The price and value of cryptocurrency: (3) Risks of cryptocurrency

in #cryptocurrency7 years ago (edited)

(Continued from "The price and value of cryptocurrency: (2) What is the fair price of Bitcoin?")

If you have only read the previous parts, you may think I am very optimistic about the future of cryptocurrency. But not absolutely.

That's because cryptocurrency has a high risk. If it overcomes the risk, cryptocurrency will bring a great change to money and finance. If not, it could vanish like a bubble.

Sailing before the wind if we live in a perfectly free market

Recently Forbes published an article titled " It's 1994 In Cryptocurrency." Until 1994, Internet was closer to a toy for a small segment of computer users. But when Netscape browser came out in 1994, normal people began using it. In 1994, Internet users were mere 0.25% of the global population. In 2017, cryptocurrency users are only 0.5% as well. Active users are only 3 million people, or just 0.04%.

Such a small number of users shows a large potential to grow, but on the other hand is cited as the basis for criticism that the price is too high for low usage.

Increasing adoption

The fact that large companies, who could headline major news outlets, are still conservative may be giving people more impression that it still lacks adoption than the reality.

In fact, it seems that cryptocurrency keeps broadening the usage base.

Bitpay, the number one Bitcoin payment processing solution company, grew 328% by dollar amount from 2016 to 2017. Not just in ecommerce but also in international and corporate transactions adoption is increasing, according to Bitpay.

According to Shopify, an ecommerce sales solution, thousands of merchants who use its solution are accepting Bitcoin payments. Considering Shopify's main users, small businesses are more aggressive in adopting cryptocurrency.

In 2017, there continue to be many news about cryptocurrency adoption.

  • The Montessori Preschool in New York decided to accept Bitcoin. Interestingly, they decided not to accept credit cards due to high fees.
  • Top Airport Parking, which provides parking lot services in major airports in the US, began accepting tens of cryptocurrencies.
  • Gotomall, the shopping mall at Gangnam Express Bus Terminal in Seoul, began accepting Bitcoin by making an alliance with HTS Coin, a cryptocurrency exchange. It expects foreign visitors and young people to use Bitcoin by accepting it as well as cash, credit cards, and Alipay.
  • Lucerne University of Applied Science and Arts in Switzerland is now allowing students to make payments in Bitcoin.
  • Sharps Pixley, a well-known gold dealer in London since 18th century, is now accepting Bitcoin. According to them, this decision means that Bitcoin investors from now can convert Bitcoin to gold which is the more traditional and safer asset.
  • In Texas, the payment for a real estate purchase was made by Bitcoin for the first time. The broker said that in his 33 years of closing deals he could not have expected something so unique to go so smoothly.

It's about private, not virtual, currency

It is an issue of regulation not of value

Cryptocurrency is penetrating human lives. Currency has a very large value for the sole function of making easy exchanges possible instead of laborious and complex barters. In addition, cryptocurrencies like Bitcoin have superior performance such as low transaction costs, high transaction speed, and not having to worry about small changes. If we just leave them, I believe they will gradually settle down as currencies.

Then is there no risk against cryptocurrency? Yes. There is. And a very large one at that. In the previous paragraph, I stated that if we left them, they would do well. But the problem is none others but that 'if we left them.'

Who is the main agent to leave them? The government is. The key risk is whether the government will leave them alone.

This was why cryptocurrency price fell sharply when the Chinese government started regulating the exchanges. The market already knows that the government is the biggest risk.

Warning of the history

We can see the history to understand the risk of the government. Before that, let's first see a history that is positive to cryptocurrency.

There is a proposition in economics called Gresham's Law. When people still used gold and silver coins, the value of currency was determined by the amount of gold or silver contained in a coin. 1 dollar meant a standard amount gold. Sometimes, however, coins were made that had less gold than the standard. The problem was that those bad coins were circulated widely while the good coins disappeared. This happened even during the 20th century.

Was this abnormal? It wasn't. People aced rationally. It is natural to want to spend the coin with less gold than the one with more.

This phenomenon shows a problem with commodity currency. Two different kinds of value exist in a single coin. One as gold, and the other as currency. People of the old times gold-based coins as they could not imagine a currency without the value of gold. But even now, when nonredeemable currency became the standard, people still do not seem to fully accept the intrinsic value of currency that is pure medium of exchange. The government, by standing behind the fiat currency, removes any such doubt, but also has the side effect of hindering people from crossing to the idea that medium of exchange itself has value

Now let's see some history that is threatening to cryptocurrency.

