A brief history of Traditional Currency
Currency has been used as a medium of exchange for goods and services for thousands of years. The use of currency has evolved over time, from the use of commodity money, such as gold or silver, to the use of representative money, such as banknotes and coins, to the use of fiat money, which is created by government decree.
The major qualities of a currency that allows it to be used a medium of exchange are:
- The first key quality of traditional currency, known as a unit of account, is its ability to serve as a standardized measure of value. This means that people can use currency to compare the prices of different goods and services, as well as to assess the worth of promises or agreements. This allows for a common understanding of the value of things, which is essential for facilitating trade and other economic interactions.
- The second key quality is that traditional currency serves as a medium of exchange. This means that sellers will accept it as payment for goods and services, with the expectation that they will be able to use it to make purchases from others in the future. This makes it a convenient and widely accepted form of payment, which helps to facilitate trade and economic activity.
- The third key quality is that traditional currency serves as a store of value. This means that people can hold onto it and use it to transfer purchasing power from the present to the future. This is important because it allows people to save and invest their money, rather than having to spend it all immediately. Traditional currency is typically relatively stable in value, meaning that it is a relatively low-risk way to store value over time.
The chart below shows the different forms of money in the form of flower petals. The money flower distinguishes four key properties of money: the issuer, the form, the degree of accessibility and the payment transfer mechanism.
We will talk about the types of money under the green and yellow petals in this article.
The dwindling public trusts in Banks and Sovereigns
The growth of the economy and the need for a more efficient, stable and reliable form of money led to the development of central banks. Central banks, which are responsible for maintaining a stable unit of account as means of payment, play an important role in overseeing and providing the payment infrastructure for their country’s currency. They work to ensure that the payment system functions smoothly and that the supply of reserves is able to respond to changing demand. Maintaining trust in the institutional arrangements through which money is supplied has been the biggest challenge for central banks and sovereigns.
This is where the decentralization of the monetary authority of the sovereigns comes in. Decentralization of monetary authority gives autonomy and independence to individuals, allowing them to make decisions about monetary policy without interference from the country’s government or central banks. Decentralization of monetary authority can also help to reduce the potential for conflicts of interest and political influence on monetary policy decisions.
The security offered by central banks is arguably the largest fiddle in the world. The majority of central banks do not now retain gold as a form of protection against the currency in use. Central banks only keep modest amounts of gold in hand for trading. In such a situation, the country’s gold reserve is directly owned by the government rather than the central bank. Around 70% of the money in use globally is not backed by gold or other precious metals. Only a government promise serves as support.
Under conventional gold standard currency, currencies derived their value from the gold/precious metals backing the currency. Under gold standard every currency was exchangeable with gold if produced to the central bank because currency in circulation is essentially the promissory note issued by central banks. After the gold standard of the currencies around the world was dropped the currencies in circulation simply became a quality printed paper with a government assigned value. It no longer was a promissory note. In Nepal every note contains this term under the name of Nepal Rastra Bank signed by the Governor of the Bank “नेपाल सरकारको जमानत प्राप्त यसको रुपैयाँ भुक्तान माग्न आएमा नेपाल राष्ट्र बैंकबाट रुपैयाँ ५ तुरुन्त पाइने छ”. What a load of horselaugh. This means if you go and ask the central bank to reimburse you the value of Rs. 5 by presenting Rs. 5, the central bank will give you Rs. 5.
Government backed currencies are the largest scam in the whole world. It is a bubble of security. It will burst once the trust system fails. When will this trust system fail? No it will not fail outright unless there are alternative currencies that could potentially be a replacement and an improvement over the traditional currency. When alternative decentralized currencies gain traction and they are feasible for global adoption any of the following major incidents in the money market could cause the currencies around the world to fail:
- In case where the countries around the world will be involved in a gold selling/buying spree that causes huge fluctuations and failures in exchange rates.In cases where a country in a strong economy issues excess currency backed by their government treasuries that causes global unsustainable inflation.
- In cases where governments or investors decided to switch away from the U.S. dollar as reserve currency, the flood of short positions could significantly hurt anyone with assets denominated in dollars.
- In cases where the US enters into domestic recession without impacting the countries around the world.
- If import activities of the US, China, Japan, Germany and other strong nations declines.
If we start, we can easily discover multiple instances where the authoritative actions of the central banks had gone horribly wrong, trying to apply peculiar or odd suited monetary policies.
- Japan in the 1990s: In the 1990s, the Bank of Japan (BOJ) implemented a series of unconventional monetary policies, including zero or near-zero interest rates and large-scale asset purchases, to stimulate economic growth and combat deflation. These policies, known as “quantitative easing,” were initially successful in boosting asset prices and stabilizing the economy, but they also led to a buildup of government debt and created asset price bubbles that eventually burst, leading to a long period of economic stagnation known as the “Lost Decade.”
- The United States in the 2000s: In the 2000s, the Federal Reserve implemented a series of monetary policy measures, including lowering interest rates to near-zero levels, to stimulate economic growth following the dot-com bubble and the global financial crisis. These policies contributed to the housing bubble and financial crisis of 2007-2008, which had severe economic and financial consequences, including high unemployment and a significant drop in the stock market.
- Venezuela: In the 2010s, the Central Bank of Venezuela implemented a series of monetary policies, including printing large amounts of money to finance government spending, which contributed to hyperinflation in the country. By 2020, Venezuela’s inflation rate reached over 4,000%, leading to widespread economic instability and suffering for the population.
- Zimbabwe in the 2000s: In the 2000s, the Reserve Bank of Zimbabwe implemented a series of monetary policies, including printing large amounts of money to finance government spending, which contributed to hyperinflation in the country. By 2008, Zimbabwe’s inflation rate reached over 500 billion percent, leading to widespread economic instability and suffering for the population.
- Turkey in the 2010s: In the 2010s, the Central Bank of the Republic of Turkey implemented a series of monetary policy measures, including lowering interest rates and expanding the money supply, to stimulate economic growth. These policies contributed to high inflation and a depreciation of the Turkish lira, leading to economic instability and a balance of payments crisis in 2018.
- Brazil in the 1980s: In the 1980s, the Central Bank of Brazil implemented a series of monetary policy measures, including high interest rates and a tight monetary stance, to combat high inflation. These policies contributed to a recession and high unemployment, leading to widespread economic suffering and social unrest.
There are just mere examples. It is more important for us to know the meaning and implications of the monetary policies taken by the central bank so that it is easier to gauge the intention and repercussions of the actions taken by the authorities. We will discuss those in another post focusing on the monetary and fiscal crisis of Venezuela, Cyprus, Nigeria and Sri Lanka.
In fact, Modern Monetary Theory is quite insulting
We have come a long way since the Keynesian Monetary Theory. The Modern Monetary Theory, albeit flexible to the central management of monetary and fiscal policies, comes at the expense of lower accountability on the side of the government. Let’s try and discuss the major tenets of the modern monetary theory and understand how loose the accountability is on the side of the government and how little is the difference between monetary and budgetary instruments:
- Government can pay for goods and services without a need to first collect money in the form of taxes or debt issuance in advance. Under the Mainstream Keynesian Monetary Theory government was an accountable organization who collected taxes or debt before they spent it. However, under the Modern Monetary Theory the government is able to create money out of thin air where basically the central bank invests in government bonds and prints the money against the security of those investments. Under modern monetary theory the government gets to spend on the promised expenditure and the people who hold the currency pay for it because of the reduced precious metal security on that currency if any. Modern Theory purports that deficit spending can drive down interest rates, encouraging investment and thus “crowding in” economic activity.
- Keynesian Theory used to view taxation as the source of government income and way to equitably adjust the wealth among the classes of the society but since the modern government is able to spend money against the promise – taxation is more often regarded as a monetary tool to drive up/down the demand for currency, discouraging bad behavior and policing the market.
- Keynesian Theory viewed sovereigns as having dual equally important mandates; price stabilization and full employment. Under modern monetary theory prices are somewhat let to find their market equilibrium and the sovereign are primarily focused in improving employment opportunities and encouraging economic activities.
Yes, money is a medium of exchange but considering how much of an influence the government has over the money in circulation – the government effectively uses it as a standard of deferred payment – because the government knows it can always reclaim it though taxes or printing additional money.
Knapp wrote in 1905 that “money is a creature of law” rather than a commodity. Knapp contrasted his state theory of money with the Gold Standard view of “metallism”, where the value of a unit of currency depends on the quantity of precious metal it contains or for which it may be exchanged. He said that the state can create pure paper money and make it exchangeable by recognizing it as legal tender, with the criterion for the money of a state being “that which is accepted at the public pay offices”.
Basically, when the Government needs money – the central prints the money for the Government.
Step One: Governments will issue Bonds in the market. Private sectors (e.g. Commercial Banks) will make investment in such bonds issued by the governments.
Dr. Cash Equivalents
Dr. Government Bonds
Step Two: Central Banks make the interest payment on such bonds on behalf of the government.
Dr. Interest Expense
Dr. Cash Equivalents
Dr. Government Bonds
Step Three: Central Banks can issue currency against the security of the Government Bonds that it holds.
Dr. Cash Equivalents
So basically, when the Government needs money – central banks lend it to them – and central banks lend this currency by issuing new currency from the same receivable which it has with the government. This all has to do with who you vote for in the general election. The political promises are mostly unachievable and are costly. The government will head into a budget deficit. In my other post we will discuss the financial position of NRB and see what securities to back the currency in the issue of Nepal and see if it is in a good position.
The Case for Decentralized Currency
Cryptocurrency is the most subversive technology in the entire world. Government can’t kill or stop bitcoin until the internet is running. But they could very easily impede its development through legislative action – which we have seen happen often around the world.
According to Jan Lansky, a cryptocurrency is a system that meets six conditions:
- The system does not require a central authority; its state is maintained through distributed consensus.
- The system keeps an overview of cryptocurrency units and their ownership.
- The system defines whether new cryptocurrency units can be created. If new cryptocurrency units can be created, the system defines the circumstances of their origin and how to determine the ownership of these new units.
- Ownership of cryptocurrency units can be proved exclusively cryptographically.
- The system allows transactions to be performed in which ownership of the cryptographic units is changed. A transaction statement can only be issued by an entity proving the current ownership of these units.
- If two different instructions for changing the ownership of the same cryptographic units are simultaneously entered, the system performs at most one of them.
Crypto is created out of thin air but its existence is verified through a decentralized blockchain system. The blockchain system is a decentralized system for verifying that the parties to a transaction have the money they claim to have, eliminating the need for traditional intermediaries, such as banks, when funds are being transferred between two entities.
In order to build the case for the Decentralized Currency lets see the features of the traditional and modern currencies and how cryptocurrency does it better or is limited in its capabilities:
How traditional currency does it
How cryptocurrency does it
Is centralized and the record keeping of transactions and ownership verification is done through the monetary market participants that are regulated by the government or central banks
The record keeping of the transactions and the ownership is made through the blockchain technology which is decentralized and the one who does the record keeping and verification is algorithmically selected who completes a proof of work system.
The annual global revenues from the transaction fees is estimated to be around 2 trillion dollars for circulating the estimated total of 6.6 trillion dollars of global currency in issue.
The global revenues from the transaction fees of bitcoin is competitively set as many nodes/participants of the blockchain would want to claim the right to write the blockchain. The market capitalization of bitcoin is very uncertain and so are the transaction fees at this stage of adoption.
The future of transaction fees
Monetary market, despite being the most efficient industry in terms of operation, still has a huge cost burden in the industry due to its high transaction fees. But considering the widespread adoption and velocity of the traditional currency it is certainly better than the transaction cost of the bitcoins at this stage.
Many cryptocurrencies are capped in quantity through algorithms. Once such a limit is reached the miners mining incentive will cease to exist and the transaction prices could go higher. But since the blockchain is a competitive platform by design the cost of transaction fees should theoretically not be absurdly higher than the cost of writing blockchain plus a reasonable profit expectation on the miner’s part.
Service and Management Fees
Traditional currencies are hard currencies. They require manpower to be handled, secured, transported, managed, counted, sorted, printed, handed and so on. There is no global estimate of these costs but certainly it is not cheap.
The service and management cost of the cryptocurrencies are practically insignificant as compared to the traditional currencies.
Traditional financial services, which can take days to process a transaction. Even when a digital transaction is instantaneous at the user’s end – it could take days for the banks to have the settlement made on their side.
Cryptocurrency transactions are typically processed very quickly, often within a few minutes. One caveat under the “proof of work” under the blockchain system is that to generate the proof for the work done the computer has to make redundant iterative calculations to prove their interest and stake their involvement.
Traditional currencies are subject to theft, hacking, account mismanagement by bankers and so on.
