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The World of Virtual Currencies by Ian Bancroft, Managing Director

30.07.14

Virtual or digital currencies are electronic currencies that are stored, exchanged and used entirely through computer media.  They are not legal tender, but provided a sufficiently large user communicate are prepared to place trust in them, they can be used for the settlement of transactions and for savings purposes.  Although such digital currencies have been in existence for quite some time, there has been a significant surge in interest over the past year in crypto currencies, which are a subset of the virtual currency universe, and in particular in 'Bitcoin', which was the first crypto-currency, launched in 2009.

What is a crypto-currency?

Crypto-currencies have some distinctive characteristics: firstly they use complex mathematics in their creation - more of this later.  Secondly, they use advanced cryptology to secure transactions.  Thirdly, and perhaps most importantly, transactions are recorded and validated through distributed databases - in effect the system is policed by the user community, and not by one central agency.

This article will focus on Bitcoin, which was the first crypto currency to gain widespread acceptance.  It should, though, be recognised that there are many other crypto currencies, some such as Dogecoin and Litecoin having achieved acceptability, but amongst the hundreds of others most could fall to the wayside or find limited or specialist use.

How did Bitcoin start?

There is some mystery surrounding its creation, and that is perhaps part of its charisma, particularly amongst the counter-culture demographic: its 'inventor' Satoshi Nakamoto, is believed to be a pseudonym of one or several mathematicians and/ or cryptographers.   The academic paper describing the creation and use of a crypto-currency was published in 2008 and the open-source software underpinning Bitcoin was released in 2009.

Akin perhaps to precious metal, Bitcoins are created by miners who must use computer power to solve a complex algorithm which validates each Bitcoin transaction, and adds it to the Block Chain.  Success is rewarded with Bitcoins.   Only 21 million Bitcoins will ever be created, with around 60 percent mined thus far, and with final mining likely to take place in 2140.  Again similar to a finite physical resource, as time progresses it will be increasingly harder to mine Bitcoins.

The attraction of Bitcoin, to some at least, is that unlike traditional 'fiat' currencies, Bitcoin is neither controlled by a State nor can the 'currency' be devalued by governments increasing the money supply.  Such can lead, in the worst instance, to hyperinflationary outcomes such as those seen in the Weimar Republic and Austria in the 1920's: what Gresham described as 'good money driving out bad'.

Another "attraction" is perceived to be the anonymity of Bitcoin, and consequently its use for nefarious purposes.  Certainly, Bitcoin's reputation was tarnished by its association with the Silk Road online black-market but the reality is that since Bitcoin's transaction ledgers - the Block Chain - are a matter of public record, Bitcoin is actually a very poor way to hide transactions.

However, more prosaically, the likely real advantage of crypto currencies will be the speed of transaction and the low transaction costs they offer, particularly for international transfers.  In theory, once a Bitcoin account, or wallet, has been established, international payments - for example a small value transaction to download music or film - can take place almost instantly, with 100 percent certainty for the vendor (no risk of fraud or chargebacks) and at a tiny cost when compared to traditional bank or credit card payments.  That said, Bitcoin is actually not terribly efficient for payments, with transaction validation potentially taking 15-20 minutes.  Other methodologies, e.g. Ripple, may therefore overtake Bitcoin for small value transactions, where time is critical.

The future for digital currencies

This disintermediation of traditional payment methods is seen as the underlying disruptive element of crypto currencies.   As part of the continued evolution of digital currencies, coin exchanges or operators want to move from what is seen as the present Wild West situation, towards a more controlled, safer environment.  This might seem paradoxical given that crypto currencies intentionally sit outside of state controls.   Isle of Man is developing a reputation as the centre of choice for digital currency activities.  The Island's Government's stated aim is to "welcome those who can meet the necessary standards while also preserving the Island's good reputation as a financial centre."

The Department of Economic Development has been working closely with the Financial Services Commission in preliminary drafting of required amendments to have digital currencies considered as property and to include digital currency businesses under the Isle of Man's anti-money laundering registration and oversight regime. The Proceeds of Crime Act 2008 is expected to have digital currency included as an activity later this year.

In 2015, the Isle of Man will see the inclusion of digital currency in the Designated Business (Registration and Oversight) Bill 2014 which will allow for the registration of businesses with the FSC.

Cayman National is working with a number of professional service providers who seek to use the Isle of Man as a well regulated base ideally placed to take this emerging market into the next stage of its evolution.

For more information, please contact either lee.penrose@cnciom.com or anita.gould-davies@cnciom.com