Topic 3.4 - Emerging Technologies: Comprehensive Study Notes on Cryptocurrency
What Is Money? The History and Functions of Currency
Functions of Money: To be considered currency, money must serve three primary evolved functions:
Unit of Account: Provides a measure of the value of goods and services. Prices are quoted in money terms rather than goods terms. For example, a Volkswagen Polo costs approximately rather than two-year-old Aberdeen Angus cattle. This common language between buyer and seller facilitates understanding of payment and supply.
Medium of Exchange: Acts as an intermediary for trading products and services. Universal acceptability is the most important aspect of this function.
Store of Value: Money must hold its value over time to solve the "coincidence of wants" problem in barter. While money may depreciate due to inflation, it possesses liquidity and portability. It can be broken into denominations, unlike many precious metals.
Characteristics of a Medium of Exchange:
Durability: Must be able to be used repeatedly. Online payments have significantly increased this characteristic.
Portability: The ability to carry currency easily. Credit cards are an evolution of this principle.
Divisibility: The ability to be subdivided (e.g., a note divided into two notes).
Uniformity: Legal notes of the same denomination must look identical.
Limited Supply: Value is maintained through scarcity regulated by central banks.
General Acceptability: It must be widely accepted to function correctly.
Evolution of Money:
Barter: The earliest form of exchange, requiring a coincidence of wants (Individual A must find someone who has what they want and wants what Individual A has).
Coins: Standardized coins were first made by the Lydians in the 7th Century BC to standardize trading.
Paper Money: Originated in China. Marco Polo described Emperor Kublai Khan issuing notes as legal tender in the 12th century. Refusing these notes was punishable by death. Merchant traders had their gold/bullion converted to this currency.
Representative/Commodity Money: Portability necessitated lodging assets like gold in banks and receiving receipts. These receipts were trusted because they could be redeemed for the underlying asset. The Bretton Woods agreement collapse in USA in 1971 marked the end of this era.
Fiat Currency: Latin for "let it be done." Established by government regulation or law. Its value relies on supply, demand, and economic confidence rather than physical properties. The notes have an implied value based on public trust.
Modern Fiat (Plastic & Electronic): The Diner’s card (1950) and American Express introduced the concept of plastic cards. This evolved into cheque books, credit cards, and the 1990s proliferation of debit cards and online services like PayPal. This has led to the diminution of cash.
Cryptocurrency vs. Fiat Currency
Performance Against the Functions of Money:
Medium of Exchange: Growing acceptance by merchants such as Tesla (briefly in 2021), PayPal, Microsoft, Starbucks, Virgin Galactic, and LOT Polish airlines. El Salvador became the first country to adopt Bitcoin as legal tender in September 2021, launching the Chivo wallet and providing free Bitcoin to citizens.
Unit of Account: Bitcoin can be broken down into small denominations (Satoshis).
Store of Value: Currently considered poor due to wild price fluctuations. Historically, it has appreciated against fiat, making holders less likely to spend it on regular purchases.
Solutions Provided by Cryptocurrency:
Counterfeit Proof: Unlike fiat currency (which has a counterfeit rate of approximately ), Bitcoin cannot be counterfeited.
Access for the Unbanked: Provides a route into financial systems for over people who have smartphones but no bank account.
Frictionless Peer-to-Peer System: Operates without intermediaries (banks/governments). Traditional fiat involves various intermediaries charging fees; Bitcoin reduces this "financial friction."
Drawbacks of Cryptocurrency:
Technical Proficiency: Users require specific expertise to navigate ownership and transactions, unlike bank accounts where the bank handles the complexity.
No Central Authority: There are no banks to underwrite transactions, provide overdrafts, or offer short-term loans.
Permanent Transactions: Decisions cannot be reversed or canceled by a central authority. Reinstatement requires the other party to create a new reverse transaction.
Types of Tokens
Coins (Exchange/Payment/Currency Tokens): Intended for use as a method of payment (e.g., Bitcoin). They use Distributed Ledger Technology (DLT) and are usually not underpinned by any person or asset. Their value derives from use as a means of exchange or investment.