Cryptocurrencies use strong cryptography to secure transactions and prevent fraud. This makes them a very secure way to store and transfer value.
Pseudonymity is not possible in the traditional banking system. The bankers are controlled by the central government and they in turn by the government which leads to the government having ultimate control over the beneficiaries of the monetary market.
Cryptocurrency users can often remain anonymous, which can be beneficial for privacy.
Accessibility and Financial Inclusion
Traditional financial services are expensive to expand. Infrastructure, human resources, profitability, overall access to other infrastructure of the development etc. makes it a challenge to expand rapidly in the remote corners of the country.
Cryptocurrencies can be used by anyone with an internet connection, which makes them accessible to people in developing countries or who do not have access to traditional financial services.
Under the traditional monetary system, any additional smart use of the money (contracts, erp, secured transfers, limited use, discretionary use, distribution, welfare transfers etc.) has to be made through a system separate from the monetary system.
Many cryptocurrencies, such as Ethereum, have the ability to support smart contracts, which are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. This can enable the creation of new types of financial instruments and streamline many business processes.
Basically, when the Government needs money – central banks lend it to them – and central banks lend this currency by issuing new currency from the same receivable which it has with the government. Money gets printed on the need of the government and the general public has to face the inflationary effect on the currency in issue as the value for the money gets decreased due to the increase in supply of money.
Cryptocurrencies are often designed to have a fixed supply, which means that the amount of the cryptocurrency in circulation cannot be increased. This can make them resistant to inflation, as there is no central authority that can print more of the currency. Moreover some of the crypto in issue gets decreased over time due to loss of the private key, lefts out to get transferred to heirs and so on – leading to net deflationary effect rather than inflation.
Digital currencies represented by the fiat currencies are digitally portable but they do have limitations in terms of the area of jurisdiction, use and convertibility.
Cryptocurrencies are digital and can be easily stored on a computer or mobile device, or in a digital wallet. This makes them very portable and easy to access from anywhere in the world.
Durability and Divisibility
Traditional currencies had to be recalled and destroyed at certain times because they are physical currencies and they wear tear and get depleted over time.
Bank notes are not divisible but the digital currencies are – but even though the digital currencies are divisible they are not splittable.
Cryptocurrencies are digital and do not physically exist, which means they are not subject to wear and tear. This makes them a durable and long-lasting form of money. Most cryptocurrencies can be divided into very small units, which makes them highly divisible and flexible for use in transactions of all sizes.
As of now traditional currencies have a clear advantage regarding its recognizability but they do have limitations in terms of the area of jurisdiction, use and convertibility.
Cryptocurrencies are becoming increasingly widely recognized and accepted, with many merchants and businesses now accepting them as a form of payment.
Transparency and Autonomy
Traditional currencies do not have transparency for the public to vouch the transactions. They do not bring autonomy as they are the promissory notes issued by the central banks and central banks have legislative authority to impede the value, circulation and use of the traditional currency.
Cryptocurrencies use a distributed ledger called the blockchain, which allows for a transparent and verifiable record of all transactions. This can help to increase accountability and reduce the risk of fraud. Cryptocurrencies allow individuals to have greater control over their own wealth and financial affairs, as they do not require the use of a traditional financial institution.
Crypto disruption could be a blessing
Is crypto a good thing? But maybe it is a bad thing? Whatever it is, the monetary market does need a revolution. The power to control the currency in circulation is too much of a power to be left with the central banks and government authorities. Crypto adoption among retail and institutional investors in 2022
When the large depository institutions like Banks, Mutual Funds and Insurance Companies accept crypto – the adoption rate will grow exponentially – but as of now many countries around the world have imposed some form of ban on the crypto currency – impeding its widespread adoption.
Over 10% of global Internet users likely own some form of cryptocurrency – 500m people if we assume 5 billion internet users. Crypto ownership and use are only legally restricted in 3% of countries worldwide and fully illegal in another 3%. According to Finbold, the countries with the highest prevalence of crypto ownership among internet users are Thailand, Nigeria, the Philippines, South Africa, and Turkey, each with between 18% and 20% of their internet users owning cryptocurrency.
As an anarchist who wants a proper replacement to the government controlled monetary system – cryptocurrency is a boon to all of us. This is like getting a seat on the rocket. You don’t ask where the seat is – you just get in the rocket. Having said that, the price discovery of bitcoin is going to be violent and volatile and graph below show the price volatility of Bitcoin.
A short on Bitcoin’s history in particular: The concept of permissionless cryptocurrencies was laid out for the case of Bitcoin in a white paper by an anonymous programmer (or group of programmers) under the pseudonym Satoshi Nakamoto, who proposed a currency based on a specific type of distributed ledger, the “blockchain”. The blockchain is a distributed ledger that is updated in groups of transactions called blocks. Blocks are then chained sequentially via the use of cryptography to form the blockchain. This concept has been adapted to countless other cryptocurrencies. Link to Satoshi’s white paper here: Link
The only way to shut down decentralized cryptocurrency is if you shut down all the internet in the world. It is backed by mathematics and the rules of protocol. It’s your money and nobody else’s.
Crypto Operandi and Jargons
Terms like Ledger, Blockchain and Mining and P2P gets thrown around by crypto libertarians as if everybody has gotten used to it. No, we haven’t yet gotten used to it – which is why we will discuss these terms below along with how the cryptocurrency translation works. Reference: Imponderable Things
Get your bitcoin wallet
Opening crypto wallet by choosing wallet alternatives here: Link
💡Having a crypto wallet only makes you a user in the environment. There are other market participants: Miners – who validates the blockchain and writes on it. Exchanges – who facilitate the users to trade bitcoins with traditional currencies. We will discuss their roles in the steps below.
Announce your transaction
At a basic level, for A to send money to B, he has to broadcast a message to the P2P network to register a transfer of certain coins from his account to B. The message could be “Transfer 5.0 BTC from A to B.”
Since the message is broadcasted in the P2P network how can one be certain that it is the message sent by A? This will be verified through the use of a digital signature system. How does digital signature system work:
Everyone gets keys
- Everyone gets a pair of keys – Private Key and Public Key. One key is created and the other is the irreversible function of the first key.
- Messages that are encoded with Private Key can be decoded only with Public Key and messages that are encoded with Public Key can be decoded with Private Key.
- Everyone else has your Public Key but only you have your Private Key.
- A encodes his message with B’s Public Key. The encoded message gets transmitted to B. B can decode the message only with B’s Private Key.
Surety Achieved: Only B can decode the message from A.
- At first – A encodes his message with A’s Private Key. Secondly – A encodes the encoded message with B’s Public Key. The encoded message gets transmitted to B. At first – B decodes the message using his private key. Secondly – B further decodes the decoded message using A’s Public Key.
Surety Achieved: Only B can decode the message from A. B is certain that the message originated from A.
- A encodes his message with A’s Private Key. The message gets transmitted to everyone. Everyone can decode the message using A’s Public Key.
Surety Achieved: Everyone who views the message is certain that it originated from A.
(This is the mechanism used to broadcast the transaction in the P2P network of a Cryptocurrency)
That’s all fine and dandy. But how is Public Key able to decode the message encoded using Private Key and vice versa? And how exactly are the messages encoded?
The messages are encoded using Public Key Cryptography systems like RSA encryption algorithm, DH key exchange protocol etc. Links
Let’s take an example of a RSA Encryption where the pair of keys (encoder and decoder) are:
Encrypt(x) = MOD(x^5, 14) and Decrypt(x) = MOD(x^11, 14). The message we want to send is “b”. Let’s encode “b”. Say numbervalue of b is 2. Then using the first key Encrypt(2) = MOD(2^5, 14) = 4. This result 4 can be decoded to mean “b” by using the other key. Decrypt(4) = MOD(4^11, 14) = 2. The text value of 2 is “b”. And hence, we have successfully encoded and decoded the text “b” using the RSA Encryption method.
How do we create the encoder and decoder key using the RSA Encryption? This could be quite a divergence from the topic we are discussing. The process involves primality testing, Carmichael’s function, Euclidean algorithm, Hamming weight, Bézout’s identity among other theories of the mathematical branches. Details in Key Generation Section here.
Wait, but aren't crypto transactions supposed to be anonymous?
In the example above we took the example between A and B. The message also contained the sender and recipient. How is this anonymous?
Answer: In fact the A and B are the public keys of the user. This is not the identity of the user. If you access Bitcoin through a TOR network that hides your IP address, you can use Bitcoin without ever revealing anything more than your public key. And to avoid someone linking your transactions together (remember, they’re all publicly stored on every computer!), you can generate a new public key for every incoming transaction. You might think that generating a public key “receiving address” could potentially create a link to your true identity, but even this step is anonymous, and amazingly, can be done with no connection to the network. You simply click a button in your Wallet software, and it randomly generates a new private and public key. Because there are so many different possible addresses, there’s no reason to even check if someone else already has that key (compare this to signing up for an email address, where almost everything you might try has been taken). In fact, if you did guess someone else’s key, you would have access to their money! This is the total number of possible Bitcoin addresses: 1461501637330902918203684832716283019655932542976 (1.46 x 10^48 or 2^160)
💡Who keeps the records of public keys?
The public key is visible in the network after a transaction has been ordered. Once the spend has been done the public key is a part of the transaction and is forever visible in the blockchain. This is the reason address reuse is discouraged so it’s better to generate a different pair of keys for every new transaction through your wallet. Your wallet records the keys generated by you through the wallet.
Your broadcast gets written in the transaction chain / distributed ledger
Once the message for the transaction is broadcasted. It gets registered in the transaction list as “unordered transaction” until it gets written in the blockchain.
💡”Ledgers” but not quite
Transactions in bitcoin are recorded in a “ledger” but this is not a typical ledger that we understand in accounting convention. It’s not a simple list of transactions – on which you can pivot or sumif to find the account balances.
Example of a typical accounting ledgerBut this is how transactions are recorded in a cryptocurrency transaction ledger:
💡Why are transactions recorded in this manner in the transaction list? There are two benefits to this.
- Efficiency: The current blockchain size is around 450GB (see latest info here: link). Looking up the entire database to calculate the person’s crypto balance is not efficient. So going through all entries in the transaction to compute the balance is not efficient. Instead it’s quicker to go to the last unspent transactions of the particular person to calculate the balances.
- Security: Another benefit to this is security. When every transaction refers to the earlier transactions – the transaction hash that is generated also acts as a safeguard for double spending attacks. Despite the immediate previous transaction’s hash is not fed to generate the new hash – the fact that the broadcast message for transaction refers to the earlier unspent transactions makes it relatively stronger in terms of the double spending attacks.
💡Difference between the “Transaction List” and “Blockchain”
We can explore the bitcoin transactions here: Transactions and the Blockchain here: Blockchain
A Bitcoin transaction is a record of a transfer of Bitcoin from one user’s Bitcoin wallet to another. It is a package of data that includes the sender’s Bitcoin address, the recipient’s Bitcoin address, and the amount of Bitcoin being transferred. When a Bitcoin transaction is made, it is broadcast to the network and temporarily stored in a pool of unconfirmed transactions, also known as the mempool. A Bitcoin block is a collection of Bitcoin transactions that have been packaged into a block. When a block is created, it is added to the chain of all existing blocks, also known as the blockchain. Each block contains a unique code called a “hash” that distinguishes it from every other block, as well as the hash of the block that came before it in the chain. This creates a secure and unbroken record of every transaction that has ever taken place on the network.
Broadcast are first stored in mempool
💡What happens in each node when the transaction message gets broadcasted?
When a payment instruction is broadcasted in the P2P network – the node that first receives it will add that transaction to its memory pool (mempool) as unconfirmed or unordered transactions and broadcast to other nodes in its network. These transactions are not a part of the transactions list at this stage. When a node receives the order for a new transaction – the node checks to make sure the transaction is valid (whether the message actually originated from the sender, whether the sender has sufficient funds to perform the transaction, whether the transaction is a duplicate etc). Then the node will add it to its mempool labeling if it is valid and this addition gets broadcasted it to all the other nodes on the network. If the node finds the broadcast invalid this will not be broadcasted to other nodes.
💡Who hosts a mempool?
The mempool is a part of the peer-to-peer (P2P) network that operates the Bitcoin blockchain. It is not a separate network or a storage location on a node’s computer. Miners also maintain a copy of the mempool in order to choose transactions to include in the blocks they are mining. When a miner creates a new block, they select a set of transactions from the mempool to include in the block. The transactions that are included in the block are then removed from the mempool and are considered to be confirmed.
💡What if all the nodes have not been able to copy all the broadcasts into its mempool?