The government did not always monopolize the issuance of currency. Until mid-19th century, the US government did not issue paper bills. It did only coins. Paper dollar bills were the bank notes of private banks. In 1850s, banks in the US issued more than 10,000 kinds of bank notes with different designs, face value, and size. They were redeemable currencies that promised to redeem in gold or silver.

Even coins that the federal government issued were in shortage, and companies, merchants, and farmers issued coins and bills. A significant part of the money was assumed by these private currencies.

Facing various private currencies, people had to be cautious in distinguishing the real from the fake. Also, when a bank goes bankrupt, the bank note became just a piece of waste paper.

So, the National Banking Act was enacted in 1863 during the Lincoln presidency. It passed the senate with a small margin of 23 to 21. Now only the banks government appointed could issue bank notes according to their credit levels, and the government did the printing firsthand. Private currency disappeared, and the currency became a monopoly business of the government.

The lesson of the history is clear. Cryptocurrencies in the market including Bitcoin are problematic not because they are virtual but because they are private. Because they are challenging the sacred ground of the currency that only the government can issue. As we see in the 19th century history of the US currency, what the government does may determine the life and death of cryptocurrency.

Stance of the government

The stance of the governments of the world is still fluid. Even when they have a stance, it is rather partial and temporary. We might almost say that there is no country which has established comprehensive and firm rules.

Nevertheless, we can group government stances on cryptocurrency that we know so far into a few. According to them, cryptocurrency is:

  1. (Almost) currency
  2. Security
  3. Property
  4. Commodity
  5. Illegal

#1 (Almost) Currency

It is the best scenario for cryptocurrency. It is being recognized as currency or medium of exchange. Standing closest to this is Japan.

Japan in 2016 passed a law that recognized cryptocurrency as asset-like values that can be used to make payments as well as be transferred digitally. That is, it was granted the status of being able to be used like a currency. In return, cryptocurrency exchanges were required to report to Financial Services Agency. In 2017, they began devising accounting standards for cryptocurrency.

Japan's efforts like these started after the bankruptcy of MT. Gox, the largest Bitcoin exchange at the time, in 2014. The Japanese government felt the need to align the legal status of Bitcoin. An unfortunate event made a momentum for having a world-leading regulatory system.

In Australia, authorities and legislators across party lines began discussing accepting cryptocurrency as a legal payment method. They strengthened supervision of exchanges and made KYC a requirement, which are viewed not just as burdensome regulations but also as indication of accepting the status of cryptocurrency.

In Switzerland, some municipalities are leading the adoption of Bitcoin as a payment method. The government of Chiasso announced in September 2017 that it would accept Bitcoin for small tax payments. Zug, another municipality, began a pilot in which it accepts Bitcoin payments for its services in 2016.

The head of Singaporean central bank said he saw no reason to regulate cryptocurrencies. It is not a proactive legalization but can be viewed as an accepting stance.

The German Finance Ministry recognized Bitcoin as a unit of account in 2013. It did not classify Bitcoin as e-money or foreign currency but stated that it was close to private money. The legislator who pushed for the recognition argued, "We should have competition in the production of money. I have long been a proponent of Friedrich August von Hayek scheme to denationalize money."

In 2017, major law firms and blockchain companies in EU proposed classification of cryptocurrency as a new asset class. It seems they are pushing for a regulatory framework on which cryptocurrency can function as currency without inconvenience.

#2 Security

Emilio Aquino, Commissioner of Securities and Exchange Commission, said this in November 2017.

"We have seen particularly in the social media sites that there are offers of initial coin offerings, most popular of which, of course (are) bitcoins and ethereum … but (there are) new ones which may be considered as securities."

His remarks are aligned with the announcement of the SEC of the US in July 2017. SEC, after investigating token sales of a virtual organization called The DAO, stated that some cryptocurrencies should be classified as securities and for sales or an ICO should register at the SEC. According to SEC's definition of securities, often called the Howey Test, cryptocurrencies whose goal is to make profits are likely to be classified as securities. This is relatively straightforward and seems to have little room for controversy.

More fundamental and difficult is the status of pure cryptocurrency whose sole function is a medium of exchange.

