Unless you have been living under a rock for the last ten years you will have heard of cryptocurrencies – but what are they? Most explanations tend to describe the technical aspects of cryptocurrencies and how they differ from fiat currency (i.e. traditional money that is issued by a central bank), but few articles explain the legal side of cryptocurrency. Hence most explanations actually get cryptocurrency wrong from the outset because, legally speaking, cryptocurrency is not a currency.

What is a Cryptocurrency?

The short answer is: a cryptocurrency is a decentralised ledger asset based on public-key cryptography. Let’s break that down.

Decentralised

Proponents of cryptocurrencies would argue that one of the big advantages of cryptocurrencies over fiat currency is that cryptocurrencies are not centrally controlled by a government or central bank.

Fiat currencies like the US dollar and pound sterling are issued by the central bank of the relevant jurisdiction. Central banks, being public bodies, are independent yet accountable to their governments who are in turn accountable to their people. A government can use its central bank to supervise the process of money creation, slowing the process to ensure price stability or speeding it up by issuing loans to stimulate the economy.

Cryptocurrencies on the other hand are not centrally controlled and they would be difficult to unilaterally control because of how they are designed. They are derived from maths and social consensus. The monetary system of a cryptocurrency does not depend on trust in a central authority or the people you're transacting with. This is because they operate on a distributed ledger.

Ledger

A distributed ledger is a public ledger (like an account or database) that can be accessed or “witnessed” by anyone. All transactions are recorded and shared on the ledger. Any changes to the ledger are copied to all participants in a matter of seconds or minutes. Blockchain operates on underlying distributed ledgers. This is why you may have heard of cryptocurrencies and blockchain used in similar contexts – because the transactions between participants sending each other Bitcoin or Ethereum are recorded on the blockchain. Unlike a centralised ledger there is no single point of failure. If a hacker were to try and change the amount of currency that a single participant had, they would have to change the amount recorded on the computers of every single participant of that currency, because each and every participant can witness the blockchain. There is no need for a central authority to keep a check on the ledger against manipulation because this can be done by all the participants themselves.

Asset

The term ‘cryptocurrency’ is actually not a very useful moniker when it comes to describing cryptocurrencies because cryptocurrencies are not actually currencies – although this distinction can differ between jurisdictions. From a legal standpoint in England and Wales, a cryptocurrency is property, it is an asset.

In the US, in 2013 Bitcoin was defined by the Financial Crimes Enforcement Network (‘FinCEN’ – the US’s Financial Intelligence Unit) as ‘a decentralized virtual currency’[1], and since 2014 it has been treated for tax purposes as property.[2] This position left the question open: is Bitcoin a currency or property?

In the UK, the situation was clarified in December 2019 by the High Court in AA v Persons Unknown[3] where it was decided that Bitcoin should be recognised as property under English common law. In reaching its conclusion, the court followed the analysis offered by the UK Jurisdictional Taskforce (“UKJT”) in its Legal Statement on Cryptoassets and Smart Contracts. Although cryptocurrencies do not sit comfortably within the definition of either choses in possession or choses in action, they do meet the four criteria of Lord Wilberforce’s classic definition of property in National Provincial Bank v Ainsworth[4] in that they are:

i)           definable;

ii)          identifiable by third parties;

iii)         capable in nature of assumption by third parties; and

iv)         have some degree of permanence.

Moreover, from a practical standpoint it makes sense that cryptocurrencies are not currency, doesn’t it? Because cryptocurrencies (at least the major cryptocurrencies Bitcoin and Ethereum) are finite whereas fiat currency is infinite.

As finite resources, cryptocurrencies are better characterised as property or assets, not money. Fiat currency can be created as quickly as printing paper (or changing the numbers in an account). Whereas, using Bitcoin as an example, the only way for more Bitcoins to be brought into circulation is for users of the Bitcoin network to “mine” them by solving mathematical puzzles with each Bitcoin taking on average 10 minutes to create.

