What if there were a way to hold and exchange money anonymously, without regulation, and without any transfer fees? Do you have questions about insuring bitcoins and other cryptocurrencies?
Now, there is a way. It’s called cryptocurrency, and it’s a fast-growing market that has been generating a lot of interest in recent years. The most popular form of the payment system is called Bitcoin and an anonymous developer created it in 2009. By December 2014, there were over 150 different cryptocurrencies in use all over the globe.
As its popularity grows, so too does general interest in regulating the industry and protecting consumers from the pitfalls of engaging in this risky new venture. This article will explain the basics of cryptocurrency, the risks involved, and new measures that have developed in the last few years to protect currency holders.
The first thing to understand is the difference between digital currency, virtual currency, and cryptocurrency, as they are not one and the same.
Digital currency is a general term that means all currency that can be held or transferred from one account to another electronically. National currencies, like the US dollar, have all been moving to digital platforms.
Virtual currency is a type of digital currency that can only be used on a specific website. They are “not based in physical reality.” For example, the creators World of Warcraft and Second Life have developed unique currencies for their websites that you can only use within the game itself. You cannot use this currency in the real world.
Cryptocurrency is also another type of digital currency; however, it is not a virtual currency. It can be used both online and in the real world in exchange for goods and services. The best-known example of a cryptocurrency is Bitcoin.
How It Works
As a cryptocurrency, Bitcoin serves as a replacement for physical money. However, much like our national currency, the exchange rates vary day to day, can be used to pay for goods and services, and accounts can be held by both individuals and companies. As of August 2015, the number of Bitcoins in circulation is over 14.4 million. The exchange rate is $284.80 in US dollars for every 1 bitcoin.
The key to Bitcoin and other cryptocurrencies is that they are decentralized. There are no digital banknotes that are issued, and there is no central authority monitoring exchanges and transactions.
Bitcoin transactions are anonymous, but a record of each currency exchange is placed into a ledger called a blockchain. Blocks are made up of a certain number of transactions. Once each block is completed, it is added to the chain by Bitcoin participants, called miners, who add a mathematical formula to the block. This is then changed into a hash, or alphanumeric sequence. The hash is linked to the block and added to the blockchain. Thus, miners are confirming that all the transactions in each block are legitimate.
Since money is not printed and then put into the market, Bitcoin operates on a peer-to-peer network that is responsible for “mining” additional Bitcoins. Miners apply the mathematical formulas that are added to each block in exchange for new Bitcoins. These Bitcoins are issued at a controlled rate. There are a pre-determined number of Bitcoins with the creation of each block.
Once you have acquired Bitcoins or any other cryptocurrency, they are stored in a wallet. A wallet contains the digital keys (also called codes). One key is held privately by the owner of the wallet and the other held publicly. Once the two keys unlock the wallet, the owner can send or receive Bitcoins to a certain address or sign a transaction. Wallets can run as a program on your computer or smartphone, through an online service, stored on a hard drive, or can be printed as a paper wallet with two QR codes—the public and private keys to your bitcoins. You can even get an engagement ring with a QR code that links to a blockchain. So far, there approximately 8 million users with Bitcoin wallets.
For Bitcoin holders, there are many advantages to using cryptocurrency. Aside from anonymity and a deregulated market, you can spend or transfer the money anywhere in the world without any fees. It’s quick and easy to use, and you don’t need to have a bank account or even a credit card.
There are also measures of protection implemented through the blockchain method. The hash attached to each block is unique. So, if there were a fake transaction—like a user trying to spend the same Bitcoins twice—then it would change the block, its hash, and all the block/hash combinations that were added to the chain after it. This makes it easier for Bitcoin users to catch the fake transactions.
Of course, there are risks involved as well. The more Bitcoin users, the greater the chance for theft. There are several high profile examples of Bitcoin theft that have been in the news recently.
For example, in February 2014, Mt. Gox, a large Bitcoin exchange system collapsed after the website went offline and reported that approximately $400 million Bitcoins had gone missing. At the time, the founder, Mark Karpeles, reported that there was a bug in the system that had affected transactions. However, in August 2015, Karpeles was arrested in Tokyo after evidence surfaced of embezzlement, issues with coding, and price manipulation. According to one report, the incident serves as a “cautionary tale for anyone with dreams of unregulated digital finance.”
It doesn’t necessarily have to be theft at an exchange company either. Any individual only needs to make small mistake to lose their cryptocurrency. In December 2013, Bloomberg TV did a segment explaining Bitcoins. One anchor gave his co-anchors a Bitcoin gift certificate on the air. Showing the audience what the gift certificate looked like was enough for one viewer to pause the show, scan the QR code, access the private key, and steal the gift certificate money. The thief posted his success online and offered to give the anchor back his Bitcoins, but the man declined saying it was a good security warning for others.
Protection Against the Risks
As a reaction to the small and large theft incidents that have occurred with the increasing usage and popularization of cryptocurrencies, regulators and insurance companies have stepped in to protect consumers.
In 2014, the IRS issued a report on currency guidance which applied directly to cryptocurrencies like Bitcoin. The notice stated that exchanges with this type of currency should be treated the same as national currencies for tax purposes. This includes reporting wages and other payments that use a currency that “operates like ‘real’ currency.”
Other attempts to impose regulations include a company still in development called Gemini that seeks to become the first US Bitcoin exchange to be regulated. Also, the state of New York has also issued its own requirements. By August 8 2015, cryptocurrency companies that offer services to New York residents need to apply for a BitLicense. New York is the first state to try to regulate Bitcoin and other companies. They want to protect local customers from instances like fraud and money laundering.
A few insurance companies and cryptocurrency exchanges have also attempted to safeguard consumers. The Great American Insurance Company now offers insurance to commercial and government clients through their Fidelity/Crime Division. The insurance protects against “employee dishonesty, money and securities, forgery and computer fraud.”
The exchange companies Elliptic, Xapo, and Coinbase offer some protection in exchange for an additional fee. They claim to be backed by insurance companies, but they haven’t released complete details about these partnerships. BitGo has partnered with the XL Group of insurance companies to offer their customers monetary protection from theft as well as internal issues at BitGo like employee dishonesty.
As insurance companies explore the possibility of creating policies for cryptocurrency holders, Lloyd’s of London issued a report in June 2015 offering additional information. Their report, titled “Bitcoin—Risk factors for insurance” detailed the risks to using or operating with Bitcoins. They state that. “Bitcoin businesses continue to face dynamic threats regardless of their security practices.”
The Lloyd’s report offers unique advice to insurance companies. Rather than continue the underwriting practice of assessing the history of a Bitcoin exchange in order to determine the risk factors and costs for insuring, they should do the exact opposite. As cryptocurrencies expand and change, insurance companies should watch these developments and attempts to improve security as a way to measure the risks.
Time will only tell what insurance companies and regulators decide as they enter into to world of cryptocurrency. As stated by Ty Sagalow, president of Innovation Insurance Group, CEO of Bitcoin Financial Group, and former chief underwriting officer and chief innovation officer at AIG, “Bitcoin theft is fundamentally a cyber risk – there are elements of crime, there are elements of professional liability – so it’s a series of types of coverages put together in a new format and applied to a whole new industry.”
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