BitcoinCryptocurrencyDigital Currency

What Is Digital Currency And How Does It Function?

Digital currency is a new electronic payment system that involves the use of software code to function as money over a computer network, much like the internet.  The most famous digital currency currently is Bitcoin.  Digital currency is built on the equivalent of a computer operating system, called a blockchain.  A digital currency has each of its monetary units (called “coins”) in an electronic registry, which is stored in computer network addresses, called “wallets”.  Wallets can be stored on the internet or specific computers or mobile phones (a hand-held computer).

A wallet has a cryptographic “public key”, which is an advanced encrypted software code with a string of numbers and letters that includes permissions to ensure privacy on the network and prevent unauthorized access to the network.  (This is where the term “crypto currency” is used to describe digital currency).  Each public key has a matching “private key”, which is known only to the owner of the digital coin.  Control of this private key is what assures control of the digital coin (and collectively the coins in the digital currency by their owners) so that a collection of private keys must be protected by passwords or other computer security means (such as difficult mathematical calculations or encrypted codes).

A digital currency issuer (usually a private company) has a registry for each of its coins called a “blockchain”.  The blockchain shows all the coins and their specific wallet addresses they are in and when each specific block in the blockchain was created for each coin and transaction recorded in the blockchain. When coins move to new owners, the blockchain creates a new block which again reflects the ownership of every coin issued by the digital currency issuer.  So to “see” where each and every coin is, one looks at the blockchain and reviews the addresses for each of the coins.  To do this, one uses a “block explorer” tool.  The newest block at the end of the chain links back to every blockchain that precedes it.  Access to the most recent blockchain allows users to follow the blockchain to observe every transaction ever made.  Since all the blockchains are building on the previous blockchains, it is impossible to change entered data.  Thus, at any time, one can read the blockchain of any digital currency (as long as the issuer has not hidden this information) and see where all the coins are located and how they were spent.

The term “mining” for digital currency refers to a computationally intensive puzzle to validate a digital coin transaction or to create new blockchains for a specific digital currency, such as Bitcoin.

Instead of “mining”, a digital currency may use a different transaction technology platform to verify each new blockchain created.  For example, when a new transaction occurs with a digital coin, it is “staked”.  “Staking” or “Proof-of-Stake” means that an algorithm is used to create the most recent blockchain in a secure and reliable manner.  Staking allows each new transaction to be connected securely to the proper blockchain or wallet holding the digital coin and to send this coin to the buyer in a transaction over the computer systems that hold the blockchain and the wallet.  Staking ensures that the transaction is recorded securely and correctly in the proper blockchain and wallet and that the algorithm proves this is the case.  Before using a digital currency, a potential digital coin buyer should verify whether there is a staking fee for each digital currency transaction.

Digital Currency’s Impact On Business

Since the blockchain operates at internet speeds, records each transaction instantaneously in a reviewable ledger, and is secure from duplicate spending of a digital coin or from counterfeiting, digital currency reduces the need for intermediaries between buyers and sellers of goods and services.  This has huge implications for business because digital currency, as a new payment system, enables private companies to build a network of businesses and consumers that accept digital currency payments.

First, digital currency reduces the needs for banks, which function as payment systems and lenders, because the electronic ledger of the digital currency automatically records a digital currency transaction for both parties to see and for future currency users to see. Second, digital currency reduces the needs for money transfer and payment businesses since the digital currency is able to travel anywhere in the world at the speed of the internet.  Third, digital currency reduces transaction costs since its blockchain ledger accurately records transactions when they occur for the transaction participants and any other parties that need to know.  Fourth, digital currency reduces disputes over ownership and source of the digital currency since it is already recorded on the blockchain.

As a new payment system, private companies are working to build a network of businesses and consumers that accept digital currency for payments.

Since digital currency is private money that is issued by a private company, there are different types of digital currency.  Bitcoin is reported to have a supply limit of 21 million digital coins with over 16 million digital coins in circulation.  Bitcoin behaves more like a commodity than a currency since Bitcoin’s value has increased from less than $1,000 in 2016 to over $14,000 by the end of 2017.  There is no set value for Bitcoin.  Its price is determined by demand and its supply for use of this digital currency.  This exposes anyone receiving Bitcoin in a transaction with the risk that the value of Bitcoin will decline and produce a loss on the transaction for the receiver.

To cash in on the rise in Bitcoin’s value, a number of “Initial Coin Offerings” (“ICOs”) have occurred in the past several years.  These ICOs caused the Securities and Exchange Commission (“SEC”) to issue a “Statement on Cryptocurrencies and Initial Coin Offerings” in a public statement dated December 11, 2017.  In this statement, the SEC states: “to date no initial coin offerings have been registered with the SEC.”

In July, 2017, the SEC issued an “Investor Bulletin: Initial Coin Offerings”, in which the SEC advised potential ICO investors that digital currency is a security when there is an opportunity to make a gain on an investment in digital currency.  When this opportunity exists, an ICO must be registered with the SEC.

In December, 2017, the SEC stopped an ICO from being issued because it was promoted as potentially increasing value (i.e. each such coin in the ICO was a security) that was not registered with the SEC.  The ICO was to be used to buy and sell restaurant services and products.  The issuer (called “Munchee”) agreed to buy and sell the ICO in a secondary market, much like an exchange for securities.

The price for a digital currency may be set as a unit of a specific currency — such as one digital coin equals one U.S. dollar, one British pound, or one Euro — or as a price for a specific commodity – such as the price of a barrel of oil in U.S. dollars.  The nation of Venezuela is attempting to issue its own digital currency – the Petro, which is backed by the price per barrel of oil from Venezuela– since its paper currency– the Bolivar — is worthless because of hyper-inflation.  The nation of Ecuador has issued its own digital currency.  Japan and Sweden have made digital currency legal tender.  Chile and Spain have legal exchanges for digital currency and encourage local businesses to use digital currency as payment.

The conclusions are (1) digital currency is a next generation product in payment systems.  Companies involved in providing payment systems — such as banks, money transferors, payments companies, and digital currency companies – are vying for entrance into this digital currency market; (2) the next development of digital currency is for these companies to obtain acceptance from businesses and consumers to use this currency for payments in commerce; (3)  fixed supply digital currency without a set price functions more like a commodity than a currency, including potential losses from declines in the price of this type of currency; (5) acceptance by governments of digital currency around the world as a new payment system is low.

 Dixon A Gardner, Associate

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