Photo: Reuters/Benoit Tessier

Cryptocurrencies are a natural convergence of the Internet and digital payment systems. It is commonplace for shoppers to pay vendors with a mobile phone linked to a bank account. What is new is that cryptocurrencies like bitcoin bypass the bank. The mediator of the transaction is a ledger maintained on a blockchain.

What would happen if bitcoin or other cryptocurrencies were adopted like a popular app on mobile phones?

The Chinese government decided it didn’t want to find out, and blocked ICOs (initial coin offerings, a means of crowd-funding using a cryptocurrency). At the same time the government is studying blockchain, the network-based brain of cryptocurrencies.

The underlying idea of blockchain is valuable to countries considering digital currencies, and it will revolutionize the IoT (Internet of Things). A blockchain is used as a distributed ledger managed by a peer-to-peer network. Generating cryptocurrencies requires enormous computing power. A detailed description is here.

Cryptocurrencies may never be as secure as the gold in Fort Knox, but they must have sufficient protection before they can issue, store and process billions, if not trillions, of their equivalent in dollars, euros or yuan. The issuance and use of cryptocurrencies raises many questions, some technical and some related to the financial and monetary architecture in place today.

The selling point of bitcoin is compelling: Cut out the middlemen of transactions (usually the commercial banks) – as well as central banks that print all the money they deem required, opportune or viable. The latter has contributed to massive debt in many countries, a lack of transparency and financial speculation that further enriched those already wealthy. Much of this wealth is hidden in offshore accounts in countries that are virtual protectorates of the world’s “leading democracies”, the architects of the current monetary system.

Fundamental flaws

Anyone with the required skills can create a blockchain. And many do. The latest figures suggest there are well over 1,000 cryptocurrencies, and the number is growing.

Former Greek finance minister Yanis Varoufakis has identified what he sees as the fundamental flaws of bitcoin. He fears the emergence of a “bitcoin aristocracy” and points to the impossibility of separating speculation from transactional use. His critique is here.

Bitcoin was introduced in 2009, the year after the financial crisis, as a software-based peer-to-peer payment system and digital currency. Its invention is attributed to the mysterious (perhaps fictitious) Satoshi Nakamoto. If Nakamoto owns a substantial number of bitcoins, as some have speculated, he could singlehandedly influence its value.

A cryptocurrency is not just one thing: It is a currency, an investment, a technology and an anti-establishment ideology. Investing in bitcoin is not for the faint-hearted.

In 2014, Tokyo-based Mt Gox, a bitcoin exchange that handled 70% of global bitcoin transactions, lost 850,000 bitcoins belonging to customers and representing an estimated value of US$450 million. The company went into liquidation. Tokyo security company WizSec concluded that most of the missing coins were stolen from the Mt Gox exchange in the period between 2011 and 2014.

This and other security concerns (North Korea is accused of attacking various cryptocurrency exchanges) has not dented faith in blockchain, and for good reason. Blockchain technology will change the way the world – and especially money – works. And it confronts governments with a dilemma. Unregulated cryptocurrencies are nearly impossible to control – and impossible to tolerate as an “insurgent” currency beyond the reach of tax authorities and central banks.

Governments are responding. This year the People’s Bank of China said it had found “irregularities” at China’s biggest trading exchanges accounting for about 98% of the global bitcoin market. The announcement came on the heels of attempts by the Chinese government to stem the outflow of yuan. Bitcoins are used to evade capital controls.

The Japanese government is preparing to impose taxes on transactions involving bitcoins and other virtual currencies, including gains from trading bitcoins on online exchanges, purchases made with bitcoins, and companies earning revenue from bitcoin transactions. The new rules may prohibit banks from handling bitcoins, and securities firms would be barred from brokering bitcoin trades.

The German Finance Ministry recognizes bitcoins as “a unit of account” comparable to foreign-exchange accounting units that are not legal tender. It sees bitcoin as a financial instrument similar to “private money” and bitcoin mining as “private money creation” with profits subject to capital-gains tax of 25% unless they are held for more than a year. The message: Feel free to use bitcoin, but make sure you pay taxes in euros.

The US Internal Revenue Service, notable for its international reach, has provided initial guidance for cryptocurrencies. For US federal tax purposes, virtual currencies are treated as property, and transactions using virtual currencies must be reported in US dollars. The FATCA (Foreign Account Tax Compliance Act) makes trading in bitcoin overseas problematic for American citizens.

Follow the money

The ideas and ideals behind cryptocurrencies are precisely the reason governments can’t allow unregulated digital currencies to go mainstream. Apart from a loss of control over the money supply, interest rates, and the ability to impose taxes, governments have long-term obligations to society, among them pension payments.

Both governments and private pension funds have trillions of dollars invested in various assets to meet pension obligations. US bonds are part of the portfolio of many pension funds. If the country were unable to collect taxes to pay the interest on its bonds, it could not meet its obligations. This would have a domino effect involving not only pensioners; it would put the entire financial and economic system at risk.

The Chinese government is speeding up investment in cryptocurrency technology to replace paper money with digital currency. The Ministry of Industry and Information Technology (MIIT) recently approved nine products that meet the country’s “trusted blockchain standards”, including Tencent Blockchain developed by online payment system Tenpay, and a platform from Chinese telecom conglomerate ZTE.

The Chinese newspaper Financial News, usually reflecting the view of the People’s Bank of China, recommended that the government accelerate the process of launching a sovereign digital currency after it curbs the risks of cryptocurrencies. The MIIT published a white paper announcing its intention to be at the forefront of blockchain technology and encouraged Chinese companies to become involved in setting global technical standards.

Bitcoin has anarchist roots in cyberpunk, a movement protesting the existing world order, including the monetary and financial system that concentrates global wealth and power in the hands of the few. Cryptocurrencies are tools to undermine this skewed system. With the Chinese government, the movement has a powerful opponent that will usurp its weapon. But when the peer-to-peer principle at the heart of cryptocurrencies becomes the foundation of a more transparent and equitable global financial architecture, which is inevitable (it is virtually impossible to make is less transparent and more inequitable), the cyberpunkers will be able to claim a major victory.

The peer-to-peer community, today’s avant-garde at the intersection of technology, community and environment, has its own view of the crypto-revolution. Says Michel Bauwens, founder of the Foundation for Peer-to-Peer Alternatives: “In P2P terms, the blockchain is very flawed. Because it relies on enormous computing power to create its currency, it is based on exponential extraction of energy from an endangered planet, and on extracting value from newcomers.”

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Jan Krikke

Jan Krikke is a former Japan correspondent for various media, former managing editor of Asia 2000 in Hong Kong, and author of Quantum Physics and Artificial Intelligence in the 21st Century: Lessons learned from China.