Cryptocurrencies
What cryptocurrencies are, how they work, the benefits and challenges they offer, and how regulators have reacted to them.
In 2022, the Government announced its vision for the UK to become a global hub for the crypto and digital assets industries. Since then, it has introduced legislation that will support the use of one type of cryptocurrency – backed stablecoins – as a form of payment. In February 2023 it launched a consultation to develop a new regulatory regime for the crypto sector.
What are cryptocurrencies?Cryptocurrencies are a digital means of financial exchange. They were originally intended to overcome limitations of existing currencies and financial transactions.
The best-known cryptocurrency is Bitcoin, but there are over 22,000 different cryptocurrencies (or ‘coins’).
Although there is some variation in the way that they work, most cryptocurrencies rely on trust in algorithms and technology. This differs from traditional ‘fiat currencies’ (like sterling or euros) whose value and reliability are guaranteed by governments and central banks.
But this entirely decentralised approach also means that there is no central authority to oversee the coin or its failures, or to stabilise its value. So its value can rise or fall quickly and dramatically. This has made many coins – notably Bitcoin – attractive as speculative investments rather than as a useful means of exchange.
Because of this, many observers (and particularly regulators) refer to them as ‘cryptoassets’ rather than ‘cryptocurrencies’.
But one type of coin – the stablecoin – is designed to eliminate volatility and so to be more useful as a means of exchange.
How do cryptocurrencies work?Users of cryptocurrencies may set up an electronic ‘wallet’ to hold funds. They may receive public and private cryptographic keys and a ‘public address’. These allow them to make and accept transfers and to withdraw funds. But many users open simpler accounts with crypto exchanges, particularly if they are more interested in speculating with cryptocurrencies.
All cryptocurrencies use distributed ledger technology (DLT) to verify transactions. In traditional currency transfer, there is limited recording of individual transactions in senders’ and receivers’ accounts. In DLT, transactions are confirmed by a wide range of participants before being added to a permanent record. The most familiar version of that record is the blockchain, as used by Bitcoin. The number of confirmations and the public record in the blockchain should, in theory, make retrospective changes to the record virtually impossible.
Benefits and challenges- Cryptocurrencies are a relatively new phenomenon. The way they operate can challenge existing systems for good or bad. The technology may have been over-hyped and presented as a solution for vague or unidentified problems.
- Because of their volatility, cryptocurrencies have often been popular in countries in economic chaos or subject to international sanctions. But many users are attracted to that volatility in the hope of making money from speculating.
- Proponents of cryptocurrencies involved have often suggested that their adoption could empower the unbanked and dramatically reduce currency transfer costs(pdf). But transactions can take some time to complete. As well as rendering the approach useless for most payments, this can give rise to higher charges for faster approval.
- Some cryptocurrencies consume vast amounts of electricity and computer processing power. This is unlikely to be sustainable for continued expansion. In February 2023, a single Bitcoin payment was said to use as much electricity as a single US household does in 27 days. But in 2022, one coin, Ethereum, reduced the number of validations required for its payments – and expected to reduce energy consumption by over 99%.
- There have been concerns that the anonymous and stateless nature of most cryptocurrencies has made them attractive to organised crime and tax evasion. While Bitcoin was indeed strongly associated with the ‘dark web’, it’s not clear how attractive crypto is to criminals. The public blockchain is public and it is often possible to track transactions.
- Cryptocurrencies can present major risks to consumers. There is little or no guarantee for protecting investment. Cryptocurrency exchanges can be hacked. Customers who lose their cryptographic keys lose all access to their funds. There is a wide range of scams that take advantage of the mystique of the cryptocurrency.
As in much of the world, the Bank of England and the Financial Conduct Authority (FCA) had until recently tended to play down the risk to established systems, while cautiously welcoming the innovation that the new technology offers. Early regulatory responses focused on:
- highlighting risks to consumers
- registering crypto businesses in line with money laundering regulations
- clarifying and updating tax arrangements relating to cryptoassets
In 2021, the Kalifa Review of Fintech argued that the UK could become “a leading global centre” for the crypto and digital assets industry.
The Government built on that vision in 2022 and since then has announced a range of initiatives that will support the growth of the industry, while continuing to protect consumers. These include:
- regulating certain stablecoins to allow them to become a “recognised form of payment” through the Financial Services and Markets Bill 2022-23
- giving the FCA more power to regulate the way that cryptoassets and crypto businesses are promoted
In February 2023 the Government launched a consultation on a new and wider regulatory regime for cryptoassets that would, among other things, require crypto businesses to:
- be authorised by the FCA
- conduct due diligence on any cryptoasset that they trade in and build in safeguards for consumers
- develop a shared understanding of what constitutes market abuse and systems for identifying and disrupting it
UK regulators also work closely with international agencies, particularly the Financial Action Task Force and the Financial Stability Board to coordinate and strengthen international policy relating to cryptoassets.