Cryptocurrency Dilemma and the Rising Investments

Since the innovation of Bitcoin by Satoshi Nakamoto in 2009, several cryptocurrencies (or “cryptos”) have been launched such as Ethereum, Tether, etc. Bitcoin is the most successful crypto. Its total market value has reached $735 billion (Table 1). The combined market value of all existing bitcoins (market capitalization) was equivalent to 1.8% of the world’s total money supply (i.e., coins, currency, demand deposits, and other assets held by central banks). Cryptos are continually growing, raising money via initial coin offerings (ICOs). The current total value of all cryptos is around $1.7 trillion, which is lower than the high value of $2.2 trillion estimated in April 2021 (all numbers given here are for May 27, 2021).

A crypto is a digital currency which can be used for making online transactions. It uses an online financial ledger having cryptography to protect every transaction. Investors take keen interest in these unregulated currencies to make high profit as compared with conventional alternative investments. Investors also buy cryptos to hedge themselves against the risk of sharp depreciation of national currencies. The global crypto industry has about 6 million active users. Speculators in the crypto market often drive their prices to reap abnormal profits. Bitcoin experienced volatile price moves this year, reaching nearly $65,000 in April before losing nearly half of its value in May. 
An entirely new ecosystem of tools is under development to leverage the benefits of cryptos. Several world central banks are exploring the adoption of crypto and blockchain technologies for making small- and large-value payments. For instance, the People’s Bank of China intends to develop a countrywide digital currency, the Bank of Canada and Monetary Authority of Singapore are experimenting its usage for interbank payment systems. 
Cryptos are not banned or considered as illegal in Pakistan. The State Bank of Pakistan (SBP) has not yet authorized companies or organizations to carry out the sale, purchase, exchange, and investment of virtual currencies, coins, and tokens. 
Some experts believe that crypto and blockchain technologies are likely to have a significant influence on the future development of payment and financial systems, while policymakers are concerned about the challenges brought about by these technological developments.
Most cryptos are built by ICT experts who focus mainly on their technological feasibility and security aspects. They often ignore the incentives of malicious attackers and the real value of cryptos. The very nature of crypto assets makes them risky but potentially extremely profitable.
Crypto is a lucrative investment for those who want to have direct (peer-to-peer) exposure to the digital currency, while a safer and somewhat less profitable alternative is to buy stocks of those firms who have ‘exposure’ to crypto. However, direct dealing allows tax evasion and saving of payments to intermediaries. Furthermore, as cryptos promote anonymity, they are used for unlawful purposes.
Unregulated cryptos’ rapid growth and its wide acceptance presents a challenge to governments. This is because they have the potential to disturb existing regulated payment and monetary systems and thus can affect the implementation of a country’s monetary policy. 
All in all, cryptos have given rise to risk and reward dilemma. This calls upon governments to introduce effective regulations to minimize the risks associated with cryptos for maximizing the reward.
How Cryptocurrency Works?
In the conventional payment system physical tokens (e.g., coins, bank notes) are used as means of payment where a direct exchange of sellers’ goods and buyers’ tokens sanctions them to make settlement. This choice is unavailable when two parties are not present at the same location (e.g., e-commerce), requiring the usage of digital tokens. 
Three main agents are involved in any crypto trade/deal: the issuer, the user, and the exchanger. The issuers of digital currency are known as administrators. Users include individuals who obtain digital currencies to transact on the network. Exchangers include all entities involved in the conversion of traditional currency to virtual currency, and vice versa. 
In the digital currency system, the method of payment is a string of bits wherein it is challenging to prevent the buyer from re-using the same bit string (digital token) repetitively by duplicating or falsifying the token. This is the so-called ‘double-spending’ problem. This potential problem can be solved by engaging a trusted third party (such as PayPal) who operates a centralized ledger and transfers balances by debiting and crediting seller and buyers’ accounts. In the absence of a trusted third party, cryptos are used as digital means of payment in a distributed network.
Cryptos use cutting-edge technologies built around blockchains and security protocols. Network nodes verify each transaction that enters the blockchain system, which works like an electronic financial ledger. This distributed network has been designed to avoid any problem of double-spending. 