Utility Tokens: Provide access to specific goods or services on a platform. Often issued via Initial Coin Offerings (ICOs) to raise finance for blockchain development. Coin offerors provide these in exchange for funding.
Security/Asset Tokens: Represent participation in physical assets (property, companies, earnings) or entitlements to dividends/interest. Economic functions are similar to equities or bonds.
Non-Fungible Tokens (NFTs): Unique units of data stored on a blockchain representing easily reproducible items like photos, videos, or audio. Unlike Bitcoin (where all coins are equal), NFTs are non-fungible (not interchangeable).
Examples: Art, Collectibles, Gaming.
Metaverse: A virtual-reality space for user interaction with computer-generated environments.
Bitcoin: The First Cryptocurrency
Origin: Whitepaper titled "Bitcoin – A Peer-to-Peer Electronic Cash System" released in October 2008 by Satoshi Nakamoto (a pseudonym).
Technical Nature: An application sitting on top of the blockchain protocol. It is an independent digital currency not pegged to fiat or gold.
Four Pillars of Innovation:
The Blockchain (public decentralized ledger).
The peer-to-peer network (protocol).
The consensus protocol (rules for verification).
The Proof of Work algorithm (mechanism for global consensus).
Supply and Issuance:
Capped at coins.
Coins are "mined" at a rate of approximately one every .
Mined by participants who verify transactions in exchange for rewards, removing the need for a central bank.
Ownership and Storage:
Proven by electronic cryptographic keys stored in a "wallet" (an electronic storage file on a device).
Private Key: Grants actual ownership; losing it means losing the Bitcoin.
Cold Storage: Printing the private key and storing it offline (e.g., in a safe) to prevent digital theft.
Denominations: The smallest unit is a "Satoshi."
Market Data: Reached an all-time high of on November 8, 2021.
The Byzantine Generals’ Problem (BGP) and Double Spending
The Problem of Double Spending: Without a central bank to verify funds (like a bank stopping a transaction if account balance is insufficient), a digital currency system needs a way to prevent a user from spending the same unit of currency twice.
Byzantine Generals' Problem (1982): Proposed by Pease, Shostak, and Lamport. It describes how distributed systems reach consensus despite erroneous inputs.
Analogy: Generals surrounding a city must agree on a plan (attack or retreat). Communication is via messengers. Some generals or messengers might be traitors (bad actors). The algorithm must ensure all loyal generals decide on the same plan and that traitors cannot force a bad plan.
Consensus in Bitcoin: Achieved via Proof of Work. Miners solve puzzles; the network accepts the block with the most computational power (hashing) performed. Every block contains a hash reference to the previous block, creating an unbreakable chain back to the coin's origin.
Byzantine Fault Tolerance (BFT): A system's ability to survive and make correct decisions despite erroneous sensors.
Example: A jet's central computer uses thousands of sensors. If one malfunctions/feeds erroneous data, the computer reaches consensus based on all other sensors to stay on the correct flight trajectory.
The Cryptocurrency Ecosystem
End-Users: Individuals or organizations holding crypto for investment, speculation, or peer-to-peer payments.
Miners: Individuals/groups who validate transactions using Proof of Work, maintaining the network's integrity.
Exchanges: Entities offering services to swap cryptocurrency for fiat currency for a fee.
Trading Platforms: Exchanges like Coinbase or Binance where users trade between themselves.
Wallet Providers:
Software Wallets: Apps for phone or computer.
Hardware Wallets: Physical USB-like devices used for cold storage.
Custodial Services: Third-party entities that manage the keys on behalf of the user.
Coin Inventors: Designers of the technical architecture (e.g., Vitalik Buterin for Ethereum, Charles Hoskinson for Cardano).
Coin Offerors: Those conducting Initial Coin Offerings (ICOs).
Smart Contracts and De-Fi
Altcoins: Classified as anything that came after Bitcoin (e.g., Litecoin, Ethereum, Ripple, Cardano).