Most of the time, not all broadcasts get copied in the mempool of all the full nodes in the network. This might be due to the network latencies, offline networks, faulty nodes, faulty validity checker, network congestion, high volume of transactions, and so on. It is not necessary for a single transaction to exist on multiple nodes in order for it to be included in a block. Instead, miners choose transactions to include in the blocks they are mining based on a variety of criteria, such as the fee paid by the sender and the size of the transaction.
💡What are nodes?
Nodes are the participants in the bitcoin network. In the context of a blockchain, a node is a computer that is connected to the network and participates in the operation of the blockchain. There are several types of nodes, including:
- Full nodes: Full nodes store a copy of the entire blockchain and validate transactions and blocks to ensure they are legitimate. They play a key role in maintaining the security and integrity of the blockchain. Eg. Users who have high investment in Crypto who require high security.
- Miner nodes: Miner nodes, also known as “mining nodes,” contribute computing power to the network to help create new blocks. When a miner successfully creates a new block, they are rewarded with a certain number of Bitcoins. Eg. Who participates and competes in writing into blockchain.
- Lightweight nodes: Lightweight nodes, also known as “light clients,” do not store a copy of the entire blockchain. Instead, they rely on full nodes to provide them with the necessary information about the blockchain. Eg. Normal Crypto Wallet Users.
💡Is mempool a part of transaction list?
No it is not a part of the transaction list. Mempool is a temporary holding area for unconfirmed transactions that have been broadcast to the network but have not yet been included in a block. A transaction list is the list of all the transactions that have been included in the blockchain.
Transactions gets written into blockchain
When a miner decides to create a new block, they typically do so by selecting a set of transactions from the mempool (also known as the “memory pool”, “transaction pool” or “unconfirmed transaction pool”), which is a list of all the unconfirmed transactions that have been broadcast to the network but have not yet been included in a block. There are several factors that miners may consider when deciding which transactions to include in a new block like: Transaction fees, Transaction size, priority for time sensitive contracts etc.
Let’s talk about the redundant mathematical exercise that a miner has to do before being able to write the selected transaction from the mempool into blockchain. In general, the main task that a miner’s computer must perform is to solve a complex mathematical problem, known as a “proof of work,” that is required to create a new block. This process involves using powerful computers to perform billions of calculations per second in an attempt to find a solution to the mathematical problem. This process is known as “mining,” and the miner’s computer that is able to solve the proof of work is rewarded with a certain number of tokens or other incentives. Once the proof of work has been solved and a new block has been created, the miner’s computer must then broadcast the new block to the rest of the network, where it is validated by other nodes and added to the blockchain if it is considered to be valid.
Because every block has a link to the previous block – the system is called blockchain
The term “blockchain” refers to the way that transactions are recorded and stored on the network. In a blockchain, transactions are grouped into blocks and each block is connected to the previous block, forming a chain of blocks. This structure allows transactions to be recorded and stored in a secure, transparent, and decentralized manner. Each block in the chain contains a record of multiple transactions, and the blocks are connected to each other in a specific order. This allows the network to maintain a complete and accurate record of all the transactions that have taken place on the blockchain, from the very first block (also known as the “genesis block”) to the most recent block.
Is it possible for two separate miners to pick same transaction to write into a block?
Yes, it is possible for two separate miners to pick the same set of transactions to include in a block. This can happen if both miners are working on creating a new block at the same time and both choose to include the same set of transactions in their respective blocks. However, it is important to note that only one of the blocks created by these miners will ultimately be added to the blockchain so there is no chance of the same transaction being added twice in the blockchain.
What are competing blocks and what happens when two miners create competing blocks at the same time?
In a blockchain, “competing blocks” refer to two or more blocks that are created at approximately the same time and that are being considered for addition to the blockchain. This can happen when multiple miners are working independently to create new blocks and add them to the chain, and they happen to create blocks at around the same time. When two miners create competing blocks at the same time, the network must choose which block to add to the blockchain. This process is known as “consensus,” and the specific rules for determining which block to add can vary depending on the specific blockchain. In most blockchains, the block that is added to the chain is the one that is considered to be the “longest” or most “difficult” to produce. For example, in the Bitcoin blockchain, the block that is added to the chain is the one that has the highest “proof of work,” which is a measure of the amount of computational effort that went into producing the block.
What is a “orphan block”?
When competing blocks are created only one gets written into the blockchain. The other blocks that are discarded are called “orphan blocks”. If a block is considered to be an orphan block, it is not added to the chain and is not considered to be part of the main blockchain. The transactions included in the orphan block may be added back to the “mempool” (the temporary holding area for unconfirmed transactions) and may be included in a future block if they are selected by a miner.
Is the problem of “competing blocks” a recurring problem if all miners want to make profit by selecting transaction with higher fees?
Although it is true that miners are generally motivated to include transactions with high fees in new blocks that they create, competing blocks are not a recurring problem in most blockchains because the probability of two miners solving a block at the same time is relatively low.
Does a miner select a set of unordered transaction or is a set of unordered transaction assigned to him?
In most blockchains, a miner has the ability to select from the mempool which transactions they want to include in a new block that they are creating.
The problem of Double Spending
The problem is called “double spending”. This redundant mathematical exercise is done to solve this problem of “double spending”.
💡What is “double spending”?
Considering that transactions are passed node-by-node through the network, there’s no guarantee that the order in which the miners receive them represents the order in which they were created. So what if one user broadcasts a transaction in the network referring to the same currency twice? Malicious users could potentially double spend using the “double spending attack”. It works as follows:
- A malicious user, A, could send a transaction giving money to B, wait for B to ship a product, and then send another transaction referencing the same “input” back to himself.
- Because of differences in propagation times, some nodes on the network would receive the 2nd “double-spending” transaction before the one to B. And when B’s transaction arrived, they would consider it invalid because it’s trying to re-use an input.
- So B would be out both his shipped product and his money.
- Overall, there would be disagreement across the network about whether B or A had the money, because there’s no way to prove which transaction came first.
In light of this, there needs to be a way for the entire network to agree about the order of transactions, which is very much a daunting challenge in a decentralized system. Bitcoin’s solution is a clever way to both determine and safeguard the ordering through a kind of mathematical race.
💡The solution to “double spending” is the creation of “blockchain”
The crypto system orders transactions by placing them in groups called blocks, and linking those blocks together in something called the block chain. This is different from the transaction chain we discussed earlier. The block chain is used to order transactions, whereas the transaction chain keeps track of how ownership changes. Each block has a reference to the previous block, and this is what places one block after another in time. You can traverse the references backwards all the way to the very first group of transactions ever made.
💡When does a transaction gets checked for “doublespend”?
Firstly, transaction broadcasts coming into the network will be checked for double spend at the time they are added and shared in the mempool. All other full nodes also validate the transactions in the mempool. Once the transactions are picked from the mempool and they are ready to be written in the blockchain they get verified at this stage too – by the writer as well as other validators. This second verification is also necessary because not all the nodes are in sync with the mempool at the initial stage and multiple nodes might have selected the same transaction twice or selected doublespend transactions to be written in the blockchain.
💡If the validators find any double spends in the block trying to get written, does the entire block gets rejected or only the specific transaction within the block?
If the validators find a double spend in a block, it is typically the specific transaction that is considered to be invalid and is rejected. The rest of the transactions in the block may still be considered to be valid and will be added to the blockchain. However, in some cases, the entire block may be rejected if it is found to contain too many invalid transactions, or if the invalid transactions are considered to be serious enough to warrant rejecting the entire block.
💡What do other miners check to validate the block?
When other miners validate a new block that has been added to the blockchain, they check the block to ensure that it is properly formatted and follows all the rules of the blockchain. They verify whether:
- The block has a valid proof of work: Which is a measure of the amount of computational effort that went into producing the block. This helps to ensure that the block was produced in a secure and decentralized manner.
- The block header: Ensure that the block is properly formatted and includes all the necessary information, such as the previous block’s hash and the block’s timestamp.
- The transactions: Ensure that the transactions in the block are properly formatted, are signed correctly, and do not contain double spends.
The redundant mathematical exercise
Transactions can be stored in a simple ledger and that’s what the cryptocurrency really is – just imaginary numbers that are digitally recorded. A simple spreadsheet/database should have sufficed the system. But since nobody centrally hosts the records in the decentralized system – and nobody trusts each other – how do we ensure that the transaction’s integrity is maintained and that everyones has a “consensus” with the record that the other person has and if not the mechanism of resolving the differences.
The difference in the database stored by each peer in the P2P network is that some might be way ahead in the process, some stuck back due to network congestion or other failures. So we ask these questions that a layman would:
- Whose copy of the data is final? Obviously, the one who has the longest list of the transaction.
Implementation in Crypto: Always switch to the blockchain with the longest header to be in sync with all other nodes.
- But how can one ensure that all the transactions that one with the longest record has listed have not been tampered? By checking that each block of transaction references the previous block of transaction through hash.
Implementation in Crypto: Ensure the block’s integrity through the hash. Any change (malicious/otherwise) in any transaction within the records would lead to change in the block hash and it will not be in “consensus” with the network and in such case the second lengthy record (from the same blockchain / other node) will be selected.
- But what if two people write into the transaction list at the same time? Obviously, only one will be accepted and the other will be orphaned.
Implementation in Crypto: When two miners solve to write a block into the chain at the same time they are called competing blocks. The block with the greater computational consumption will be able to write into the blockchain. Competing blocks if uncontrolled could bring potential for lack of consensus in the blockchain as everyone will claim to have their copy of the blockchain to be the latest one (i.e. the one with max height). For this, competing blocks are made to be a rare occurrence and the process of creating a new block and adding it to the blockchain is designed to be competitive, but also to reach consensus on the state of the blockchain. For this each miner has to select a pool of transactions from the mempool and go through a completely unrelated mathematical computation (called proof of work) to prove that they invested a certain computational power to claim to write into the blockchain. This redundant exercise spreads out the chance of many nodes in the chain getting their blocks solved at the same time as these are fairly complex computations and the probability of its solvability gets spread so the chance of competing blocks being created at the same time is a rare occurrence. The network can ensure that only a limited number of blocks are created per unit of time, which helps to prevent competing blocks from occurring too frequently.
What does this “redundant” exercise achieve?
Solving the complex mathematical problems in the proof of work mechanism has the following two objectives:
- To be able to spread the ability to write into the blockchain so the chance of competing blocks being created at the same time is a rare occurrence.
- It also ensures the security and integrity of the blockchain, as it helps to prevent malicious actors from creating large numbers of fake blocks or transactions in an attempt to manipulate the blockchain.
- It ensures the entire network to agree about the order of transaction to solve the problem of “doublespend”.
What is the “maths”?
The maths behind the blockchain process is trying to decode a SHA256 hash. SHA refers to Secure Hashing Algorithm. Blockchain solution is that each valid block must contain the answer to a very special mathematical problem. Computers run the entire text of a block plus an additional random guess through something called a cryptographic hash until the output is below a certain threshold. A hash function creates a short digest from any arbitrary length of text, in our case, the result is a 32 byte number. Here are some examples of the specific hash function Bitcoin uses, SHA256 to give a hexadecimal number (remember the below has outputs are digits not strings):
- SHA256(“short sentence”)
- SHA256(“The quick brown fox jumps over the lazy dog”)
- SHA256(“The quick brown fox jumps over the lazy dog.”)
Note how much the output changes as a result of a single extra period at the end of the third example. The output is completely unpredictable, so the only way to find a particular output value is to make random guesses. It’s very much like guessing the combination to a lock. You might get lucky on your first guess, but on average, it takes many guesses. In fact, it would take a typical computer several years of guessing to solve a block. With every computer in the entire Bitcoin network guessing numbers, it takes about 10 minutes on average for someone to find a solution. The first person to solve the math problem broadcasts their block, and gets to have their group of transactions accepted as next in the chain. The randomness in the math problem effectively spreads out when people find a solution, making it unlikely that two people will solve it at the same time.
“Hashing” is not “encryption”.
Hashing is not Encryption because we do not ever need to decode a Hash. Unlike the encryption and decryption technologies – it is not possible to use the hash to generate the originating message or document. Hashing algorithms use modulus, wraps and mixers to generate a fixed length hash for any size of input and if we even so much as change a single “.” in the original file the new hash will be completely different. It is called the avalanche effect of hashing.
So what is the “miner’s computer” doing? They try various “nonce” to reach a hash within threshold.
