Cryptocurrency unencrypted < Risk Management Partners

Published by FP Admin on May 21, 2020

Cryptocurrency unencrypted

An introduction to cryptocurrency and its risks.

AUTHOR: Philip Farrar, National Development Director, Risk Management Partners Ltd.

On 15 February 1971 the coins and notes we use today (as cash) were introduced into circulation in the UK for the first time as the UK went decimal.

If the head teacher of my primary school had said as she showed us the shiny new coins: ‘….and in about 50 years children you will have access to digital money that will be encrypted. You will not understand it, nor be able to see it, or touch it, but trust me, it’s the future…’ I think we would have all thought she was mad!

But in 2020 it’s here, and it’s called cryptocurrency!

As cash is almost made redundant and cheques are being phased out, with both replaced by chip and pin and contactless payments, not only are the means and process by which we pay for goods and services changing, so is the currency in which we have the option to trade.

Business is changing too. Since 2017, kik, the social media messenger platform has accepted cryptocurrencies as payment, and in 2019 Facebook launched its own cryptocurrency, Libra. In 2018 the first cashless bar opened in Manchester and the first cashless pub in Ipswich. They accept payments with a chip and PIN or contactless bank card or phone, or a cryptocurrency.

We have already had the first house purchase using cryptocurrency1 and some councils accept cryptocurrency payments for council taxes and fees. Many companies and organisations now use cryptocurrency for regular payments and charges.

Cryptocurrencies may not be new, but in-depth knowledge of their use (and associated risks) is still growing. It may become
more common in everyday transactions, but cryptocurrency culture is not commonly understood. Insurers and the insured both need to get to grips with cryptocurrencies to manage the risks wisely

What is cryptocurrency?

Cryptocurrency is electronic money. This is a medium of exchange using cryptography encryption to secure transactions and control the creation of new units.

It has no physical presence (there are no coins or notes) and it is mainly stored in ‘electronic wallets’. It can be used to purchase goods and services (online and offline).

In law cryptocurrency is not considered as cash. It falls under the definition of property, as defined by the Proceeds of Crime Act 2002.

The currency is not controlled by any government(s), banks, or finance houses. It is a decentralised currency, with no overall government, country or person in control of it. There are a number of cryptocurrencies, including some familiar names such as Bitcoin (BTC) and Dash (DSH). Bitcoin is the best known and has the greatest market share.

It can help to understand cryptocurrency by contrasting it with other electronic money, for example PayPal. PayPal is a form of electronic money controlled by PayPal (owned by eBay). PayPal checks all PayPal transactions and validates them. If person Y wants to pay person Z £500, PayPal checks Y is good for the £500 and transfers it to Z and updates both Y’s and Z’s accounts and balances to show this transaction.

Cryptocurrency on the other hand uses a peer- to-peer network of lots of users (or ‘miners’) spread throughout the globe, to verify each transaction. There are in excess of 200,000 BTC miners spread across the world, hence the decentralisation. These miners keep a ledger of transactions they all agree on and share via the peer-to-peer network.

If Y wants to send 1BTC to Z, everyone running the validation programme or the ledger; (the miners), must agree that Y is good for the 1BTC, then Y can send it to Z and everyone then agrees this transaction and updates the balances of Y and Z. For doing this a random miner is rewarded with some newly created BTC.

Every transaction is recorded in a ‘block’ of roughly 1,000 to 2,000 transactions and is built on the previous block of verified transactions, hence the term ‘blockchain’. Anyone with an internet connection can see the whole of this ledger and blocks and can view every transaction ever made1.

Bitcoin

Bitcoin was created in 2009 by Satoshi Nakamoto, which may, or may not be a pseudonym. Bitcoin, as the name suggests, is a form of currency used entirely within the digital realm. There are no official physical bitcoins, nor is there a central bank (such as the Bank of England) to monitor the currency.

Understanding cryptocurrency

The value of a cryptocurrency will always be central to how widely adopted it is. It is a question of supply and demand. In this way it is likely that the early adopters such as Bitcoin and its competitors will continue to exist and grow but new and emerging currencies using the same technology will struggle.

