07th March 2020 : The Hindu Editorials Notes : Mains Sure Shot
- Note – Cryptocurrency is recently in the news and there is a lot of ambiguity about it.
- So today we will get all the things clear about what is cryptocurrency, what is blockchain, how cryptocurrency mining work and other related titbits.
What is cryptocurrency?
- Cryptocurrency is best thought of as digital currency (it only exists on computers). It is transferred between peers (there is no middleman like a bank). Transactions are recorded on a digital public ledger (called a “blockchain”). Transaction data and the ledger are encrypted using cryptography (which is why it is called “crypto” “currency”). It is decentralized, meaning it is controlled by users and computer algorithms and not a central government. It is distributed, meaning the blockchain is hosted on many computers across the globe. Meanwhile, cryptocurrencies are traded on online cryptocurrency exchanges, like stock exchanges. Bitcoin (commonly traded under the symbol BTC) is one of many cryptocurrencies; other cryptocurrencies have names like “Ether (ETH),” “Ripple (XRP),” and “Litecoin (LTC).” Alternatives to Bitcoin are called “altcoins”.
How to use cryptocurrency?
- Cryptocurrency is roughly the equivalent of using PayPal or a Debit Card, except the numbers on the screen represent cryptocurrency instead of fiat currency like a dollar. All a new user needs to do is set up a Coinbase account. With Coinbase users can buy, sell, send, receive, and store Bitcoin, Bitcoin Cash, Ether, and Litecoin (Coinbase provides an all-in-one wallet, broker, and exchange service making them a one-stop-shop for new users.
- The basic concepts are: To use cryptocurrency, you don’t need to understand it (any more than you need to understand the monetary system to use a debit card). However, if you want to understand cryptocurrency you need to understand the concept of digital currency, the concept of blockchain (both as a public ledger of transactions and a technology), and the concept of cryptography.
- After-all, cryptocurrency is a digital currency, where transactions are recorded on a public digital ledger called a blockchain, and every process along the way is secured by cryptography.
- Cryptocurrency works a lot like bank credit on a debit card. In both cases, a complex system that issues currency and records transactions and balances works behind the scenes to allow people to send and receive currency electronically. Likewise, just like with banking, online platforms can be used to manage accounts and move balances. The main difference between cryptocurrency and bank credit is that instead of banks and governments issuing the currency and keeping ledgers, an algorithm does.
How does cryptocurrency work?
- Transactions are sent between peers using software called “cryptocurrency wallets.” The person creating the transaction uses the wallet software to transfer balances from one account (AKA a public address) to another. To transfer funds, knowledge of a password (AKA a private key) associated with the account is needed. Transactions made between peers are encrypted and then broadcast to the crypto currency’s network and queued up to be added to the public ledger. Transactions are then recorded on the public ledger via a process called “mining” (explained below). All users of a given cryptocurrency have access to the ledger if they choose to access it, for example by downloading and running a copy of the software called a “full node” wallet (as opposed to holding their coins in a third party wallet like Coinbase). The transaction amounts are public, but who sent the transaction is encrypted (transactions are pseudo-anonymous). Each transaction leads back to a unique set of keys. Whoever owns a set of keys, owns the amount of cryptocurrency associated with those keys (just like whoever owns a bank account owns the money in it). Many transactions are added to a ledger at once. These “blocks” of transactions are added sequentially by miners. That is why the ledger and the technology behind it are called “block” “chain.” It is a “chain” of “blocks” of transactions.
How does blockchain work?
- The blockchain is like a decentralized bank ledger, in both cases the ledger is a record of transactions and balances. When a cryptocurrency transaction is made, that transaction is sent out to all users hosting a copy of the blockchain. Specific types of users called miners then try to solve a cryptographic puzzle (using software) which lets them add a “block” of transactions to the ledger. Whoever solves the puzzle first gets a few “newly mined” coins as a reward (they also get transaction fees paid by those who created the transactions). Sometimes miners pool computing power and share the new coins. The algorithm relies on consensus. If the majority of users trying to solve the puzzle all submit the same transaction data, then it confirms that the transactions are correct. Further, the security of the blockchain relies cryptography. Each block is connected to the data in the last block via one-way cryptographic codes called hashes which are designed to make tampering with the blockchain very difficult. Offering new coins as rewards, the difficulty of cracking the cryptographic puzzles, and the amount of effort it would take to add incorrect data to the blockchain by faking consensus or tampering with the blockchain, helps to ensure against bad actors.
