Risks Associated with Cryptocurrencies
In general, a cryptocurrency can be defined as a form of digital currency that is used in place of the generally accepted currency like Australian Dollar and British Pound. Although it is not backed or recognised by the central bank or any monetary authority in any particular country, some people tend to use cryptocurrency as a mode of payment that is stored, transferred and traded electronically. In the 10 years since it was first introduced, cryptocurrency has become extremely popular. However, the problems of scalability and volatility still exist with these currencies and hence they are still not recognised by the Central Bank in Australia. There are still a few risks associated with them which have an adverse impact on the financial securities. They also pose some concerns to the financial system prevalent in the country. In order to understand the same, the role of various regulating authorities like Reserve Bank of Australia (RBA), Australian Taxation Office (ATO), Australian Prudential Regulation Authority (APRA) and Australian Securities and Investment Commission (ASIC) are first understood. The analysis then moves on to the concerns posed by the cryptocurrency to the financial system as suggested by the Reserve Bank of Australia.
Cryptocurrencies began in the year 2009. Since, their introduction the term ‘Bitcoin’ has become synonymous with cryptocurrency. However, the reach of these currencies has been limited to being regarded as a speculative high-risk investment and not as a payment system. Bitcoin was launched in the year 2008 by a whitepaper report with the pseudonymous name of Satoshi Nakamoto (ElBahrawy et al. 2017). The chief motive behind this currency was to create a ‘peer-to-peer’ version of electronic cash which eliminated the need for depending on third party financial institutions to complete a transaction. The transaction takes place through a network and depends on various established cryptographic techniques like hashing and digital signatures for its verification. Throughout the network, a form of consensus mechanism is developed which is necessary for a transaction to be validated. The technology on which a cryptocurrency runs is known as a Distributed Ledger Technology (DLT). The DLT is responsible for various aspects like who can see or keep a copy of the ledger of a transaction and determining the mechanism for distributing the currencies (Dark et al. 2019). It also determines the way in which the data in a particular platform is structured. Blockchain is one of the methods of structuring and distributing the data. There are various other alternatives available for the same. The DLT technology has not just been limited to the cryptocurrencies. It is also used in other aspects like utility tokens and security tokens. These tokens, along with the cryptocurrencies are known as the ‘crypto-assets.’ The chief benefit of using cryptocurrencies is that it removes the necessity of middlemen and uses complex algorithms to complete a transaction. Due to the anonymity available by using Bitcoin, it is used as a mode for money laundering by criminals.
Concerns for the Financial System from a Central Bankers Perspective
Initially when they were introduced, cryptocurrencies were meant to be used as a payment mechanism by most of the parties. However, as stated earlier, this has not been the case. They have become a high-risk speculative investment and not just continued to be a payment mechanism. One of the main problems is that it is legally difficult to determine who the owner of a particular cryptocurrency is. The private keys have been found to be not completely fool-proof and can be compromised. This problem can be solved through the creation of a centralised digital vault which stores all the private keys. However, storing these keys is a complicated process and makes the concept of cryptocurrency redundant as the storage services can only be provided by large scale financial institutions like custody banks. This also compromises the peer-to-peer technology used by the cryptocurrencies. The other risk attached to the cryptocurrency markets is the different legal frameworks present across the world. Due to the differing nature of these legal principles, any country can choose to impose legal and regulatory measures on the functioning of a cryptocurrency. This uncertainty leads to a wide swing in the values of the cryptocurrency on a regular basis and significantly impact their values in the market (Harwick 2016). It had also been found that this volatility causes significant risks in trading in cryptocurrencies and is also responsible for the formation of price bubbles. While they are considered to be a good source of investment by speculators, their inability to retain the value for a long time causes the underlying financial securities to quickly lose their value (Bucko, Palová and Vejacka 2015). Another reason for this price surge was found to be the lack of knowledge of speculators about the actual functioning mechanism of the Bitcoin or other cryptocurrencies. One of the key functions of money is to act as a store of value. However, the fluctuating price levels of Bitcoin suggest its inability to operate as a currency and hence it also remains another form of investment and not become a widely accepted payment mechanism. Unlike traditional financial securities, the value of a cryptocurrency does not merely depend on the value but also on the aspect of security. As some of the websites in which the cryptocurrencies are traded have been found to be vulnerable to hackers. Hacking the coin itself is much more difficult than hacking the cryptocurrency exchanges (Jabotinsky 2018). There have also been speculations about rampant insider trading, competitor collusion and unethical market manipulation practices in the cryptocurrency trading. An estimated $1.7 billion dollars was stolen from the cryptocurrency market in the year 2018. This puts the credibility of the entire market into jeopardy. The lack of a robust fiscal policy developed by the central banks and other monetary authorities also increases the uncertainty aspect. The legal and economic changes that may occur in this area may happen on an overnight basis and the value of the financial securities in which they are traded tend to fall drastically.