A typical cryptocurrency blockchain contains the following information within it:
- (A) The block height i.e. the block number
- (B) The transaction data purposed to be included in the block
- (C) Hash of the previous block
- (D) The golden “nonce” that the miners iteratively brute force to be able to generate a close approximation to the “target hash”
We know that the Output Hash of this block is the SHA256(A+B+C+D) – a random hash number. The network sets a target of what the output hash should be (say the Output Hash should have 4 leading zeroes) and the miner gets to iteratively test various “nonce” (he cannot change other parameters of the block because the block should remain immutable) to get to the target hash. This is a pure brute force iteration made through the miner’s computer and due to the avalanche effect of the SHA256 hashing algorithm – the miner is never able to establish a trend to predict the required nonce faster and faster. This is because hashing algorithms use modulus, wraps and mixers to generate a fixed length hash for any size of input and if we even so much as change a single “.” in the original file the new hash will be completely different. The miner who guesses the nonce to reach the target hash will then be able to write his set of transactions / block into the blockchain.
What will happen if the miners drop off the crypto network?
Cryptocurrency blockchains bitcoin are made to be flexible. If miners have to drop off in the network because they can’t make money then the mathematical exercise discussed above will be simpler as the difficulty will adjust depending on the total computing power existing on the network. And mining will become more profitable for those still on the network. The difficulty will be lowered by setting a target hashes that are more easier to brute.
Mining Pools: When capitalization meets decentralization
As mentioned before, on average, it would take several years for a typical computer to solve a block, so an individual’s chance of ever solving one before the rest of the network, which typically takes 10 minutes, is very low. To receive a steadier stream of income, many people join groups called mining pools that collectively work to solve blocks, and distribute rewards based on work contributed. These act somewhat like lottery pools among co-workers, except that some of these pools are quite large, and comprise more than 20% of all the computers in the network. The fact that some of these pools are so large has some important implications about security. As mentioned before, it’s very unlikely for an attacker to solve several blocks in a row faster than the rest of the network, but it is possible, and the probability increases as the attacker’s processing power gains in proportion to the rest of the network. In fact, one of the mining pools, BTC Guild, has solved 6 blocks in a row by itself, and has voluntarily limited its members to ward off distrust of the entire bitcoin network. The current recommendation is to wait for a transaction to make it into at least one block, or get one confirmation, before considering it final. And for larger transactions, wait for at least 6 blocks. In light of BTC Guild’s ability to solve 6 blocks in a row, you might want to wait even longer. The more confirmations that the merchant waits for, the more difficult it is for an attacker to successfully reverse the transaction in a blockchain—unless the attacker controls more than half the total network power, in which case it is called a 51% attack.
Reaching Finality, Appending Block to BlockChain
Finality is the level of confidence that the well-formed block recently appended to the blockchain will not be revoked in the future (is “finalized”) and thus can be trusted. Most distributed blockchain protocols, whether proof of work or proof of stake, cannot guarantee the finality of a freshly committed block, and instead rely on “probabilistic finality”: as the block goes deeper into a blockchain, it is less likely to be altered or reverted by a newly found consensus.
Some glossary for extra nerds
In each block (let’s take an example of block number 770,139 in Bitcoin Blockchain): Link
- Hash: Unique identifier used to identify a particular block
- Capacity/Fill: The “fill” of a block in a blockchain refers to the percentage of the block’s capacity that is being used by transactions. For example, if a block has a capacity of 10 transactions and it currently contains 5 transactions, it could be said to have a fill of 50%. The fill of a block can be an important consideration in the operation of a blockchain, as it can affect the overall performance and scalability of the network. If the fill of blocks is consistently high, it can indicate that the network is operating at or near capacity, which can lead to delays in the processing of transactions and potentially higher fees for those looking to have their transactions included in the next block.
- Distance: Time since the block was mined
- Height: An incremental number given to each new block in the blockchain
- Value: USD Value of all the transactions within the block when it was mined. Value today is the present value of the amount.
- Input Value and Output Value:
If the block contains block reward then the output value is greater than the input value. Otherwise the output value and the input value are generally the same.
- Fees Kb: Is a short for “fees per kilobyte”
- Fees kWU: Is a short for “fees for weight units”
- Fee Range meaning: A fee range of 0-157 sat/vByte might indicate that a fee in the range of 0-157 satoshis per virtual byte is sufficient to get a transaction included in the next block.
- Satoshi: In the context of Bitcoin, a satoshi is the smallest unit of the cryptocurrency, equal to 0.00000001 bitcoin. The unit is named after the pseudonymous creator of Bitcoin, Satoshi Nakamoto.
- Depth: Depth is the total number of confirmations for a block in a blockchain. It refers to the number of blocks that have been added to the chain since the block in question was included. In other words, it is a measure of how deep the block is in the blockchain.
- Version: The “version” of a blockchain refers to the specific implementation or protocol that is being used to maintain the chain. Different versions of a blockchain may have different features or characteristics, and may be designed to operate in different ways.
- Difficulty: Mathematical value of how hard it is to find a valid hash for this block. This is a index that is used to tie break the competing blocks,
- Weight: A measurement to compare the size of different transactions to each other in proportion to the block size limit
- Minted: Static reward for the miner who calculated the hash for this block.
- Miner: The one who mines the block.
How is cryptoeconomics justified?
Trust System: What backs Cryptocurrency?
Electricity, internet and fancy math are the three main things that backs cryptocurrency nothing else. So people have been bold enough to say that crypto is just another monopoly money, internet money, or a fancy scam in the world.
People often ask what backs the cryptocurrency? Unlike traditional money it is not backed by any security. But the same could be asked for the rest of the currency in issue in the globe. 70% of the fiat money in the currency is not backed by gold after the gold standard was withdrawn. So the same question for the currency backing could be asked for the traditional fiat currency as well.
There are several arguments that have been made in favor of cryptocurrency. One argument is that cryptocurrency has the potential to serve as a decentralized and secure means of storing and transferring value. Because cryptocurrencies are based on blockchain technology, they are distributed and secure, which means that they are less vulnerable to tampering or fraud than traditional financial systems. Another argument for cryptocurrency is that it can provide a way for individuals to store and transfer value without the need for intermediaries, such as banks or financial institutions. In traditional financial systems, these intermediaries can be expensive and can introduce delays and other inefficiencies into the process of storing and transferring value. Cryptocurrencies, on the other hand, can allow for direct, peer-to-peer transactions without the need for intermediaries, which can make the process faster and more efficient. Cryptocurrencies are also often argued to have the potential to provide greater financial inclusion, as they can allow individuals in countries with underdeveloped financial systems to store and transfer value in a way that is secure and independent of traditional financial institutions.
Major milestones in the cryptocurrency adoption
- The first notable retail transaction involving physical goods was paid on May 22, 2010, by exchanging 10,000 mined BTC for two pizzas delivered from a local pizza restaurant in Florida, marking May 22 as the Bitcoin Pizza Day for crypto-fans.
- The Electronic Frontier Foundation, a non-profit group, started accepting bitcoins in January 2011.
- In May 2011, bitcoin payment processor BitPay was founded to provide mobile checkout services to companies wanting to accept bitcoins as a form of payment.
- In June 2011, WikiLeaks and other organizations began to accept bitcoins for donations.In September 2012, the Bitcoin Foundation was launched to “accelerate the global growth of bitcoin through standardization, protection, and promotion of the open source protocol”.
- In October 2012, BitPay reported having over 1,000 merchants accepting bitcoin under its payment processing service.
- In November 2012, WordPress started accepting bitcoins.
- April 2013, Bitcoin gained greater recognition when services such as OkCupid and Foodler began accepting it for payment.
- On 17 May 2013, it was reported that BitInstant processed approximately 30 percent of the money going into and out of bitcoin, and in April alone facilitated 30,000 transactions.
- That same month, The D Las Vegas Casino Hotel and Golden Gate Hotel & Casino properties in downtown Las Vegas announced they would also begin accepting bitcoin.
- On 18 June 2014, it was announced that bitcoin payment service provider BitPay would become the new sponsor of St. Petersburg Bowl under a two-year deal, renamed the Bitcoin St. Petersburg Bowl. Bitcoin was to be accepted for ticket and concession sales at the game as part of the sponsorship, and the sponsorship itself was also paid for using bitcoin.
- In July 2014, Newegg and Dell started accepting bitcoin.
- In December 2014, Microsoft began to accept bitcoin to buy Xbox games and Windows software.
- In February 2015, the number of merchants accepting bitcoin exceeded 100,000.
- In 2015, the MAK (Museum of Applied Arts, Vienna) became the first museum to acquire art using bitcoin, when it purchased the screensaver “Event listeners” of van den Dorpel.
- In November 2016, the Swiss Railway operator SBB (CFF) upgraded all their automated ticket machines so that bitcoin could be bought from them using the scanner on the ticket machine to scan the bitcoin address on a phone app.
- According to Accenture, an application of the diffusion of innovations theory suggests that blockchains attained a 13.5% adoption rate within financial services in 2016, therefore reaching the early adopters’ phase.
Block Rewards: Why do miners do what they do?
Miners mine because they obtain mining rewards for their involvement in the network. The mining reward obtained by the miner who successfully gets to write in the blockchain is a newly minted coin in the system. The rewards paid to miners increase the supply of the cryptocurrency. By making sure that verifying transactions is a costly business, the integrity of the network can be preserved as long as benevolent nodes control a majority of computing power. The verification algorithm requires a lot of processing power, and thus electricity in order to make verification costly enough to accurately validate public blockchain. Not only do miners have to factor in the costs associated with expensive equipment necessary to stand a chance of solving a hash problem, they further must consider the significant amount of electrical power in search of the solution. Generally, the block rewards outweigh electricity and equipment costs, but this may not always be the case. The current value, not the long-term value, of the cryptocurrency supports the reward scheme to incentivize miners to engage in costly mining activities.
Every node in a decentralized system has a copy of the blockchain. Data quality is maintained by massive database replication and computational trust. No centralized “official” copy exists and no user is “trusted” more than any other. Transactions are broadcast to the network using the software. Messages are delivered on a best-effort basis. Early blockchains rely on energy-intensive mining nodes to validate transactions, add them to the block they are building, and then broadcast the completed block to other nodes. Blockchains use various time-stamping schemes, such as proof-of-work, to serialize changes. The growth of a decentralized blockchain is accompanied by the risk of centralization because the computer resources required to process larger amounts of data become more expensive.
Transaction Fees: What will miners do thereafter?
Transaction fees for cryptocurrency depend mainly on the supply of network capacity at the time, versus the demand from the currency holder for a faster transaction. The currency holder can choose a specific transaction fee, while network entities process transactions in order of highest offered fee to lowest as the miners are able to select their batch of unordered transactions from the mempool at their will. Cryptocurrency exchanges can simplify the process for currency holders by offering priority alternatives and thereby determining which fee will likely cause the transaction to be processed in the requested time.
Crypto Exchanges: and who is Sam Bankman Fried?
A cryptocurrency exchange is a platform that allows users to buy, sell, and trade cryptocurrencies. These exchanges typically allow users to exchange one cryptocurrency for another, or for fiat currency (such as US dollars or euros). Cryptocurrency exchanges can be online platforms, mobile apps, or physical locations where users can buy, sell, and trade cryptocurrencies. They may offer a variety of payment methods, such as bank transfers, credit or debit cards, or other digital payment systems. Cryptocurrency exchanges play an important role in the cryptocurrency ecosystem, as they provide a way for users to buy and sell cryptocurrencies and to exchange them for other assets. They also provide a way for users to speculate on the price of different cryptocurrencies, which can be a source of risk and volatility in the market.
There are some globally renowned cryptocurrency exchanges: Binance, Coinbase Exchange, Kraken, KuCoin etc. FTX was one of them that was owned by Sam Bankman Fried that collapsed following defrauding the customers. Bankman-Fried allegedly used billions of dollars of FTX customer funds for his personal use, to make investments and millions of dollars of political contributions to federal political candidates and committees, and to repay billions of dollars in loans owed by Alameda Research, a cryptocurrency hedge fund also founded by the Bankman-Fried. Bankman-Fried also allegedly defrauded lenders to Alameda Research and equity investors in FTX by concealing his misuse of customer deposits in financial information that was provided to them. Still under investigation, Bankman-Fried started lending the funds collected from its customers at FTX to Alameda Research against the security of virtual currencies from Alameda.
Deflationary effect of Crypto
Cryptocurrencies are often designed to have a fixed supply, which means that the amount of the cryptocurrency in circulation cannot be increased. This can make them resistant to inflation, as there is no central authority that can print more of the currency. Moreover some of the crypto in issue gets decreased over time due to loss of the private key, lefts out to get transferred to heirs and so on – leading to net deflationary effect rather than inflation.
There are also purely technical elements to consider. For example, technological advancement in cryptocurrencies such as Bitcoin result in high up-front costs to miners in the form of specialized hardware and software. Cryptocurrency transactions are normally irreversible after a number of blocks confirm the transaction. Additionally, cryptocurrency private keys can be permanently lost from local storage due to malware, data loss, the destruction of the physical media or seizure by the authorities etc. This precludes the cryptocurrency from being spent, resulting in its effective removal from the markets leading to the so-called deflationary effect of the currency – the estimate of the fraud ranging between 8-15 billion USD.
