point and then collapse since it is supported by pure market speculations.

  Through this logic, it may seem apparent that all cryptocurrencies including Bitcoin are cyclical bubble markets if they can survive more than one outburst. However, this is not the case since owning Bitcoin or another cryptocurrency can offer a level of pleasure to the individual because they appreciate the technological innovation or some other form of thought. Transcending the thought, when a country issues their form of money like the dollar, it generally will survive; people have a sense of nationalism and give the monetary compensation value. This offers an answer to Brad DeLong’s question “Placing a floor on the value of bitcoins is . . . what, exactly?” (394). Ultimately, having a community of dedicated users establishes a fundamental value for each cryptocurrency to come in existence.

 When it comes to understanding the “bubble” aspect to market evaluations, White in his article reminds us of important factors. Firstly, major fiat currencies like the dollar, euro, and others trade amongst each other and are used well above their fundamental value. With a positive surplus of a currency assets and a strong commitment, bubbles in an emerging market are a good thing because White states:

As any asset which is used widely in exchange will trade at a price higher than its “fundamental,” and the asset’s liquidity premium—the difference between the actual price and the fundamental—is a measure of the asset’s social contribution as a medium of exchange.

Bitcoin offers its users the ability to exchange decentralized currency with little to no transactional fees. By also removing the free access to the coins by implanting a set number of Bitcoins, this enforces the right to digital property through cryptographic keys. These are all important areas for understanding the strengths cryptocurrencies must occur to become adopted on a global scale.

 To further understand the argument about the legitimacy of cryptocurrencies, it is important to view the digital coin as an asset and or a piece of property. Viewing the experimental technology in this light highlights the first major barrier cryptocurrencies are facing in widespread adoption. In Kelvin Low and Ernie Teo’s article, “Bitcoins and Other Cryptocurrencies as Property,” they begin by illustrating the definition of “property” through the difference of in rem and in personam (242). In the former, in rem is a general liability versus in personam being a general personal liability. Cryptocurrencies are generally seen as currency or a form of electronic cash, which would give them in rem status. However, as addressed in the above article, cryptocurrencies can also be in personam since they are not incorporeal or bank money (247). Since bitcoin is not a tangible nor a debt, the question remains open as to how bitcoin can be classified as property.

  As addressed earlier, cryptocurrencies rely on a blockchain which is secured by cryptographic keys on the public ledger. It is this notion of cryptographic keys that receives most of the attention when defining “property.” Low and Teo bring in a general consideration about bitcoin by stating “there is no such thing as a Bitcoin… if you own a bitcoin, what you actually own is the private cryptographic key to unlock a specific address” (247). The issue with this type of conceptualization is it limits Bitcoin as to owning only private information. In regards to the definition of property, there are no laws that link owning private information as a piece of property. Low and Teo state that if there were laws in place where an individual could own private information, this would infringe on the first amendment of the US constitution as it would prohibit the flow and freedom of information. To begin creating legislation to determine what kind of property cryptocurrencies could be, they would have to be careful in the wording as to not give “exclusive” control over the cryptographic keys but a rather “limited” control. For instance, the right to a cryptographic key would be in effect to transfer out information in the public bitcoin address (Low and Teo 248). Furthermore, an individual could then acquire cryptographic keys through a transfer process where a new cryptographic would be generated and linked to the original key to give them the right to transfer information. Before the widespread adoption of cryptocurrencies as a currency or even a commodity can exist, the definition of what cryptocurrencies are, how they work in certain contexts, and how as they relate to digital property must be worked out.