All transactions that enter in the blockchain system are traceable, thus providing an unquestionable record. The security protocols built in the ledger do not allow removal or alteration of transaction details, thus creating a complete record of all transactions involving the currency.
Moreover, blockchain provides verification of the ownership of each unit and helps in creating and executing smart contracts, involving a transfer of title. The smart contract is a set of instructions for making certain calculations, sending transactions, and storing information. Corresponding public key is used to authenticate this signature. As soon as the signature is verified, the transaction is complete and becomes part of the blockchain. The process of verification of transactions is executed by a miner. This process is called ‘mining’. A miner is the creator of a crypto who solves complex problems and puzzles to create blockchains and ‘unlock’ virtual coins for receiving a reward. 
Every crypto asset is held in a digital wallet, known as an “e-wallet”, which maintains a complete transaction history. Given the secure nature of the blockchain network, its theft can be reduced significantly. While securities are in place that does not mean cryptos are un-hackable.
Regulations for Cryptos in Pakistan
The Government of Pakistan (GoP) realizes that cryptos have the potential to challenge existing systems of currency and payments and some of their users take undue advantage by engaging in illicit activities. In the absence of a law to regulate crypto trade, the GoP has taken certain measures.
In May 2017, the State Bank of Pakistan (SBP) stated that it does not recognize digital currencies. On April 6, 2018 the SBP prohibited dealings in Virtual Currencies/Tokens in its circular: 
“Virtual Currencies (VCs) like Bitcoin, Litecoin, Pakcoin, OneCoin, DasCoin, Pay Diamond, etc. or Initial Coin Offerings (ICOs) tokens are not legal tender, issued or guaranteed by the GoP. SBP has not authorized or licensed any individual or entity for the issuance, sale, purchase, exchange or investment in any such Virtual Currencies/Coins/Tokens in Pakistan. In view of the foregoing, all Banks/DFIs/Microfinance Banks and Payment System Operators (PSOs)/Payment Service Providers (PSPs) are advised to refrain from processing, using, trading, holding, transferring value, promoting and investing in Virtual Currencies/Tokens. Further, banks/DFIs/Microfinance Banks and PSOs/PSPs will not facilitate their customers/account holders to transact in VCs/ICO Tokens. Any transaction in this regard shall immediately be reported to Financial Monitoring Unit (FMU) as a suspicious transaction”. 
The Federal Investigation Agency (FIA) is investigating against the people dealing in cryptos. Moreover, the Federal Board of Revenue is investigating the traders of digital currencies for tax evasion and money laundering.  
In January 2021, the SBP stated in the Sindh High Court that it had never declared it illegal. Consequently, the bench ordered retraction of the 2018 circular and restrained the FIA from harassing the petitioner thus giving a respite to the crypto investors. 
As the SBP circular became redundant, the Khyber Pakhtunkhwa government announced plans to build two hydroelectric-powered pilot mining farms to capitalize on the global crypto market.
Recently, the State Bank Governor stated that the central bank is studying digital currency very carefully. He expressed that the SBP-issued digital currency will assist in financial inclusion, documentation of financial transactions, and fight against money laundering and terror financing. 
Circumvention of Regulations
Regulations have not reduced the demand for cryptos, rather demand has shifted towards unregulated/underground platforms who provide little protection to investors. It has given an opportunity to money launderers to enter this market by defying regulations and has become a source of tax evasion/avoidance. In the presence of regulations, foreign financial companies operating cryptos are hesitating to invest in Pakistan.
Although PayPal has declined to enter the Pakistan market, it is providing services through its subsidiary Xoom to electronically transfer funds. Other e-wallets and exchanges are expected to enter the market. This would only happen with the development of a stable and supportive regulatory framework. On their part, crypto companies should comply with all local rules and regulations, especially documenting their clients’ assets like other stocks to make them part of the tax net.
The Size of Crypto Market in Pakistan
Pakistani investors are increasingly adopting cryptos as they view them as a part of their long-term portfolios. Pakistan is ranked amongst the top 20 countries by crypto adoption. It is estimated that the country has over 9.0 million crypto owners, 4.1% of total population. Bitcoin has fully penetrated Pakistan. It can be noted from the rise in “bitcoin” and “crypto” online searches following the indications that crypto regulations will be introduced soon.
The payment system in Pakistan has experienced a great deal of innovation, including payment solutions such as “Easypaisa”. The growth of payment systems indicates that there is potential for the growth of cryptos in Pakistan. According to the SBP, “Pakistan has witnessed 100-200% growth in online banking during the COVID-19 pandemic as the country has a huge tech-savvy population. The number of registered online banking users surged to 13.22 million, which increased the value of internet-based financial transactions to over Rs. 2 trillion in September 2020”. 