The problem is “double-spending” and the solution is “blockchain”
Double-spending is a potential flaw in a digital cash protocol in which the same single digital token can be spent more than once. Unlike physical cash, a digital token consists of a digital file that can be duplicated or falsified. As with counterfeit money, such double-spending leads to inflation by creating a new amount of copied currency that did not previously exist. This devalues the currency relative to other monetary units or goods and diminishes user trust as well as the circulation and retention of the currency. Fundamental cryptographic techniques to prevent double-spending, while preserving anonymity in a transaction, are blind signatures and, particularly in offline systems, secret splitting.
In a decentralized system, the double-spending problem is significantly harder to solve. To avoid the need for a trusted third party, many servers must store identical up-to-date copies of a public transaction ledger, but as transactions (requests to spend money) are broadcast, they will arrive at each server at slightly different times. If two transactions attempt to spend the same token, each server will consider the first transaction it sees to be valid, and the other invalid. Once the servers disagree, there is no way to determine true balances, as each server’s observations are considered equally valid. Most decentralized systems solve this with a consensus algorithm, a way to bring the servers back in sync. Two notable types of consensus mechanisms are proof-of-work and proof-of-stake.
Blockchain relies on a combination of cryptographic techniques and a decentralized network of computers to prevent double spending. When a transaction is broadcast to the network, it is added to a pool of unconfirmed transactions called the “mempool.” Miners, who are responsible for adding transactions to the blockchain, take transactions from the mempool and validate them. This involves checking that the transaction is valid (e.g. the sender has sufficient funds) and that it has not been previously included in the blockchain. If a transaction is valid, the miner will add it to a block, which is then broadcast to the network. Once a block is added to the blockchain, it becomes very difficult to change or reverse the transactions contained within it. This is because each block in the blockchain contains a cryptographic hash of the previous block, along with a timestamp. If someone were to try to alter a previous block in the chain, it would cause the hash of that block to change, which would also cause the hashes of all subsequent blocks to change.
Since the entire network is constantly updating and reconciling the blockchain, this would be quickly detected and the altered block would be rejected by the network. This makes it very difficult to double spend, as any attempt to do so would require a significant amount of computing power and would be quickly detected by the rest of the network.
But “proof of work” is lackadaisically sluggish
In order to prevent double spending attacks and competing blocks being generated at the same a rare occurrence – blockchains under many cryptocurrency systems are maintained under the proof of work system that is in itself a boon and bane.
In August 2014, the bitcoin blockchain file size, containing records of all transactions that have occurred on the network, reached 20 GB (gigabytes). In January 2015, the size had grown to almost 30 GB, and from January 2016 to January 2017, the bitcoin blockchain grew from 50 GB to 100 GB in size. The ledger size had exceeded 200 GB by early 2020. As per the most recent data as of 2022 the size of the ledger has now exceeded 450 GB. This is becoming more challenging for the nodes to handle.
Alternative cryptocurrencies often have underlying differences when compared to Bitcoin. For example, Litecoin aims to process a block every 2.5 minutes, rather than Bitcoin’s 10 minutes, which allows Litecoin to confirm transactions faster than Bitcoin. Another example is Ethereum, which has smart contract functionality that allows decentralized applications to be run on its blockchain. Networks could consent to have the overall difficulty of the hash identification simpler and thereby easing and expediting the process of writing into the blockchain but it comes with security related issues that we discussed earlier like: double spending attacks, concurrent creation of competing blocks etc. But the problem with the lackluster speed of the finalization of the “proof of work” based blockchain is a real problem. On 24 January 2018, the online payment firm Stripe announced that it would phase out its support for bitcoin payments by late April 2018, citing declining demand, rising fees and longer transaction times as the reasons. Certainly when writing your transaction into the block could take 10 to 15 minutes, crypto payment for a normal morning coffee doesn’t quite make sense.
Cryptocurrencies versus Everyone
Privacy Laws from the past
While privacy laws are important for protecting individuals’ personal information, they can also present challenges for the development of cryptocurrency. Privacy laws can also impact the innovation within the cryptocurrency industry. For example, some privacy-enhancing technologies may be restricted by law, which could limit their development and adoption. Some governments have implemented strict regulations on cryptocurrency in an effort to protect consumer privacy. These regulations can limit the ability of cryptocurrency companies to operate, which can hinder the development of the industry.
The principle of the cryptocurrency’s technology is particularly conflicting with the GDPR laws of the European Union. With the April 2016 adoption of the General Data Protection Regulation in the European Union, questions regarding blockchain’s compliance with the act have arisen. GDPR applies to those who process data in the EU and those who process data outside the EU for people inside the EU. Personal data is “any information relating to an identified or identifiable natural person”. Because identities on a blockchain are associated with an individual’s public and private keys, this may fall under the category of personal data because public and private keys enable pseudonymity and are not necessarily connected to an identity. Such pseudonymity protocols of the decentralized platforms could be viewed as defying the legislative provisions of the country.
While on the other hand, a key part of the GDPR lies in a citizen’s right to be forgotten, or data erasure. The GDPR allows individuals to request that data associated with them be erased if it is no longer relevant. Due to the blockchain’s nature of immutability, potential complications if an individual who made transactions on the blockchain requests their data to be deleted. Once a block is verified on the blockchain, it is impossible to delete it.
There are a number of instances in which hackers have stolen large amounts of cryptocurrency from exchanges. The hacks have occurred since the inception days of the cryptocurrencies and resulted in the loss of millions of dollars worth of various types of cryptocurrency. The exchanges that were hacked include Bitstamp, Mt. Gox, Bitfinex, NiceHash, Youbit, Coincheck, Bitcoin Gold, Coinrail, Bancor, Zaif, Binance, Africrypt, PolyNetwork, Liquid, Cream Finance, BadgerDAO, BitMart, VulcanForge, Qubit Finance, and Wintermute. In some cases, the exchanges were able to reimburse their customers for their losses, while in others the exchanges filed for bankruptcy. It is important for individuals to be aware of the risks associated with using cryptocurrency exchanges and to take steps to protect their assets.
Here is a wikipedia article discussing the crimes related to cryptocurrencies: Cryptocurrency and crime – Wikipedia
Cryptocurrencies are susceptible to hacks for a number of reasons. One reason is that they are based on complex computer algorithms that can be difficult to secure. Hackers can exploit vulnerabilities in the code or find ways to manipulate the system in order to steal cryptocurrency. Another reason is that many cryptocurrency exchanges and wallets are not as secure as traditional financial institutions as the open source principle of the cryptocurrencies are not able to secure much required time and effort for uptodate security protocols. These exchanges and wallets may not have the same level of security measures in place, such as strong authentication protocols or secure infrastructure. As a result, they can be more vulnerable to attacks.
The legal status of cryptocurrencies is contentious in many countries around the globe. Many western countries have accepted the use of bitcoin but only few countries around the world have outright accepted crypto as legal tender. In some countries the legal regime has not been taking pace with the development in the crypto market and thus the interpretations derived from the old laws have been contentious. While some on the extreme end, have imposed some form of full or partial ban on using or storing the bitcoins.
The legislation on the acceptance or ban (partial or full) on the transactions has implications in many laws of the country:
- Whether the cryptocurrencies be treated as cash or investment – will have direct implication in the direct tax applicable on it.
- Whether any form of indirect taxes like (sales or excise taxes) should be applicable on the sale transaction of the cryptocurrencies. Countries like Israel have treated cryptocurrency as a digital product and also imposed it as a sales tax. In the UK crypto are treated as foreign currency and thus are not subject to any indirect taxes.
- Some legislative bans also emerged from the environment’s perspective. The EU had seen the discussions imposing a ban on the cryptocurrencies that use the “proof of work” model as they are known to consume a lot of energy for the mining related computation as discussed above.
- Some legislative bans also emerged from the money laundering and prevention of illegal activities. Many countries around the world have concluded that cryptocurrencies pose challenges to countries in anti-money laundering/counter terrorist financing regulation and supervision.
- Many nations are treading the water with the crypto economy and instead looking into the viability of introducing the central bank backed digital currencies.
- Few legislations (e.g. Australia) have instead treated exchanges and markets of cryptocurrencies as money service businesses requiring legal registrations and many disclosures and KYC requirements defeating the major objective of the cryptocurrency – that is anonymity.
- Some countries have adopted banking related bans in the cryptocurrency where the financial institutions are not permitted to facilitate any cryptocurrency-related transactions although holding, using cryptocurrency outside the banking industry is not considered illegal.
- Some countries like Slovakia have not deemed cryptocurrency as banned and are still treated as currency/coin. By the power of the Central Bank Act – since these currencies are not issued by the central banks and not a part of the convertible foreign currencies – holding, minting or using cryptocurrencies becomes illegal in default.
- In countries like the Central African Republic, El Salvador cryptocurrencies are treated as legal tender.
In the major adopter and market of the cryptocurrency i.e USA – things are quite different. The U.S. Treasury classified bitcoin as a convertible decentralized virtual currency in 2013. The Commodity Futures Trading Commission, CFTC, classified bitcoin as a commodity in September 2015. Per the Internal Revenue Service (IRS), bitcoin is taxed as a property.
See complete list on the legality of the bitcoin here in this particular wikipedia article: Legality of cryptocurrency by country or territory – Wikipedia
Mining has become so absurdly expensive
Due to the use of ASCIs by the miners and the pooling of the mining resources in the network the mathematical exercise to find the hash has become really challenging. Application-specific integrated circuits (ASICs) are microchips that are specifically designed to perform a single task. They are built to optimize a particular function, such as mining cryptocurrency, and are much more efficient at performing that task than a general-purpose microprocessor.
ASICs are used in a variety of applications, including cryptocurrency mining, machine learning, and data processing. They are often preferred over general-purpose microprocessors because they can perform their intended task much faster and with less energy consumption. However, ASICs are also more expensive to produce than general-purpose microprocessors and are less flexible, as they can only be used for their intended task. They also become obsolete more quickly than general-purpose microprocessors, as advances in technology can quickly render them outdated.
It takes an estimated 1,449 kilowatt hours (kWh) of energy to mine a single bitcoin. That’s the same amount of energy an average U.S. household consumes in approximately 13 years. Given the high amount of energy needed to mine bitcoin, it can be a costly venture to get into.
Mining equipment requires a lot of power, and it could cost as much as 73,000 dollars to process a Bitcoin, depending on the electricity costs in one’s area. Many people wonder how many Bitcoins can be mined by a person in a day. There are currently 6.25 bitcoins produced in each block, and a block is produced every 10 minutes. This means that there are 6.25 (Bitcoins per block) x 6 (blocks per hour) x 24 (hours per day) = 900 bitcoins produced each day.
The Old Hangover & New Wash Trading
The “hangover” of traditional, or fiat, currency may be one factor that is hindering the wider adoption of cryptocurrency. Some individuals and businesses may be hesitant to adopt cryptocurrency because they are more familiar with traditional forms of currency and may not fully understand how cryptocurrency works.
In addition, traditional financial systems and infrastructure, such as banks and payment networks, have been in place for many years and are well-established. This can make it difficult for cryptocurrency to gain widespread adoption, as it requires individuals and businesses to change the way they handle and manage their financial transactions. Other factors that may be hindering the adoption of cryptocurrency include regulatory uncertainty, concerns about security and volatility, and the lack of widespread merchant acceptance.
But that is the problem with trying to move into the new cryptocurrency system from the old one. A new discovery with the cryptocurrency is that many people believe that the crypto-trading is rife with wash trading. Wash trading is a process, illegal in some jurisdictions, involving buyers and sellers being the same person or group, and may be used to manipulate the price of a cryptocurrency or inflate volume artificially.
Another problem is the lack of knowledge among the users for the widespread adoption of crypto. Many people either fail to understand the difference between currency and investment, whether the currencies are regulated by the money market, whether the investment they made in the crypto are media enticed or rational decisions and so on. These doubts and lack of knowledge has been persisting even among the most avid liberal crypto adopters.
