Cryptocurrency, Functioning, Advantages & Disadvantages, Concerns

Cryptocurrency is a form of digital currency that uses cryptography to secure transactions and control the creation of new units. Bitcoin, launched in 2009, was the first widely adopted cryptocurrency. Unlike fiat currencies which are issued by central banks, cryptocurrencies operate independently of any central authority. The transactions are recorded on a decentralised public ledger called the blockchain. 

Cryptocurrencies allow peer-to-peer transactions across borders almost instantaneously at very low costs. However, cryptocurrencies are highly volatile and speculative. As of November 2023, there are 10,748 total cryptocurrencies and the total market cap of all cryptocurrencies is $2.41 Trillion.

What is Cryptocurrency?

It is a medium of exchange, created and stored electronically on the blockchain, using cryptographic techniques to verify the transfer of funds and an algorithm to control the creation of monetary units. The first decentralised cryptocurrency was Bitcoin, created in 2009. 

Working of Cryptocurrency 

Cryptocurrencies operate on blockchain technology, they differ from sovereign-issued fiat currencies and operate independently of central banks. The key principles are:

• Decentralisation: Cryptocurrencies are not issued by any central authority. The network is distributed across nodes that maintain and update the ledger. 
  • This avoids centralised control over currency issuance and transactions.
• Blockchain Technology: The transactions are recorded in encrypted ‘blocks’ that are chained together chronologically and distributed across the network. 
  • This creates an immutable, transparent ledger of all transactions validated by consensus algorithms.
• Encryption: Cryptography like public-private key pairs, digital signatures and hash functions are used to secure transactions and sign up to the network anonymously. 
  • Advanced cryptography ensures the security and legitimacy of transactions.
• Smart contracts: Self-executing programmable contracts allow automated transactions between parties without intermediaries. 
  • Ethereum provides a platform for creating decentralised applications using smart contracts.
• Supply limits: Many cryptocurrencies like Bitcoin have a limited total supply. New coins are ‘mined’ by solving complex math problems. 
  • With finite supply, increased adoption drives up the price, termed ‘digital gold’.
• Consensus protocols: Participants in the network adhere to specified rules and protocols to validate transactions. 
  • For instance Bitcoin uses a ‘proof-of-work’ system where miners compete to solve complex computational problems and get rewarded in bitcoins.

Proof-of-Stake vs Proof-of-Work

These are cryptocurrency consensus mechanisms for processing transactions and creating new blocks in a blockchain. A consensus mechanism is a method for validating entries into a distributed database and keeping the database secure.

How Cryptocurrency Trading Works?

Cryptocurrencies operate independently of any regulatory authorities, existing as a concept beyond the confines of traditional banking systems. Various coins, with Bitcoin leading the way, contribute to the diverse landscape of digital currencies. Participants can obtain, trade and use cryptocurrencies in the following ways:

• Mining new coins: Coins are awarded to miners who solve intricate mathematical puzzles using specialised computer systems and add blocks to the blockchain. Bitcoin rewards get halved periodically to control supply.
• Buying, Selling, and Storing: Users can obtain cryptocurrencies through central exchanges, brokers, or individual owners, with platforms like Coinbase streamlining the process. 
  • After the acquisition, cryptocurrencies are stored in digital wallets, classified as "hot" or "cold." Hot wallets, connected to the internet, provide convenient transactions but are vulnerable to theft. 
  • On the other hand, cold storage, while more secure, poses transactional challenges.
• Payments and Transactions: Cryptocurrencies provide a fast, cheap way for cross-border P2P payments and transactions. Merchants accepting cryptocurrency payments are growing. 
  • Debit cards allow crypto-holders to make purchases.
• Investing and Trading: The volatile prices attract investors and traders seeking high returns. 
  • Derivatives like options and futures are emerging. However, the risks are high due to volatility.
• Converting to Fiat Currency: Users can liquidate crypto holdings by converting to traditional currency through exchanges, brokers or P2P transfers. But taxes apply to capital gains.

