By Dr Soha Maad
Introduction
Various global, financial and regulatory authorities and bodies are attempting to define a framework for virtual assets in order to leverage potential market growth and reduce risk of misuse of virtual assets. In this article we consider the basics of virtual assets as defined and proposed by the Financial Action Task Force (FATF), the International Monetary Fund (IMF), the Group of 20 (G20), the Financial Stability Board (FSB), and the International Federation of Accountants (IFAC). The article overviews the characteristics of virtual assets, the major participants in the virtual asset system, the taxonomy of virtual assets, the transaction cycle of virtual assets, potential impact on financial system, potential impact on economic growth, and challenges and potential misuse of virtual assets. The article concludes with future outlook and glossary of terms related to virtual assets.
Characteristics of Virtual Assets
According to the Financial Action Task Force (FATF), the term ‘virtual asset’ refers to any digital representation of value that can be digitally traded, transferred or used for payment. It can perform following functions:
• Medium of exchange
• Unit of account
• Store of value, but does not have legal tender status in any jurisdiction
Virtual Assets are not issued nor guaranteed by any authority, and fulfils the above functions only by agreement within the community of users of the virtual assets.
Virtual Assets and e-money both are digital currencies. The difference between them is that e-money is backed by the fiat currency (currency that has legal tender status), used as transfer mechanism for fiat currency. However, the Virtual assets are not backed by the fiat money, created and held electronically, and can be traded digitally to transfer value.
Virtual Assets System
The major participants in the virtual asset system are:
- Administrator: is the person or entity, which issue centralized virtual asset, establish the rules for its use; maintain a payment ledger; and has the authority to redeem the virtual asset.
- Miner: is the person or entity that participates in a decentralized virtual asset network by running special software to solve complex algorithms in a distributed proof system used to validate transactions in the virtual asset system.
- Exchanger: is the person or entity engaged in business of virtual asset exchange for real currency, funds, or other forms of virtual asset for a commission. The exchangers accept a wide range of payments, such as cash, wires transfers, credit cards, and other virtual assets. Individuals typically use exchangers to deposit and withdraw money from virtual asset accounts. Some of the well-known exchangers are Bitfinex, Coinbase, Bitstamp, Poloniex, Coinmama, CEX.IO etc.
- User: is a person/entity who obtains virtual asset and uses it to purchase real or virtual goods or services or send transfers in a personal use. Users can obtain virtual asset in several ways. For example, they can (1) purchase virtual asset, using real money from an exchanger or directly from the administrator/Miner (2) engage in specific activities that earn virtual asset payments (e.g., respond to a promotion, complete an online survey, provide a real or virtual good or service); (3) self-generate units of the virtual asset currency by “mining”
- Virtual Asset wallet: is the software application for holding, storing and transferring bitcoins or other virtual assets.
- Wallet provider: is an entity that provides a virtual asset wallet for holding, storing and transferring bitcoins or other virtual assets. A wallet provider facilitates participation in a virtual asset system by allowing users, exchangers, and merchants to more easily conduct the virtual asset transactions. The wallet provider maintains the customer’s virtual asset balance and generally also provides storage and transaction security. Some of well- known Wallet providers are Bitcoin Core protocol, Electrum, Exodus, Jaxx, Copay, Coinbase, Blockchain etc.
Taxonomy of Virtual Assets
Based on the involvement of different participants from virtual asset system, virtual assets can be distinguished into centralized and decentralized Virtual assets:
|
Criterion |
Centralized |
Decentralized |
|
Software Architecture |
Centralized |
Distributed (Blockchain) |
|
Issuer |
Administrator |
Miner |
|
Exchange Rate |
Pegged |
Floating |
|
Convertibility |
Exchanged for fiat currency |
Exchanged for fiat currency |
|
Participants |
Administrator, Exchanger, User |
Miner, Exchanger, User |
|
Examples |
E-gold, WebMoney, Linden Dollars |
Bitcoin, Onecoin, Litecoin, Ripple |
The decentralized virtual assets are particularly vulnerable to money laundering and terrorism financing abuse, due to easy convertibility and distributed architecture, which provides anonymous transfer of funds without passing through a central authority.
