With the launch of Bitcoin in 2009, cryptocurrency crossed over from being nothing more than an academic idea to becoming a (virtual) reality. Since then, there has been an explosion in the number of different cryptocurrencies on the market and, with it, an ever-growing need for certainty over their legal implications.
Central banks, tax agencies, and regulatory authorities in the country and across the world are all working to decipher the meaning and nature of virtual currencies. In the meantime, investors are cashing in on huge profits from investing in these digital assets and assuming a lot of legal risks in the process.
Is cryptocurrency legal, and how is it protected? Here’s everything you need to know.
What Is Cryptocurrency?
Cryptocurrency or “crypto,” for short, refers to any form of currency that exists in digital format. It uses cryptography to secure and verify transactions and does not rely on a central regulating or issuing authority. Instead, it runs on a decentralized system to issue new units of currency and record transactions. Bitcoin, Litecoin, and Ethereum are among some of the more popular cryptocurrencies.
How Is Cryptocurrency Protected?
To understand how cryptocurrency is protected, you first need to understand how the entire system works. Crypto runs on a distributed, decentralized public ledger referred to as a blockchain.
You can think of this ledger as a database distributed between several nodes in a computer network that stores transaction information in a digital format. Unlike a conventional database made up of tables that hold data, a blockchain consolidates data into blocks, and each block has a specific capacity of information it can hold.
Once this capacity is reached, the block is closed and assigned a unique timestamp and unique identifier known as a cryptographic hash. A link to the previously filled-up block is generated, and the newly-formed block is attached to it, forming a chain of information-carrying blocks, hence the term “blockchain.”
The hash has two main functions:
- To protect the information held in a block by preventing anyone without the required code from accessing this information; and
- To protect the block’s position on the chain by identifying the block that came before it.
The cryptographic hash comprises a series of alphabetical and numerical characters that could run up to 64 digits long. Any new information added to the blockchain is encrypted with a hash, making it permanent and unchangeable.
If someone attempted to tamper with a block held by one of the nodes on the network, it would be easy to identify and rectify the block in question since it wouldn’t match the identifiers embedded in the majority.
Before you can transact crypto on the blockchain, you need two keys: a public key and a private key.
A private key is essentially a digital signature that’s only available to the crypto asset owner. You would need it to authorize any transaction you do.
On the other hand, a public key is used to validate the private key when receiving transactions. Crypto transactions can only be identified by their respective keys and are anonymous.
If an unauthorized third party gets a hold of your private key, they can use it to access your crypto assets and transfer them out of your wallets. Because of the anonymous nature of these transactions, tracing the culprit is near impossible without the help of law enforcement machinery.
How Many Cryptocurrencies Are There?
At the time of this publication, there were more than 18,000 cryptocurrencies listed on CoinMarketCap, with Bitcoin, Ethereum, Tether, BNB, and USD Coin taking the top five spots on the list. Eighteen thousand different types of coins is a lot, if you think about it – which begs the question: Why are they so many to begin with?
The main reason for this growing number of cryptos has to do with the fact that there’s virtually no entry barrier. This means that anyone who wants to create a crypto coin can do it—even you. You don’t need any technical expertise to do it either. You can hire an expert off a freelancing site like Fiverr and have them do it for you for as little as 20 bucks. It is that easy.
This wasn’t always the case, especially in the earlier days when Bitcoin was the only cryptocurrency around. That is until developers began to create altcoins.
Bitcoin vs Altcoin – What’s the Difference?
To understand the difference between the two, we’ll first start by defining what each term means.
What Is Bitcoin?
When Bitcoin was first launched in 2009, it became the world’s first cryptocurrency. Its founder, Satoshi Nakamoto, who’s remained anonymous to date, created it to be a decentralized, distributed, digital currency whose operation did not rely on banks or any other financial institutions.
Since then, several newer cryptocurrencies have emerged, many of which are technologically more advanced and optimized to make transactions faster and more efficient. Today, the majority of crypto users use it primarily as a store of value rather than a unit of exchange.
Since it is more well-known compared to the other cryptocurrencies on the market, it enjoys a fast-mover advantage, which partly explains the wide value margin it enjoys.
You might ask: How many bitcoins are there? The current circulating supply of the cryptocurrency is approximately 19 million out of the maximum available supply of 21 million.
How Does Bitcoin Work?
Bitcoin runs on blockchain technology. Here’s a rundown of how it works:
1. Wallet Creation
If you’re a new user, you need to install a Bitcoin wallet on your mobile phone or computer. The application will generate your Bitcoin address, although you can always create more as needed.
If you need to send or receive payment in Bitcoin, all you need to do is share your Bitcoin address with them and vice versa, just like you would with a regular email address. The only difference is your Bitcoin address will only be used once.
As stated before, blockchain refers to a shared public ledger. The Bitcoin network runs on this system and logs all confirmed transactions. Every time a new transaction is validated, it is added to the chain and is how Bitcoin wallets can compute the user’s available balance.