Pakistan has a total of 180 million mobile phone connections for a population of 220 million. More than half of these mobile phones use the advanced 3G/4G internet. Thus, with such fundamentals and basic infrastructure, Pakistan carries vast potential to emerge as a key player in crypto and blockchain technologies.
About 100 different digital coins were traded daily across all mediums before the 2018 SBP prohibition, but afterwards some trading platform decided to close their business. This immediately caused a plunge in the crypto market, but the business volume gradually picked up after alternative trading methods were discovered. A caveat to SBP prohibition order was that it only restricted banks, PSOs and PSPs from dealing cryptos, so if you are not dealing with these entities, you can continue to own and trade virtual currency in Pakistan. Hawala operators are facilitating the transfer of funds in offshore crypto exchanges in return for payments made domestically.
Binance, a crypto exchange, is now the fourth most downloaded app in Pakistan. Social media sites are now full of relatively unknown wallets and shady platforms. Social media influencers on Twitter, with millions of followers, are advising retail investors on how and where to invest in the crypto space.
Pakistan’s first and only crypto, Pakcoin (PAK) was launched in 2015, which was explicitly mentioned in the SBP’s prohibition. Its price has jumped by over 60% after the SBP prohibition.
Risks Associated with Unregulated Cryptos 
Cryptos have not come without associated risks. Major concern is about their potential integration in the country’s monetary system, especially as appropriate regulations are not developed. 
Some platforms are involved in illegal activities. They usually simulate a monetary system and use it as a front for illegal transactions, such as money laundering, and drug trafficking, etc. With growth in crypto transactions, it is likely that the size of the ‘shadow economy’ could rise sharply. This is mainly because crypto transactions are very difficult to trace back to the owner of e-wallet.
With the growing use of cryptos as means of payment, evasion of taxes has become a major concern for tax collectors. This is primarily because there is no limit on the number of wallets a user can maintain, thus allowing trade without disclosing information about the owner of the wallet. Without appropriate regulation, cryptos are foiling the government’s efforts in reducing tax evasion.
Crypto exchanges are vulnerable to being hacked and becoming targets of other criminal activities. Such security breaches have caused heavy losses to investors as their digital currencies were stolen. Thus, strict monitoring to protect the digital currency from cyber theft will remain a major challenge in the future.
Cryptos are highly sensitive to speculation. The Bitcoin bubble is often feared. Many people invest in cryptos with the hope to profit from speculation. 
Cryptos have the ability to create volatility in the financial system by disrupting the capital markets. Volatility could potentially cause major economic crisis. 
Authorities need to frequently review these risks and provide regulatory solutions.
Digital assets have become a critical part of the global payment system. Thus, prohibiting cryptos would not be feasible. This is because bans do not work beyond borders. So, a country adopting cryptos by introducing appropriate regulations early stands to gain. In this context, it needs to be emphasized that:

▪ Without global coordination, the treatment of violators would remain unpredictable. Thus, globalized strategies need to be devised for coordinated regulatory efforts.
▪   At the national level, a formal regulatory structure consistent with the legal system should be developed rather than allowing a structure that is administrated by a group of individuals without any unified goal. 
▪  The SBP needs to act only to prevent wrong use of cryptos and blockchains. It should not prohibit buying, selling, or holding of cryptos. Digital currency should be allowed to be held as an asset.
▪ Growth of fintech is vital for the future of the economy, which would draw knowledge and knowhow gained from the adoption of blockchain technologies. Therefore, domestic enterprises should be encouraged to take advantage from these technologies. 

Increasing popularity of cryptos underscores the constraints of the global financial system to manage their growing needs and concerns. Technology has always preceded regulations, thus making regulatory solutions more complex. There is therefore a need for regulators to address this global technological challenge by quickly adopting a proactive approach to regulate the riskier aspects of cryptos to harness the opportunity of technology by joining global efforts.

The writer is a Professor of Economics at the School of Social Sciences and Humanities at NUST, Islamabad. 
E-mail: [email protected] 

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