Imagine a country which has a large economy and a despotic regime. This place is prosperous despite having complex and arbitrary rules and regulations designed to keep non-oligarchs perpetually nervous. Everybody has to carry an internal passport. Censorship and surveillance are all-pervasive. Bank accounts can be frozen at will. Property is confiscated on a whim.

Nothing is denied to the oligarchs and their little princes and princesses. But non-oligarchs must ask permission even for simple things like getting married, having children, running businesses, et cetera. Those who have become rich, never mind how, want to store nest eggs abroad in case the regime suddenly goes after them. But of course, it’s a criminal offense to walk into the bank and convert local currency.

So how do they do this?

One method is to deal in art objects. Buy a curio in local currency. Then sell that curio abroad in a foreign currency. Even if they do not make a profit, they at least would own some foreign exchange, having bypassed exchange regulations.

Suppose the curio in question is just a few lines of computer code? So buy some lines of computer code in local currency, and sell those lines for foreign currency. Even better, if they can do this transaction anonymously, for that would ensure that their stash of foreign exchange would not even come to the knowledge of the snoopy authorities.

Welcome to China (did you think I was referring to someplace else?), a large prosperous nation with currency controls and a one-party government. Welcome to bitcoin, ethereum, litecoin, et al, – computer codes that are curios and crypto-currencies.

Bypassing currency controls

Bitcoin is of course, the most well-known and oldest of these virtual currencies. And, bitcoin is extensively used to bypass currency controls, not just in China, but in Greece and other places as well.

Bitcoin has become popular in India as well. Volumes of rupee trading in bitcoin have exploded this year – over 2,500 Indians trade bitcoins daily. Not coincidentally, demonetisation of 86% of Indian currency on November 8 triggered off an explosion of interest. Some estimates indicate that rupee-denominated bitcoin trades now generate the third-largest volumes after American dollar and yen.

Bitcoin has now been around for many years and its codes are open-source. But many people don’t understand how it works. [Please jump to the end of the article for a brief explanation].

Internationally, bitcoins are traded on multiple financial exchanges and they’ve shot up in value over the last year. Most exchanges insist on some degree of “Know Your Customer” or KYC details, but there are loopholes. For example, the same person could own many wallets in which the coins are held.. It is possible to layer trades such that it is impossible to figure out who sold what, when. What’s more, the underlying reason for a trade is irrelevant – all that is known is that a coin has moved from one wallet to another.

Image credit: AFP

Government recognition

Most governments don’t recognise bitcoin as currency. In fact, most governments don’t even classify these as anything at all. These can be passed off as computer code (which is the literal truth) or as digital curios(ities). Japan is one of the few exceptions – the Bank of Japan imposes stringent restrictions on use but Japan does recognise bitcoin as legal tender. South Korea also has rules for bitcoin-denominated payments and transfers.

Whatever governments may say, bitcoins are a currency simply because people accept them as a medium of exchange for goods and services. Apart from being accepted for normal transactions, crypto-currencies like bitcoins are also used for cross-border money transfers, for money-laundering and ransomware payments, and for drug deals and targeted assassinations on the Dark Web. Initial coin offerings, commonly known as ICOs, have become popular as well, since these bypass the usual regulations about raising “cash” for a new business.

Bitcoin prices went through the roof last year as trading volumes zoomed. In January 2016, bitcoin was trading at $429 per coin – it peaked out at $4,969 this month, just before China came down like a ton of bricks on coin-trading. Ethereum, another crypto-currency, did even better than the bigger bitcoin. Ethereum was trading at $2.84 in January 2016 and it hit a recent high of $394.

In India, the Mumbai film industry seems to love bitcoin, given the number of celebrities who have burbled about it. But the Chinese crackdown and fears that India might see a similar crackdown have led to wild swings in rupee-values of bitcoin. The bitcoin was trading at Rs 3.01 lakh on September 1, it dropped to Rs 1.95 lakh on September 15 as panic took hold, and it is back to Rs 2.58 lakh on September 20.

