Definitions and Key Features of Cryptocurrencies, Tokens, and Regulatory Approaches to Them
The popularity of cryptocurrency has been rising sharply along with its value. Today there are over seven thousand cryptocurrencies and tokens in circulation with a total market capitalization of over EUR 348 billion. [1] In the crypto industry, it is constantly emerging new crypto projects, products, and services, as well as innovatory kinds of crypto exchanges such as DEXs. These processes expanded the use of different terms, such as cryptocurrency, token, electronic money, virtual currency, digital currency, which are often misapplied and do not actually mean the same thing.
In an attempt to clear up things, we will examine the term cryptocurrency and its specific features, consider the terms mentioned above in reference to cryptocurrency and each other, and also look over various attitudes of countries and organizations towards cryptocurrency.
Cryptocurrency
The cryptocurrency was intended to become a revolutionary means of payment and a medium of exchange, removing the need to rely on any third party like banks in transactions. Bitcoin as the first cryptocurrency was designed in 2009 to be an electronic coin functioning on top of “an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” [2] Since then, cryptocurrencies have received wide recognition as a means of exchange for goods and services in many parts of the world. A set of money-like inherent features of cryptocurrencies as fungibility (full interchangeability with others), divisibility, portability, and durability by increasing public involvement lately was supplemented by such features as acceptability and scarcity. Nowadays, Bitcoin and many altcoins are accepted by many companies, organizations, and retailers worldwide. Scarcity of many cryptocurrencies secured by their deflatory nature. Besides, to enhance the value of the cryptocurrency unit caused by its shortage, lots of locking mechanisms have been invented that encourage crypto holders to stake a cryptocurrency but not to use it as money (e.g., Decred staking). Accordingly, cryptocurrencies are commonly used, much like real-life digitally circulated money. They are transferred, used for payment, used as a store of value or as a unit of account, they can also be traded on crypto exchanges. What is more, in day-to-day life it is possible to purchase or sell cryptocurrencies through crypto ATMs or even to pay at stores using crypto debit cards which work just like any other conventional debit card. Crypto exchanges and projects focusing on developing crypto payment systems have made substantial progress in this sector. For instance, a Coinbase card allows users to spend funds from crypto wallets stored on Coinbase exchange; in a payment platform Wirex cryptocurrencies sent to its accounts from external crypto wallets can be converted into everyday purchases, while SnowGem is to produce a debit card, which along with other features, can be loaded with the coins made by running SnowGem nodes or by swapping different cryptocurrencies within their non-custodial mobile wallet (BitFrost) to stable coins like USDC. [3]
Currently, there is no state jurisdiction under which a cryptocurrency has a status of legal tender. The aforementioned processes have been going mostly without their integration into states’ monetary systems. Though some countries, like Senegal, Tunisia, Venezuela, have implemented the idea of issuing blockchain-based national digital currencies which are entirely dependent on the central banking system. [4] Most certainly, such national digital currencies can be viewed only as “quasi cryptocurrencies” as they are basically digital substitutes for paper national currency and do not possess a key cryptocurrency’s feature — decentralization.
A cryptocurrency is created and functions on a specific P2P network system — an independent and decentralized blockchain. There are different types of blockchains varying on a core layer, viz. a consensus algorithm (PoW, PoS, DPoW, etc. or their hybrids), all of which apply cryptographic techniques to secure cryptocurrency transactions.
Regarding a cryptocurrency as money, decentralization of a blockchain plays a key role because there is no central authority, institution, individual who issues, leverages over, or deactivates the cryptocurrency. All blockchain’s processes are governed by strict mathematical rules incorporated into the system (which are subject to changes only by consensus of the majority of nodes), and a record of all transactions is kept in a distributed immutable ledger. A cryptocurrency keeps circulating unless its native blockchain ceases to exist. That can happen, for instance, if there are less than three nodes left on the blockchain or having perpetrated a 51% attack, an intruder makes modifications to the blockchain’s protocol.
A cryptocurrency relates to a middle layer of a blockchain, represents a native digital value for that blockchain, and is not backed by any authority, nor is it a digital representation of any other asset, service, or good. Within the blockchain, a cryptocurrency serves primarily as an incentive for nodes’ operators to run the P2P network system by rewarding them with a certain number of cryptocurrency if a block is successfully built. In addition, on some blockchains cryptocurrency coins can function as a voting unit used by network participants to initiate proposals or make decisions. Some cryptocurrencies like Ether, NEO have more functions as they are used within their blockchains to facilitate smart contracts built on them. Even before entering the financial market and getting money value, within the blockchain cryptocurrency have their own “functional” value, e.g., in PoS a node with a larger amount of collateral accumulates more cryptocurrency coins and therefore can conceivably have more voting power.