 Another key area in which cryptocurrencies are facing a major hurdle and keeping them from being adopted is the energy consumption needed to run the blockchain. In the article, “Bitcoin Mining and Its Environmental Effects,” Serif DİLEK and Furuncu Yunus bring important claims to understanding what the blockchain is doing to the environment. The authors state that “nearly 80% of the world’s energy consumption on fossil fuels and that this situation is not likely to change” in the future as demand from other technological devices increase. The fundamental usage of minining used to solve complex cryptographic puzzles is a rather inefficient system because there is no measurable runtime. Due to this, in a 2014 study, it was found that Bitcoin consumes the same amount of energy as the country Ireland (O’Dwyer and Malone 97). In another 2017 study, Power Compare found that Bitcoins average energy consumption had reached 37 Tera Watts an hour which is equivalent to producing 162 kg of Carbon Dioxide from burned fossil fuels (DİLEK and Yunus 98).  Every day the difficulty to mine a bitcoin is increasing which is causing a proportional increase in the power demand to make the computation. To reduce the global energy demand, it has been advised to move large mining operations over to renewable sources of energy such as geothermal turbines located in Greenland. If bitcoin and cryptocurrencies are to change the world for the better, then certain changes in the fundamental system of how the blockchain operates needs to occur or more renewable sources of power need to be created.

 With bitcoin and cryptocurrencies offering a new type of currency to the world, there are additional legal barriers that they need to get through. Firstly, the most important factor in determining the legitimacy of cryptocurrencies relies upon determining what kind of asset they are: currency, security, or commodity. Author Mitchell Prenti discusses this important topic in his essay “Digital Metal: Regulating Bitcoin as a Commodity,” in which he discusses how each definition can and cannot apply. To begin understanding Prenti’s argument, it is also important to know that the Financial Crimes Enforcement Network (FinCen) tried to implement the Bank Secrecy Act to regulate the market (Prenti 616). Enacted in 1970 the Bank Secrecy Act was a response to potential money laundering in financial systems (Ly 596). This was later retracted as FinCEN stated Bitcoin was “outside its purview” (Prenti 621). Ultimately, this has still left Bitcoin uncategorized.

 To begin understanding Pernti’s argument for why virtual coins are not a “currency,” one needs to know the formal definition of a currency. The United States Department

of the Treasury defines currency as, “[t]he coin and paper money of the United States or of any other country that is designated as legal tender and that circulates and is customarily used and accepted as a medium of exchange in the country of issuance.” While the definition is accommodating in most regards, what is important to note is at the end of the definition where currency is must be exchanged in a country – meaning currency needs a government and country to define what is their currency. The main problem, as talked about earlier in this paper, Bitcoin and other cryptocurrencies have no central authority let alone a country who employs them (Pertni 621). Even if this hurdle could be overcome, cryptocurrencies could not still fit the definition since there is a limited supply and the price fluctuates too quickly. Those issues themselves are even harder to address because it one alters the fundamental technology and two requires cryptocurrencies to become more liquid.

  Others have suggested that bitcoin be classified as a security if it cannot fit the definition a currency. This is a favorable option since most users buy bitcoin and cryptocurrencies with the hope of receiving profit from their transaction. Furthermore, there are extensive regulations on securities to protect investors from fraudulent assets. Enacted in 1934, the Securities and Exchange act governs the exchange of securities like: notes, bonds, and investment contracts (Ly 598). The question whether bitcoin can fit into one of the three categorizes of securities results in looking towards investment contracts as they have a permissive definition. Per Pernti, Bitcoin meets the first criteria of the Howey investment test because cryptocurrencies have monetary value (Pernti 623). However, bitcoin and other cryptocurrencies fail the second test of the Howey investment test since the blockchain system does not meet the definition of horizontal and vertical “commonality.” As stated by Pernti:

Horizontal commonality examines the relationship between all investors in an enterprise and whether all the investors’ pooled funds are exposed to the same risks.131 In contrast, vertical commonality examines the relationship between investors and the promoter, and how closely the investors’ profits are tied to the promoter’s efforts (624).

Again, the main issue with cryptocurrencies is that since there is no central authority over the system it is hard for existing financial institutions to determine the vertical commonality of the investment contract. Likewise, there is a varied usage of bitcoin since it can be used as an investment asset or a currency. By not being able to meet the definition of second Howey test, it would be hard to call bitcoin and cryptocurrencies a security.