Some genuine limitations of cryptocurrencies that hinders wider implementation
|Ledger file size||Because of the fact that all transactions since the genesis of the block are recorded in the block the ledger file size has been increasing exponentially. This limits the use of the crypto blockchain as the everyday means of payment. The issue goes well beyond storage capacity, and also extends to processing capacity: only supercomputers could keep up with verification of the incoming transactions. The associated communication volumes could bring the internet to a halt, as millions of users exchanged files on the order of magnitude of a terabyte.||One potential solution to the issue of increasing ledger file size in Bitcoin is to implement a technique called “block pruning.” This involves discarding old, unnecessary block data from the local copy of the blockchain in order to reduce its size. Another potential solution is to implement a “sidechain,” which is a separate blockchain that is pegged to the main Bitcoin blockchain. Transactions that are not critical to the security of the main blockchain can be moved to the sidechain, which would help to reduce the size of the main blockchain. Other potential solutions include increasing the block size limit, implementing more efficient compression techniques, and using off-chain transactions to move some activity off of the main blockchain.|
|Congestion||The scalability of blockchain-based cryptocurrencies can be limited by congestion, resulting in delays in the processing of transactions. In order to limit the number of transactions added to the ledger at any given time, new blocks can only be added at pre-specified intervals. If the number of incoming transactions exceeds the maximum size permitted by the protocol, the system becomes congested and many transactions are placed in a queue. This can result in high fees and long wait times for transactions to be processed, which can hinder the usefulness of cryptocurrencies for everyday transactions. This issue is at odds with an important property of current money, which is that the more people use it, the stronger the incentive to use it.||Increasing the block size limit would allow more transactions to be processed at once. However, this can also lead to scalability issues in the future as the network grows. Another solution is to use “off-chain” transactions, which are transactions that occur outside of the main blockchain. This can help to reduce congestion on the main blockchain by moving some of the transaction activity to a separate, parallel network. Another potential solution is to implement a technique called “sharding,” which involves dividing the blockchain into smaller pieces (called “shards”) and distributing the workload across multiple nodes. This can increase the overall capacity of the network and reduce congestion. Another approach is to build “layer 2” solutions on top of the main blockchain, such as the Lightning Network for Bitcoin. These solutions can allow for more transactions to be processed off of the main blockchain, reducing congestion and improving scalability.|
|Unstable Value||One key issue with cryptocurrencies is their unstable value. This arises from the absence of a central issuer with a mandate to guarantee the currency’s stability. Well run central banks succeed in stabilizing the domestic value of their sovereign currency by adjusting the supply of the means of payment in line with transaction demand. They do so at high frequency, in particular during times of market stress but also during normal times.|
There aren’t any technical solutions to this widespread problem. It could come if the followings can be achieved altogether or at stages:
|Transaction Fees||Although the cryptocurrency mining has an efficient reward system due to the other inherent limitations like limited block size, increased demand or low block rewards the transaction fee for the bitcoin transactions could surge.||Widespread adoption, increased block size, off chain transactions like lightning technology etc could potentially help reduce the high crypto transaction fees.|
|No Shock Absorbers||In a typical monetary market central authority, such as a central bank, is typically responsible for managing the supply of a means of payment (e.g. a currency) in order to keep it in line with transaction demand. This authority is willing to take on risk and potentially incur losses in order to stabilize the value of the currency. In contrast, in a decentralized network of cryptocurrency users, there is no central authority with the incentives or obligation to stabilize the value of the cryptocurrency. As a result, the value of the cryptocurrency may decrease whenever demand for it decreases.||There may not be a potential one option solution for this problem. Widespread adoption of the cryptocurrency could solve this problem.|
|Crypto Proliferation||The rapid emergence of new cryptocurrencies, which are often very similar to one another, can contribute to unstable valuations in the cryptocurrency market. There are currently several thousand cryptocurrencies in existence, and the proliferation of new ones makes it difficult to accurately estimate their total number. The historical precedent of private banks issuing new types of money, as described in the passage, suggests that this liberal issuance of new money does not typically lead to stability.||As this is expected to be a decentralized market gaining the trust of the adopters is the only solution.|
NRB and Crypto: Was outright ban was a right decision?
As discussed above in “Legislative Bans” section – different countries around the world have adopted different forms of adoptions for prohibition on the cryptocurrencies.
Whatever happened in Nepal
Digital currencies have the potential to shape the future of the financial world, but they are still in an experimental phase. Nepal’s economy, which is prone to volatility, has been assumed as not being ready to fully embrace cryptocurrencies. Uncontrolled and unregulated money flow could potentially destabilize Nepal’s economy. Instead of completely banning cryptocurrencies, Nepal’s financial regulators could temporarily suspend their use while studying how the country could potentially benefit from them. India has taken a similar approach, placing cryptocurrencies in a gray area while researching their potential uses. Current financial laws in Nepal restrict the outward flow of money from the country, making it difficult to realize the potential of digital currencies. In order to keep pace with the changing global financial environment, Nepal’s financial laws must be updated to include a regulatory mechanism for digital currencies and their mining. One potential solution is for the government to mine digital currencies and for citizens to create a “recorded and registered” wallet to buy digital currencies from the government and pay fees, similar to paying taxes, to use them.
But as per NRB, According to the Nepal Rastra Bank Act and the 2019 Foreign Exchange Regulation Act, Nepal Rastra Bank has officially declared Bitcoin and other cryptocurrencies as illegal forms of financial tender. Significant events from the crypto related transactions in Nepal were:
- 13-Aug-17: Reiteration by NRB that Cryptocurrency are illegal in Nepal
- 30-Oct-17: Two arrested for operating bitcoin racket – The Himalayan Times
- 9-Sep-21: Reiteration by NRB that Cryptocurrency are illegal in Nepal
Another question we keep asking – and we will discuss further in the “tax and accounting” section below – is whether cryptocurrency should be regulated by central banks or the securities board? If it is not treated as a means of payment but just as a digital token with highly fluctuating value – then by definition it is an investment asset and should this not fall under the purview of the securities board? Or should not any decision for ban/encouragement of the cryptocurrency be made in the mutual consultation of both the entities so that there is minimized risk of “disproportionate restrictions” being imposed when only one sector of the market (i.e. NRB) is involved?
What is the legality of cryptocurrency in India?
In early 2018 India’s central bank, the Reserve Bank of India (RBI) announced a ban on the sale or purchase of cryptocurrency for entities regulated by RBI. In 2019, a petition has been filed by Internet and Mobile Association of India with the Supreme Court of India challenging the legality of cryptocurrencies and seeking a direction or order restraining their transaction. In March 2020, the Supreme Court of India passed the verdict, revoking the RBI ban on cryptocurrency trade.
Link to the Supreme Courts of India’s decision in the case of Internet and Mobile Association of India v. Reserve Bank of India the court bashed down the circular issued by Reserve Bank of India. The circular issued, tends to put a ban on the trading of virtual currencies also known as crypto currencies. The court was of the view that the restrictions imposed by the Reserve Bank of India on banks and other entities in regard to the trading of virtual currency is unfair and therefore declared the restrictions to be unviable on the “grounds of proportionality”.
The issues raised in the the said petition also are relevant questions that we should be asking on the cryptocurrency ban in Nepal:
- Whether the prohibition by NRB has infringed on the Fundamental Right of freedom to trade guaranteed under Constitution or is this prohibition based on the expression of public interest?
- Whether the central bank should get the authority to regulate cryptocurrency or not?
- Whether the decision to prohibit the regulation of cryptocurrency was a matter to be decided by legislation or by executive authority?
We will do a deep dive into the topic in our another post also looking at the court decisions and EU parliaments report on Cryptocurrencies and Blockchain in our another article.
Should Nepal now do what Russia has done?
Russia has a banking ban in cryptocurrencies but mining of the cryptocurrency is legal in Russia. A bill on digital financial assets was introduced in the State Duma on 20 March 2018. It defines cryptocurrency mining as “activities aimed at the creation of cryptocurrency with the purpose of receiving compensation in the form of cryptocurrency.” and treats it as an “entrepreneurial activity subject to taxation if the miner exceeds the energy consumption limits established by the government for three months in a row.” Even when acknowledging that the introduction of the crypto into the country’s monetary system could be disruptive and often with unintended consequences – the mining of the crypto itself does not bring this hassle. Russia being an oil rich country with energy going into excess waste at the drilling zones, a good way to make a use of those wastes is to run power hungry computers to mine the crypto and exchange them for value in the crypto market elsewhere. It is a very perfect balance – keeping in pace with the modern technology while at the same time deferring the disruptiveness of the cryptocurrencies in the monetary market unless more stable technology or regulations are introduced.
Could Nepal do something similar? Especially when we have huge totally renewable hydro energy coming into supply in excess in the next few years. This even adds to building a case for why now the ban of crypto by NRB should be partially lifted considering our economy. Outright total ban was not a good idea by NRB – author’s opinion.
The “Cat Meme” money that is NFT
If we had started this article with just discussing NFT may be my first try to explain this “cat meme” NFT thing would be something like: An NFT, or non-fungible token, is like a special sticker or toy that you can only get one of. It’s stored on something called a “blockchain,” which is kind of like a really big computer that keeps track of things.
But no, since we have already discussed the meaning of P2P network, blockchains, nodes, consensus and all here is what NFT is: An NFT, or non-fungible token, is a type of digital asset that is stored on a blockchain. Unlike other digital assets, such as Bitcoin or Ethereum, which are interchangeable and can be easily exchanged for other assets of the same type, NFTs are unique and cannot be exchanged for other assets in a one-to-one manner. They are often used to represent ownership or authenticity of a digital item, such as a piece of art, a collectible, or a digital asset in a video game.
Because NFTs are stored on a blockchain, they are secured using cryptographic techniques and can be verified as being unique and genuine. This makes them useful for verifying the ownership or authenticity of digital items, as well as for tracking the ownership and provenance of these items over time. Some common use cases for NFTs include art auctions, collectibles, and gaming items.
One important aspect of NFTs is that they are non-fungible, which means that they cannot be replaced or exchanged for other assets in a direct, one-to-one manner. This is in contrast to fungible assets, such as cryptocurrencies, which can be easily exchanged for other assets of the same type. This non-fungibility is what gives NFTs their unique value and makes them useful for representing unique or rare digital items. For example, imagine that you own a rare baseball card. This baseball card is unique and has a certain value because it is one-of-a-kind. You could not easily exchange it for another baseball card or for something else of equal value, because it is non-fungible. In contrast, something that is fungible, like a dollar bill, can be easily exchanged for something else of the same type (e.g., another dollar bill) or for something of equal value (e.g., four quarters).
💡That aside – what gives this “cat meme” a silly million dollar value? Well nothing. The same could be asked for what gives the value to the “Mona Lisa” art? Although it is priceless and not up for sale – bids put it somewhere in the range of a billion dollars? What gives? See there is no answer to that. If a sufficient group of people think a “digital token” for “cat meme” is valuable – the “cat meme” is valuable. It’s just that the ownership is in the not immutable digital format rather than being a tangible format.
💡And about this “cat meme” NFT – Why would you pay for it – when you can watch it for free? The same question goes for the “Mona Lisa” art too. Why pay?
💡So can I create a NFT of Mona Lisa and sell it? What is the difference between a Mona Lisa NFT created by me or by the Louvre Museum themselves?
It is possible to create an NFT of a digital version of the Mona Lisa or any other artwork. This could include digital copies of artwork, photographs, videos, music, or other types of digital media. However, it is important to note that creating and selling an NFT of someone else’s artwork or other intellectual property may infringe on their copyrights or other rights. In general, it is a good idea to obtain permission from the copyright owner before creating and selling an NFT of their work. It is also worth considering that the value of an NFT may depend on its authenticity and provenance. If you create an NFT of a digital copy of the Mona Lisa, it may not be perceived as being as valuable as an NFT created and authenticated by the Louvre Museum or another reputable institution that holds the original artwork.
💡See the entire transaction history and bid of the CryptoPunk 3100 NFT
💡So does it make sense to remain anonymous in the blockchain if you are purchasing a NFT? Like our previous answer it is comparable to buying an artwork (a digital kind). So it is entirely up to you to disclose your credentials in the blockchain, disclosing who you are or leaving it to the private announcement with your close friends at the home party and remaining anonymous in the blockchain. It’s entirely your decision. Most NFTs are created in ethereum’s NFT blockchain. Browse them here: Link to NFT Explorer
Accounting and Taxation of Crypto
Summary from Applying IFRS Accounting by holders of crypto assets by EY:
- In order to be considered cash, a crypto-asset would need to be generally accepted as a medium of exchange and considered a suitable basis on which a holder could measure and recognise all transactions in its financial statements. Where cryptocurrency is recognized as legal tender it invariably is a “cash”. But in absence of the recognition as a legal tender they do not typically meet the definition of “cash equivalent” as their value changes are extremely volatile.
- Many crypto-assets would meet the relatively wide definition of an intangible asset. Crypto-assets generally meet the relatively wide definition of an intangible asset, as they are identifiable, lack physical substance, are controlled by the holder and give rise to future economic benefits for the holder.
