Blockchain and Virtual Currency – Origins of the Cryptocurrency “Boom” and Some Murky Realities

CybeRiskBlog, Cybersecurity

Blockchain

Attention – both positive and negative – continues to be drawn to the emerging blockchain technology, and its potential to disrupt and transform the way we do business, and the ways in which cyber-security may be enforced and deployed.

Much of the negative attention has been focused on the blockchain’s application in financial circles – most especially in the proliferation of so-called virtual or “cryptocurrencies” being traded outside the jurisdiction of traditional regulatory frameworks.

As recently as last week, federal authorities in the United States shut down the operations of one of the highest ranking virtual currency traders (the Bitcoin platform BTC-e), in a move that highlights the need for greater oversight and governance in at least some aspects of the evolving blockchain ecosystem.

The Blockchain Ideal

Existing legal, economic, and political frameworks rely on the creation and archiving of contracts, and the recording of the transactions and activities that they’re drafted to govern. Regulatory authorities, bodies of procedure and legislation, databases, libraries, and ledgers lie at the heart of these traditional systems of operations and administration.

The “distributed ledger” or blockchain exists in contrast to this model, by doing away with the need to rely on documents, centralized authorities or data stores for the authentication of identities or the processing and verification of transactions. By making a digital instance of the same dynamically updated transaction ledger available to each participating member of a network, peer-to-peer authentication and verification procedures become possible.

The mixed key pair encryption associated with each transaction or “block” in the chain provides (at least on the surface) an assurance of confidentiality within the network, while the ability to configure a blockchain to perform designated transactions automatically has implications for a wide range of use cases, including the communication, software updating, and security monitoring of devices used for infrastructure provision and the Internet of Things (IoT).

But while the blockchain as a foundational element has the potential to disrupt and transform the digital economy, IT, and cyber-security for the better, there are wider concerns about some of the applications and usage of this technology in the financial arena.

Blockchain – Disruption Through Bitcoin

In the public perception, “blockchain” and the Bitcoin cryptocurrency remain intimately linked – and it is true that the development of the virtual currency market has been a fueling factor in blockchain evolution. Considerable economic successes have helped to cement this association in the popular consciousness.

Blockchain itself was introduced in October 2008 as part of the proposal for Bitcoin, the virtual currency laid out in the November 2008 essay “Bitcoin: A Peer-to-Peer Electronic Cash System” published pseudonymously by “Satoshi Nakamoto.” Despite having no issuer or central administrator, Bitcoin assures its users of “unrestricted negotiability” (just like real money) which allows it to be transferred directly between parties, and “divisibility”, which allows face values to be added.

The currency is generated through “mining” – a process where identifying the hash function needed to add a new block to the existing chain earns the host computer that succeeds in this calculation a certain number of Bitcoin.

The cryptocurrency was estimated to have achieved a value of around $92 billion in Bitcoin transactions in 2016 and is a prime example of what Harvard Business Review analysts Marco Iansiti and Karim R. Lakhani describe as a “single-use foundational technology” application. It creates a lower cost and highly focused alternative to traditional processes like instant payments, foreign currency dealing, and asset trading.

Blockchain – Localization and Growth Potential

Looking beyond single-use applications, one likely trajectory for blockchain adoption could see the development of localized private networks enabling multiple organizations to be connected via a distributed ledger.

Moves in this direction are already being made in the financial services sector. For example, Bank of America, Fidelity Investments, JPMorgan, Standard Chartered, and the New York Stock Exchange are experimenting with blockchain technology as an alternative to manual and paper-based transaction processing in a number of areas, such as cross-border settlement, foreign exchange, trade finance, and securities settlement.

These kinds of developments may herald a move toward the formation of private blockchains created to serve specific functions in a range of industries.

Blockchain and The Cryptocurrency “Boom”

The success of Bitcoin as a standalone application has inspired the proliferation of a number of other virtual currency systems, based on the blockchain model: Largely unregulated digital money platforms, using credits or tokens issued and usually controlled by their developers, used and accepted between members of a particular virtual community, and capable of being stored, transferred, or traded electronically.