Fiat currency, on the other hand, is not just issued by the central bank but it is also “created” by commercial banks by way of fractional reserve trading. This foundational principle of banking is the concept that banks only have to hold a fraction of the money that is deposited (this is the reserve requirement of the central bank) and the rest of the deposit can be loaned out into the economy.[5] If a customer deposits £10,000 and the reserve requirement is 10 percent then the bank keeps £1,000 in reserve and loans out £9,000. The customer retains the right to take out their full deposit of £10,000 (i.e. the deposit liability remains) and therefore the bank has effectively created £9,000. The fractional reserve principle is one of the main channels of money circulation and credit multiplication in the economy, raising overall levels of liquidity.[6]

Nor are cryptocurrencies very liquid since each “coin” is very expensive. If one were to attempt to treat cryptocurrencies as money, one would run into the same problem as if one attempted to treat factories as money or diamonds as money. Whereas a dollar confers a small amount of value in comparison and of course a dollar is divisible into cents which confer even less.

Public-key cryptography

Public-key cryptography, also known as asymmetric encryption, is a system whereby pairs of keys – public and private keys – are generated by an algorithm that are mathematically connected. The public key can be made public and distributed but this will not compromise the private key – you cannot derive the private key from having knowledge of the public key. Information can be encrypted using the public key but it can only be decrypted with the intended recipient’s private key.

A way to visualise the process would be a locker in a locker-room. The number of the locker would be the public key. Anyone is allowed to know the number of the locker but they won’t know what information is kept inside. Whereas the locker can be unlocked with the private key belonging to the person for whom the information is intended.

In the context of cryptocurrency, public-key cryptography ensures that only the owner of a cryptocurrency wallet can withdraw or transfer the cryptocurrency.

Where does the value of a currency come from?

It used to be the case that the value of a US dollar was derived from how much gold it could be exchanged for, and the value of any other currency could be derived from how many dollars they could be exchanged for. This was the gold standard, where the inherent value of all currencies were linked either first-hand or second-hand to an underlying commodity, namely gold.

This came to an end in 1971 when President Nixon decoupled the US Dollar from gold. Since then the value of any currency is based on trust and it is easy to believe in fiat currencies because they are regulated and backed by government decree and have been used continuously. This is not insignificant – like money, contracts are enforceable because ultimately the world’s governments say so. Fiat currency therefore is not “based on nothing” as some may suggest.

The negative aspect of the decoupling of the dollar and gold was that it has allowed for momentous inflation which has made everyone’s money worth less. However, the positive aspect that is often forgotten is that it also allowed for tremendous expansion as the world’s economies developed. If there is only a finite amount of money in the world, it is more difficult to fund a large amount of major projects.

Likewise critics of cryptocurrencies would also suggest that cryptocurrencies have no inherent value but that’s not entirely true either. As assets, cryptocurrencies can act as a store of value like other forms of property such as works of art. Moreover, certain assets online can only be purchased by way of cryptocurrencies. Transactions on certain blockchains all take place via certain cryptocurrencies. As certain blockchains and the technology that they enable become more important and more essential for businesses, so too will the cryptocurrencies connected to those blockchains. And in certain jurisdictions cryptocurrencies may even come to act as a more stable alternative to the native currency.

Because of the cryptocurrencies’ fundamental differences to fiat currency – the problems of liquidity, their finite nature and the lack of government control – it is unlikely that a cryptocurrency would displace fiat currency. That is a good thing because such displacement would destabilise the financial system and lead to widespread panic and economic chaos. However, as we can see today, both can happily coexist side-by-side which is fitting because they accomplish different things.

[1] Jennifer Shasky Calvery, ‘Statement of Jennifer Shasky Calvery, Director, Financial Crimes Enforcement Network, United States Department of the Treasury’ (FinCEN, 19 November 2013) <https://www.fincen.gov/news/testimony/statement-jennifer-shasky-calvery-director-financial-crimes-enforcement-network> accessed 28 June 2021

[2] IRS, ‘IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply’ (Internal Revenue Service, 25 March 2014) <https://www.irs.gov/newsroom/irs-virtual-currency-guidance> accessed 28 June 2021

[3] AA v Persons Unknown [2019] EWHC 3556 (Comm)

[4] National Provincial Bank v Ainsworth [1965] 1 AC 1175

[5] Federal Reserve Bank of Chicago, Modern Money Mechanics (May 1961) 3

[6] Sir Ross Cranston, Emilios Avgouleas, Kristin van Zwieten, Christopher Hare and Theodor van Sante, Principles of Banking Law (3rdedn., OUP, 2017) 3