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.

In this article we will take a look at what exactly cryptocurrencies are, the potential impact of this disruptive technology, and their application as a source of short and long-term finance.

Digital assets

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.

In order 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 (ie 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 fiat currency system, however the way that cryptocurrencies operate is very different.

Distributed ledger

Fiat currencies operate through a central banking system. The central records are held at the central bank, 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.

A distributed 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 presents a clear 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 hacked and altered; a near impossible task.

Benefits of cryptocurrencies

The decentralised network on which cryptocurrencies operate means that cryptocurrency, unlike fiat currency, is not regulated nor reliant on a central bank (which may collapse) or government (which may become unstable). This offers several benefits:

  • Reduced currency risk
  • Avoidance of bank or regulator transaction fees
  • Easier business transactions with wider range of domestic and international users
  • Cryptocurrencies could also potentially offer a more stable currency to locations with unstable local currencies

Limitations

However, cryptocurrencies are still an emerging area and to date they remain largely unregulated.

The extent to which regulations are in place also 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 the majority of countries, does not class cryptocurrencies as legal tender and they are not governed by any specific laws. However, exchanges are legal and the registration requirements of the Financial Conduct Authority (FCA) must be complied with.

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. 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.
  • 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.

Cryptocurrencies as a means of exchange:
Cryptocurrencies can be used in a similar way as cash for the payment for goods and services. However, not only are they are not widely accepted by retailers they are volatile and as such an unreliable store of value.

In most locations globally, cryptocurrencies are not legal tender and considered to be neither money, nor a currency.

However, the use of cryptocurrencies as a medium of exchange offers some benefits, for example transactions can be carried out much faster, and at lower cost, due to the involvement of fewer intermediaries. The lack of a central system also means the risk of outages is greatly reduced resulting in a more stable platform for transactions.

The use of cryptocurrencies in this way is now declining as users move increasingly towards holding cryptocurrencies as an investment.

Cryptocurrency investments:
At present, the biggest use of cryptocurrencies is an investment, with many attracted by the widely publicised high gains made by others, such as during the Bitcoin bubble of 2017.

Cryptocurrencies are traded on exchanges, similar to those used for trading stocks and shares and offer the possible benefit of widening access to new investment opportunities. However, the risk to which consumers may be exposed is significant, both due to the lack of regulation and the potential for loss, such as when the bubble ‘burst’ in early 2018. The relative anonymity of users also increases the risk that cryptocurrency investment will be used for money laundering or other financial crimes.

Initial coin offerings (ICOs):
Cryptocurrencies can also be used as a method of raising finance. This is achieved through the creation of a decentralised network in an ICO.

ICOs have a degree of similarity with Initial Public Offerings (IPOs) in mainstream investment. However, there are some key differences.

  • Supporters, not investors: ICOs involve supporters who buy into the system. This is similar to the approach used in crowdfunding; however, while crowdfunding involves making donations, in an ICO the supporters receive a potential reward as a motivation to invest.
  • There is no controlling authority to govern ICOs due to their decentralised nature.
  • Unlike IPOs, ICOs are, in the most part, unregulated. This increases the potential for scam ICOs targeting under-informed investors drawn by the possibility of high returns

Originally, ICOs were used by tech entrepreneurs as a method of raising the finance they need to create a new blockchain-based cryptocurrency or related app or system. Supporters buy-into the system, receiving tokens in the new currency in exchange. Unlike shares received in an IPO, the tokens in an ICO have no inherent value, however if the system was successful the tokens would become valuable. A number of successful ICOs have rewarded supporters with quick, large returns.

This niche approach to raising finance allows the company to raise funds very quickly, and to bypass the heavily regulated, lengthy processes associated with raising funds via a bank or venture capitalist, making them very tempting, particularly to new companies in the technological sectors.

The popularity of ICOs soared in the latter half of 2017 at which time they overtook venture capital as the primary source of funding in the blockchain sector.

Suitability, Acceptability and Feasibility of ICOs as a source of finance:
Companies, particularly in the technological sector, may consider ICOs as a source of potential short or long term finance. The suitability, acceptability and feasibility of this option as opposed to traditional sources of finance for the company will depend on how aligned it is with the strategy and operations of the company.

