Banking Article, Banking Finance 2022, Banking Finance January 2022

BLOCKCHAIN AND CRYPTOCURRENCY

Abstract

Finance has long been a very conventional field with no major breakthroughs happening for many years until the introduction of Bitcoin in 2008 by an anonymous person/group going by the name of Santoshi Nakamoto. Some people look at cryptocurrency as a major technical breakthrough in the field of Finance that has the potential to change the way we transact, while some look at it with skepticism since it can lead to increase in underground transactions. Through this paper we first try to understand what does ‘Cryptocurrency’ mean and briefly explain how does blockchain works,then whether truly cryptocurrencies are fool proof with no chance of fraud, and lastly,Reserve Bank of India’s opinion on cryptocurrencies. The universe of cryptocurrencies comprises of various tokens and talking about each one of them is beyond the scope of this paper. In this paper we try to focus only on Bitcoin.

Understanding the term ‘Cryptocurrency’

  • Before defining cryptocurrency, we must understand the characteristics of currency. A well-functioning currency should have 3 functions:
    • Store of Value: Store of Value means that the value of a currency should be stable over time. Due to high volatility this criterion is not met by cryptocurrencies.
    • Unit of Account: Unit of account means that money should allow us to easily determine the value for goods and services and allow us to compare them to each other. The volatility of Bitcoin makes it difficult for us to consider it as a unit of account.
    • Medium of Exchange: Medium of Exchange means that money should allow buyers and sellers to make transactions. Bitcoin partially fulfills this criterion but slow transaction speeds, high volatility poses some hurdles.

Since cryptocurrencies do not fulfill these criteria defining cryptocurrency as ‘virtual currency’ would not be inaccurate.

  • Now coming to Cryptocurrency, the Inter RegulatoryWorking Group on Fintech and Digital Banking set by RBI in 2017, defines cryptocurrency as digital representations of value, issued by private developers and denominated in their own unit of account. They also added that cryptocurrencies are not necessarily attached to a fiat currency but are accepted by natural or legal person as a means of exchange.

Brief understanding of Blockchain and Bitcoin

Blockchain technology is like a digital public ledger where all the transactions and digital events that have taken place are recorded. Every transaction that is recorded on blockchain has to be verified by the consensus of majority of network participants and once a transaction has been included in the chain of blocks it can’t be erased without the consensus of a majority of network participants.

Bitcoin is one of the first cryptocurrencywhich was coined using blockchain technology. Traditionally while transacting online there is a need for a trusted third party to verify each transaction but Bitcoin eliminates the need for any third party to verify each and every transaction instead it uses a peer to peer based system of transactions that facilitates every transaction without having the need to go to any financial intermediary.

Each transaction is protected using a digital signature and each transaction is sent to the public key of the receiver signed using the private key of the sender. Each of these transaction is broadcasted to every node in the Bitcoin network and is then recorded in the public ledger after verification. Every block is connected to the previous block using a hash number and also every block has a unique hash number embedded in itself as well.However, these transactions come in random order to the nodes which can create a problem of double spending. To combat this problem of double spending bitcoin requires a network of participants to agree upon a single history of order in which the transactions were received. The person receiving money, needs proof that majority nodes(network of participants) agree that the particular transaction was the one that was first received.

While talking about Blockchain many people refer to it as a fool proof network of transactions but there is one loophole is this entire system. As per the author of the Bitcoin Whitepaper- Santoshi Nakamoto, this system of nodes approving a transaction before it is added to the block is fool proof as long as the “ honest nodes collectively control more CPU power than any other cooperating group of attackers”. This means that if a group of attackers can get more than 51% CPU power they can get around the system and manipulate it according to their will. This loophole is referred to as the known limitation of ‘the proof of work’.