Role of Regulating Authorities in Cryptocurrency Market
In any country, the efficient functioning of the financial system is essential for the benefit of the economy. Financial system includes all the financial regulatory bodies and important financial institutions which have a major say in the important decisions related to the country. Chief amongst them is the Reserve Bank of Australia (RBA). Established under the Reserve Bank Act 1959, the main objective of the bank is to contribute towards maintaining stability in the currency of Australia and to ensure the economic prosperity amongst the people of the nation. The bank maintains the inflation levels in the economy and controls all aspects related to the currency supply which it considers to be necessary. However, as stated by the Central bank, Bitcoin is extremely volatile in nature to be considered as the main currency of a particular country. Another problem with it is its inability to store value like gold or the traditional currencies used worldwide. One of the main concerns of crypto currency payments is the requirement of a strong network for processing the payments. This necessitates the presence of a constant network on a regular basis. This makes the cryptocurrency into something that is accessible to only a selected group of people. Another concern identified by the RBA is the lack of scalability in cryptocurrencies. The information that can be obtained by a Bitcoin block is limited. Due to this, the time taken to validate an individual Bitcoin block is much more than that taken by the normal currency transaction. This is the reason why the number of cryptocurrency transactions that happen in a second are less than 10. In comparison, the Australian Payments Platform called the Fast Settlement Service undertakes and settles 1000 transactions in a second. Adopting to a cryptocurrency as the main currency would significantly slow down the speed at which transactions take place and thereby negatively impact the financial system as a whole. Another problem is related to the validation of the blocks. If two miners compete to validate a block and do it at the same time, only one of those gets validated and the other remains as an orphan block. It takes more time to validate this block and add it to the chain of existing transactions. The lack of promptness in completing the transactions is a major problem with the cryptocurrencies. One of the major functions of the RBA is to maintain stability in the economy. Cryptocurrencies act as a major hindrance to this stability that is essential for the functioning of the financial system. Another problem is the decentralised nature of the functioning of the payments system. Due to the anonymity provided by Bitcoin and other currencies, there need to be stricter regulations to ensure that the currency exchange does not take place for funding money laundering and terrorism practices. The cost of maintaining a cryptocurrency network is very high and the power consumed by them is also much higher than usual. It had been reported that the power consumption involved in maintaining the consensus in the payments system was equal to the power consumption of Switzerland. This brings in a lot of environment related problems which impact the country as a whole (Dark et al. 2019).
Conclusion
The Australian Taxation Office (ATO) is responsible for collecting taxes from individuals for the gains made by them in a particular year. However, due to the anonymity provided by a cryptocurrency transaction, it becomes extremely difficult to identify the parties who have entered into a transaction and hence levying tax on an individual almost becomes impossible. However, the ATO has recently stated that it would seek the identity of the people involved in a cryptocurrency transaction thereby effectively putting an end to the anonymity aspect. The confusion caused by these currencies in the Australian taxation system is also very high. These currencies are treated as a property for Income and CGT purposes. There was also the problem of charging double taxes from the businesses who accepted cryptocurrencies as a form of accepting payments. In June 2017, changes were made to the definition of digital currency under the GST Act and taxation rules again became more complex (Cassidy et al. 2018).