Cryptocurrency Types

While all cryptocurrencies rely on the shared principle of a consensus-based, decentralised, and immutable ledger to facilitate digital value transfer among trustless parties, distinctions, both subtle and overt, exist among them. Cryptocurrencies come in various forms, each with its unique purpose and application, all while maintaining the core principle of a decentralised digital ledger:

• Payment Cryptocurrencies: These are designed for peer-to-peer transactions without the need for intermediaries. 
  • Examples include Bitcoin, Litecoin, and Bitcoin Cash. They operate on their blockchain and have a limited supply.
• Stablecoins: These are tied to reserve assets like traditional currency to reduce volatility. 
  • USD Coin and Tether are examples. Their goal is to maintain price stability.
• Utility Tokens: These grant access to a specific product or service. 
  • Filecoin, for instance, is used for cloud storage, and Chainlink is used for smart contracts.
• Security Tokens: These represent investment assets like stocks, bonds, and commodities in a digital format.
• Governance Tokens: These allow holders to participate in the governance of the blockchain protocol. An example is MakerDAO.
• Central Bank Digital Currencies (CBDCs): These are digital versions of fiat currency issued by central banks. Examples include eCNY and Digital Yuan.

Cryptocurrency Significance

Since the functioning of cryptocurrency is based on blockchain technology, it offers transparent operations that empower businesses and serve as a tool for economic empowerment.

• Economic empowerment: Cryptocurrencies streamline fund transfers between two parties by eliminating the middleman. This makes transactions more efficient and cost-effective compared to other online methods.
• Enhanced security: Encryption and blockchain consensus protect transactions, provide transparency and build trust without revealing user identities.
  • Operating on a peer-to-peer network, cryptocurrencies help prevent corruption by tracking funds and transactions. 
• Business empowerment: Cryptocurrencies, like Ethereum that enable smart contracts, complement the technology revolution.
• Transparency: The ethos of cryptocurrencies emphasises transparency. Most of these protocols are built on open-source code, which is freely available for redistribution and modification.
• Independence from traditional banking: Cryptocurrencies operate independently of any central authority or traditional financial institution. 
  • In countries with a history of corruption or an unreliable banking system, cryptocurrencies offer a valuable alternative for storing and transferring wealth.
• Financial inclusion: Cryptocurrencies like Celo can address financial inclusion, a significant barrier in economic development due to the lack of access to formal financial sectors and discrimination. 
  • They have the potential to overcome accessibility challenges through mobile-based blockchain systems.
• Decentralised financial services: Cryptocurrencies offer services such as loans, savings accounts, and insurance through decentralized applications (DApps) operating on blockchain networks. 
  • For instance, DApps like AAVE, Compound, and MakerDAO allow users to earn interest on their cryptocurrency holdings or borrow against them without needing a traditional bank account.

Cryptocurrency Limitations

Cryptocurrencies, while offering numerous benefits, also come with certain limitations, including high volatility, susceptibility to criminal activities, and potential threats to energy security.

• High volatility: Cryptocurrencies, due to the lack of a central regulatory agency, are subject to high fluctuations. 
  • For instance, the Reserve Bank of India has warned against cryptocurrency transactions, citing potential risks to financial stability.
• Financial instability: The widespread adoption of cryptocurrencies and large volume of anonymous transactions could undermine monetary policy effectiveness, exacerbate fiscal risks, and threaten global financial stability. 
  • The IMF, for example, has warned El Salvador, which has adopted Bitcoin as legal tender, about the risks associated with unregulated assets.
• Cyber threats: Cryptocurrency platforms are vulnerable to hackers and malicious use, leading to potential issues such as system trading manipulation and other fraudulent activities. 
  • For instance, private keys stored by wallet service providers are often prone to malware or hacking.
• Criminal activities: The anonymous nature of transactions raises concerns about potential misuse for activities like terror financing and money laundering. 
  • A global framework has been suggested for dealing with crypto assets, which includes licensing crypto service providers and implementing anti-money laundering and counter-terrorist financing standards.
• Energy security and Climate change: Cryptocurrencies require significant electricity for mining, which can result in greenhouse gas emissions. The rapid growth of crypto-assets could potentially affect climate commitments to reach net-zero carbon pollution. 
  • For example, the total electricity use of Bitcoin mining in 2018 was equivalent to that of mid-sized economies like Switzerland.

