By Shiv Kumar Bhasin, CTO, State Bank of India
In the wake of significant spurt in valuation of bitcoins, the Reserve Bank of India says that it has not given any license/authorization to any entity / company to operate such schemes or deal with bitcoin or any virtual currency.As such, any user, holder, investor, trader, etc. dealing with Virtual Currencies will be doing so at their own risk.
The RBI stated five major risks of trading in bitcoins. The first is the fact that digital currencies, being in electronic format, are prone to losses arising out of hacking, loss of password etc. The second risk is the lack of any authorized central agency to regulate the payments or to turn to for redressal of grievances. The third is that there is no underlying of asset for VCs, making the value a matter of speculation. Fourth is that the exchanges are located in various parts of the world, making the law enforcement a tricky thing for the multiple jurisdictions available. Fifth is that trading may subject the user to illicit and illegal activities since the VCs, can easily be used for illegal activities anonymously.
It is a concern that the public may be attracted to invest in cryptocurrencies, such as bitcoin, due to the recent escalation in their prices. However cryptocurrencies are not legal tender.
Cryptocurrencies are not issued by any government and are not backed by any asset or issuer. The recent surge in the prices of cryptocurrencies is driven by speculation. The risk of a sharp reduction in prices is high. Investors in cryptocurrencies should be aware that they run the risk of losing all their capital.
Worries about a bitcoin bubble has been growing as its price has risen some 1,700 per cent since the start of 2017 to as high as US$19,666 on last Sunday.
Bitcoin has no natural intrinsic value. Can you buy a house with it? Can you use it for daily interactions? It may be valued at US$18,000 right now but what I want to know is how you convert it into fiat currency and realise that value. The risk comes at the moment of conversion. Anxiety is mounting as mainstream exchanges launch bitcoin contracts, lending them an air of legitimacy.
Some of the world’s largest derivatives exchange operators are launching bitcoin futures trading, seeking to capitalise on the mania for the booming digital currency. But exchanges can also be dicey. As most operators of platforms on which cryptocurrencies are traded do not have a presence in India, it would be difficult to verify their authenticity or credibility. There is greater risk of fraud when investors deal with entities whose backgrounds and operations cannot be easily verified.
Cryptocurrency transactions are generally anonymous, which makes them vulnerable to being misused for unlawful activities. Would digital currency exchange businesses will be subject to Anti-Money Laundering, Anti-Terrorism Financing and other legal & regulatory frameworks? If a cryptocurrency intermediary is found to have used cryptocurrencies illegally, its operations could be shut down by law enforcement agencies. There is also a risk of loss should the cryptocurrency intermediary be hacked, as it may not have sufficiently robust security features.
Warning that investors could be left high and dry, Members of the public who lose money from investing in cryptocurrencies will not be able to rely on any protection afforded under legislation administered by Regulatory bodies in India.
What is Bitcoin?
Bitcoin is global, borderless money which anyone with an internet connection can use. It is an electronic cash system. It allows for people to move bitcoins, the currency of Bitcoin, between each other without using a bank or any other trusted third party. It resembles traditional bank notes and coins in that way, but it is purely electronic and used over the Internet. The Bitcoin currency is not tied to any specific fiat currency like the US dollar or the Indian Rupees; It has free floating exchange rates against all fiat currencies. You can buy and sell bitcoins for fiat currencies on several exchanges. No government or company is controlling Bitcoin. Instead, thousands of computers around the globe, the Bitcoin network, collectively keep the system working day and night, seven days a week. You don’t need to register or sign up anywhere to use Bitcoin, you just need a computer program, like a mobile app to use it.
There are number of cryptocurrencies available over the internet, so far thereare over 1324 cryptocurrencies and growing. A new cryptocurrency can be created at any time. By market capitalization, Bitcoin is currently the largest blockchain network, followed by Ethereum, Bitcoin Cash, Ripple and Litecoin.
Bitcoin is used by many different actors, like savers, merchants, traders for many different purposes like payments, remittances and investments. A network of computers, the Bitcoin network, validate and keep records of all payments.It solves problems with inflation, borders, segregation and privacy by providing limited supply, decentralization and borderlessness.
Inflation means that the purchasing power of a currency decreases.
Problems with Traditional Financial System
Bitcoin solves several problems with the traditional financial system.
