Financial Innovation: “Cryptocurrencies”

Financial Innovation: “Cryptocurrencies”

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Updated February 7, 2018
Financial Innovation: “Cryptocurrencies”
A “cryptocurrency” (sometimes referred to as virtual
Payers and payees in these networks are typically identified
currency, a term that can also refer to a broader class of
by a pseudonym (often a string of numbers and characters),
electronic money) acts as money in an electronic payment
called an address, which is linked to a public key. They also
system in which transactions are validated by a
need a password, called a private key, in order to process a
decentralized network of computers rather than a third-
transaction. The address identifies to the users of the
party intermediary, such as a bank. The use of this financial
blockchain that the identity controlling the public key owns
technology (or fintech) potentially creates certain benefits,
cryptocurrency, which can only be used when they apply
poses certain risks, and raises a number of questions for
their private key to it. Because of the platforms’ security
policymakers. This In Focus examines cryptocurrencies and
protocols, losing the public or private key often means
related policy issues.
losing access to the cryptocurrency. Together the public and
private keys are sometimes called a wallet in which an
Background
individual’s cryptocurrencies are stored when the individual
A central difficulty with sending payments electronically is
is not using them in transactions.
the “double spending problem.” Sending an electronic
message or digital file directly from a payer to a payee in
People may “mine” certain cryptocurrencies, earning newly
the hopes that it will act as a transfer of value is
created units of the currencies by performing certain work
problematic, because payees cannot confirm that a payer
for the platform, such as validating incoming transactions.
has not sent that same message or file to multiple other
Alternatively, people can acquire cryptocurrencies on
payees. Because money in such a system can be double (or
exchanges with payment of official government-backed
any number of times) spent, it would not retain its value.
currencies or other cryptocurrencies. Although
cryptocurrency ledgers are believed to be mathematically
Traditionally, this problem has been resolved by involving
secure, vulnerabilities in wallets and exchanges have been
at least one centralized, trusted intermediary—such as a
exploited, causing losses for individuals and exchanges.
private bank, government central bank, or other financial
institution. The trusted intermediaries maintain ledgers of
One likely reason cryptocurrencies have recently become a
accounts recording how much money each participant has.
prominent issue is the sudden appreciation (and subsequent
To make payment, an electronic message or messages are
depreciation) in value of many of them. For example,
sent to an intermediary or to and between various
according to one company that tracks prices, the value of a
intermediaries, instructing each to make the necessary
Bitcoin rose 1,884% from $968 at the beginning of 2017 to
changes to their ledgers to transfer value from one account
$19,194 at its peak in December 2017, as shown in Figure
to the other.
1. The value then fell 44% to $10,797 a little more than a
month later.
In 2008, Bitcoin created a new solution to the double-
spending problem through the use of blockchain
Figure 1. Value of Bitcoin
technology, which is now frequently used to enable other
various cryptocurrencies, such as Ether, Alpha Coin, and
Papyrus. Blockchain uses cryptography, file sharing and
user agreement to ensure that each transaction is secure,
that the groups of transactions that form blocks are secure,
and that the entire ledger (or blockchain) is secure. Through
this system, parties that do not trust each other can
nevertheless exchange value without a centralized
intermediary, because they trust the decentralized network
and its cryptographic protocols.
Cryptocurrencies act as money in these virtual platforms
that maintain digital ledgers, which appear virtually
impossible to falsely manipulate. The transfer of a
cryptocurrency from one member of a network to another