There are deflationary and inflationary cryptocurrencies. The former is of a fixed supply, such as Bitcoin and Litecoin — at the point in time when their supply reaches the 21 million coins and the 84 million coins respectively, there will be no coins being mined. Accordingly, it can be supposed that by then the existing coins may have increased in value, as their total amount is limited. Such cryptocurrencies as Ether, Cosmos, Algorand are inflationary, i.e. the coins are continually created without limited supply. The main issue with such currencies is that their value can potentially decrease as the supply grows (that is generally addressed by burning cryptocurrency, buying back and holding it). However, the inflationary nature of cryptocurrencies should not be considered as their disadvantage, given that it pursues practical purposes. For example, Monero provides for tail emission which means that block reward ceased by now will commence again at the end of May 2022. This ensures the miners always have an incentive to mine in order to keep the security of the network and competition between them decreases fees. [5] It is worth noting that Monero tail emission can also be viewed as “deflationary”, as the demand in the coins (due to lost or burned coins) would increase faster than their emission.
Cryptocurrency is stored in a cryptocurrency wallet, i.e. a program (either online or offline) or a device, which consists of pairs of public and private keys. A public key is a public address that is used to send or receive cryptocurrencies. A private key is the most essential aspect to be concerned with when it comes to blockchain. It gives access to cryptocurrencies stored in the corresponding public address and employing a digital signature enables spending cryptocurrencies from it. Thus, there is a specific rule of cryptocurrency usage: whoever has a private key controls all the crypto assets kept in a tied public address or a wallet to access multiple accounts simultaneously (these options are subject to the type of the wallet — with a raw private key or a mnemonic seed). There are cryptocurrency wallets in which a crypto owner has full control over his private keys and assets (non-custodial wallets), and wallets where a third party holds his private key while the owner only authorizes transactions (custodial wallets). In the latter case, the owner should exercise particular caution when he sends his assets to a custodial wallet of a third party, such as a centralized crypto exchange, as the private key along with his funds gets out of his control going over to the third party. If this exchange is hacked or banned by a government, the assets may be lost irrevocably. For this reason, crypto users should not share their private keys with anyone not intended to take control of the assets but always adhere to the following rule: “not your keys — not your money”.
Cryptocurrency blockchain may be regarded as one of the most transparent payment systems ever created. A public online ledger in perpetuity records every single transfer performed between crypto addresses. In ledgers of Bitcoin, Bitcoin Cash, Ripple, without special permission or login into “client personal accounts” everyone can track all transactions of any public address, amounts of transactions, their date and time, as well as to figure out a balance of a particular address (by adding up all the outputs connected to the address). These public addresses are created individually by each owner’s wallet and considered to be pseudonymous, i.e. identified by a string of letters and numbers which are not linked to proper names of the transacting parties. Still, real holders of crypto addresses can be identified when they, for example, transfer cryptocurrency to exchanges or organizations that collect client’s identity information. Therefore, these types of blockchains are not fully anonymous. The possibility of anyone to observe the moving of crypto transactions raised lots of public concerns, causing many blockchains to have advanced the level of privacy for their transactions ensuring untraceability. At the forefront of the privacy movement there are such anonymous cryptocurrencies as Monero (“ring confidential transactions” and “stealth addresses”) and Zcash (“a zero-knowledge proof”) which have developed mechanisms obfuscating the identities of the sender, the receiver, and the transaction amount and thus providing their users with privacy (but still anonymity of these cryptocurrencies has previously been brought into question). [6]
Token
On a technical level the main distinction between cryptocurrencies and tokens is that the latter is issued as an asset either on the layer of decentralized applications of independent blockchains with its own cryptocurrencies (e.g., Sqrl on Telos blockchain — EOSIO protocol) or on dependent, second layer blockchain protocols built on the independent blockchains (e.g., Tether USDT on the Omni Layer Protocol on the Bitcoin Blockchain in 2014). Thus, tokens share with cryptocurrencies the same important feature, namely, cryptographic protection and secure recording of transactions on the blockchain to which a token’s ledger is tied. Nowadays, there are several popular platforms on which tokens are created, such as Ethereum, NEO, Waves, Tron, etc.
The purposes of tokens differ, as their governance, functional and technical parameters can be determined by any rules programmed by their creators. Tokens can be kept decentralized or centralized; in the latter instance, tokens are fully controlled and managed by specific individuals and at any moment can be deactivated by them.
