Digital forms of money 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 adopted crypto assets as financial products because they are secure, easy to access, and cheap to transact. However, the risk associated with it can either be accepted, managed with ways to mitigate them, or avoided entirely. Crypto assets require difficult policy choices, such as clarifying the role of the public and private sectors in providing and regulating digital forms of money. However, in most cases, risks and costs outweigh potential benefits, and the risks must first be understood.
Crypto assets are thus fundamentally different from other kinds of digital money. They are highly volatile assets and are well-known for their ability to generate potentially high returns, which could just as easily result in 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 privately issued tokens based on cryptographic techniques and denominated in their unit of account. Although these risks are understood mainly by many that enter the market, little to no thought is usually given to certain other risks associated with a specific cryptocurrency.
What are cryptocurrency and financial products?
In a nutshell, financial products are contracts that are bought and sold on a marketplace. Financial instruments may also be divided according to an asset class, which depends 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 that is an intangible, digital currency that uses a highly sophisticated kind of encryption called cryptography to secure and verify transactions as well as to control the creation of new units of currency. According to an expert at Bitsoft 360, cryptocurrency is designed to work as a decentralised medium of exchange independent of a financial institution or any other central authority. Bitcoin is the most well-known cryptocurrency but it is not the only one. Significant types of cryptocurrencies include Ethereum, Ripple, and LiteCoin.
Multiple countries have adopted crypto assets as a financial product. For instance, a notice dated 19 October 2022 from the country’s Financial Sector Conduct Authority in South Africa has declared crypto assets 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 traded, transferred or stored electronically for payment, for investment and other forms of utility. Deputy Governor of South Africa’s central bank Kuben Naidoo said that “this summer, the bank had come to view cryptocurrency as a financial asset and was looking into regulating the sector.” France is also one of the countries that allow cryptocurrencies to be used as a form of payment. In May 2022, France granted Digital Asset Service Provider (DASP) registration to 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 granted legal tender status, this means that they would have to be accepted by creditors in charge of monetary obligations, including taxes, similar to money issued by the central bank. There can also be laws passed to label crypto assets as a form of national currency, such as an official monetary unit and a mandatory means of payment for everyday purchases.
Households and businesses would have little incentive to price or save in a parallel crypto asset. It is said that crypto assets are unlikely to catch on in countries with stable inflation, exchange rates, and credible institutions because their value is too volatile and unrelated to the real economy. Moreover, in some countries, laws forbid or restrict payments in other forms of money. These could tip the balance towards the widespread use of crypto assets. If goods and services were priced in a crypto asset, households and businesses would spend significant time and resources choosing which money to hold instead of engaging in productive activities.
Risks involved with crypto assets as official financial products
Government revenues would be exposed to exchange rate risk if taxes were quoted in advance in a crypto asset while expenditures mainly remained in the local currency or vice versa. Monetary policy would lose bite, and financial integrity could suffer. Without robust anti-money laundering and combating the financing of terrorism measures, crypto assets can be used to launder ill-gotten money, fund terrorism, and evade taxes. This could pose risks to a country’s financial system, fiscal balance, and relationships with foreign countries and correspondent banks.
The Financial Action Task Force has set a standard for regulating virtual assets and related service providers to limit financial integrity risks. But enforcement of that standard is not yet consistent across countries. Legal tender status requires that a means of payment be widely accessible. Internet access and technology needed to transfer crypto assets remains scarce in many developing countries, raising issues about fairness and financial inclusion. Moreover, the official monetary unit must be sufficiently stable to facilitate its use for medium-long-term monetary obligations.
Cryptoasset use would undermine consumer protection. Households and businesses could lose wealth through large swings in value, fraud, or cyber-attacks. While the technology underlying crypto assets have proven to be highly robust, technical glitches could occur. Mined crypto assets use an enormous amount of electricity to power the computer networks that verify transactions.
With all that being said, the advantages of cryptocurrency and blockchain technologies, including the potential for cheaper and more inclusive financial services, should not be overlooked. It’s 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 information purposes and does not serve as a piece of legal advice.