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What is cryptocurrency?
Cryptocurrencies or crypto assets are digital representations of value, cryptographically secured and verified on blockchain networks.
Units of cryptocurrency are known as tokens, and may be held or exchanged for other cryptocurrencies or fiat currencies, or used to pay for goods and services in the real world.
The availability and use of cryptocurrencies has increased dramatically over the past decade. Representing a disruptive challenge to existing financial systems, the global spread of cryptocurrency has prompted regulators to introduce new legislation including licensing, record-keeping, and reporting laws. With that in mind, firms that provide cryptocurrency services should understand how the technology works and the relevant compliance considerations.
How does cryptocurrency work?
Cryptocurrency tokens are transmitted and tracked on blockchain networks which are a form of distributed ledger technology (DLT). Without a centralized server or authority to govern them, cryptocurrencies are effectively decentralized currencies that do not require a central bank to set rates and policies. When cryptocurrency transactions take place, they are verified online via a complex cryptographic process and grouped into ‘blocks’, before being added to the larger blockchain as a permanent record available to every user.
The verification process for these transactions requires the consensus of other blockchain users. Every block that is added to the chain earns verifying users a reward in the form of cryptocurrency: this process is known as ‘mining’. The two broad types of verification process are:
- Proof-of-work: Blockchains that use proof-of-work consensus require users to devote computing power to the cryptographic verification process. The more powerful their computer, the more blocks a user can verify. Bitcoin is an example of a proof-of-work cryptocurrency.
- Proof-of-stake: In proof-of-stake consensus, users verify new blocks based on the amount of the blockchain’s native cryptocurrency that they hold. The higher their stake, the greater their opportunity to verify a given transaction. Ethereum is an example of a proof-of-stake cryptocurrency.
Crypto assets have value because of the role they play within their blockchain networks. Some tokens may be required to pay for services on a blockchain while others may confer governance rights to holders.
What types of cryptocurrency are available?
Since any organization may develop and launch their own digital tokens, there are thousands of varieties of cryptocurrency. Some varieties are tradeable on crypto exchanges while others are non-tradeable and exist only to perform functional roles on a blockchain.
Bitcoin is the oldest and most prominent cryptocurrency, with a market cap of over $969 billion, followed by Ethereum with a cap of $222 billion. Unlike Bitcoin, the Ethereum blockchain is open source and is used for more than just transaction verification: developers may deploy their own decentralized apps (dApps) one Ethereum and even launch their own tokens.
What are cryptocurrencies used for?
Beyond their financial value, cryptocurrency tokens may serve a specific function on their blockchains.
The wider crypto landscape is populated by tokens that serve an array of private and commercial functions facilitated by dApps. Native crypto tokens are often required to pay for on-chain services: many cryptocurrencies power decentralized financial (DeFi) apps however, alternative uses include gaming and data sharing. In some contexts, merchants accept varieties of cryptocurrency as payment for goods and services.
How are cryptocurrencies regulated?
The disruptive speed and anonymity benefits of cryptocurrency have caught the attention of financial authorities around the world as criminals use crypto assets to evade legal scrutiny and exploit the legitimate financial system.
In some jurisdictions, regulators have taken an open and progressive approach to cryptocurrencies, integrating them into the financial system by adapting existing laws or introducing new legislation. In such jurisdictions, cryptocurrency exchanges have licensing and registration requirements and must comply with anti-money laundering (AML) record-keeping and monitoring laws. In particularly progressive jurisdictions, such as Switzerland and Japan, cryptocurrencies are even accepted as legal tender.
By contrast, some jurisdictions have rejected cryptocurrencies, introducing laws to ban their use and exchange. China and Japan, for example, have not only banned crypto exchanges but have considered blanket bans on cryptocurrency mining. Other jurisdictions, such as the US and the UK, have taken cautious approaches, applying existing registration requirements to cryptocurrency exchanges while exploring their ongoing effects on the financial regulatory landscape.