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Financial technology, or Fintech, is a powerful new technology that has the potential to revolutionise the ways in which financial services are used and delivered. One of the most well-known applications of Fintech is the development and use of cryptocurrencies. The arrival of Bitcoin and the subsequent high financial gains that were quickly made by some of those involved generated significant media attention.

Essentially, a cryptocurrency is a digital asset. While it works in a similar way to traditional currencies, it has no physical form and exists solely as digital code. To be considered an asset, digital assets must offer the holder the right to use. In a cryptocurrency system, the holders of the digital code (cryptocurrency units) have the right to use or exchange that data, either for other digital assets (units of a different cryptocurrency) or more traditional items such as goods or services.

On the face of it, this exchange is very similar to the use of money in a traditional currency system; however, the way cryptocurrencies operate is very different. Traditional currencies operate through a central banking system, transactions are carried out and authorised by the bank clearing system using manual processes and the bank oversees and takes ultimate responsibility for that currency. In a cryptocurrency system, there is no central bank, no central records and no central authority. It is operated instead using a distributed ledger system. This ledger is, in effect, a huge database of which there is no single definitive version. The ledger is instead ‘distributed’ meaning that it is multiplied and held on every computer that is connected to the cryptocurrency network. When a change is made, such as a transaction taking place between two users of the cryptocurrency, the transaction will be authorised, not by a bank or other centralised authority, but by a consensus mechanism carried out by the network connected to the ledger. Once approved, every single copy of the ledger, on every single computer is updated to reflect the change.

This may offer an advantage over the traditional banking system in which central records could be hacked and manipulated. To successfully manipulate a distributed ledger system every single copy of the ledger would need to be altered, a near impossible task.

Many inexperienced investors seem to be seduced by stories of the huge profits that can be made; however, cryptocurrencies are still an emerging area and to date, they remain largely unregulated. The extent to which regulations are in place varies significantly around the world. For example, in China cryptocurrency exchanges are illegal and regulation is harsh. Japan on the other hand has a progressive regulatory environment for cryptocurrencies and they are considered legal tender. In the United States, laws and regulations vary from state to state, meaning there is no consistent approach in the country itself.

The UK, like many countries, does not class cryptocurrencies as legal tender and they are not governed by any specific laws; however, exchanges are legal. The European Union recently formally signed its landmark Markets in Crypto Assets (MiCA) regulation into law, taking the bloc closer to becoming the first major jurisdiction in the world with tailored rules for the sector.

This low regulatory environment, combined with the relative anonymity afforded by the blockchain technology on which cryptocurrencies are built, presents serious risks, including:

lack of accountability, as there is no one to govern the system and law enforcement is challenging as a result. The lack of a central authority also means a lack of consumer protection. For example, there will be no collective deposit insurance scheme to reimburse investors who lose funds due to hacking. Investors may lose their funds if their password is lost. This is because users are identified in the system using keys rather than personal data. This makes it much harder and sometimes impossible to confirm identity.

There is also an increased risk of tax evasion as cryptocurrency transactions take place outside the formal banking system. The current generation of cryptocurrencies are complex and difficult to track, making cryptocurrency transactions much harder to account for, increasing the ease with which they can be omitted from taxable income reports. Due to the high levels of confidentiality afforded to users, along with the challenges of tracking transactions, cryptocurrencies can facilitate illicit activity, such as money laundering or illegal drug transactions.

Despite these limitations, cryptocurrency use continues to rise as users move increasingly towards holding cryptocurrencies as an investment. So, if you are considering cryptocurrencies, only invest money that you can afford to lose!

Robert Downes QFA RPA is a Qualified Financial Advisor and Retirement Planning Advisor. You can contact him through John F. Loughrey Financial Services by telephone on 074-9124002 or by email on robert@jfl.ie