Lentis/Cryptocurrency

Overview

Cryptocurrencies are electronic currencies that operate in a cryptographically-secure network. Their distributed, peer-to-peer model and and low transaction fees allow individuals to transfer funds directly between each other, reducing the need for central third-party institutions in the financial system (e.g., the Federal Reserve). Their novel operating model has attracted attention from individuals, governments, academics, and industry. However, cryptocurrencies have created friction with regulatory institutions because user's anonymity is secure on the network, making it easy for criminals to conduct operations or launder money. Like any currency, adoption depends on people's acceptance of them as payment.

Bitcoin

There are hundreds of cryptocurrencies in existence today, a handful of which are valuable. Bitcoin is the first, most valuable, and most popular cryptocurrency. A single Bitcoin has ranged in price from as little as a nickel to peaking over $1100.

Created in 2008 by Satoshi Nakamoto on the P2P Foundation's forums, it was initially used by a niche group of cyber-security and computer-network enthusiasts. Satoshi Nakamoto is a pseudonym, and the real Satoshi may be a male, female, or group of software developers. Regardless, building the Bitcoin system required expert knowledge in peer-to-peer networks, economics, and software development. Various attempts by journalists to unveil Satoshi's true identity have failed.

At a high-level, Bitcoin can be thought of as a large accounting ledger that volunteers monitor for accuracy. The ledger is encrypted, to prevent altering transaction logs. For more information on the technical details, see Satoshi's paper.

Bitcoin can be acquired either through a currency exchange or through mining. Mining is the process where a person volunteers their computing resources to verify previous transactions and encrypt new ones. The first computer to encrypt a new block of transactions is rewarded with newly minted Bitcoin.

Bitcoin will be the focus of this article, as there is a plethora of information on it and its discussion relates to all cryptocurrencies.

Interested Parties

IMF

Though the IMF currently takes no action to directly regulate cryptocurrencies, they have publicized their thoughts on them. In a 2014 draft on monetary and financial statistics, the IMF did not recognize Bitcoin as a currency, stating, "Bitcoin also does not meet the definition of a currency." Similarly, when asked about the disruptive potential of cryptocurrencies in a 2014 interview, Christine Lagarde (Managing Director) said "To have alternative monetary systems in place is only acceptable provided that there is enough scrutiny, enough transparency, enough governance, so that those key obstacles are avoided.". As cryptocurrency adoption grows, the IMF may employ more regulations to counter their concerns.

IRS

According to tax guidelines released in early 2014, the IRS treats virtual currencies as property, not currencies, and subjects it to capital gains taxes[9][10]. In doing so, the IRS has laid the groundwork to regulate virtual currencies. As one of the key agencies involved against tax evasion and money laundering techniques, the IRS supports regulation as a tool to protect against criminal activity. That being said, cryptocurrency, by design, is very hard to regulate as there is not a centralized owner to make responsible. The IRS is currently facing staggering levels of tax noncompliance with reporting income associated with cryptocurrencies. For example, each year from 2013 to 2015 only around 800-900 people filed necessary forms indicating that they had sold cryptocurrency. In order to combat this, the IRS is focusing regulations on cryptocurrency exchanges, specifically Coinbase, to send data of users who have bought, sold, sent, or received more than $20,000 in the last year. These regulations set a clear precedent, allowing the IRS to issue summons to other cryptocurrency exchanges to reveal user identities.

Banks

Banks are largely skeptical of supporting cryptocurrencies because of the risks they must take on. Cryptocurrencies are lightly regulated by governments, so the cost of doing the regulation falls on banks as they must meet their own regulatory standards. Given the use of cryptocurrencies for criminal activities (e.g., money laundering), the risks and costs for performing such regulation are high. Moreover, Bitcoin's low transaction fees contrast to the higher fees charged by banks, increasing competition between the two.

Rabobank

Some international banks such as the Dutch Rabobank have taken more extreme measures to fight back against Bitcoin users. Experts monitoring exchanges were able to cancel customer transactions involving Bitcoin before they were able to be completed. Customers were not explicitly told that the reason that their transactions were failing because of the involvement with cryptocurrencies; rather they were given messages involving incorrect errors that they were unable to fix, even after calling to ensure that the transactions they were making were legitimate Rabobank has not released a statement on these actions, but the ethical and legal repercussions are still a major source of contention for all involved parties. More legislation will likely be needed for Bitcoin in order to set standards for modern banking systems to deal with cryptocurrency.

Bitcoin Foundation

One major example of a reputable company in favor of a growing cryptocurrency market is the Bitcoin Foundation, whose main goals are to standardize, protect, and promote Bitcoin They openly state in their mission statements that Bitcoin are only as valuable as the code behind them, and they recognize the need to keep an emphasis on cryptography in order to make this cryptocurrency more accessible and safe for customers. They are in favor of less regulation because they wish to shift control from banks to consumers, and they organize lobbying efforts to reach this goal.. The Bitcoin Foundation does not want Bitcoin spending to be completely uncontrolled, but they advocate more research and understanding by legislators before any major laws are passed concerning regulation.