Most currencies are subject to inflation. Some more than others. For example the Zimbabwean dollar during 2007-2008 inflated nearly 1023%, peaking at 80 billion percent per month during a few months in 2008. That is an average daily inflation rate of nearly 100%. Prices roughly doubled every day. Extreme cases of inflation like this are called hyperinflation. Hyperinflation is usually driven by a rapid increase in the money supply. Government sometimes increase in money supply as a tool to extract value from its population to pay for expenses like national debt, warfare or welfare. If this tool is over-used, the risk of hyperinflation is apparent. An increasing money supply will most likely lead to a depreciation of the currency. This in turn pushes people to exchange their local currency for goods or currencies that better holds value, which further drives the value of the currency down. This can spiral down to extremes like in Zimbabwe. The result is devastating for people as they see their life savings diminish to virtually nothing.
Moving value across national borders using fiat currency is hard, expensive and sometimes even forbidden. There is cross boarder remittance fees & charges etc. paid by the remitter to his/her remitting bank.
To contrast the above, moving fiat currency within the borders of a nation state is usually very convenient. For example, you can hand over cash directly to the recipient, or transfer money using some mobile app made specifically for the currency. As long as you stay within one country and one currency, fiat currencies usually does a pretty good job.
This segregation between banked people and unbanked people is driven by a number of factors: Banking services are too expensive for a large portion of the population. In order to use bank services you need documentation, like an ID card, that many people don’t have.
Virtual Currencies offer many potential benefits, including greater speed and efficiency in making payments and transfer–particularly across borders–and ultimately promoting financial inclusion.
Cross Border benefit led to the case with Coins, a mobile-first, blockchain-based platform that facilitates cheap remittances& promotes financial inclusion, bill payments and mobile airtime top-ups.
One of the important ways to increase financial inclusion is facilitating the transition from people being purely cash-based to be able to access and use [their] money online. In this regard, cryptocurrencies work very well as railways for seamless fund transfers and being able to pay for services
Apart from the huge problems in the previous sections there are several other problems with traditional money. Governments, regulators, and law-enforcement agencies can easily – trace/censor payments, freeze/seize funds.
Bitcoin Differences over Traditional Finance
Bitcoin offers a fundamentally different model than traditional financial institutions. Let us explore the major differences one by one.
Instead of a central organization controlling the currency, like the Reserve Bank of India, the control is distributed among thousands of computers, called Bitcoin nodes. No single node or group of nodes have more privileges or obligations than any other node. This equality between nodes makes Bitcoin decentralized, as opposed to centralized systems like an Internet Bank service or the Google search engine.
In a centralized system, the service is controlled by a single entity like a Regulator/Bank. It implies that this single entity can decide who gets to use the service and what the user is allowed to do.
With a decentralized system like Bitcoin it is extremely hard to control how and by whom the system is used. No matter where or who they are, or whom they are sending money to, the Bitcoin system will treat all users equally. There is no central point in the Bitcoin system that can be exploited to censor payments, deny users service or seize funds. The decentralization is also a way to make it nearly impossible to change the rules of the currency without broad consensus. If a node or a group of nodes does not obey the rules they will be ignored by the rest. For example, one rule is that the money supply of Bitcoin is limited to 21,000,000 bitcoins (21 million/2.1 crore Bitcoins), and that limit is nearly impossible to change due to decentralization.
Bitcoin payments takes time to confirm. A typical payment will confirm within 20 minutes. The recipient will see the payment immediately, but he cannot trust the payment until it is confirmed by the Bitcoin network. This limitation can also be fixed by systems built on top of Bitcoin, for example the Lightning Network. The confirmation time of Bitcoin is nowhere near the confirmation times of VISA or MasterCard, where a merchant must wait for weeks before being sure that the transaction is not reversed. Merchants usually take on some risk to avoid having their customers wait weeks before delivering the goods or service. Bitcoin cuts this waiting period significantly, but it is still too long for truly instant payments.
How is Bitcoin valued?
As you could guess – Speculation, the price of a bitcoin can fluctuate quite dramatically. But where is this price actually coming from? There are several Bitcoin exchanges, mostly Internet based. They resemble stock markets, where users wanting to sell bitcoins are matched with users wanting to buy bitcoins. Different markets can have different market prices depending on the supply and demand on that market. For example, in countries like Venezuela where the government try to hinder the Bitcoin market, the supply will be low. But the demand is high, because people want to escape from their hyper inflating currency. These factors drives the Bitcoin price up in that market compared to for example the US and European markets where people can trade more freely.
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