Tokens can be of the same characteristics as cryptocurrencies — the so-called currency tokens. The tokens function as a means of payment (e.g., USD Coin). If so provided by the protocol, currency tokens can be used as remuneration for the nodes of a blockchain or as a voting tool granting voting rights to their owner.
Utility tokens are created to be used within the ecosystem of a blockchain to give the tokens holder access to its functions or to purchase goods and services. For instance, the Kryll token (KRL), an ERC20 based token, is used on the platform Kryll.io (a platform for trading strategies building) in order to fuel live trading strategies and to execute them automatically in the cryptocurrency markets.
Another category of tokens is security tokens. They encompass tokens that are principally issued with a purpose to raise public funds for crypto projects. Such tokens are offered through ICOs and represent an investment in an enterprise made by investors in anticipation of future profits from the increased value of the tokens. However, the actual ownership in that enterprise is not conceded to the token owners. This fundraising tool, being initially strengthened in an unregulated environment, allowed many scammers to take advantage of the investment rush. Therefore, regulators across the globe have started to develop and implement statutes on ICOs and safeguards for individuals investing in such tokens.
Further, there are tokens that resemble conventional financial instruments but in the form of digital assets run on the top of blockchain — equity tokens and debt tokens. The former represents an ownership share in a corporation (e.g. shares of Quadrant Biosciences Inc.), the latter constitutes bonds or mortgages. In fact, plenty of things can be tokenized: goods, services, financial assets — tokens can become a digital representation of all of them.
Governance tokens provide their holders — community members with the right to manage or participate in the governance process of the cryptocurrency network. The decision-making processes are usually made through voting and may concern updating or changing parameters in a codebase or governance, introducing new products and services, hiring staff, advertising, and so on. For example, an automated liquidity protocol Uniswap allocated Uniswap community members its tokens — UNI, allowing them to take part in governance decisions regarding UNI community treasury, the protocol fee switch, Uniswap Default list, etc. [7]
In comparison to cryptocurrencies, tokens can be non-fungible, and each token can represent a unique and non-interchangeable asset (e.g., CryptoKitties built on ERC-721).
It is worth mentioning that many tokens can fall into several types of the classification, so the types of tokens should be considered as interrelated.
Digital currency, virtual currency, electronic money and states’ approaches to cryptocurrency
Digital currency is considered to be an umbrella term for all forms of a digital representation of value used as a medium of exchange that can be transferred, stored, and traded electronically. Specifically, all types of digital cryptocurrencies have no physical existence and correspond to a balance recorded in certain databases (network databases, electronic computer databases, etc.).
Digital currencies can be divided into regulated by a government and unregulated currencies. In the first instance, a state’s central bank can issue a digital form of its fiat currency notes (also known as “traditional digital assets”). The most used term for this type of digital currency is electronic money. Under the Article 2(2) of Directive 2009/110/EC, electronic money means “electronically, including magnetically, stored monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transaction, and which is accepted by a natural or legal person other than the electronic money issuer.” [8] In other words, electronic money represents a claim to physical legal tender and on its issuer.
In the instance with unregulated digital currencies, they are not regarded as being legal tender (although their denomination can be attached to it), as created without involving traditional financial institutions, such as central banks. They may be under control of developers, organizations, or may be run by a network protocol. Not being backed by any central bank, their value is based on the underlying asset specified by developers or merely on users’ willingness to pay for them. Independence on the rules applied to national currency provides for more simplified ownership transfer across jurisdictional borders. (It should be noted that the term “unregulated digital currency” in this context is used as opposed to the term “regulated digital currency”; as we will consider below in some state jurisdictions the former has been regulated.)
Unregulated digital currencies are more widely known as virtual currencies, the term which embraces lots of digital asset types, including cryptocurrencies. There is a contrary view that says cryptocurrencies are not subject to the term virtual currencies, but “completely separate to virtual currencies” primarily because the latter is used as a payment method among members of certain online communities that is controlled by its developers. [9] With that said, virtual currencies are deemed to be controlled online currencies integrated into specific ecosystems like game ecosystems or virtual domains. Such a position was likely formed due to the definition provided in 2012 by the European Central Bank (ECB) [10], which limited the usage of virtual currencies to a specific virtual community. Since then, the positions of the regulatory institutions have been reconsidered accepting a more wide-ranging concept, accurately summing up cryptocurrency. In 2014 the European Banking Authority defined virtual currency as “a digital representation of value that is neither issued by a central bank or a public authority, nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred, stored or traded electronically.” [11] According to an ECB’s report of 2015 — virtual currency is “a digital representation of value, not issued by a central bank, credit institution or e-money institution, which, in some circumstances, can be used as an alternative to money.” [12] The approach combining virtual cryptocurrencies with virtual ones is also traced in other regulatory and non-regulatory documents issued in the EU. For instance, Directive EU 2018/843 (also known as the “5th AML Directive”) defines virtual currencies as “a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically.” [13]
We can distinguish between convertible and non-convertible (closed) virtual currencies. In the former case, the currencies can be exchanged back-and-forth for fiat money. All cryptocurrencies are convertible (provided there is enough liquidity); other examples include WebMoney. In their turn, non-convertible currencies cannot be substituted for fiat money and are designed to operate in closed-loop environments (e.g., World of Warcraft’s Gold, Ultima Online’s Gold Coins, Amazon Coins).