Silk Road Users

Because Bitcoin are directly transferred from person to person without any regulation from a bank or trail indicating where the money was spent, they are ideal for criminals to use for buying illegal goods online. The Silk Road was an online black market part of the Deep Web, and customers could spend Bitcoin on whatever goods they found. Once the Silk Road became more popular among customers, the Drug Enforcement Administration and Department of Justice were called upon to shut down the site. This led to the eventual arrest of Ross William Ulbricht, the alleged owner of the site, and the website being seized by the FBI. Since then, the Silk Road 2.0 has also sprung up and been shut down by the government, and any Bitcoin seized on the sites were auctioned off by the United States government at extremely low prices relative to the average Bitcoin value at the time.

Interesting Examples of Bitcoin Usage

Kristopher Koch's Massive Windfall

In 2009, Kristopher Koch purchased $26.60 worth of Bitcoin while studying cryptocurrency for his thesis paper. He stored the private keys for these coins on his local computer and forgot about them for years. In the media frenzy surrounding Bitcoin during April 2013, he checked the value of his Bitcoin just to see if they were still worth any money. To his surprise, Koch discovered that his purchase was now worth over $886,000. He waited until the price of Bitcoin on the ever-changing market went up a little more, then sold them all to purchase a new apartment. This kind of gain is not typical for all Bitcoin investors; however it is an example of both how the market for Bitcoin is growing and how average people can stand to gain a great deal if they are willing to take the risk that Koch did.

James Howell's Huge Loss

When James Howell purchased 7,500 Bitcoin in 2009 he chose to store them on his local computer rather than storing them in an online wallet such as MultiBit in order to keep his money safe from outside intruders such as hackers. Howell unfortunately then spilled lemonade on his laptop computer and mistakenly threw away the entire machine without removing the hard drive storing the Bitcoin first. Once he realized his mistake, the hard drive was already deep in a landfill somewhere in Wales, and there was no chance of him recovering it without first investing more money into retrieval techniques. Howell has calculated the value of his Bitcoin since he lost them and estimates that he lost somewhere around $7.5 million due to one crucial error. Despite this major loss, Howells has remained a very vocal supporter of Bitcoin and maintains his beliefs that cryptocurrency will soon be the funds that all business transactions occur will use in the future.

The Currency Market as a Zero-Sum Game

Zero-Sum Games

Banks and cryptocurrency supporters can be seen as competing for the same space in the financial market. In economics, game theory is used to define the “game” in which parties compete. Games are classified as either zero-sum or non-zero-sum games. In zero-sum games, the gains of one participant are balanced exactly by the total losses of other participants; the amount of whatever is being played for stays constant. In non-zero-sum games, participants’ gains and losses do not have to be balanced by those of other participants. As such, there is a possibility that the actions of one participant can be for the mutual benefit of all participants (the “win-win” situation). Zero-sum games have been used to define many social systems. Professor John Mearsheimer views international power as a zero-sum game. Mearsheimer writes, “any country that improves its position in the global balance of power does so at the expense of other states, which lose relative power.”

If participant groups view the currency sector of the financial market as a zero-sum game, then it will directly influence their actions. In fact, some of the actions and words from participants would indicate that they have adopted a zero-sum mentality. Clearly, the banks that are currently shutting down accounts of Bitcoin users such as Wells Fargo and Rabobank would indicate that banks are fearful of the growing influence of these virtual currencies. Yves Mersch, a member of the executive board of the European Central Bank stated “Euro banknotes and coins are a method of payment of stable value, acceptance of which is compulsory, and thus they are superior to alternative methods of payment. Of these, I would like to mention…virtual money.” Rather than trying to incorporate virtual currencies, banking institutions are trying to undermine them while propping up traditional currencies.

The Role of Regulators

The examples of users losing large sums of money and assets being seized by banks illustrate that a lack of regulations creates an environment in which no legal recourse can be taken by those who have felt they have been wronged. Regulators, though, have yet to respond in full to the rise of virtual currencies as seen through the inaction of groups such as the IMF and Federal Reserve. If the currency market is truly a zero-sum game, this proposes a unique problem for regulators. By nature of the game, any action taken by regulators will either help or harm any parties involved. Thus, when crafting regulations, these organizations must consider the nature of the market and the impact of their actions on the parties involved.

Decentralized Applications (dApps)

Most cryptocurrencies today operate on blockchain technology. Many currencies, such as Ethereum and NEO , have leveraged their blockchain foundation to build a platform for making decentralized applications. A decentralized application is one that connects users and services directly, cutting out sources of centralization (i.e. companies), that pose risks to end-users’ data, money, and participation. Decentralized apps serve to cut out corporations in favor of community management and more user-benefits. They achieve this through cryptographically ensuring that all code run on the distributed network is immutable and open source. An example of a use-case for dApps is a decentralized Twitter, with no corporate backing, that is immune to censorship.