represents a valid transfer of value. The transfers are
Source: Bitcoin.com accessed on January 30, 2018.
validated by the network’s members and not by a
Potential Benefits
centralized third-party or a payment system that involves
such intermediaries.
As discussed above, traditional monetary and electronic
payment systems involve a number of intermediaries such
as government central banks and private financial
institutions. To carry out transactions, these institutions
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Financial Innovation: “Cryptocurrencies”
operate and maintain extensive electronic networks and
who have the authority to withdrawal currencies from
other infrastructure, employ workers, and require time to
circulation) qualify as money services businesses (MSBs)
finalize transactions. To meet costs and earn profits, users
subject to federal regulation. Among other things, MSBs
of the systems are charged fees. Cryptocurrencies aim to
must register with and report suspicious transactions to
provide a payment system that is more efficient, faster, and
FinCEN and maintain anti-money laundering compliance
less costly. In addition, the pseudonymity of transactions
programs.
offers greater privacy that could be valued by some users.
Taxes. The Internal Revenue Service has issued guidance
Potential Obstacles
stating that virtual currencies should be treated as property
It is not clear if cryptocurrencies will be able to deliver
(as opposed to currency), meaning that users owe taxes on
these hoped-for efficiencies, because they currently face
any realized gains whenever they dispose of virtual
certain limitations. For money to be effective, it must serve
currency, including when they use it to purchase goods and
as a medium of exchange widely accepted across the
services. The guidance further indicates that when an
economy and act as a “store of value.” Unlike the U.S.
employee is paid in virtual currency, it will be taxed as
dollar or other government backed currencies,
wages.
cryptocurrencies are not legal tender, meaning creditors are
not legally required to accept them to settle debts. In
Consumer Protection. Because consumers are not
addition, consumers may be hesitant to place their trust in a
necessarily familiar with cryptocurrencies, they could be
decentralized computer network of pseudonymous
charged excessive fees when using or exchanging the
participants that many do not completely understand. These
currencies; deceived about their true value; or unaware of
characteristics may impede the widespread adoption of
the risks of loss of value or electronic theft. Cryptocurrency
cryptocurrencies. Furthermore, the values of many
exchanges may be required to obtain money transmitter
cryptocurrencies have recently been highly volatile,
licenses from the states in which they operate, and to abide
potentially making them a poor store of value.
by any consumer protection requirements imposed on
money transmitters by state law.
In addition, even if a cryptocurrency is able to achieve
widespread acceptance and a stable value, the system is not
Investor Protection. Cryptocurrencies have or may
costless. The fast processing of payments requires
become the underlying asset in certain financial products—
performing computations, which are extremely difficult and
including initial coin offerings (ICOs) wherein
require investment in computers and servers and the
cryptocurrencies are sold to raise capital; exchange traded
consumption of electricity. Given these costs, whether or
funds (ETFs) wherein a fund invests in a portfolio of
under what conditions greater efficiency than the existing
cryptocurrencies; and futures contracts wherein parties
system can be achieved is uncertain.
agree to buy, sell, or trade cryptocurrencies at a future date.
In these cases, questions about investor protections have
Policy Issues
been raised. Some observers are concerned these products
Cryptocurrency transactions involve money transfers,
create the opportunity for investors to take on risks they do
exchanges, and investment products. Policymakers have
not understand or to become victims of fraud. The
created an existing regulatory framework to address risks
Securities and Exchange Commission (SEC) has indicated
related to these activities. Because these currencies are new
that depending on their specific features, ICOs may result in
and evolving, it is not yet clear how effective the tools and
offerings of “securities” subject to federal regulation. The
authorities available to regulators are when applied to
SEC also regulates the majority of ETFs, and has sought
cryptocurrencies.
public comment on proposals related to Bitcoin-based
ETFs. The Commodities Futures Trading Commission
Some observers argue that certain regulations restrict the
regulates derivatives contracts in virtual currencies, and
adoption and use of beneficial cryptocurrencies and should
exchanges on which such contracts trade. Both agencies
be relaxed. In contrast, others argue that current regulation
have issued statements outlining their general approach to
provides inadequate protections against potential risks and
the regulation of virtual currency products.
that regulation should be strengthened.
CRS Products
Crime. The pseudonymous and decentralized nature of
CRS Report R43339, Bitcoin: Questions, Answers, and
cryptocurrency transactions could provide an additional
Analysis of Legal Issues, by Edward V. Murphy and M.
means to launder money, evade taxes, fund terrorists, or
Maureen Murphy
bypass financial sanctions the U.S. government has
imposed on other countries.
CRS Legal Sidebar WSLG1856, For First Time, FinCEN
Imposes Penalty on Foreign-Based Virtual Currency
The Department of the Treasury’s Financial Crimes
Exchange for Violations of Anti-Money Laundering Laws,
Enforcement Network (FinCEN) has issued guidance
by M. Maureen Murphy
explaining how regulations designed to curtail these
activities apply to the use of virtual currencies. FinCEN has
David W. Perkins, Analyst in Macroeconomic Policy
indicated that exchangers (people engaged in the business
of exchanging virtual currency for real currency, funds, or
IF10824
other virtual currency) and administrators (people engaged
in the business putting virtual currency into circulation and
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Financial Innovation: “Cryptocurrencies”

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