Three distinct classes of virtual currency have been identified:

  1. Closed virtual currency schemes: Sometimes known as “in-game only” schemes, where users typically subscribe to the platform for a fee, and gain virtual credits based on their online performance and activities.
  2. Virtual currency with unidirectional flow: Here, real money may be used to buy virtual currency at a specific exchange rate – but the virtual currency isn’t convertible back to standard cash. The virtual money may generally be used to buy virtual products and services, though some schemes allow the purchase of real-world commodities.
  3. Virtual currency with bi-directional flow: Virtual money may be bought and sold in exchange with real-world currency, and used in purchasing physical goods and services.

Following on the heels of Bitcoin, other projects like Ethereum, XRP, and Dogecoin have emerged to contribute to a global ecosystem that (as of 2015) includes around 500 virtual currencies with a total market capitalization of about €3.3 billion ($3.9 billion). With some notable exceptions (such as the CAD-coin digital currency being tested for interbank transfers by The Bank of Canada), these currency schemes are intended to operate as far removed from official regulatory structures and scrutiny as is legally possible.

The Murky Reality of Cryptocurrency

It’s this lack of regulatory controls which contributes in large part to the somewhat murky image that cryptocurrency schemes like Bitcoin have in the popular press. Rightly or wrongly, virtual currency platforms are seen as a haven for tax dodgers, or worse, a facilitator for the accumulation, disbursement, and laundering of the proceeds of crime – all the way from fraud and extortion through to drug and people trafficking, cybercrime, and terrorism.

The fact that Bitcoin has established itself as the currency of choice for purveyors of ransomware has contributed to this impression – a view that’s being reinforced by the information emerging from the U.S. Department of Justice indictments against the organizers of the BTC-e trading platform, where charges including 21 counts of money laundering, and operating an unlicensed money transmittal business are underpinned by an assessment that the scheme itself was founded on a “criminal design.”

Virtual Currency and the Risk to Consumers

For consumers, virtual currency schemes can represent a multi-part threat to both their savings and their identities.

The successful hacking assault which took down the Japan-based Mt. Gox trading platform (which at one time dominated the Bitcoin sector, processing 80% of all bitcoin-to-currency transactions) began in June 2011 and had bankrupted the enterprise by February 2014 – to the tune of almost $400 million of customer funds. The attack targeted the non-blockchain protected back-end systems serving the network – a vulnerability which has yet to be fully addressed in subsequent deployments.

Like the currencies themselves, fluctuations in the virtual currency exchange market are largely unregulated, leaving customers/investors uncertain as to the value of their assets from one moment to the next. For instance, in 2014 the one-day price drop for Bitcoin was as high as 80%.

Service charges for virtual currency transactions are determined on an arbitrary basis (often at the whim of the platform developers), in some instances making it more expensive to use a virtual currency than a regular credit card.

Accountability issues are also a problem, with no hard and fast rules as to who is liable to make restitution in cases where the virtual currency’s holding company goes out of business, a customer loses their private encryption keys or a host of other conditions.

The vulnerability of blockchain’s auxiliary systems to hacking also potentially exposes customer data to the threats of identity theft, virtual currency theft, and fraud.

Virtual Currency – Regulatory and Legal Moves

The Philippines has recently distinguished itself by becoming one of the first governments in Southeast Asia to formally regulate digital currency – at a time when the Reserve Bank of India and the Central Bank of China are looking to impose stricter guidelines aimed at stemming the growth of virtual currencies in their jurisdictions.

In the USA, virtual currency exchanges (including those using kiosks) are required to register with the Financial Crimes Enforcement Network (FinCEN) – a division of the U.S. Treasury Department. It was the high-profile BTC-e platform’s continued failure to do this which likely earmarked the Bitcoin exchange as a target for investigation and the indictments which have ultimately led to its closure.

The fact that law enforcement agencies are now prepared to act against virtual currency exchanges that don’t comply with official regulations (and with the elimination of one of the alleged major resources for traders in the “black economy”) a dichotomy may emerge in the sector, with more legitimate operators registering their platforms in accordance with the stated laws of their regions of operation, and other players relocating to the “Dark Web” to operate underground.

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Blockchain and Virtual Currency | The Risks of the Cryptocurrency "Boom"
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Blockchain and Virtual Currency | The Risks of the Cryptocurrency "Boom"
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Attention continues to be drawn to emerging blockchain technology and virtual currencies like Bitcoin and its potential to disrupt the way we do business.
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CybeRisk Security Solutions
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