Summarizing the above, digital currencies can be deemed as a superset of electronic money, virtual currencies, and other possible forms of digital presentation of value. Within this framework, virtual currencies include such separate subsets as cryptocurrencies, other convertible virtual currencies, and closed virtual currencies of the restricted usage (e.g., in-game currencies or currencies circulating within a particular social network).
Although some policymakers at European and international levels consider cryptocurrencies basically as a form of virtual currencies (ECB, IMF, EBA, ESMA, World Bank, and FATF [14]), there is no commonly accepted legal definition of cryptocurrencies or a single approach to their comprehensive statutory regulation. Furthermore, cryptocurrencies are objects of various relations that need to be regulated, for instance, taxation, consumer protection (e.g., warning about the risks involved), anti-money laundering and due diligence procedures, regulation of activities of financial service providers and other concerned market participants, etc. Laws, policies, and regulatory implications on these issues, including the categorization of cryptocurrencies’ status tend to vary significantly among countries and even among their competent authorities.
In the EU specific supranational framework regulation on cryptocurrency as a currency has not been passed yet. It is reported, however, that by 2024 the EU is to introduce comprehensive legislation that will promote blockchain and crypto assets in the financial sector. [15]
So far, the EU members have implemented the 5th EU Anti-Money Laundering Directive. Some of them, guided by the recommendations issued by the FATF in 2019 (regarding “know your customer” and anti-money laundering standards) and other EU bodies, have developed their own regulatory rules on cryptocurrency. However, the intensity of rulemaking among the EU members varies a lot.
On the one hand, in Cyprus, despite the regulator’s efforts to foster innovation within the blockchain sector, there is no specific regulation on cryptocurrency, limited as of today by several warnings issued by the Central Bank of Cyprus and the Cyprus Securities and Exchange Commission to potential investors and investment firms. Still, it is not prohibited to use cryptocurrency, including as a means of payment. In particular, the University of Nicosia was intended to become the world’s first to accept bitcoins for tuition. [16]
On the other hand, some EU countries recognize the potential that the blockchain offers to various areas of the economy and take the opportunity to become a world leader in this sector. Thus, in Switzerland, the government’s general attitude towards cryptocurrency is very positive. [17] There is no tailor-made regulation for cryptocurrencies, yet this subject has been already adequately regulated by various sectoral requirements (e.g., rules for bitcoin kiosk operators and blockchain companies, anti-money laundering rules, [18] etc.). Cryptocurrencies are classified as a means of payment or money, having been distinguished from utility tokens. Not being a legal tender, cryptocurrencies are widely used and have adopted typical functions of money. For instance, from 2016 the Zug city accepts Bitcoin and Ether for tax payment, and from February 2021 this practice is to be expanded within the whole canton of Zug. [19]
The German authorities have also developed a handful of rules applicable to cryptocurrencies, although their attitude to cryptocurrency is more precautionary due to consumer-protection considerations. German law considers cryptocurrencies as financial instruments (that are used as a means of exchange among physical and legal persons), and it obliges cryptocurrency issuers, wallet providers, and cryptocurrency exchanges to obtain a license from the regulator. [20] From the beginning of 2020, bank customers can hold cryptocurrencies in their bank accounts, as German banks are allowed to store and to sell cryptocurrencies to both retail and institutional investors. [21]
In the United States, in a country where the usage and trading of cryptocurrencies are explicitly allowed (although they are not integrated into the state’s financial structure), the federal government has not yet adopted coherent framework law concerning the crypto industry. At present, some federal agencies treat cryptocurrencies in different ways, depending on the sphere of their authority. As an illustration, the Commodity Futures Trading Commission, exercising control over commodity derivatives transactions, views cryptocurrencies as commodities; the Internal Revenue Service considers cryptocurrency as property for tax purposes; the Financial Crimes Enforcement Network treats cryptocurrency as money in relation to “know your customer”, and anti-money laundering matters; the Securities and Exchange Commission views them as securities to which applicable the securities laws on registration, disclosure and anti-fraud requirements. [22]