The main purpose of the Australian Prudential Regulation Authority (APRA) is to regulate bodies in the financial sector in accordance with the other rules of the Commonwealth that are related to prudential regulation and retirement income standards. Other responsibilities of the bodies include maintaining efficiency, balance and competition in the financial system of Australia (Apra.gov.au. 2019). However, the volatile and uncertain nature of the cryptocurrencies poses a serious threat to the objectives of APRA. It has also been found that the behaviour of the cryptocurrencies is significantly different from that of the fiat currencies and their analysis needs to be specialised in nature. The models that are needed to measure the fluctuations in the cryptocurrencies need to be much more dynamic than those related to the regular models and hence the chances for error in this regard are much higher (Phillip 2018).
The Australian Securities and Investment Commission (ASIC) released a set of guidelines in 2017 in which it considered cryptocurrencies to be a legitimate form of currency. Emphasis was also laid on the misleading conduct involved in cryptocurrencies and the time from when the regulations under Corporations Act 2001 would become applicable. The Commission also stressed the fact that anything which carried the label of a crypto-asset did not necessarily constitute a financial product. The changes that were made by the ASIC to its regulations very plenty. These were done to accommodate the concept of cryptocurrencies in the general business guidelines followed by other corporations (Anthony, Prasad and Sadique 2018). However, the business model has still not been able to be brought under a predetermined set of rules like the traditional corporations.
Conclusion and Recommendations
In conclusion, it can be said that the cryptocurrencies have come a long way since they were first introduced in 2019. Initially, there were concerns about the primary key which was responsible for the storage of a transaction as it could have been easily hacked. At present, hacking the actual Blockchain or the transaction has become extremely difficult. However, concerns still remain about the security aspects of these currencies. This is specifically true in the case of the websites handling the currencies. The uncertain legal and security aspects cause high fluctuations in the value of a cryptocurrency and ultimately lead to huge capital losses to the people who have invested in them. The cost of maintaining a network of cryptocurrency is much higher than the normal currency. The power consumption and the speed of processing a transaction is also much higher in case of the currency. Hence, adopting them in place of the existing currencies is an impracticable move in the current market conditions. Any future developments which make the currencies more environmental friendly and increase the processing speed are essential for a wider usage of the currencies. The regulations governing the cryptocurrencies should also be more dynamic and take their uncertain nature into consideration. This will enable the governing bodies to run the financial system more efficiently than before.
References
Anthony Das, C., Prasad, K. and Sadique, M.S., 2018, July. Cryptocurrency a Bit unregulated? In International Conference on Business and Banking V (ICBB V).
Apra.gov.au. 2019. Accountability and reporting | APRA. [Online] Available at: https://www.apra.gov.au/accountability-and-reporting#targetText=In%20providing%20this%20regulation%20and,financial%20system%20stability%20in%20Australia. [Accessed 5 Oct. 2019].
Bucko, J.O.Z.E.F., Palová, D. and Vejacka, M., 2015. Security and trust in cryptocurrencies. In Central European Conference in Finance and Economics (pp. 14-24).
Cassidy, J., Cheng, M.H.A., Huang, E. and Le, T., 2018. A Toss of a (Bit) Coin: The Uncertain Nature of the Legal Status of Cryptocurrencies. In Proceedings of Asia Conference on Business and Economic Studies (ACBES) by University of Economics Ho Chi Minh City on 8th–9th Sep 2018 at Ho Chi Minh City, Vietnam. (pp. 254-264). UEH Publishing House.
Dark, C., Emery, D., Ma, J. and Noone, C., 2019. Cryptocurrency: ten years on. Australia: Reserve Bank of Australia.
ElBahrawy, A., Alessandretti, L., Kandler, A., Pastor-Satorras, R. and Baronchelli, A., 2017. Evolutionary dynamics of the cryptocurrency market. Royal Society open science, 4(11), p.170623.
Harwick, C., 2016. Cryptocurrency and the Problem of Intermediation. The Independent Review, 20(4), pp.569-588.
Jabotinsky, H.Y., 2018. The Regulation of Cryptocurrencies-Between a Currency and a Financial Product. Hebrew University of Jerusalem Legal Research Paper, (18-10).
Phillip, A., 2018. On Gegenbauer long memory stochastic volatility models: A Bayesian Markov chain Monte Carlo approach with applications.
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