Cryptocurrencies work extremely similar to one another. There are minor differences in the coding and the ‘back end’ of the protocol, however as a user interface they are almost identical. Having a good understanding of one cryptocurrency will therefore give you a sound understanding in how they work as a whole.

Anyone who follows the movements in the cryptocurrency market will appreciate that currencies can fluctuate widely. In the couple of days I have been preparing this article, Bitcoin has increased by around six per cent from £7,069.88 to £7,535.94 in value1. However on 30 March bitcoin, like all currencies in response to the pandemic, had dropped to £5,141.75.

Cryptocurrencies like bitcoin are technically worthless as a commodity. They do not physically exist and are not accepted as legal tender by the majority of the world’s retailers. However, it is useful in paying for commodities anonymously, which makes it attractive to the criminal fraternity. This represents a real challenge to law enforcement agencies in tracing and monitoring such transactions.

Anonymity

Due to the fact it is decentralised (no government or bank has overall control of cryptocurrencies after all), one of the differences between using bitcoin and regular money online is that bitcoin is not linked to any real-world identity. Unless someone chooses to link their name to a bitcoin address, it is hard to tell who owns the address.

Bitcoin does not keep track of users; it keeps track of addresses where the money is. Each address has two important pieces of cryptographic information, or ‘keys’: a public one and a private one. The public key, which is what the ‘bitcoin address’ is created from, is similar to an email address. Anyone can look it up and send bitcoins to it. The private address, or private key, is similar to an email password, so only the owner can send bitcoins from it. Because of this, it is very important that this private key is kept secret.

To send bitcoins from an address, you have to prove to the network you own the private key that corresponds to the address, without revealing the private key. This is done with a branch of mathematics known as public key cryptography.

Confused? You are not the only one! Think how the insurance industry has struggled to get to grips with this currency, recognise and measure risk, consider risk management solutions, and in turn develop policy cover.

PayPal

PayPal is not a cryptocurrency but does get confused as one. Established in 1998, one of PayPal’s founders was Elon Musk. It became
a wholly owned subsidiary of eBay in 2002, when eBay bought it for $1.5 billion. eBay spun off PayPal in 2015, when it was worth close to $50 billion. Since 2018 PayPal has once again been an independent company. It ranked 222nd on the 2018 Fortune 500 of the largest United States corporations by revenue. Moving money around is a lucrative business.

Insurance

As with many new things, the insurance industry has been slow to develop policies and cover dealing with cryptocurrencies. This has been because of the lack of control around such currencies; the issues of legal identity; the difficulty in measuring a loss or value; and probably fundamentally, because most of the industry, (like the public) doesn’t understand or feel comfortable with the subject.

The main part of the public sector exposed to cryptocurrencies is the police. Such currencies can often be confiscated as part of a clampdown on criminal activity. Confiscation can run to the equivalent of £1 million in any one year. Other than some very modest limits under property policies, there is an absence of cover should a loss arise.

This is a challenge to all parties involved. Those who have need for cryptocurrency cover could do more to explain risk and claims’ solutions to the market, and underwriters in turn could be more imaginative in developing solutions.

One way or another though, the market will get to grips with the challenge and ultimately this will be reflected in the developments in policy wordings: it will just take a while to get there. But there are market developments with the development of standalone solutions.

Cryptocurrency unencrypted was published in Spring 2020 stronger, ALARM’s member journal. ALARM is a membership organisation run by members, for members, supporting risk professionals that support our communities and citizens. For more information, please visit alarmrisk.com.

Published Date 26th May 2020

Disclaimer

This article and related document links do not purport to be comprehensive or to give legal advice. While every effort has been made to ensure accuracy, Risk Management Partners cannot be held liable for any errors, omissions or inaccuracies contained within the article and related document links. Readers should not act upon (or refrain from acting upon) information in this article and related document links without first taking further specialist or professional advice. Risk Management Partners Limited is authorised and regulated by the Financial Conduct Authority. Registered office: The Walbrook Building, 25 Walbrook, London EC4N 8AW. Registered in England and Wales. Company no. 2989025

Disclosure

Risk Management Partners Limited is authorised and regulated by the Financial Conduct Authority. Registered office: The Walbrook Building, 25 Walbrook, London EC4N 8AW. Registered in England and Wales. Company no. 2989025