Image credit: Reuters

Enter RBI

Will the Reserve Bank of India try to regulate bitcoins and other crypto-currencies? Almost certainly. No government that imposes capital account currency controls can afford to ignore non-fiat currencies. Will the Indian government mess up attempts at regulation? Almost certainly. The RBI doesn’t have a shining track record in terms of its recent actions and it could fumble this task, for sure.

In fact, the RBI is supposedly considering setting up its own crypto-currency , which is a step in the wrong direction. Crypto-currencies work for people who want anonymity and who are seeking alternative stores of value. No fiat currency , crypto or not, can reasonably offer this combination.

What’s more, crypto-currencies have features (and bugs) that fiat currencies don’t and that’s precisely why users love them. The blockchain system of generating an exact increase in money supply gives comfort to speculators. This eliminates worries about inflation caused by a sudden expansion of money supply by the central bank since there is no central bank and the money supply is governed by pure maths. This also makes fractional reserve banking cumbersome since currency swaps or exchanges are always required for such actions.

Also, while bitcoin, ethereum, and other crypto-currencies can be banned by government decree, these cannot be withdrawn from circulation except by peer-to-peer consent. A fiat crypto-currency – well, that could be deleted in a minute at the whim of an oligarch. Indians started trading in bitcoins and other crypto-currencies enthusiastically after Nov 08, 2016, precisely because they became wary about such possibilities. It’s hard to see a fiat crypto-currency catching on.

Image credit: AFP

What is Bitcoin: For those who came in late...

The individual (or committee) that conceptualised the bitcoin called themselves Satoshi Nakamoto. The virtual coin was designed to allow for transactions between individuals who did not know each other without any oversight or interference from governments or central banks.

Each bitcoin consists of unique computer codes. Each coin can be split into fractions and those fractions are also each identified by unique codes. The smallest fraction is named the “Satoshi” in honour of the creator.

Each coin and its owner can be identified by using a combination of private-public keys. The public key, which everybody knows, identifies the coin. But only the owners know the private key and can thus identify themselves. To put it another way, the owners are the owners because they have the private key.

To use a physical analogy, think of a banknote inside a locked, transparent case. The number of the note can be read by all. But only the owner can unlock the case. If you can unlock the case, you own the money. Yes, this lays the crypto system open to hacks and if you forget the private key, the coin is lost, forever.

Coins are held in digital wallets. Many programmers have created free digital wallets, which can just be downloaded by anybody, anonymously. Anyone can create their own digital wallet, or even just write down their private key on a piece of paper.

Coins are generated by solving complicated mathematical problems that require vast amounts of computerised number-crunching. This is called mining. Anybody can use a personal computer to solve these problems in order to own the newly-minted coins. (Warning: This will take a lot of computer time and it’s a very intensive process). “Mining” syndicates have been founded to pool computer resources dedicated to this task. The money supply is exactly regulated by that mathematical system of generation. It cannot be tampered with.

Every transaction with every coin from the instant of generation is recorded in an open ledger called the blockchain. That ledger is constantly updated. It can be downloaded and checked by anybody. When a new transaction is made, the blockchain is used to check that 1) the coin exists and 2) the coin is not being used for two transactions simultaneously. The coin-owner transfers ownership to somebody who uses a different private key to “lock” it. A transaction is accepted as valid only when a large majority of people have checked the blockchain and agree that the transaction is valid.

There is no RBI or Federal Reserve guaranteeing the validity of the coin; the bank is replaced by a peer-to-peer network. This verification can be interfered with only by collusion between a large number of network members. The network runs into millions of people but it has happened.

The blockchain is an incredible concept and it’s now being used for multiple other purposes. But the original blockchain led to slow verifications – transactions could take days. Some (actually the majority) of bitcoin users have agreed to replace the blockchain with a new blockchain which has more capacity and lends itself to faster verification. So there are now two types of bitcoin – bitcoin and bitcoin cash. A given coin can be traded/ transacted on either. Many other crypto-currencies have adopted various elements of bitcoin and tweaked those to try and create more secure and convenient protocols.