#3 Property

This is an argument that cryptocurrency is not a currency but an asset that has value. The IRS of the US, which leads the financial order of the world, has this stance.

In 2014, the IRS classified cryptocurrency as property. So capital gains from cryptocurrency trades should be taxed like capital gains from real estate transactions. As cryptocurrency is not currency, which itself is a kind of property, IRS stated that taxation related to foreign currency gain or loss was not to be applied.

In addition, states in the US are not imposing sales tax when buying cryptocurrencies. Therefore it is in a better position than gold is to work as a medium of exchange.

#4 Commodity

Korean government revealed in November 2017 that it was considering classifying cryptocurrency as commodity and imposing value-added tax on its trades. If it were implemented, people would have to pay 10% additionally when buying cryptocurrencies and to report summary of all transactions to the tax authority periodically. It would not be just problematic for investing on an exchange but also very inconvenient as currency to be used for commerce.

If Korea imposed VAT, it would be an exceptional case. Japan exempted consumption tax, EU VAT, and Australia GST(goods and services tax). Though CFTC of the US defined cryptocurrency as commodity, it seems because cryptocurrency needed to be commodity for the registration of Bitcoin futures to be allowed.

#5 Illegal

There are countries that banned cryptocurrency. Bolivia, Ecuador, Kirgizstan, Bangladesh, Nepal made the use of cryptocurrency illegal. Main reasons seem to be concerns about abuses like money laundering and capital leakage.

While it seems considering legalization, Vietnam's central bank announced that cryptocurrency is illegal.

There are also countries that partially illegalized cryptocurrency. China banned use of cryptocurrency by banks and other payment processing companies but continues to allow person to person uses. In Taiwan, installation of cryptocurrency ATM was banned.

Korean government has shown negative views including the possibility of limiting cryptocurrency trades.

In summary

It seems there are more countries that are favorable than hostile to cryptocurrency. According to Blackmoon Crypto, a cryptocurrency startup, 63% of the countries that were researched until July 2017 were favorable or mostly favorable to cryptocurrency. Notably, advanced countries like Japan, the US, and EU were favorable.

Considering this, the following are thought to be mainstream views.

  • Cryptocurrency is not legal tender, but asset similar to currency.
  • VAT or sales tax is not imposed on buying cryptocurrency.
  • Buying and selling goods and services with cryptocurrency is allowed.
  • You need to pay tax for the gains you make from cryptocurrency trades, like from other properties.

If it were to be this kind of regulation, accepted as legal currency or not, there will be no problem in functioning as currency. We can view it as a favorable environment for cryptocurrency.

But, there is one very important issue remaining.

Government-issued cryptocurrency

There is another action of the government that can have as serious impact as regulation of cryptocurrency itself. It is creation of the government's own cryptocurrency.

As we saw before, paper bills were issued first by private banks, but later the government did it by itself. It is entirely possible that a similar thing happens in cryptocurrency. It feels natural to add crypto dollars to existing coins and bills.

After revealing negative views about cryptocurrency, mentioning high risk, Putin and high officials of Russia announced that they would create CryptoRuble.

The economy minister of Abkhazia, a state yet to be recognized, talked about its plan to issue cryptocurrency, saying that they could even abandon fiat currency.

President Nicolas Maduro of Venezuela, where Bitcoin is popular due to its instable national currency, publicly stated that its government would issue cryptocurrency. He said the cryptocurrency would be backed by the country's natural resources like petroleum.

India, China, Canada, Sweden, and other countries are also studying the possibility.

The Fed of the US is not considering the issuance of cryptocurrency yet, but there is a voice urging such an initiative. Australia is in a similar situation.

In 2017, BIS recommended central banks to think about the possibility of issuing cryptocurrency. Christine Lagarde, managing director of IMF, also said it was not impossible for IMF to make SDR (special drawing right) a cryptocurrency.

A modern government, much softer and more polished than was in 19th century, will feel it very uncomfortable, especially in countries like the US which symbolizes the market economy, to illegalize cryptocurrency that has become synonymous to creative innovation.

But for the government and the central bank, it is obviously not desirable to concede control over currency. It is not just the government. Banks, credit card companies, and other payment processing companies who reside in the financial system based on fiat currency may feel the same.

So, for the incumbent currency and monetary ecosystem, it is likely the best defense to add crypto version to fiat currency.

Then the question is, who will win between national and private cryptocurrencies?

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