- Some entities could hold crypto-assets for sale in the ordinary course of business and, as such, would be able to recognise these as inventory. Commodity broker-traders, who acquire and sell crypto-assets principally to generate profit from fluctuations in price or broker-traders’ margin, also have the option of measuring their crypto-asset inventory at fair value less costs to sell.
- Some contractual crypto-assets could meet the definition of a financial asset if: they entitle the holder to cash, another financial instrument, or the right to trade financial instruments under favorable terms; or they are, in effect, electronic share certificates that entitle the holder to the net assets of a particular entity.
- Some contracts to trade crypto-assets are accounted for as derivatives, if the contract can be settled net or if the underlying crypto-asset is readily convertible to cash, despite the crypto-asset itself not being a financial instrument, provided that certain criteria are met.
Regarding taxation of cryptocurrency – which was discussed in the “legislative ban” section above – it mainly depends on whether cryptos are viewed as currency or investment. When viewed as currency their sale, purchase, price fluctuations are treated as realized currency exchange loss/gain and accounted for taxes as and when they occur. Whereas when viewed as investment taxation would apply on the investment assets only at the time of realization – under the purview of the Income Tax Act, 2058 of Nepal.
Regarding Indirect taxes – when viewed as currency – currency itself is a mode of transaction and not any good/service so indirect taxes would not principally apply. But when cryptocurrencies are viewed as digital tokens (a goods / service in kind) – jurisdiction may apply indirect taxes on the cryptocurrencies – as Israel has adopted.
Many jurisdictions who have legalized cryptocurrencies as a form of investment do face a struggle to bring it into the tax purview because the transaction in bitcoin is by principle designed to be anonymous. Especially those who engage in many microtransactions do not report their crypto earnings in their tax filings. In attempts to enforce these rules and avoid potential tax fraud, revenue department has called on crypto currency exchanges and users to report users who have sent or received more than a certain threshold of amount in filings but this in principle again defeats the principle of anonymity and decentralization – upon which the crypto currencies are built. Any step that authorities try to regulate crypto will in default be seen as the perfect opposite to cryptocurrency philosophy. So it has developed its reputation as the “currency of anarchists”.
Some interesting FAQs in Crypto Economy
Why does Bitcoin have a theoretical cap whereas Ethereum doesn’t?
Bitcoin has a theoretical maximum supply of 21 million bitcoins, which is expected to be reached around the year 2140. This cap was built into the Bitcoin protocol to ensure that there is a limited supply of bitcoins and to prevent inflation. On the other hand, Ethereum does not have a maximum supply limit. The Ethereum protocol was designed to allow for the creation of new Ethereum tokens over time. This is done through a process called “mining,” in which new Ethereum tokens are released as a reward for validating transactions on the Ethereum network.
The decision to include a maximum supply limit in the Bitcoin protocol was made in order to mimic the scarcity of physical commodities, such as gold. Ethereum, on the other hand, was designed to be more flexible and to allow for the creation of new tokens to meet the needs of the network. This difference in design is one of the reasons why Bitcoin and Ethereum have different supply limits.
Does this mean new Ethereum coins will be issued unlimitedly into the future? Although it is theoretically possible for an unlimited quantity of Ethereum tokens to be issued over time new tokens are released through a process called “mining,” in which miners validate transactions on the Ethereum network and are rewarded with a certain number of Ethereum tokens. The rate at which new Ethereum tokens are released is controlled by the Ethereum protocol and is designed to decrease over time. Whereas for Bitcoin the underlying reasoning of the limitation on the number of the currency goes well beyond the economics – this limitation is expected to bring stability, value and trust in the bitcoin network.
Additionally there is a limit in the size of the block in the bitcoin blockchain. What is the reason for this? Each block contains information about who sends and receives a given unit of bitcoin (a transaction), as well as the signature that approves each transaction. Originally, there was no limit to the size of blocks. However, this allowed malicious actors to make up fake “block” data that was very long as a form of denial-of-service attack (DoS attack). These fake blocks would be detected, but doing so would take a very long time, slowing down the whole system.
Bitcoin’s transaction throughput is limited by two parameters: (i) the block time determines how often a new block is added to the chain, (ii) the block size determines the amount of data that can be added with every block. Bitcoin has a block time of 10 minutes and a block size of 1MB.
Hardforks and Softforks of Crypto
Hard forks and soft forks can be used to add new features to a blockchain, to reverse transactions (in the case of a blockchain that allows for reversibility), or to address security vulnerabilities. They are an important part of the process of updating and improving blockchain networks.
A hard fork is a change to the blockchain protocol that is not backwards compatible. This means that in order for the changes to be implemented, all nodes on the network must upgrade to the new version of the protocol. If some nodes do not upgrade, they will be unable to validate transactions and will be effectively “forked off” from the main network. A soft fork, on the other hand, is a change to the blockchain protocol that is backwards compatible. This means that nodes on the network can choose whether or not to upgrade to the new version of the protocol. If some nodes do not upgrade, they will still be able to validate transactions and will remain part of the main network.
For example, Ethereum was hard-forked in 2016 to “make whole” the investors in The DAO, which had been hacked by exploiting a vulnerability in its code. In this case, the fork resulted in a split creating Ethereum and Ethereum Classic chains. A more recent hard-fork example is of Bitcoin in 2017, which resulted in a split creating Bitcoin Cash. The network split was mainly due to a disagreement in how to increase the transactions per second to accommodate for demand.
The waste of energy: Is this true?
The passage discusses the high energy consumption of certain cryptocurrencies, particularly those that use proof-of-work (PoW) consensus algorithms, such as Bitcoin and Ethereum. These cryptocurrencies require a large amount of energy to validate and verify transactions through the process of “mining,” in which miners compete to add new blocks to the ledger. This energy consumption has been criticized as a waste of resources and has led to the release of significant amounts of carbon dioxide. In contrast, some newer cryptocurrencies, such as Cardano, Solana, and Polkadot, use proof-of-stake (PoS) consensus algorithms, which are less energy-intensive. In 2021, a study by Cambridge University found that Bitcoin’s energy consumption was on par with that of entire countries such as Argentina and the Netherlands, and in March 2021, Bill Gates called Bitcoin “not a great climate thing” due to its energy consumption. Some cryptocurrency developers are considering switching to “Proof of Stake” from “Proof of Work” algorithms to address this issue.
See the detailed wikipedia article here: Environmental impact of Bitcoin – Wikipedia
What is the Ethereum Merge?
Ethereum merge is the transition of the Ethereum cryptocurrency from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) mechanism. In a PoW system, miners compete to solve math equations and add new blocks to the blockchain, while in a PoS system, node operators stake a certain amount of the cryptocurrency as collateral in order to become network validators and earn rewards. The transition to PoS is intended to increase decentralization, improve security and scalability, and reduce energy consumption by 99% and inflationary growth of Ethereum.
There are certain risks associated with switching to PoS algorithms of writing blockchain. One risk is the possibility of a denial-of-service (DoS) attack, in which a potential attacker could disrupt the network proposer and potentially gain control of transactions. Another risk is the centralization of staked ETH in staking pools, which could lead to the concentration of validator nodes under the influence of centralized entities and increase the risk of censorship or governance takeover.
Lightning Network finally makes Bitcoin Scalable?
The Lightning Network is a layer on top of the Bitcoin blockchain that allows for fast, cheap, and scalable transactions. It is designed to allow users to send and receive Bitcoin payments quickly and without incurring high fees, even when the main Bitcoin blockchain is congested.
The Lightning Network works by creating payment channels between two or more parties. These channels can be used to send unlimited amounts of Bitcoin back and forth between the parties without the need to record each transaction on the blockchain. When the parties are finished using the payment channel, they can close it and the final balance is recorded on the blockchain. This process allows for fast, low-cost transactions that do not contribute to blockchain congestion.
The Lightning Network is still an experimental technology and is not yet widely used, but it has the potential to significantly improve the scalability and usability of Bitcoin for everyday transactions. Lightning network could potentially improve the scalability of the Bitcoin network because as of now when VISA is able to process 4,000 transactions per second the capacity of Bitcoin network is limited only to 7 transactions per second. Lightning network could add new separate chain for small trivial payments and at a certain time they get written into the main blockchain.
Are escrow transactions possible in cryptocurrency?
A multisignature (also known as “multisig”) digital wallet is a type of cryptocurrency wallet that requires more than one private key to authorize a transaction. This can be seen as an added security measure, as it means that multiple parties must agree to a transaction before it can be completed. In a multisig wallet, the wallet owner can specify how many private keys are required to authorize a transaction and who has access to each key. For example, a wallet owner might specify that three keys are needed to authorize a transaction, and provide one key to each of three different trusted parties. In this case, all three parties would need to agree to a transaction before it could be completed. Multisig wallets can be useful for organizations or groups that want to ensure that multiple people are involved in managing and approving transactions. They can also provide an added layer of security by requiring multiple keys to be compromised before a transaction can be made.
Multisig technology can be used to secure escrow transactions by requiring multiple keys to authorize the release of funds. For example, in a multisig escrow transaction, the escrow agent might hold onto the funds and require two out of three private keys to authorize their release. One key might be held by the buyer, one key by the seller, and one key by the escrow agent. This would ensure that all parties involved in the transaction must agree before the funds can be released.
How does Web 3.0 tie in?
Web 3.0, also known as the “Semantic Web,” is a concept that refers to the next generation of the Internet, in which machines and systems will be able to understand and interpret the meaning of the data that is shared online. This will be made possible through the use of advanced technologies such as artificial intelligence (AI), machine learning, and natural language processing (NLP).
Cryptocurrencies and blockchain technology are expected to play a significant role in the development of Web 3.0. One of the key characteristics of cryptocurrencies is their decentralized nature, which means that they are not controlled by any central authority or organization. This decentralized structure allows for the creation of a more open and transparent Internet, where data can be shared and accessed by anyone without the need for intermediaries. In addition, cryptocurrencies and blockchain technology can be used to create secure and transparent online systems for storing, sharing, and accessing data. For example, blockchain-based systems could be used to store data about the ownership and provenance of digital assets, such as music, art, or other types of intellectual property. This could help to create a more transparent and fair system for artists and creators to monetize their work online.
Will blockchain interoperability / standardization ever be possible?
As it had happened with the proliferation of private banking during the old days – interoperability between the different blockchains serving similar needs could help build trust in the system. Interoperability between different blockchain platforms, which refers to the ability of different blockchains to communicate and exchange data with one another, is an area of active research and development in the blockchain industry. There are a number of challenges that need to be addressed in order to achieve interoperability between different blockchain platforms, including differences in the underlying protocols, consensus mechanisms, and data structures used by different blockchains.
Despite these challenges, there are a number of initiatives and projects that are working towards achieving interoperability between different blockchains. For example, there are a number of projects that are developing interoperability protocols, such as Cosmos and Polkadot, that aim to enable different blockchains to communicate and exchange data with one another. There are also initiatives that are focused on developing cross-chain technologies, such as atomic swaps and hash time-locked contracts, which can enable the exchange of assets between different blockchains without the need for a trusted third party. It is likely that interoperability between different blockchain platforms will be achieved to some degree in the future, but it is still an active area of research and development and there is much work that needs to be done in order to achieve full interoperability between different blockchains.
In April 2016, Standards Australia submitted a proposal to the International Organization for Standardization to consider developing standards to support blockchain technology. This proposal resulted in the creation of ISO Technical Committee 307, Blockchain and Distributed Ledger Technologies. The technical committee has working groups relating to blockchain terminology, reference architecture, security and privacy, identity, smart contracts, governance and interoperability for blockchain and DLT, as well as standards specific to industry sectors and generic government requirements. More than 50 countries are participating in the standardization process together with external liaisons such as the SWIFT, EU Commission, ITU and UNECE.
Everything that can be tokenized – will be tokenized
Tokenization refers to the process of converting real-world assets or liabilities into a digital representation, or token, on a blockchain. This can be applied to various types of assets, such as contracts, securities, supply chain management, domain names, patents and copyrights, peer-to-peer energy trading, notarization, and identity verification. Tokenization allows for increased efficiency, transparency, and security in the handling and transfer of these assets. It also has the potential to disrupt traditional intermediaries and market structures in various industries. There are several companies and organizations working on implementing and advancing the use of tokenization in different sectors.
