Decoded: What is a cryptocurrency and how does a blockchain work?

The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 is likely to be tabled in Parliament soon. While details of the Bill are not yet known, various voices from within the government have talked about imposing a blanket ban on cryptocurrencies or experimenting with them or allowing them in only limited and closely monitored scenarios. But what is this “currency” that’s making the world go round? To know, let’s get back to basics.

What is a cryptocurrency?

It’s a virtual currency. Every crypto-coin is a unique code, like the serial number on a banknote. Transactions are verified via an electronic ledger called the blockchain (details below).

How is cryptocurrency created and stored?

Coins are created by solving mathematical puzzles in a computer-intensive process called “mining”.  Coins are stored in “wallets”, which are digital directories accessed by passwords. Coins can be broken up into smaller unique units. You can trade a hundred-millionth of a bitcoin. 

Who controls and verifies cryptocurrency?

Cryptos are crowd-controlled. The blockchain is checked to verify a proposed transaction. When a majority of those viewing the blockchain agree that “coin no xxxx” can be transferred from “Wallet A” to “Wallet B”, the transaction is cleared and a new entry made in the blockchain.

How many cryptocurrencies are there?

The S&P crypto index, which is due for launch, will track 550 cryptocurrencies am­ong the thousands available. The imp­ortant cryptos include the original Bitcoin ($1 trillion market value) and Eth­ereum (over $10 billion market value).

Are cryptocurrencies linked to anything in value?

Most are not linked to any asset. Some are “stable-coins” linked to an asset like the US dollar, or a basket of currencies. Facebook is heading a cryptocurrency consortium, which will link the proposed currency “Diem” to a basket of underlying currencies. China is launching a cryptocurrency, controlled by the Chinese central bank, the People's Bank of China.

Are cryptocurrencies used in transactions?

Yes, though this is not very common. But it’s popular for remittances. Brokerages on buying and selling crypto (say buying bitcoin in dollars and selling bitcoin in rupees) is lower than bank charges for USD-INR transfers. Some companies use cryptos for currency swaps. Tesla accepts bitcoins for cars. Cryptos are also popular in gaming and online casinos. Since they are hard for authorities to track, they are notoriously used in drug deals and cybercrimes.

Can you buy or trade cryptocurrencies legally?

Yes, on many trading platforms in multiple currencies. About Rs 35-40 crore of rupee-denominated transactions happen daily.

Why are Indian regulators confused about these new assets?

Regulators have to define cryptos before they can work out tax implications. Are these art objects or currency or something else? Many nations (Japan, Korea, Australia, etc) have clarified tax implications of cryptocurrencies. India has not. Indian regulators are worried about impacts on remittances of roughly $80 billion per annum. They are unhappy the inability to trace crypto transactions.

Is a ban likely in India?

There are strong rumours about a legislative ban. But it will be impossible to ban cryptos without altering many other regulations. A resident Indian can remit money abroad legally for many purposes, including investment in overseas assets. Therefore, they may trade cryptocurrencies through overseas brokerages. Restricting crypto trades will impact such regulations. It will also hurt all who have invested in good faith.

Why are cryptos hard to use for transactions?

Cryptos are extremely volatile. Transactions are slow — the blockchain mu­st be checked by many people before a transaction clears.

Why are cryptos unsuitable for traditional banking?

Fractional reserve banking works as follows. You deposit Rs 100 and the bank lends out Rs 90 (keeping Rs 10 in reserve in case you wish to withdraw some cash). That Rs 90 is again lent out, or used for other purposes. The bank doesn’t issue physical notes. Nor do lenders down the line. This effectively creates money. This is impossible with cryptocurrencies. Each coin has a unique code. Loans mean transferring specific coins.

Why are there worries about the crypto carbon footprint?

Mining is computer-intensive, with specialised chips and huge power consumption. Globally, crypto mining consumes the same amount of power as nations like Belgium. Where this is not renewable power, it leads to large carbon impact.

How does a blockchain work?

The history of every coin is recorded from its mining through every transaction in a blockchain. Imagine many glass lockers, containing specific notes with unique serial numbers. The lockers can only be operated by somebody with a password. But they are visible to all. If the owner of a locker wishes to transfer a specific coin to another locker, viewers check 1) if the coin is in the given locker 2) a double transaction is not being attempted. 

Many people can see a blockchain and download copies. Every proposed transaction must be confirmed by the majority viewing it. Once a transaction is accepted and entered in a blockchain, it’s hard to alter, or conceal it. Given the multiple copies, forging blockchains is very hard.

How else are blockchains used?

Banks use these for internal audits. Frauds like Nick Leeson at Barings Bank (using a secret account) or Nirav Modi (where one Punjab National Bank officer sanctioned huge concealed forex transactions) are impossible.

Blockchains are also used in refugee aid programmes by the UNHCR. Refuge­es are identified by biometrics (iris scans and fingerprints). They can pick up food, etc, with records kept on a blockchain. 

What are the more unusual ways to use blockchains?

Blockchains are used to validate art, fine alcohol, non-fungible tokens (NFTs) and luxury goods. Say, an artist creates a limited-edition of 100 signed prints, or a distillery produces 100 bottles of single malt, or a designer makes 100 signed handbags. Each item is given a unique code and put on a blockchain with transaction history. Forgeries are easy to flag.

Blockchains are also used to avoid censorship. The record is unchangeable and multiple copies are easily made. Chinese students have sometimes reported putting “anti-national” information on blockchains.

What are “trustless contracts”?

Blockchains can create “trustless contracts”. Say, a municipality hires a contractor to build a sewage network to service 100 households. The municipality puts the money in escrow and creates a blo­ckchain for those 100. When the households agree they are satisfied, money is automatically released. No bribery, no delays.