Instances of Cryptocurrency Hijacking

  • As per Coinbase- a cryptocurrency exchange platform, they noticed some anomalies in the Ethereum Classic blockchain on 1st May2019 which led them to halt all interactions with the Ethereum Classic Blockchain. After a few days it was discovered that it was a coordinated attack on the ETC’s blockchain and in total 219,500 ETC whose value was approximately around $1.1 million, though none of the Coinbase accounts were impacted by the attack.
  • On 10th August 2021, the largest cryptocurrency hack was reported. Polynetwork, a decentralised finance platform that connects different blockchains so that they can work together disclosed an attack on its platform where hackers transferred $610 million worth cryptocurrency from the platform to external wallets. Poly network in their communication urged the hackers to return the stolen cryptocurrencies and in a strange turn of events the hackers did return the stolen cryptocurrencies.
  • In 2014,MtGox – a Japanese Cryptocurrency exchange, who was at that time the world’s largest cryptocurrency exchange platform filed for bankruptcy stating $460 million worth of cryptocurrencies were stolen from their exchanges. As per the company there was a vulnerability in their systems that were exploited by the attackers.

Reserve Bank of India’s stance on Cryptocurrency

Central Banks across the world have a different take on cryptocurrencies but all of them share a single view point on the possibility of using cryptocurrencies for terrorist financing and Money Laundering.

RBI on 6th April 2018 had issued a circular directing entities regulated by RBI to not deal in virtual currencies. Also ordered to stop providing services and terminate relationships with entities dealing in virtual currencies. This order was challenged in court by various parties who had vested interest in cryptocurrencies.While defending its order in court RBI cited a paragraph from the 2015 Report on ‘Emerging Terrorist Financing Risks’ by FATF which in brief mentioned that Virtual Currencies such as bitcoin present a great opportunity for financial innovation but at the same time allows anonymous transfer of funds internationally. This has attracted attention of many criminal organisations and pose a threat for Terrorist Financing.

Use of cryptocurrencies to transact funds internationally can be compared with Hawala transactions. Hawala Transactions operate outside the jurisdiction of Traditional Banking System. It was originated in India and the transfer of money takes place between Hawala dealers or ‘Hawaladars’. To explain Hawala transaction in brief; if a person wants to send money abroad, instead of going through the traditional banking system, the person can contact a ‘hawaladar’ who contacts the other hawaladar sitting in the intended country and directs him/her to deliver the money to the final destination. The entire system of Hawala works on trust and is more cost effective, efficient and most importantly does not leave any paper trail which makes it a perfect source of money laundering. Hawala transactions are completely illegal in India and Pakistan.

In response to RBI, the cryptocurrency exchanges argued that RBI has no power to ban trading in virtual currencies since they are not a legal tender and are not included in the credit system of the country. Also, virtual currencies do not satisfy the characteristics for it to be termed as money, namely – Mediumof Exchange, Unit of Account and Store of Value. Hence, cryptocurrencies fall outside the jurisdiction of the Central Bank’s power to regulate it. Another point raised by the virtual currency exchanges is that RBI classifies all the cryptocurrencies as anonymous whereas most of the cryptocurrencies are ‘pseudo-anonymous’, which also acknowledged by the European Parliament.  Pseudo anonymity means that identities on the blockchain are not directly linked to the real world identities but with enough efforts one can trace back a transaction to the source. Hence, pseudo anonymity while assures unidentifiability but does not guarantee it.The court ruled in the favour of the virtual currency exchanges and ordered RBI to take back its orders.

Government of India is also preparing to introduce ‘the Cryptocurrency and Regulation of Official Digital Currency Bill’ to regulate cryptocurrencies, in the Winter session of Parliament this year. The Bill seeks to prohibit all private cryptocurrencies in India; however, it plans to allow the technology underlying cryptocurrencies, i.e., Block-chain, and its uses. The Bill also plans to create a facilitative framework for creation of the official digital currency to be issued by the Reserve Bank of India.

Conclusion

The paper began by defining cryptocurrencies and how terming them as a ‘virtual currency’ would be incorrect. It then proceeded towards briefly explaining the main concept behind blockchain and how is blockchain incorporated in Bitcoin. Instances were provided on how the ‘limitation ofproof of work’ and the inefficient system of the virtual currencyexchanges is being exploited by hackers rendering cryptocurrencies to actually not be ‘fool proof’. Throughout this paper we try to refrain from putting forward any personal opinion around cryptocurrencies instead we have to present the facts as documented in the official resources. We encourage the reader of this document to personally read in depth about the topics touched here and personally understand the scope and limitations of this technology.

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