Many things that can be tokenized as a “digital asset” could benefit from blockchain due to the decentralization and security offered by the blockchain. These could include:
- Creation of Smart contracts
- Recording of investment instruments in blockchain disrupting the securities trading market
- Trade of non fungible precious commodities, artifacts and metals
- Protection of digital property like designs, codes, arts etc
- Alternative to the current domain name systems served through decentralized blockchain
- Many platforms for P2P trading that could be industry/profession specific
- Document hashes and notarization/verification industry
- Interbank settlement system of the of the private banks
Central Bank Digital Currency
A central bank digital currency (CBDC) is a digital version of a country’s fiat currency, issued and backed by the central bank. It is intended to be used as a means of payment in the same way as traditional fiat currencies, and can be used by individuals, businesses, and financial institutions. CBDCs are different from cryptocurrencies such as Bitcoin, as they are issued and backed by a central authority and are not decentralized. Some of the potential benefits of CBDCs include faster and cheaper payment processing, increased financial inclusion, and improved monetary policy transmission. However, there are also potential risks and challenges associated with the implementation of CBDCs, including cybersecurity threats and the potential impact on the stability of the financial system.
Considering the global context of study regarding the usage and feasibility of digital currency, Nepal Rastra Bank (NRB), in its Monetary Policy 2021/22, had also announced to conduct a study on CBDC in Nepal. A high-level CBDC steering committee headed by the Deputy Governor was formed to steer preliminary studies, plans, and activities relating to CBDC.
The committee created a study task force of officials from different related departments to prepare a concept report on CBDC. Here is a link to the consultation paper released by NRB on the implementation of the CBDC system in Nepal: Central Bank Digital Currency (CBDC): Identifying appropriate policy goals and design for Nepal
Although it seems that the central banks have been motivated to explore CBDC to find a better way to meet their key policy goals such as improving access to payments, promoting financial inclusion, enhancing the resilience of the payment system, safeguarding the central bank’s monetary sovereignty, reducing currency management costs, enhancing the efficiency of the cross-border payment system, promoting financial transparency, improving monetary policy transmission mechanism, promoting financial stability and supporting the government for welfare distribution – there are widespread concerns on the negative or imposing implication of them on the general public.
We will discuss them in the form of FAQs that gets randomly thrown around in the context of CBDCs, cryptocurrency and this frontier Web 3.0 technology:
How does CBDC differ from Traditional Money, Crypto, Digital Wallet, or E banking?
- CBDC although being issued by central banks and backed by the same securities that the traditional currencies usually are – there is no need to print or mint CBDCs like traditional currencies.
- CBDC is different from cryptocurrencies in that it is issued and backed by a central bank, whereas cryptocurrencies are decentralized and not backed by any central authority.
- CBDC is also different from digital wallet services like esewa. Digital wallet services are private payment systems that facilitate the transfer of traditional currencies held in financial institutions.
- Clearing institutions like Connect IPS, FonePay etc are part of the monetary system but are not directly related to the currency market as they are involved in the clearing and settlement system.
- CBDC is similar to e-banking in that it allows for the electronic transfer of funds, but it is a form of government-issued currency rather than a banking service provided by the financial institutions of the monetary market.
What are the benefits of implementing CBDC in Nepal?
Improving access to payments
Many central banks see CBDC as a means of enhancing access to payment services for the unbanked, i.e., those without access to a transaction account. Some countries are worrying about the declining use of cash and increasing dependence of people on private monies as this could lead to difficulty in accessing payments when sudden disruptions occur in the payment and settlement systems. Therefore exploring if a CBDC could help achieve or safeguard universal access to payments could be one benefit.
Promoting financial inclusion
Average global smartphone penetration is over 80 percent. As CBDC uses a digital platform, it is easier for central banks to facilitate the delivery of financial inclusion products in a targeted and quicker way. A mere bank account could also facilitate the delivery of financial services, in critical periods such as natural disasters, the digital platform acts faster and more resilient than cash.
Enhancing resilience of the payment system
Central banks manage physical currencies by setting up various currency chests in different parts of the country and conducting frequent currency transfers to these chests. However, during critical situations such as natural disasters, currency transfers might be impeded. Though private e-monies (regulated) might help people get access to payments, these are not always resilient means. This is where CBDC could benefit users.
Safeguarding the central bank’s monetary sovereignty
Retaining the monetary sovereignty of central banks challenged by private e-monies, declining the use of cash and the rise of decentralized currencies has also been another key motivation for the exploration
Reducing currency management costs
The management of fiat currency is expensive, particularly in developing countries, due to the costs of distribution, security, safety, and reliance on bank branches. CBDC can lower the cost of maintaining the supply of physical currency and protect it from counterfeiting risks.
At least one percent of the GDP is spent in management of the traditional currencies.
Enhancing the efficiency of the cross-border payment system
CBDC is expected to bring cross-border payments efficiency by simplifying intermediation chains, increasing speed, and lowering costs. Cross border payment are challenging and inefficient due to high
cost, low speed, limited access, insufficient transparency, fragmented and truncated data formats, complex processing of compliance checks, limited operating hours, legacy technology platforms, long transaction chains, high funding costs, and weak competition etc. CBDC is likely to reduce the cost of sending remittances and save billions of dollars each year. The average cost of sending remittances remained at an average of 4.5% percent in Nepal during the last recent periods.
Promoting financial transparency
The widespread use of CBDC, and the obsolescence of paper currency, would discourage tax evasion, money laundering, and other illegal activities that are made easier by paper currency, especially, large-denomination bills.
Improving monetary policy transmission mechanism
Central banks use benchmark policy rates to show their monetary policy stance, which can influence other interest rates in the economy, the exchange rate, and the prices of some assets. The zero lower bound (ZLB) constraint refers to a situation in which central banks cannot stimulate demand by further lowering short-term interest rates because market participants would prefer to hold cash instead of investing at negative rates. The exploration of central bank digital currencies (CBDCs) has focused on overcoming the ZLB constraint in order to make monetary policy more effective. Some see CBDCs as a way to strengthen monetary policy transmission mechanisms and eliminate the effective lower bound on interest rates, while others see CBDCs as a way to remove the ZLB constraint and increase the central bank’s control over the interest rate.
Promoting financial stability
Central banks have a mandate to ensure financial stability, which refers to the smooth functioning of the financial system and its ability to withstand shocks without disruption. Some central banks have explored the use of central bank digital currencies (CBDCs) as a means of supporting financial stability by promoting the adoption of digital payments, improving anti-money laundering efforts, and supporting banks’ ability to finance the economy. Some studies have shown that a carefully designed CBDC may actually decrease financial fragility rather than increase it. However, switching from deposits to a CBDC may initially create a shortage of cash reserves for banks, potentially leading to panic or a bank run. Once the central bank lends an equal amount of CBDC to banks as the deposits in CBDC accounts, the quantity of CBDC increases and does not require reserve holdings, potentially enhancing financial stability by increasing the supply of private credit and lowering nominal interest rates.
Supporting government for welfare distribution
CBDC is being explored by some central banks as a way to quickly deliver government stimulus payments to the public during crises in a targeted manner, particularly in island states that are at high risk for disasters such as rising sea levels. These transfers can be “programmable,” with conditions such as expiration or requirements to spend the funds at specific vendors or within specific time. CBDC can also be used to increase financial inclusion, growth, competitiveness, and resilience for citizens.
But do we as public really want the “CBDC” system?
There are concerns that government use of central bank digital currency (CBDC) could potentially be used to control people or infringe on their property and privacy. There are several skepticism or doubts in the CBDC system.
Adequate legal and regulatory framework
There are legal and regulatory questions surrounding the issuance of central bank digital currency (CBDC), including whether central banks have the authority to issue digital currency and whether it should be considered legal tender. 85% of central bank laws among International Monetary Fund member countries limit the power to open cash current accounts to a limited category of institutions, while a minority allow for the opening of current accounts to the broader public. Some argue that central banks with explicit power to open cash current accounts for the state and financial institutions could offer account-based CBDC to them within the same laws, and vice versa in the case of individuals. However, if the central bank law is silent on opening current accounts, it may be implied once a critical mass of central banks issue account-based CBDC to the general public.
Capacity development and restructuring at central banks
Central banks need to have the necessary regulatory expertise and technological capacity in order to implement and effectively manage a central bank digital currency (CBDC) project. This might involve central banks taking time to learn technological implications, policy implications, forming research committees or reprioritizing the work of existing staff.
Developing required infrastructure
Central banks need to have the necessary technical and regulatory expertise and infrastructure in place before launching a CBDC. This includes telecommunications, software, authentication, cybersecurity, operational risk mitigation, and other technical capacities. The CBDC system may also be vulnerable to outages in electricity and internet connections, and risks of failures of these services. It may be necessary for central banks to have the technical and technological know-how to deal with these issues in order to ensure the success and stability of a CBDC system.
Enhancing public adoption
CBDC must be widely adopted by the public in order to be successful. Factors that contribute to this include the ability to meet unmet user needs, achieve network effects, and utilize existing technology and infrastructure. Central banks should design CBDC with peer-to-peer functionality to facilitate adoption, and should consider promoting adoption and training campaigns to help certain groups in society, such as those with lower levels of financial education or those in the shadow economy, to use digital solutions. Public authorities can also help facilitate adoption by disbursing social benefits and transfers in CBDC or allowing consumers to pay taxes in CBDC.
CBDC may lead to a reduction in the balance sheets of commercial banks and an increase in the balance sheet of the central bank. This could lead to an increase in the cost of credit for consumers as commercial banks may have to raise interest rates on deposits and borrow more from the central bank, leading to a decrease in banking activity. The rise in credit costs will lower bank banking. If the disintermediation is severe, banks then seek to borrow from central banks expanding the central bank’s balance sheet.
CBDC could be convenient only for tech-savvy citizens if not designed around the poor and technically lagged people. The rise in the mobile phone penetration rate in developing countries does not ensure that people get access to financial inclusion products as the majority of them carry normal cell phones that are cheaper but not smarter. So, CBDC should also be designed to promote people’s access to financial inclusion products through feature phones.
Data exposure and breach
CBDC could potentially lead to increased access to personal financial data by central banks and financial intermediaries, which could raise concerns about privacy and data protection. The use of transactional data for credit evaluation and cross-selling initiatives could also be a potential issue. Additionally, the potential for pressure from agencies investigating cases of corruption and money laundering to access this data may discourage the use of CBDC by the general public.
Operational failure of the system
Central banks need to consider the risk of cyber attacks and technical failures when implementing a CBDC system. It is important to put in place proper controls and processes to mitigate the risk of large-scale attacks from advanced persistent threats, and to continuously monitor for threats. Technical issues, such as expiring identity certificates, can also lead to operational failures of the system.
Adoption of inappropriate technology
Central banks need to carefully consider the technology they use for CBDC, as it must be scalable, secure, low-latency, and privacy-preserving. The choice of technology is important as central banks may be responsible for various aspects of the payments value chain, including customer interface, technology maintenance, and transaction monitoring. If any of these functions are not satisfied, it could harm the reputation of the central bank. The field of CBDC research is still young and there are limited examples or testing at scale, so it is important for central banks to carefully evaluate their options.
Impact on central bank’s seigniorage
Central bank seigniorage is the income earned by central banks from issuing banknotes, holding foreign exchange reserves, investing, and buying bonds as part of asset purchase programs. Seigniorage income is generated when central banks lend money to commercial banks in the form of cash and reserves and receive assets in exchange, which they then invest or earn interest on. The use of CBDC could reduce seigniorage income for central banks and potentially lead to a reliance on government funding, which could undermine their autonomy. A significant decline in the use of banknotes, especially higher denominations, could also lead to a decrease in seigniorage income.
Impact on numismatic activities
Numismatics, or the study of old and rare currencies, may be impacted by the issuance of central bank digital currencies (CBDCs). Physical currencies can help researchers study the monetary and political history of a country, and their rarity adds value to collectors. The issuance of CBDCs may lead to a decrease in the availability of physical currencies, which could have an impact on numismatics. Some experts suggest that the European Union should review their legal acts to regulate the issuance of digital collector coins in order to take advantage of new technologies.
CBDCs may be privacy invasive because they can potentially allow central banks and financial intermediaries to have access to a large amount of personal financial data. This data could potentially be shared with agencies investigating cases of corruption, money laundering, and terrorism financing. This could discourage people from switching to CBDC from physical cash, as they may be concerned about their privacy. Additionally, the design of CBDC systems could worsen privacy and data protection issues if transactional data is unlawfully used for credit evaluation and cross-selling initiatives.
Risk of Seizure and Financial Censorships
It is possible that a government or law enforcement agency may attempt to seize or freeze the funds held in a CBDC account as part of an investigation or legal action. To minimize the risk of seizure and for the popular adoption of CBDCs it is better if they can be operated with pseudonymous or anonymous accounts. It is also important for the central bank to have clear and transparent policies in place for handling cases where the seizure of CBDC funds is deemed necessary, to ensure that these actions are carried out in a fair and transparent manner – otherwise it may just be a tool for the power peddling tool for the government for financial censorships.