Cryptocurrency – that is, any type of decentralized digital currency used through the internet – makes headlines all the time.
Since the first and most well-known cryptocurrency (Bitcoin) entered the scene in 2008, digital currencies have multiplied in nature and scope. Today there are thousands of cryptocurrencies, like Ethereum, Tether and Dogecoin (which started as a joke in 2013).
To be sure, there are many promising aspects of crypto. For example, transactions tend to be less expensive and the approach is considered more “open” than traditional banking systems. Such characteristics may lead to broader financial inclusion, particularly for the historically “unbanked.”
But some of the news about cryptocurrency is not so rosy.
Here are three overarching reasons why it pays to be cautious when it comes to crypto.
- It’s not well understood and it constantly evolves – presenting implications for market stability, regulations and taxes.
- Wallet owners can be harder to trace than those holding traditional currency.
- Cryptocurrency has been linked to fraud schemes, scams and serious criminal activities.
What is blockchain?
Blockchain powers bitcoin, storing everything of digital value. Each new transaction is stored in a block that gets added to a chain of existing records – so it serves as a public ledger of all transactions. Its security technique makes the blockchain a tamper-proof record of all network transactions.
Crypto: Not fully understood, constantly changing
Even though it has been around for over a decade, many businesses and governments still don’t fully understand the nuances of how crypto works. But financial institutions and regulators can’t ignore it – because it’s growing quickly and having a clear effect on assets and revenue streams.
Crypto’s characteristics – fast-growing, nonstandardized and ever-evolving – raise implications for market stability, regulations and taxes. Here’s a quick look at what that means.
So far, crypto has tended to be less stable than traditional currencies. Consider that:
- Cryptocurrency has not been standardized like traditional money – in fact, the notion of standardization goes against the grain of how crypto works.
- Crypto operates as a decentralized system of finance that is not tied to central banks or issued by governments. Because the currency operates so differently from traditional money, crypto is a whole new paradigm – a money revolution – for banks and other traditional players.
- Investments in cryptocurrency are, by nature, more speculative than traditional money investments. While there can be big gains, there’s also money to be lost. Consider the downfall of cryptocurrency exchange FTX as an example.
While things have started to change in the realm of regulations, many countries still do not routinely regulate crypto the same way as government-issued currencies. Underlying reasons are the uniqueness and complexity of cryptocurrency assets and transactions, and the variety of players involved.
Assuming everyone agrees that crypto should be regulated – not everyone does – all this leads to debates about who should regulate crypto, and how.
Consider the issues regulations could cover: Taxation, cybersecurity, financial disclosures, consumer protections – even the climate impact of mining cryptocurrency. But few things are clear-cut when it comes to cryptocurrency. For example, there’s debate about whether crypto should be regulated as a commodity (a form of value, like gold) or a security (in which people invest, hoping for a return).
There are also many different interests involved when it comes to regulating cryptocurrency.
According to this International Monetary Fund article, “The actual or intended use of crypto assets can attract at once the attention of multiple domestic regulators – for banks, commodities, securities, payments, among others – with fundamentally different frameworks and objectives. Some regulators may prioritize consumer protection, others safety and soundness or financial integrity. And there is a range of crypto actors – miners, validators, protocol developers – that are not easily covered by traditional financial regulation.”
What are non-fungible tokens (NFTs)?
NFTs are real-world items that are turned into unique digital assets (things like digital art, trading cards and music). Only one person can own the original asset – although others can make copies. NFTs are frequently purchased using cryptocurrency, using the blockchain for transactions. The Verge has a fun way of describing NFTs.
Most of us can count on regularly paying taxes to the government. But when it comes to cryptocurrency, tax authorities suspect that many have gotten away without paying their fair share in the past.
One reason is that there has been a lack of agreement about how to manage purchases, ownership and sales. After all, cryptocurrency transactions take place outside of existing financial systems and transactions are semi-anonymous.
All this is changing, of course. As tax rules evolve to include cryptocurrency, global tax authorities and citizens alike must be aware of the nuances behind this evolving landscape. The 2022 tax return in the US, for example, asks filers to answer this question: “Did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Crypto wallet owners: Who are they?
Crypto relies on peer-to-peer based internet transactions, which implies that just two parties are involved – without any middlemen, like banks. Every cryptocurrency transaction is publicly verified and recorded, so the crypto wallet address is visible to everyone.
It might seem that such transparency would make it simple to link the wallet address to an individual wallet owner (the original person who held the crypto funds). But historically, this has been difficult.
Wallet addresses are not directly linked to an individual identity or IP address. Tracing the owner requires forensic analysis to associate wallets, transactions and information collected by cryptocurrency exchanges that adhere to know-your-customer (KYC) regulations.
The link with fraud, scams and other serious crime
There are two conflicting ways to think about cryptocurrency and crime.
- Because crypto transactions are transparent (detailing a complete history of transactions), should it be less attractive to use in conjunction with fraud, scams and other crimes?
- Or, because it can be hard to trace cryptocurrency to an individual wallet holder, is it more likely to be tied to fraud and scams as well as criminal activities like money laundering, terrorism, and human and drug trafficking?
“Cryptocurrencies like bitcoin are obvious targets for money laundering,” according to Andreas Kitsios of SAS. “The transactions may be transparent, but the source of the money is not necessarily checked, and the ultimate owner of a crypto wallet cannot easily be traced. Not to mention that cryptocurrencies can even be mined through powerful computing infrastructure (which, in turn, can be procured using cash – adding another layer of obscurity).”
Cryptocurrency and money laundering
Crypto and virtual currencies have opened the door to new methods of laundering funds. For example, bitcoin ATMs can have “holes” in their AML compliance methods. And the degree of regulatory compliance by online cryptocurrency trading markets (exchanges) varies.
Criminals use other methods, too, such as “tumblers.” Tumblers are mixing services that split up dirty cryptocurrency, sending it through a series of different addresses and eventually recombining it into clean funds – for a hefty fee.
As with most new things, there’s much to learn about cryptocurrency – for individuals, financial institutions, tax authorities and governments. Many people were wary of fintech years ago, for example.
While we should be cautious with cryptocurrency, remember that education is key. Instead of dismissing opportunities, we should learn as much as we can about the positive opportunities this digital currency presents for our world.