The first installment of a Global Finance series explaining the ins and outs of cryptocurrencies.
In the shadow of the financial crisis of 2007 and 2008, the world saw the launch of Bitcoin trading in 2010. A 2009 paper published online by the cryptocurrency’s mysterious creator, who used the pen name Satoshi Nakamoto, argued there was need for a new “peer-to-peer” electronic cash system explicitly designed for Internet commerce that would not require trusted intermediaries like banks to function.
Nakamoto argued that the bank-led trust model made Internet-commerce transactions more costly than he believed necessary, particularly when payments were ‘reversible’ or disputed, which require bank mediation. Instead of relying on trust, Bitcoin uses a “cryptographic proof-of-work,” hence the term ‘cryptocurrency.’
The term ‘crypto’ actually refers to the cryptographic keys used to secure or encrypt each Bitcoin transaction. Nakamoto maintained that the cryptographic proof-of-work and the non-reversible nature of Bitcoin transactions provide an extra layer of protection for Internet sellers or merchants from fraud and avoided the additional costs and disputes associated with the trusted third-party model. However, whoever possesses the cryptographic keys also has complete control of the cryptocurrency they represent, similar to a bearer instrument.
Other characteristics, such as the distributed and open nature of the cryptocurrency ledgers (or blockchains) in which transactions are recorded, distinguish cryptocurrencies from other digital currencies or forms of electronic money, including central bank issued digital currencies (CBDCs).
Are cryptocurrencies securities, commodities, or currencies?
Much like a fiat currency, cryptocurrencies can be used to pay for things, but they are not a widely used unit of exchange. They are also not a great store of value, given their volatility. Nevertheless, in an economic crisis or environment where low or negative interest rates persist, some argue that cryptocurrencies provide a dependable store of value.
Most cryptocurrencies’ volatility can be attributed to their limited supply. In addition, large players buying and selling cryptocurrencies like bitcoin have market-maker powers, which contributes to their volatile pricing.
So if cryptocurrencies don’t fulfill the criteria of a currency, what are they?
Investors, traders, and users often refer to cryptocurrencies as commodities or digital assets, as their volatility makes them the perfect vehicles for speculative investment that do not correlate with other financial markets.
However, regulators have expressed diverging views on whether they should classify cryptocurrencies as commodities; securities, which are more highly regulated; or currencies.
The US Securities and Exchange Commission (SEC) views some cryptocurrencies, like Ripple’s XRP, as an investment contract, and hence a security, since Ripple Labs developed, distributed, and sold XRP, which meets the definition of a security set forth by the US Supreme Court’s Howey Test. However, Ripple maintains that XRP is a commodity.
Finance professionals should pay close attention to how different regulators classify cryptocurrencies, particularly if they are investing or trading in them. National regulators can adopt different approaches, and sometimes many in the same jurisdiction. For example, the US Internal Revenue Service treats cryptocurrencies as property in its taxation guidance, while the US Financial Intelligence Unit (FinCEN) regulates them like currencies. Meanwhile, the US Commodity Futures Trading Commission, which regulates much of the derivatives markets, treats Bitcoin and Ether as commodities.
However, financial regulators and tax authorities may have to redefine how they treat Bitcoin in light of El Salvador’s adoption of Bitcoin as a secondary legal currency on June 8. Some market watchers argue that El Salvador’s actions, which other countries could copy, means there is a solid justification for classifying Bitcoin as a currency.