 The last important classification cryptocurrencies could fall under would be a “commodity.” Commodities are generally defined as items sold with a consistent quality and quantity in a global market. Realistically, this definition captures the economic behavior of cryptocurrencies best. Bitcoin users will buy bitcoin to exchange them for goods and services in their respective community and they will also buy the coin to have an investment contract. Taking an alternate view, before currency was used on a large scale past civilizations would barter with certain products like four bales of hay for four loaves of bread. Clearly past civilizations were using commodities as a medium of exchange. Per Pernti, “Bitcoin acts as a money commodity in its community of users, from a pricing standpoint” since it is valued like other commodities. Like other products such as gold and silver, the price for the commodity originates simply at the relationship between demand and scarcity. Remember there are only 121 million bitcoins available and other cryptocurrencies are required to have a fixed amount.

 While it seems commodities offer the best definition for virtual coins, some argue there is no inherent use value of cryptocurrencies. This is an important factor to have in defining something as a commodity because traditionally commodities have been physical items. Cryptocurrencies are not tangible, but “Bitcoin’s inherent value is found in its ability to decrease the transaction costs of exchanging property online” (Pernti 629). With the creation of the blockchain, online retailers no longer must go through services like PayPal or a trusted bank where they get charged a flat fee or a percentage of the transaction. There is also a fundamental level of trust built into the system because of how the blockchain is secured in a cryptographic chain.

 This paper has gone into depth discussing the history, underlying technology, and certain barriers that must be overcome for cryptocurrencies to be legitimized. The term itself, “cryptocurrencies,” is confusing because Bitcoin and the like are not a currency but rather a commodity. Understanding this important distinction now allows us to place cryptocurrencies in the hands of the CFTC to keep the emerging market safe. By doing this, the market is sure to flourish since it will allow new investors to pump money into market cap. Symbiotically as this is happening, the public can now view cryptocurrencies as a safe option to possibly use cryptocurrencies as a currency. There may be a day soon when major retailers will accept bitcoin and other legitimate cryptocurrencies because they can trust the dectralized system to receive payment for their inventory. Overall, cryptocurrencies are still growing currently but it does not take away from the fact that they are a trusted source of monetary exchange; they are a legitimate commodity.

Work Cited

  • DİLEK, Şerif, and Yunus FURUNCU. “Bitcoin Mining and Its Environmental Effects.” Ataturk University Journal of Economics & Administrative Sciences, vol. 33, no. 1, Jan. 2019, pp. 91–105. EBSCOhost, search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=134856137&site=ehost-live&scope=site.
  • Lerer, Mordecai. “The Taxation of Cryptocurrency.” CPA Journal, vol. 89, no. 1, Jan. 2019, p. 40. EBSCOhost, ezproxy.mclennan.edu/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=f6h&AN=134179705&site=eds-live.
  • Low, Kelvin FK, and Ernie GS Teo. “Bitcoins and Other Cryptocurrencies as Property?” Law, Innovation & Technology, vol. 9, no. 2, Dec. 2017, pp. 235–268. EBSCOhost, doi:10.1080/17579961.2017.1377915.
  • Ly, Matthew Kien-Meng. “Coining Bitcoin’s ‘Legal-Bits’: Examining the Regulatory Framework for Bitcoin and Virtual Currencies.” Harvard Journal of Law & Technology, vol. 27, no. 2, Spring 2014, pp. 587–608. EBSCOhost, search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=97133050&site=ehost-live&scope=site.
  • Nguyen, Tram, et al. “Factors Affecting Bitcoin Price in the Cryptocurrency Market: An Empirical Study.” International Journal of Business & Economics Perspectives, vol. 13, no. 1, Fall 2018, pp. 106–125. EBSCOhost, ezproxy.mclennan.edu/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=133549558&site=eds-live.
  • Prentis, Mitchell. “Digital Metal: Regulating Bitcoin as a Commodity.” Case Western Reserve Law Review, vol. 66, no. 2, Winter 2015, pp. 609–638. EBSCOhost, search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=114060257&site=ehost-live&scope=site.
  • Tsukerman, Misha. “The Block Is Hot: A Survey of the State of Bitcoin Regulation and Suggestions for the Future.” Berkeley Technology Law Journal, vol. 30, Sept. 2015, pp. 1127–1169. EBSCOhost, search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=112303709&site=ehost-live&scope=site.
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