Cryptocurrency | 01 Feb 2023

For Prelims: Cryptocurrency, Blockchain Technology, Central Bank Digital Currency (CBDC).

For Mains: Impact of cryptocurrency on Indian economy.

What is Cryptocurrency?

How Does Cryptocurrency Work?

  • Transactions with cryptocurrency are recorded on a public digital ledger called blockchain.
    • This ledger is maintained by a network of computers around the world, and each new transaction is verified and added to the blockchain by these computers.
    • This decentralization and use of cryptography make it difficult for anyone to manipulate the currency or the transactions recorded on the blockchain.
  • To use cryptocurrency, individuals or businesses must first acquire a digital wallet, which is a software program that stores the user's public and private keys.
    • These keys are used to send and receive cryptocurrency, and they are also used to verify transactions on the blockchain.
  • Users can acquire cryptocurrency through a process called "mining" which involves using computer power to solve complex mathematical equations, which validate and record transactions on the blockchain, in return for a certain amount of cryptocurrency.

What is Blockchain Technology?

  • Blockchain technology is a decentralized, digital ledger that records transactions across a network of computers.
  • Each block in the chain contains a number of transactions, and every time a new transaction occurs on the blockchain, a record of that transaction is added to every participant's ledger.
    • The decentralized nature of technology ensures that no single entity can alter or delete previous transactions, providing a high degree of security and transparency.
  • Blockchain is the foundation of cryptocurrencies such as Bitcoin, but it has many potentials uses beyond digital currencies.

What are Some Examples of Cryptocurrencies?
Bitcoin (BTC):
  • It is the first and most well-known cryptocurrency, created in 2009.
  • Bitcoin was invented by an unknown person or group of people using the name Satoshi Nakamoto and was released as open-source software in 2009. It is considered the first decentralized cryptocurrency.
  • Bitcoin has no single administrator, and the currency can be sent electronically from user to user on the peer-to-peer bitcoin network without the need for intermediaries.
  • Transactions are verified by network nodes through cryptography and recorded in a public distributed ledger called a blockchain.

Ethereum (ETH):
  • Ethereum (ETH) is a decentralized, opensource blockchain platform that enables the creation of smart contracts and decentralized applications (dApps).
  • It uses its own cryptocurrency, Ether, as a means of payment for transaction fees and services on the Ethereum network.
  • It also has a built-in programming language that enables developers to create and deploy their own decentralized applications on the Ethereum network.

Litecoin (LTC):
  • Litecoin (LTC) is a peer-to-peer cryptocurrency and open-source software project.
  • It is inspired by and nearly identical to Bitcoin (BTC) but with faster transaction confirmation times and a different hashing algorithm.
  • It is designed to process small transactions faster and more efficiently than Bitcoin.

Ripple (XRP):
  • Ripple (XRP) is a digital asset and cryptocurrency that is designed to facilitate fast and inexpensive international money transfers.
  • It is built on the Ripple Protocol, a decentralized open-source protocol for facilitating cross-border payments.
  • Ripple can be used to transfer any currency, including USD, EUR, and Bitcoin, and it can also be traded on digital currency exchanges.
Bitcoin Cash (BCH):
  • Bitcoin Cash (BCH) is a cryptocurrency that was created as a result of a hard fork from Bitcoin in 2017.
  • It has a larger block size limit (8MB) compared to Bitcoin (1MB), allowing for faster and cheaper transactions.
  • It is considered by some to be a "purer" version of Bitcoin, as it adheres more closely to the original vision of Bitcoin as a peer-to-peer electronic cash system.

    What is the Legal Status of Cryptocurrency?

    • In India:
      • The legal status of cryptocurrency in India is currently in a state of flux.
      • The Reserve Bank of India (RBI) has issued several warnings against the use of cryptocurrencies, stating that they pose risks to investors and are not legal tender.
      • In 2018 the Supreme Court struck down a circular of Reserve Bank of India, which bans financial institutions from dealing in digital or cryptocurrencies.
      • In 2022, the Government of India mentioned in the Union budget 2022-23 that-the transfer of any virtual currency/cryptocurrency asset will be subject to 30% tax deduction.
    • Elsewhere:
      • At present, El Salvador and the Central African Republic (CAR) are the only two countries in the world where Bitcoin functions as a legal currency.
      • However, many countries have taken steps to recognize and regulate the use of certain cryptocurrencies, such as Bitcoin.
        • Some countries, such as Japan and South Korea, have issued regulations for cryptocurrency exchanges.
        • Nations like Germany and Switzerland, have recognized Bitcoin as a "legal means of payment."
      • Other countries, such as China and Russia, have taken a more cautious approach and have imposed restrictions on the use of cryptocurrencies.

    What is India’s Central Bank Digital Currency?

    • The Central Bank Digital Currency (CBDC) pilot launched by the RBI in the retail segment has components based on blockchain technology.
    • CBDCs are a digital form of paper currency and unlike cryptocurrencies that operate in a regulatory vacuum, these are legal tenders issued and backed by a central bank.
    • It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency.
    • Digital currency refers to the digital version of the Indian rupee, which is also known as the digital rupee or e-rupee.

    What are the Challenges?

    • Volatility: Cryptocurrency prices are highly volatile, which makes it difficult for businesses to accept it as a form of payment.
    • Regulation: There is a lack of clear regulation around cryptocurrency, which makes it difficult for businesses and individuals to know how to legally use it.
    • Security: Cryptocurrency exchanges and wallets are susceptible to hacking attacks, which can result in the loss of funds.
    • Adoption: Despite its growing popularity, cryptocurrency still has low adoption rates, which makes it difficult for individuals to use it as a form of payment in everyday life.
    • Scalability: The scalability of cryptocurrencies is limited, which makes it difficult for the technology to handle a large number of transactions.
    • Energy consumption: The process of verifying transactions in a cryptocurrency network, known as mining, is energy-intensive, and contributes to climate change.

    Way Forward

    • Clarity on the legal status of cryptocurrencies is important for their widespread adoption and use. When governments provide a clear framework for cryptocurrency, it creates a more stable environment for businesses and individuals to invest in and use them. This can also encourage innovation and growth in the industry.
      • The examples of countries like El Salvador and the Central African Republic recognizing cryptocurrencies as legal tender show that it is possible for governments to embrace this new technology and create a favorable environment for it to thrive.
    • The RBI has started a blockchain-based Central Bank Digital Currency (CBDC) pilot program. The government should take this into consideration because cryptocurrency is based on blockchain technology as well.
    • Launching cryptocurrency with a strong regulatory framework can ensure its proper use, prevent fraud and illegal activities, and increase consumer protection. On the other hand, a complete restriction of cryptocurrency may stifle innovation and limit its potential benefits to society.
    • The classification of cryptocurrencies as either goods or asset classes is still unclear and subject to change in many countries, including India. Currently, software is considered a good and can be taxed as such under Indian law. Profits and earnings from the sale of cryptocurrencies are considered taxable income, but only after the legalization of cryptocurrencies.