By contrast, in Russia, the authorities made an effort to provide the foundation for further Russian cryptocurrency legislation having enacted the law “On Digital Financial Assets”. [23] The law lays down the prohibition of using cryptocurrencies as a payment method for Russian companies and tax residents, including indirectly cryptocurrency payments like “exchange of assets” when parties agree to transfer cryptocurrency in return for goods. It is worth mentioning that the scope of legal usage of cryptocurrencies is still uncertain, as there have been proposed amendments to the law which provide for a ban of all cryptocurrency transactions except the obtaining of assets through inheritance, bankruptcy, and enforcement proceedings. By late 2020 it is expected another law to be passed (“On Digital Currency”) which will envisage the further detailed regulatory framework for cryptocurrency. [24] Meantime, Binance, the world’s largest crypto exchange, has been blacklisted by the Russian regulator Roskomnadzor by adding it to the domain name register containing information prohibited for distributing in Russia. [25]
There are also countries with a more radical approach to cryptocurrencies which imposed a blanket ban on any activities involving cryptocurrencies (Algeria, [18] Pakistan, [26] Morocco [27]). It is important to point out that some countries have moved away from the “total ban” approach that had been earlier pursued, making steps towards the legalization of some crypto activities within their jurisdiction (Vietnam, [28] Egypt [29]).
From the different perspectives set above, we can conclude that the cryptocurrency has a unique nature and is not attributed to any actual class of assets.
Summarizing the key features, a cryptocurrency:
· is a convertible virtual currency;
· used as a complete alternative to electronic money while having more functionality than electronic money;
· is run on an autonomous decentralized blockchain not operated by any control centre;
· is not backed by any central bank, its value determined by the public’s “willingness to pay”;
· is pseudonymous; in some instances, a cryptocurrency can be anonymous. The level of anonymity one can achieve depends on the type of blockchain is used;
· has a unique approach to ownership that is established with the possession of private keys.
A token is a broader concept than cryptocurrency. Tokens are divided into several categories, among which, based on their purpose, we can equate currency tokens with cryptocurrencies.
In the regulatory space, the approaches to cryptocurrency vary, although more and more countries tend to move towards embracing the advantages offered by blockchain technologies in general and cryptocurrencies in particular. Certainly, there are still lots of associated risks to be assessed and managed in this fast-changing sector. But being isolated from the crypto-using rest of the world presumably would not work either, provided cryptocurrency does not recognize national borders, is unaccountable to any authority, and its acceptance has been facilitating intensely by many companies operating worldwide online payments. That is why it has become increasingly clear that the mass adoption of cryptocurrencies as a means of payment is just a matter of time.
References
[1] CoinMarketCap
[2] Satoshi Nakamoto. Bitcoin: A Peer-to-Peer Electronic Cash System. 2009
[5] Moneropedia
[6] Remaining Anonymous: Which Crypto Privacy Solution Works Best? — Andrey Shevchenko, April 2, 2020
[7] Uniswap
[9] Differences Between Tokens, Coins and Virtual Currencies, Explained — Stephen O’Neal, July 29, 2019
[10] Virtual currency schemes. European Central Bank. 2012
[11] Opinion on ‘virtual currencies’. European Banking Authority. 2014
[12] Virtual currency schemes — a further analysis. European Central Bank. 2015
[14] Prof. Dr. Robby Houben, Alexander Snyers. TAX3 study on cryptocurrencies and blockchain. 2018
[15] EU to introduce crypto-assets regime by 2024, EU documents say — Huw Jones, September 18, 2020
[18] Digital Currencies: International Actions and Regulations
[20] Stefan Henkelmann, Lennart J. Dahmen. Blockchain & Cryptocurrency Regulation 2020. Germany
[21] Germany Passes Law Enabling Banks to Store Cryptocurrencies — Tim Fries, July 7, 2020
[22] How the US and Europe Are Regulating Crypto in 2020 — Elena Perez, July 20, 2020
[23] Federal Law №259-FZ of 31.07.2020 “On Digital Financial Assets”
[25] Binance’s announcement. September 25, 2020
[26] Two cryptocurrency traders arrested in Shangla — Shahab-ud-Din, January 24, 2020
[27] Morocco Regulators Warn of Penalties for Cryptocurrency Use — Sujha Sundararajian, November 21, 2017
[28] Ministry to set up research group on crypto currency — May 11, 2020
[29] Egypt Lifts Ban, Will Allow Licensed Cryptocurrency Companies — John Biggs, May 29, 2019