The Transaction Cycle of Virtual Assets
The transactions of virtual assets rely on public and private keys (provided through Virtual asset Wallet) to transfer value from one person to another. The safety, integrity and balance of virtual asset ledgers is ensured by a network of mutually distrustful parties (miners) who protect the network in exchange for the opportunity to obtain a randomly distributed fee.
The transaction cycle to transfer virtual asset such as bitcoin from one person to another involves:
- Virtual Asset Wallets: The individuals (sender and receiver) require Virtual Asset Wallets for performing a transaction in virtual assets. A Virtual Asset Wallet contains a public key and a private key.
- Address Creation: The receiver randomly generates a new address (public key) for the sender using the Wallet.
- Payment Submission: The sender will enter the unique address (public key) shared by the receiver in the wallet along with amount of virtual asset to be sent.
- Signature: The sender will digitally sign the transaction with unique private key, which will prove the integrity of transaction.
- Propagation and validation: The transaction will flood through the distributed network to nodes who perform verification checks and re-propagate the verified transaction to other peers in the network.
- Creation of Block: After validation, the miners will include the transaction in the next block to be mined.
- Proof-of-Work: The miners will compete each other to calculate a hash that will solve the Proof-of-Work. This process takes 10 minutes on average.
- Confirmation of transaction: Once the transaction is included in a block, the sender and receiver will receive a confirmation in their Wallets that the transaction has been completed.
Once the transaction gets included in a block, it cannot be reversed or tempered. A set of virtual asset’s transactions creates a block and these blocks kept on creating with the transactions, hence this process is termed as Blockchain.
IMPACT ON FINANCIAL SYSTEM
Virtual assets may increase the efficiency of financial system by complementing and substituting existing currencies and assets. Virtual assets could improve the efficiency and convenience of payment and settlement systems, as their transaction fees are low and they can be transferred without physical or time constraints and engaged in transactions with versatile manners. However, current virtual assets have limited functions of money, due to high price volatility, social costs and low acceptance. Furthermore, virtual assets incorporated into the financial market as new assets could expand investment portfolios providing functions of speculation, diversification, and hedging capabilities.
IMPACT ON ECONOMIC GROWTH
Virtual assets can contribute to financial innovation and economic growth by expanding the blockchain ecosystem through enhancing blockchain’s network externality. Virtual assets contribute to the growth of blockchain ecosystem by providing economic incentives to coin miners. The growth of ecosystem in turn, leads to an increase in the value of virtual assets, reducing the opportunity cost of holding virtual assets and eventually contributes to its own development. Additionally, growing interests in virtual assets can also lead to the growth of innovative industries such as metaverse, Non-Fungible Token (NFT), and Decentralised Finance DeFi as well as improving financial services using blockchain.
CHALLENGES AND MISUSE OF VIRTUAL ASSETS
The low transparency and the lack of regulatory framework are major challenges facing virtual assets markets. Guaranteed anonymity in transactions increases chances of illegal transactions. The price volatility of virtual assets and market liquidity risks are also major challenges.
Moreover, there are various potential misuses of virtual assets by criminals for money laundering purposes. Potential misuse include:
- Predicate crime: raising funds through illegal activity by selling illegal goods or services in return for virtual assets.
- Placement: converting ill-gotten virtual assets into fiat currencies within a traditional financial system.
- Hiding: Crypto-based transactions can generally be followed with blockchain analytics, however there may not be any link between a transaction and any given individual when conducted outside of the regulatory perimeter. Criminals can also use anonymizing services like mixers and tumblers to break the links between crypto transactions.
- Layering: Converting fiat assets into virtual assets, exchanging virtual assets, conversion between virtual assets and converting virtual assets into fiat currencies.