Ethereum (Launched July 30, 2015): The second-largest cryptocurrency; introduced programmable "smart contracts."
Smart Contracts: Self-executing computer code encoded into the blockchain. They act like escrow accounts that automatically execute when milestones are met.
Example: Mary buys inventory from Susan across the globe. The smart contract releases staged payments to Susan once a track-and-trace number is detected in the logistics system.
Oracles: Third-party data feeds used to verify real-world milestones for smart contracts.
Characteristics: Immutable (cannot be edited once agreed), self-verifying, auto-enforcing, and cost-saving.
Drawbacks: Not currently legally binding; written in machine code which may be difficult for non-experts to audit.
Ricardian Contracts: Invented by Ian Grigg in 1995. They merge legal contracts with blockchain code. They are both human-readable (legal language) and machine-readable (code), making them legally binding and auto-executing.
De-Fi (Decentralized Finance): Distinguished from Traditional Financial Services by being decentralized, permissionless, and transparent.
The Crypto Assessment Framework™
Purpose: A five-part guide for accountants to identify questions and actions regarding client crypto activities.
1. The Client Perspective:
Understand if the client is new (AML procedures).
Identify the specific crypto instrument.
Determine intentions (investment vs. business use).
Determine if the client has direct possession of keys.
2. The Risk Perspective:
Profile: Change in risk profile due to the pseudo-anonymous nature of transactions.
Source of Funds: Risks of money laundering or criminal financing (e.g., Silkroad history).
Consensus Mechanism Risk: Understanding Proof of Work vs. Proof of Stake.
Key Management:
Web Wallets: Least secure; trusting a third party.
Desktop Wallets: User has control but needs strong anti-intrusion software.
Mobile Wallets: Risks of theft or hijacking.
Hardware/Paper (Cold Storage): Offline and most secure.
Smart Contract Risk: Legal remedies, enforcement precedents, regulatory differences, and information security hacks.
3. The Audit Perspective:
Ownership: Verifying possession of the private/public key pair.
Third-Party Custodians: Substantiating agreements, access rights, and safeguards in case of custodian liquidation.
Records: Ensuring appropriate disclosure and valuation.
Testing: Matching keys to fund reports and establishing correct conversion rates at acquisition/disposal.
4. Financial Reporting (IAS/IFRS):
Cash/Cash Equivalents: Under IAS 7/32, crypto typically does NOT qualify as cash (no right to coins/notes) or cash equivalents (too volatile).
Intangible Assets (IAS 38): The default classification (non-monetary asset without physical substance).
Initial Measurement: At cost.
Subsequent Measurement (Cost Model): Carried at cost less impairment. Assessed annually. If fair value is less than carrying amount, impairment is recognized in P&L.
Subsequent Measurement (Revaluation Model): Only if an active market exists. Increases in value go to Other Comprehensive Income (OCI); decreases below cost go to P&L.
Inventory (IAS 2): Applied if the entity is a broker-trader holding crypto for sale in the ordinary course of business.
Mining: Recognized at fair value. Mining equipment (PPE) is depreciated, but operational mining costs are generally expensed as they don't meet asset recognition tests.
5. Taxation Perspective:
Republic of Ireland (Revenue Rules):
Income/Corporation Tax: Standard rules apply to trading profits. Accounts for tax must be in Euro/Functional currency, not crypto.
CGT: Applied at for individuals/companies on investment gains.
VAT: Exchanging crypto for fiat is exempt (Hedqvist case). Goods/services sold for crypto are subject to VAT based on Euro value at supply.
PAYE: Value of crypto emoluments at the time of payment must be converted to Euro for payroll taxes.
Northern Ireland/UK (HMRC Rules):
Classification: Exchange tokens are "chargeable assets" for CGT/CT if they have a value that can be realized. HMRC does not consider crypto to be "money" or "currency."
Tax Rates (2021-22): CT at ; CGT at or .
Stamp Duty: Not applicable to crypto transfers themselves (not 'stock' or 'marketable securities') but applicable if crypto is used as consideration for land (SDLT) or securities (SDRT).