What is cryptocurrency mining?
- People who are running software and hardware aimed at confirming transactions to the digital ledger are cryptocurrency miners. Solving cryptographic puzzles (via software) to add transactions to the ledger (the blockchain) in the hope of getting coins as a reward is cryptocurrency mining.
How does cryptography work with cryptocurrency?
- The keys that move balances around the blockchain utilize a type of one-way cryptography called public-key cryptography. The “hashes” (the one-way cryptographic codes that tie together blocks on the blockchain) use a similar type of cryptography. Meanwhile, transaction data sent and stored on the blockchain is tokenized (tokenization is a type of one-way cryptography that points to data but doesn’t contain all the original data). The key to understanding these layers of encryption which ensure a system like Bitcoin’s (some coins work a little differently) is found in one-way cryptographic functions (cryptographic hash functions, cryptographic tokens, and public-key cryptography are all names for specific, but related, types of one-way cryptographic functions). The main idea is that cryptocurrency uses a type of cryptography that is easy to compute one way, but hard to compute the other way without a “key.” Very loosely you can think of it like this, it is easy to create a strong password if you are in your online bank account, but very hard for others to guess a strong password after it has been created.
How does one obtain or trade cryptocurrency?
- Cryptocurrency can be obtained most of the same ways other types of currencies can. You can exchange goods and services for cryptocurrency, you can trade dollars for cryptocurrencies, or you can trade cryptocurrencies for other cryptocurrencies. Trading is generally done via brokers and exchanges. Brokers are third parties that buy/sell cryptocurrency, exchanges are like online stock exchanges for cryptocurrency. One can also trade cryptocurrencies directly between peers. Peer-to-peer exchanges can be mediated by a third party, or not. Please be aware that cryptocurrency prices tend to be volatile. One should ease into cryptocurrency investing and trading and be ready to lose everything they put in (especially if they invest in or trade alternative coins with lower market caps).
- Generally there are tax implications to trading or using cryptocurrency.
- It is important to understand the tax implications. In short, you’ll owe money on profits (capital gains) and may owe sales tax or other taxes when applicable.
Question – The SC ruling gives relief to cryptocurrency exchanges, but they still need to be regulated. Discuss.
Context – The verdict of the SC.
Why in news?
- The Supreme Court struck down as “disproportionate” a 2018 circular by the Reserve Bank of India (RBI) that directed entities not to provide services to those trading in “virtual currencies” (cryptocurrencies).
Why the ruling?
- Despite ministerial committee recommendations, and warnings by institutions such as the RBI about the problematic nature of their payment and exchange methods, the use of virtual currencies over the Internet continues to remain legal in India.
- But the immediate effect of the RBI circular was to choke the agencies that sought to provide a platform to facilitate trading in cryptocurrencies by cutting them off from banks.
- This, the petitioners claimed, had a chilling effect on the fledgling cryptocurrency exchanges industry in India and went against their entrepreneurial right to operate a business enshrined in Article 19(1)(g).
What did the court say?
- The Court conceded this limited point saying that the “RBI has not come out with a stand that any of the entities regulated by it… have suffered any loss… on account of [cryptocurrency] exchanges” and this provides relief to the firms providing the virtual exchanges.
- After a decade or so of deployment and use, the pros and cons of cryptocurrencies are now well known.
- The primary misgiving with cryptocurrencies such as Bitcoin has remained the highly speculative nature of assessing their value. For example, from humble beginnings, the cryptocurrency traded at a peak of $20,000 in mid-2018 before crashing to $3,000 by the end of the year, signaling the volatility that came to be associated with this instrument.
- This limited its original purpose of becoming an alternative and stable currency that is not backed by any central institution but derives trust from its intricate blockchain ledger system.
- Moreover, reports suggest that bitcoins, with their assured anonymity, remain popular with currency speculators, and in use in illicit transactions over the “dark web”.
- But their utility due to the robust nature of the blockchain algorithm is also not to be sneezed on i.e. should be seen with suspicion.
- Cryptocurrencies have now been adopted by international trading firms for use in lending, raising funds for other crypto projects besides facilitating easier cross-border payments.
- It is for these utilities that the Indian government should err on the side of jurisdictions such as the European Union which have not outrightly banned the instrument and have sought to regulate its functioning.
- The 2019 Bill even proposed the creation of a “digital rupee” as official currency. It is now up to authorities to find the right “regulatory balance” on cryptocurrencies, a task that is easier thought than done, considering their ever-evolving nature due to technological innovation.