February 3, 2016
Digital currency has become a phenomenon that has gained a lot of attention in the past years. It represents a set of Web-based mediums for exchange (just like physical money, but Internet-based). Virtual currency and cryptocurrency are both different types of digital currencies and in the case of the second one, the whole world has been a hub for development and implementation. Cryptocurrencies gained significant attention and there are numerous cryptocurrencies with surprisingly high market capitalization. However, the future of digital money has been a debatable topic despite an initial interest as there are certainly compelling reasons to believe that one of the most adopted and well-known cryptocurrencies—bitcoin—may be dead soon.
As digital money gains more traction, it attracts the attention of governments in the countries where digital money may become a significant means of transaction. One of the interesting encounters and conclusions regarding digital currencies was made by HM Treasury last year. The UK government’s economic and finance ministry has presented a comprehensive report on digital currencies in which one of the most interesting parts is related to the risks digital money carry. Let’s take a closer look at HM Treasury’s findings on the risks hidden beyond convenience that the UK government warns against.
In October 2014, the National Crime Agency (NCA) assessed the nature and scale of the threat posed by digital currencies and concluded that the predominant criminal use of such currencies was on online marketplaces for the sale and purchase of illicit goods and services. Even though the scale of the threat was difficult to assess, NCA warns that there was little evidence to indicate use by established money laundering specialists or that digital currencies played a role in terrorist financing. The NCA also judged that the majority of illicit digital currency spends were for low-value transactions.
The crime risks are related to the fact that digital currencies can offer a degree of anonymity to users, and that this factor could be a driver of criminal activity. Moreover, the use of specific digital currencies and anonymizing services can increase the degree of user anonymity.
Some financial institutions even characterized digital currencies as anonymous and untraceable, but many of the submissions from users, digital currency firms and consultancies could challenge the opinion calling the submission pseudonymous rather than anonymous.
Professionals also added that blockchain technology comes in handy by registering the historical transactions, which could potentially prove to be helpful for regulators and law enforcement.
Among other risks were features that may attract illegitimate and legitimate users alike, including lower costs, faster settlement times, and the ease of transferring funds across borders.
There are other potential criminal activities that could involve digital currencies. In fact, digital currencies have been in evidence as a payment vehicle, such as the buying and selling of illicit goods and services via online marketplaces (ex: the Silk Road), and cases where computers have been infected with ransomware and criminals have demanded payment in digital currency.
However, HM Treasury also brought up factors that may complicate the use of digital currencies by criminals. Among those factors are transparency and visibility of transactions, the need for some technical familiarity or expertise, the relatively small number of individuals and businesses accepting digital currencies as payment for goods and services, low numbers of total transactions and low levels of liquidity in digital currency systems.
Digital currencies could create significant obstacles for the enforcement of financial sanctions related to their nature. The degree of anonymity, the ability to make payments across borders without going through intermediaries, and the fact that there may be no third-party authorities with the ability to freeze or reverse digital currency payments—all those factors perceived as advantages of digital currencies carry significant risks.
Even if through the regulation digital currency wallets are matched with real identities, there will be a loophole: users could easily create multiple new addresses, transfer funds without going through third-party wallet providers, and use anonymizing services.
Risks to users
As we know, cryptocurrencies offer a secure way of transferring value between users across the digital currency network. However, there could be security issues for users at various points where they are obtaining, holding or transferring digital currency funds.
One of the biggest problems for users could be related to price volatility as digital currencies are not backed by any authority or pegged to any other currency or commodity. In the case of decentralized digital currencies, the absence of an overarching authority with control over transactions and therefore, the irrevocable nature of digital currency payments poses a significant risk to a user.
Even though digital currencies can empower users with greater freedom and personal control over their own money, they can, in turn, place greater responsibility on individuals to protect their funds. In case something goes wrong, an individual will not have any authority arm to lean on.
In addition to an exclusive personal responsibility, extra risk is added by the exchanges. Exchanges and wallet providers may unconsciously expose users to a higher risk as they are a great target for hackers.
There are other factors adding up to a complete uncertainty when it comes to individuals using digital currencies. Non-face-to-face nature of transactions, the anonymity of actors in such situations, the fact that firms are not registered with any authority, and lack of clarity over the application of existing consumer or buyer protection rights—all contribute to the important issue of a high personal risk and no protection and guarantee whatsoever when it comes to digital currencies.
Monetary and financial stability
The relatively low adoption of digital currencies poses a low risk to monetary and financial stability at the moment. Digital currencies face certain obstacles reaching mainstream acceptance and becoming a serious rival to stable national currencies. However, if digital currencies did become sufficiently widespread, the risks could be highly significant in impact. If digital currency usage grew considerably, this could limit the effectiveness of monetary policy tools, for example, central bank policies and objectives relating to money supply and inflation in the economy.
It is also a possibility that the fixed supply of digital currencies could result in deflation, and as a consequence, economic depression. If used on a scale wide enough, digital currencies could also limit the ability of governments to respond to financial crises.
In addition, if an unforeseen flaw in a digital currency network emerges, there could be significant fluctuation in values and instability across markets.