In 2017, there were significant technological developments to blockchain technology that sparked a massive increase in dApp development, along with a surge in price these currencies. The open sourced, community-driven, profitable nature of dApps attracted much development and a large user base[CITE]. Here are some notable examples of dApps that generated publicity:

• Open Bazaar: connects buyers and sellers directly with zero platform fees
• Steemit: decentralized social network where users get paid to post
• Numerai: crowd sourced hedge fund
• Opus: let’s music creators keep 100 percent of the revenue they earn \ldots

[CITE]

Opponents of dApps cite the plague of ponzi-scheme dApps as a reason for their bearish prediction[CITE]. Opponents also claim that dApps are simply attempting to replace their centralized counterparts with no new features, no new functionality, and no compelling reason to switch. They view this recent upswing in popularity as a fad, likening it to the open source movement in the 2000s which involved the failure of the OpenOffice platform[CITE].

Startup Fundraising

The startup funding space is a heavily regulated industry, necessitating investors to a special status in order to participate in these risky ventures. This special status is known as an accredited investor. In order to obtain this status, one must satisfy one (or more) requirements regarding income, net worth, asset size, governance status or professional experience. One such requirement is that a person must have an income exceeding $200,000. These requirements block investment opportunities for approximately 8% of Americans.

Cryptocurrency disrupts this space, by providing companies alternate routes to obtain funding for their businesses. This method is known as an Initial Coin Offering (ICO), where a company mints its own decentralized token which lives on the blockchain of an accepted cryptocurrency. This token serves as a future unit of business functionality that will be accepted by the business when it’s defined targets have been met[CITE].

These ICO’s allow young startups to bypass the strict regulations on accredited investors, targeting an untapped global market, and most importantly allowing the company to retain control of its shares [CITE]. Unfortunately, the high risk, high reward nature of this investment pathway has created some perverse incentives for companies to overhype their products, specifically targeting the naive investors that accreditation regulations mean to protect[CITE].

Bitconnect

Bitconnect is a cryptocurrency whose goal was to serve as a peer-to-peer financial lending platform that allowed users to earn interest on their lending. Bitconnect gained immense traction from investors, as it promised a 1% daily return on investment, achievable through a claimed “trading bot and volatility software” [CITE]. It’s market cap quickly grew to over $2.6 billion until early January 2018 when the Texas State Securities Board issued an emergency cease and desist, citing the venture as a ponzi scheme[CITE]. Within a weak, Bitconnect’s price was down to under 1% of its peak value and continued a gradual decline for the coming months[CITE].

Ponzicoin

Some cryptocurrencies are fully transparent about their intents. Ponzicoin, a cryptocurrency which had the same underlying business model as Bitconnect, was fully transparent as to the risk and nature of its functionality. Despite literally telling users that the crypto was a ponzi scheme, Ponzicoin still grew to a market cap of $250,000. At this point, the developer, Rishab Hedge, deactivated the cryptocurrency, claiming that he had set this up as a joke which had gone too far.

Criminal Activity

Cryptocurrency has the latent function of enabling many different forms of illegal activity. It’s decentralized, anonymous nature make it easy for those with malintent to easily circumvent authorities, streamlining crime. The prevalence of this distributed crime has dramatically increased in the last few years, spreading into many facets of industry. This section will focus on the most widespread uses of cryptocurrency as a tool for nefarious purposes.

Darknet Markets

Cryptocurrencies can be directly transferred from person to person anonymously, without any regulation from a bank. This is ideal for criminals to buy and sell illegal goods online. The Silk Road was the biggest online black market part of the Deep Web, and customers could spend the cryptocurrency, Bitcoin, on items such as drugs, cyber-arms, weapons, counterfeit currency, stolen credit card details, and forged documents. In 2013, the Federal Bureau of Investigation (FBI) shut down the site. This led to the eventual arrest of Ross William Ulbricht, the alleged owner of the site, and the website being seized by the FBI. Since then, the other alternatives has also emerged and many have been shut down by the government. All cryptocurrency seized on the sites were auctioned off by the United States government at extremely low prices relative to the average Bitcoin value at the time.

Money Laundering

According to the Wall Street Journal, over $88 million has been known to be laundered through 46 cryptocurrency exchanges. Criminals can use these exchanges to transfer money anonymously between different cryptocurrencies to hide their assets. This has led to the rise of anonymity-centric cryptocurrencies such as monero, which is suspected to "mask transactions throughout the money laundering process."

Cryptojacking

Cryoptojacking is a new type of hacking where malicious software secretly accessing computers in order to mine cryptocurrencies. This is a type of crime emerged due to the rise of cryptocurrencies. As cryptocurrencies increased in value and more people mined it, the complexity of generating new coins became significantly more difficult. This led to millions of users being hacked in order to secretly steal computational power from their computers. According to Mcfee Antivirus, there have been 2.5 million instances of crypto-jacking in second quarter 2018, which is an over 500% increase since 2017.