When assessing this, the company will need to take into account the pros and cons of carrying out an ICO and consider the significance of these to their organisation.

Let’s look first at what factors might draw companies towards using ICOs as a source of finance.

  • Money can be raised quickly. ICOs allow a company to raise funds much faster than they could using a more conventional source of finance. This is likely to be appealing to a company that is at an early stage of start up as it would allow them to raise all the necessary funds straight away. The founders could then spend their time developing their product, rather than spending a lengthy period of time on fundraising activities. For this reason, they may consider an ICO to be suitable for such a company where there may not yet be many stakeholders beyond the founders, and so the speed with which money can be raised for the venture may also be a factor that influences the acceptability of ICOs as a source of finance.

  • Cheaper. The lack of intermediaries in an ICO make them significantly cheaper than more traditional sources of finance as many of the settlement and transaction charges will be avoided. For a company who may struggle to raise the funds through conventional methods the ICO may be considered to be a more feasible financing route.

  • Ease. The process is simple and there are few barriers to entry. Again, making ICOs a potentially more feasible source of finance, particularly for early-stage start up companies.

  • Global investor base. ICOs are carried out exclusively online and are available to potential investors regardless of location. There are also no restrictions as to who can invest in the ICO increasing the chances that investors will be found. These factors could be very appealing to companies based in countries in which there is limited access to venture capital perhaps making ICOs a more feasible source of finance.

  • Immediately liquid investments: unlike in traditional routes where it may take a number of years for the funds invested in a company to be repaid, investments in an ICO become liquid immediately after a token is listed on an exchange. Faster liquidity is attractive to investors, so may increase the likelihood of investments being made in the ICO in the first place. The founders may consider this an indicator that they will be more likely to generate the funds they need.

However, there are also factors that would negatively affect the extent to which an ICO might be considered to be a suitable, acceptable and feasible approach to raising finance.

  • Funds received quickly, and up-front. While the advantage of quickly raising capital was seen above, there are also risks involved. ICOs allow companies to raise money up front, and the amount they receive may be more than they actually need. This immediately will misalign the interests of the founders and the investors. When applying for finance through a traditional route, the start-up company would have to pass through multiple rounds and milestones. Each one would provide the investors with assurance over the competence of the team and their product. If this is bypassed, and the founders receive significant funds up front, there is no incentive for them to prove their worth to the investors. This is likely to lead to over-spending and as a result, the company may not perform as well as it could, potentially even leading to failure. This raises questions around the suitability of this source of finance.

  • No standards for white papers. To launch an ICO, all a company needs to do is publish a ‘white paper’ with details of the concept that the tokens will be issued in exchange for cryptocurrency. Unlike the documents required in more formal financing routes, there are no standards governing what should be included in the white paper. This may mean important information is omitted, indicating that perhaps the company is not ready to launch its product. However, this would not be identified as it would in traditional financing routes, the ICO would go ahead and possibly the investors would lose their money and the venture would fail. ICOs are unlikely to be suitable for over-enthusiastic start-ups rushing into raising finance before they are ready.

  • Anonymity, and lack of transparency and oversight. Anonymity and lack of transparency are inherent within blockchain technology and make ICOs a target for money laundering and terrorist financing. The general lack of regulation and oversight of ICOs, and the variations in the approach to ICOs worldwide means that there is little comeback for investors when things go wrong. This may increase investors’ reluctance to buy into to an ICO, thus making it less likely the finance will be raised and calling the feasibility of the ICO as a finance source into question.

  • Fraud and cybersecurity risk. Ponzi schemes (fraudulent investing scams) involving virtual currencies have created nervousness among investors. If ICOs develop a poor reputation, their acceptability and feasibility as a source of finance are likely to be reduced. Cryptocurrencies are also susceptible to hackers and other cybersecurity issues.

When assessing whether or not an ICO is appropriate, the company will need to look at these factors alongside their strategy, objectives, operations and risk policies to inform the extent to which it would be considered a suitable, acceptable and feasible decision.

Written by a member of the Strategic Business Leader examining team