Forms of digital currency have the potential to provide cheaper and faster payments, enhance financial inclusion, improve resilience and competition among payment providers, and facilitate cross-border transfers. Some countries have embraced crypto assets as financial products because they are secure, easy to access, and inexpensive to trade. However, the risk associated with it can either be accepted, managed with means to mitigate it, or completely avoided. Crypto assets require tough policy choices, such as clarifying the role of the public and private sectors in providing and regulating forms of digital currency. However, in most cases, the risks and costs outweigh the potential benefits, and the risks must first be understood.
Crypto-assets are therefore fundamentally different from other types of digital currency. These are highly volatile assets and well known for their ability to generate potentially high returns, which could just as well lead to significant losses. The market risk associated with cryptocurrencies is a direct result of their volatility, global political and regulatory impact, borderless demand, and constantly active market. Crypto-assets are tokens issued by individuals based on cryptographic techniques and denominated in their unit of account. Although these risks are mostly understood by many people entering the market, little or no attention is usually paid to certain other risks associated with a specific cryptocurrency.
What is cryptocurrency and financial products?
In summary, financial products are contracts that are bought and sold on a market place. Financial instruments can also be divided according to an asset class, depending on whether they are debt-based or equity-based. A financial product is an instrument in which people can either make financial investments, borrow or save money.
Cryptocurrency is a type of digital asset which is an intangible digital currency that uses a highly sophisticated type of encryption called cryptography to secure and verify transactions as well as to control the creation of new monetary units. According to an expert from Bitsoft 360, cryptocurrency is designed to operate as a decentralized medium of exchange independent of a financial institution or other central authority. Bitcoin is the best known cryptocurrency but it is not the only one. Major types of cryptocurrencies include Ethereum, Ripple, and LiteCoin.
Several countries have adopted crypto-assets as a financial product. For example, a dated notice On October 19, 2022, the country’s Financial Sector Conduct Authority in South Africa declared crypto assets to be a financial product. The notice, which takes effect immediately and falls under the Financial Advisory and Intermediary Services Act 2022, defines a crypto asset as a digital representation of value that a central bank does not issue but can be exchanged, transferred or stored electronically for payment, investment and other forms of utility. South Africa’s central bank Deputy Governor Kuben Naidoo said that “over the summer the bank came to view cryptocurrency as a financial asset and was considering regulating the sector.” France is also one of the countries that allow cryptocurrencies to be used as a means of payment. In May 2022, France granted Digital Asset Service Provider (DASP) registration with Binance allowing it to operate its cryptocurrency exchange.
What does it mean to make crypto assets legal tender?
Bitcoin and its peers have mostly remained on the fringes of finance and payments – if crypto assets were legal tender, that means they would have to be accepted by creditors bearing monetary obligations, including taxes, similar to money issued by the Central Bank. There may also be laws passed to label crypto assets as a form of national currency, as an official unit of currency, and a mandatory means of payment for everyday purchases.
Households and businesses would have little incentive to value or save in a parallel crypto asset. Crypto-assets are said to be unlikely to spread to countries with stable inflation, exchange rates, and credible institutions because their value is too volatile and unrelated to the real economy. In addition, in some countries, laws prohibit or restrict payment in other forms of currency. These could tip the scales towards widespread use of crypto assets. If goods and services were priced in a crypto asset, households and businesses would spend a lot of time and resources choosing what money to hold instead of engaging in productive activities.
Risks associated with crypto-assets as official financial products
Government revenues would be exposed to currency risk if taxes were quoted in advance in a crypto-asset while expenditures remained mostly in local currency or vice versa. Monetary policy would lose its bite and financial integrity could suffer. Without strong anti-money laundering and anti-terrorist financing, crypto assets can be used to launder ill-gotten money, fund terrorism, and evade taxes. This could pose risks to the financial system, fiscal balance, and relations with foreign countries and a country’s correspondent banks.
The Financial Action Task Force has established a standard to regulate virtual assets and related service providers to limit financial integrity risks. But the application of this standard is not yet uniform from one country to another. Legal tender requires a means of payment to be widely available. Internet access and the technology needed to transfer crypto assets remain scarce in many developing countries, raising questions of equity and financial inclusion. In addition, the official monetary unit must be stable enough to facilitate its use for medium and long-term monetary obligations.
The use of crypto-assets would compromise consumer protection. Households and businesses could lose wealth due to large fluctuations in value, fraud or cyberattacks. While the technology underlying the crypto assets has proven to be very robust, technical issues could arise. Mined crypto assets use an enormous amount of electricity to power computer networks that verify transactions.
That said, the benefits of cryptocurrency and blockchain technologies, including the potential for cheaper and more inclusive financial services, should not be overlooked. It is paramount that investors educate themselves to understand the technology and its associated risks, especially now that the asset class is a regulated financial product in South Africa. Note that this article is for informational purposes and does not constitute legal advice.