- Integration: similar to laundering of dirty fiat money, an online company that accepts crypto payments can be formed to legitimize income and clean dirty cryptocurrency.
Future Outlook
A structural change of the virtual asset market is expected in the future. More robust regulatory frameworks are expected to be in sight in order to ensure consumer protection and the soundness of financial system. Since 2020, major countries like the European Union EU and the United States US have been preparing regulatory measures to protect consumers and secure financial stability.
The issuance of central bank digital currency (CBDC) will be actively considered to improve the security and efficiency of payment and settlement systems. The timing and form of the introduction of CBDC, as well as its implications on the monetary policy and financial sectors, are being carefully considered in various countries around the world including Arab countries.
Virtual assets are changing the face of finance and their use is growing rapidly, similarly
the virtual asset service provider sector is growing equally fast. New regulatory obligations and rules will have an impact on both virtual assets and virtual asset service providers in equal measure.
Glossary of Terms
Below is a glossary of terms related to virtual assets based on definitions from Financial Action Task Force (FATF), International Monetary Fund (IMF), Group of 20 (G20), Financial Stability Board (FSB), and the International Federation of Accountants (IFAC).
Virtual Asset (VA): A virtual asset is a digital representation of value that can be transferred or used for payment. It does not include digital fiat currencies.
Cryptocurrency: A decentralised virtual asset that is protected by cryptography that can
be used as a means of exchange, transferred, stored and traded electronically. The most
popular of the thousands of cryptocurrencies are Bitcoin and Ether.
Non-Fungible Token (NFT): A completely unique virtual asset. While there are many
Bitcoins, there is only one of each NFT. These often represent a specific piece of digital
artwork or some other digital or real property.
Virtual Asset Service Provider (VASP): A business that provides any of the following
services: transferring or exchanging between virtual assets and fiat currencies, or between different virtual assets; safekeeping/administration of virtual assets; and providing financial services related to virtual asset issuance.
Virtual currency wallet: A mean for holding, storing, and transferring virtual assets.
Smart contracts: are automatically executed contracts following predetermined process in the blockchain network.
Decentralised Finance (DeFi): indicates financial services implemented without centralized intermediaries.
Stablecoin: A type of crypto-asset designed to maintain a stable value relative to a specified asset or a pool of assets. Depending on the type of their collateral backing as well as their price stabilization mechanisms, stablecoins can be classified into cash-based, asset-based, crypto-asset-based, and noncollateralized (algorithmic) stablecoins.
Distributed Ledger Technology (DLT): DLT is a database that is stored, shared, and synchronized on a computer network. Data is updated by following rules for achieving consensus among the network participants. allows for data to be stored at multiple locations (“decentralized”) on a shared network allowing participants to track the ownership and transfer of virtual assets.
Crypto assets: Is a digital representation of value, made possible by advances in cryptography and distributed ledger technology.
Global Stablecoins (GSCs): Addressing the regulatory, supervisory and oversight requirements of Digital Money Across Borders, GSCs are built on an existing large and/or cross-border customer base, which have the potential to scale rapidly to achieve a global or other substantial footprint. GSB is also defined by G20 as stablecoins with the potential for mass adoption.
Blockchain: is a distributed database or ledger that is shared among the nodes of a computer network. As a database, a blockchain stores information electronically in digital format. Blockchains are best known for their crucial role in cryptocurrency systems, such as Bitcoin, for maintaining a secure and decentralized record of transactions. The innovation with a blockchain is that it guarantees the fidelity and security of a record of data and generates trust without the need for a trusted third party. One key difference between a typical database and a blockchain is how the data is structured. A database usually structures its data into tables, whereas a blockchain, as its name implies, structures its data into chunks (blocks) that are strung together.
Central Bank Digital Currency (CBDC): is a digital liability of a central bank that is widely available to the general public. Like existing forms of money, a CBDC would enable the general public to make digital payments. A CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.