That way, any new transaction can be verified to confirm its integrity and validate that the sender owns the Bitcoins. The chronological order in which data on the blockchain is stored alongside its integrity is enforced using special encryption technology known as cryptography.
A transaction in the crypto world is defined as a transfer of value between different Bitcoin wallets, which is then added to the blockchain. Every transaction is signed by a “seed” or private key, which functions as a form of mathematical proof that its origin is the owner’s wallet. This signature also bars anyone from altering the transaction once it has been completed. The transaction is broadcast to the Bitcoin network, and confirmation typically takes 10-20 minutes via a process referred to as mining.
Mining, which is essentially a distributed consensus system, is the method used to validate pending transactions on the network before they can be added to the blockchain. It enforces the chronology of the chain, protects the network’s neutrality, and allows different nodes on the network to “agree” on the system’s state.
For a transaction to be confirmed, it needs to be packed into a block embedded with very specific cryptographic protocols, which prevent blocks from being altered in any way since doing so would interfere with the integrity of all the subsequent blocks.
What Are Altcoins?
“Altcoin,” which is short for “alternative coin,” is the general term used to denote any other cryptocurrency apart from Bitcoin. Early altcoins were developed simply as an improvement on the performance of Bitcoin or for some other function entirely.
Ethereum is by far the most popular altcoin in the crypto ecosystem. Cumulatively, altcoins have a market share of approximately 40%, excluding Ethereum, which has nearly 25%. Bitcoin occupies the rest of it.
Proof of Stake vs Proof of Work
One of the defining characteristics of cryptocurrencies is that they are decentralized and distributed. That said, the fact that they didn’t rely on a central authority like a bank or financial institution to verify transactions presented a major challenge for crypto.
Bitcoin, Bitcoin Cash, Ethereum, and Litecoin overcome this hurdle by adopting a mechanism known as proof of work. On the other hand, Avalanche, Cardano, Solana, and a wide range of other platforms have taken a different approach by using proof of stake.
While the two mechanisms are similar in that they are both consensus mechanisms for processing transactions and validating new block entries in a blockchain, the difference lies in how they achieve this goal. Additionally, proof of stake also consumes significantly less energy than its proof of work counterpart.
How Does Proof of Stake Work?
In proof of work, the network nodes use up large amounts of computational resources to generate new valid blocks, which they then agree to add to the blockchain.
On the other hand, in proof of stake, the network nodes put up collateral or a “stake” in the form of cryptocurrency to back the newly-formed block they want to be added to the chain. Although it’s not based on the “one-person-one-vote” premise, it works a little like voting.
Instead, the network of participants, referred to as “validators,” stake a specific amount of cryptocurrency backing the block they want to be integrated into the chain. The amount restrictions vary depending on the blockchain. Holders of crypto “vote” to approve verified transactions in exchange for newly-minted cryptocurrency over time.
Crypto Security Tokens vs. Utility Tokens – What’s the Difference?
While coins and tokens all fall under the same generic umbrella of “cryptocurrency,” they refer to two completely different things. Coins generally denote currency and have a cash equivalent based on demand and supply market forces. On the other hand, tokens denote some type of non-cash-based asset, such as a stake in the ownership of an item with special rights within a blockchain.
Tokens themselves can have value but are not a means of transferring that value. They exist for things that might be more complicated than simple monetary transactions.
For instance, crypto security tokens are tied to securities offerings. Companies issue them as a way to invest in their long-term growth and are regulated like the conventional securities you find in traditional markets.
A utility token is usually issued at an initial coin offering (ICO) and is designed to give preferential treatment (a lot like a “golden ticket”) to token holders. Preferential treatment might be a discount to items in the company’s product line, such as software packages or SaaS platforms.
What Are Meme Coins?
A meme coin is exactly what it sounds like—a cryptocurrency whose creation was inspired by a meme or an internet joke. Dogecoin is a well-known cryptocurrency created from a photo of a Shiba Inu that went viral. What initially started as a joke went mainstream and became increasingly popular and rose in value, and is currently worth about $0.12 per coin.
On March 9, 2022, President Joe Biden signed an executive order that directs federal government agencies, key among which are the Treasury and Commerce departments, to coordinate efforts to regulate digital assets, including cryptocurrencies. The idea is to come up with a comprehensive framework that addresses the emerging opportunities and risks posed by virtual assets.
A 2020 IMF cryptocurrency regulation report had previously echoed these sentiments raising questions on whether the existing regulatory framework and restrictions could adapt to the changing cryptocurrency conditions. The report stated that effective regulation of these digital assets could minimize the risks that come with external socio-economic pressures that often plague financial markets.
Until then, the question remains: How will cryptocurrency impact the future of law? The reality is the cryptocurrency is largely unregulated, with many federal agencies, including the Internal Revenue Service (IRS), the Financial Crimes Enforcement Network (FinCen), the Securities and Exchange Commission (SEC), and the Commodities and Futures Trading Commission (CFTC) all claiming jurisdiction over digital assets. The outcome of the newly-instituted executive order will determine the future of cryptocurrency vis-à-vis regulated cryptocurrency brokers and investors alike.
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