Potential Applications of Cryptocurrency

Cryptocurrency, powered by blockchain technology, has a wide range of applications across various industries. Some key applications include:-

• Financial services: Blockchain technology enhances settlement speed, simplifies operations like tracing bank guarantees, and enables real-time transactions, reducing costs for businesses. 
  • For example, JP Morgan uses its in-house cryptocurrency JPM Coin to settle transactions between institutional clients in seconds instead of days.
• Healthcare: Blockchain improves payment processing, electronic medical records, and data security in healthcare, enhancing efficiency and security. 
  • The state of Andhra Pradesh uses blockchain to secure patient data, prevent fraudand also to store Land records.
• Retail: Retailers are utilising Non-Fungible Tokens (NFTs) on blockchains to engage customers with exclusive digital assets and experiences. 
  • Brands like Adidas and Nike have launched NFTs and Metaverse stores.
• Marketing and Advertising: Blockchain can increase security and transparency in sharing customer data and reduce fraud in digital ad buying. 
  • IBM uses blockchain in its digital advertising solutions to combat ad fraud.
• Real estate: Blockchain can streamline property transactions, ensuring transparency and security in real estate deals. 
  • In 2021, a Delhi-based startup facilitated India's first real estate tokenisation project using blockchain.
• Lending: Blockchain facilitates faster and less expensive lending processes by eliminating intermediaries. 
  • Indian P2P lending platforms like LenDenClub use blockchain for loan processing and payments.
• Voting: Blockchain can enhance the security and transparency of voting processes, ensuring tamper-proof records. 
  • The Election Commission of India is exploring blockchain to enable remote voting.
• Gambling: The gambling industry can benefit from blockchain's transparency, enabling fair games and anonymous transactions for players. 
  • Online gaming platform Winz.io uses blockchain and cryptocurrency.

Cryptocurrency in India

The role of cryptocurrency in India is still evolving. RBI often raises concerns concerning the volatile nature of cryptocurrency.

• India, under its G20 Presidency, worked on a global framework to manage global issues about crypto and related assets.
  • Global framework on dealing with crypto assets has suggested licensing crypto service providers. It has recommended the implementation of the Financial Action Task Force’s anti-money laundering and counter-terrorist financing (AML/CFT) standards in the cryptocurrency sector.
• Levy of Tax:  As per budget 2022-2023 cryptocurrencies and non-fungible tokens (NFTs), would attract a 30 % tax on any income from their transfer. 
• Central Bank Digital Currency: The RBI has rolled out a pilot in the retail version of CBDC or e-rupee on December 1, 2022.
  • CBDCs are the legal tender issued by a central bank in a digital form. Their value is linked to the issuing country’s official currency.
• The Draft Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019: The draft Bill seeks to prohibit mining, holding, selling, trade, issuance, disposal, or use of cryptocurrency in the country.

Cryptocurrency UPSC PYQs

Question 1: With reference to ‘Bitcoins’, sometimes seen in the news, which of the following statements is/are correct? (UPSC Prelims 2016)

1. Bitcoins are tracked by the Central Banks of the countries.
2. Anyone with a Bitcoin address can send and receive Bitcoins from anyone else with a Bitcoin address.
3. Online payments can be sent without either side knowing the identity of the other.

Select the correct answer using the code given below:

(a) 1 and 2 only

(b) 2 and 3 only

(c) 3 only

(d) 1, 2 and 3

Answer- (d)

Cryptocurrency FAQs

Q1. What are cryptocurrency wallets?

Ans. Cryptocurrency wallets are software programs to store public and private keys that enable users to send, receive and monitor their digital currency holdings and transactions. Hardware wallets and paper wallets are more secure from online theft.

Q2. What is crypto mining?

Ans. Crypto mining involves validators verifying pending crypto transactions and bundling them into timestamped blocks that are cryptographically chained to previous blocks. This maintains the integrity of blockchain ledgers. Successful mining is rewarded with crypto token incentives.

Q3. What is a stablecoin?

Ans. Stablecoins are cryptocurrencies designed to minimize volatility in valuations seen in other cryptos. This is achieved by pegging stablecoins to real-world assets like bank deposits, bonds, currencies (ex: USD) etc worth the value printed as coins to engender trust.

Q4.Can Bitcoin be hacked?

Ans. While Bitcoin's blockchain technology itself has proven impenetrable by cybercriminals so far, Bitcoin exchanges and individual digital wallets are vulnerable to hacking attacks and thefts as has been evidenced across many incidents over the years. Improved cybersecurity is an ongoing challenge