ELP Podcast Series - Unfolding Blockchain Technology and Derivation of Cryptocurrency

In this episode of the ELP Podcast series, we are going to understand the science behind the derivation of cryptocurrency. Since its creation, cryptocurrency, has seen astronomical growth over the world and in India. However, the phenomenon of cryptocurrency and the manner in which transactions relating thereto operate is particularly difficult to describe in familiar jargon, given the dynamic technology on which it functions. There have been talks about the central government intending to introduce the Cryptocurrency Regulation Bill. There is a lot of anticipation and speculation on the exact scheme of regulation that is required for cryptocurrency. Therefore, in today’s podcast, both Nishant and Yash will throw light on conceptual and fundamental aspects of the cryptocurrency itself. 

Transcript

Unfolding blockchain technology and derivation of cryptocurrency

 Introduction 

 1.       Hello everyone, I welcome you all to today’s edition of ELP’s podcast on the heavily discussed topic of “cryptocurrency”. In today’s podcast, ELP’s Senior Partner Nishant Shah who co-heads the tax practice of the firm along with Yash Desai who has extensively studied and written about various aspects of cryptocurrency, will discuss on the genesis, technology and derivation of cryptocurrency. 

2.       Since its creation, cryptocurrency, has seen astronomical growth over the world and in India. However, the phenomenon of cryptocurrency and the manner in which transactions relating thereto operate is particularly difficult to describe in familiar jargon, given the dynamic technology on which it functions.

3.       As most of you must have heard, there have been talks about the central government intending to introduce the Cryptocurrency Regulation Bill. The discussion on the said Bill, earlier proposed to be taken up in the upcoming budget session of FY 2022-2023, is now reported to be further delayed, because the Government is in the process of seeking further inputs. There is a lot anticipation and speculation on the exact scheme of regulation which is required for cryptocurrency. 

4.       In this background, we thought it would be important to take a step back and understand the science behind derivation of cryptocurrency. So, in today’s podcast, both Nishant and Yash will throw light on conceptual and fundamental aspects of the cryptocurrency itself.   

5.       I would like to first start with Nishant. Nishant could you first give an introduction to the concept of “cryptocurrency”? 

1.      What does the term “cryptocurrency” signify?   

 1.       Thank you Stella

2.       Before we further delve into the regulatory aspects of cryptocurrency and thereby other connected issues such as taxation, it is important to understand the genesis, purpose, potential and thereby the inherent nature and understanding of cryptocurrencies. 

a.       By genesis we mean the science behind the invention and evolution of cryptocurrency. 

b.       Purpose is intended to define what cryptocurrencies are intended to replace. 

c.       The steady and unprecedented rise in the value of cryptocurrency needs to be understood to verify whether there is an actual tangible position for the value that it commands. This in turn provides a direct correlation for the demand supply of cryptocurrency, which requires us to understand the source and manner of cryptocurrency.

Meaning of cryptography: 

d.       At the outset, the term “crypto” is derived from the word “cryptography” which is a technique or a method for protecting information and communication by coding such information and communication in alphanumerical terms. The term cryptography can be broken into “crypt” means “hidden-secret” and the suffix “graphy” means “writing”, which means cryptography is a form of hidden-writing which is undertaken with the help of alphanumerical codes under computer programming. 

Meaning of the term cryptocurrency: 

a.       This is clearly getting technical but let me try to simplify and explain. Let us understand currency in the word “cryptocurrency”. The term currency here is much different from the normal understanding of the currency as issued by different nations. Currency here is actually the prize earned for the efforts and skill invested in the process of validation of transactions under blockchain technology, thereby resulting in creation of a block in that blockchain network. 

b.       Therefore, in other words, the term currency denotes the value or return i.e received or earned by the creator of such block, which thereby results in extension of network of blockchain which is undertaking safe transactions using the blockchain technology. This activity of investing effort and skill which results in the reward of cryptocurrency in technical terms is known as “mining”.

c.       Now therefore before going further and to better understand the concept of cryptocurrency, it is important that we understand the concept of blockchain technology and the process of mining of cryptocurrencies within this technology. 

2.      What is blockchain technology?  

The need for blockchain technology: 

a.       Thank you, Nishant. 

b.       Before we delve into the details of how blockchain technology operates, it becomes extremely important to understand what is the purpose of blockchain and why was it introduced. One theory for the introduction of “blockchain technology” is that the 2008 global economic crisis which is considered to be as a result of the manipulation of financial transactions or double spending at the hands of financial institutions.

c.       I would like to explain this slightly more in detail: 

d.       Traditional banking systems and businesses are centralized, meaning that these systems indicate very clearly who owns what or who owes whom. Such data is kept on a private network and relied upon on the trust of the overseeing body (which are the financial institutions - with which deposits and banking transaction are undertaken). Therefore, the system depends upon people’s trust that the bank or business is keeping proper track of the ins and outs of user’s money and information. 

e.       If there is any breach of financial trust, it will create concerns for the public in general. Also, any technological lapse would expose the sensitive personal information of millions of people. So, there has arisen need for scrutiny in inner workings of the financial system, and that is where as a substitute to these entities, the blockchain technology plays its part. Now, through the technology that blockchain operates, it allows a safe, secure and a direct window of transactions between the participants and avoids the interaction of the financial institutions as intermediary between participants. 

f.        That’s why blockchain technology was introduced as a result for the need to identify such alternative mechanisms to the existing systems in which financial institutions operate. 

Stella: Thank you for providing the introduction and the need for Blockchain technology, Yash. Could you now throw some light on how the technology of blockchain actually works and operates?

 Meaning and operation of blockchain technology: 

a.       Sure stella. 

b.       To begin with, Blockchain is a form of Distributed Ledger Technology (DLT) and is essentially a decentralized and trust less system that can be shared and viewed by all users.  

c.       Let me simplify this, blockchain is a technology by which transactions, primarily financial transactions, between two persons are secured through the process of encryption and decryption. 

d.       For example: Mr XYZ transfers 50,000 dollars to Mr ABC. The transfer of funds will be encrypted with certain alphanumerical codes under the blockchain technology and only Mr ABC (who is the recipient of funds) will be able to decrypt or receive this transaction. This procedure ensures security to the transaction of transfer of funds and prevents malicious attacks by hackers, since the entire transaction is encrypted. The process of verifying whether a particular transaction is being correctly encrypted and subsequently decrypted is known as “validation” under blockchain technology, which process is undertaken by a computer system or people called miners or stakers. 

e.       So, one aspect which is important to understand here is that blockchain as a technology involves the critical procedure of “validation”.

f.        Once a particular transaction is validated, it is incorporated in a “block”  

g.       At this juncture, I would urge our listeners to imagine an actual block in this case and a financial transaction, say, transfer of funds is one transaction in block. Similarly, there could multiple transactions of sale, purchase, income or expenditure in a block, which requires to be validated.

h.       Once the entire block is validated by a computer, it is added to the next sequence of blocks. It is important to note that each block which is validated and added in the sequence will have an element of the previous block. In this manner previous block is always linked to the next block, forming an entire link of blocks known as “blockchain”  

i.         Once a block is created and validated by the blockchain, it can never be destroyed or altered unless 51% of the blockchain agrees and determines that the change is needed.   

j.         Within mature ecosystems like Bitcoin’s blockchain, this type of coordination would require massive global efforts, rendering hacking an actual blockchain virtually impossible. 

k.       This enables highest level of security to each transaction of the block, and therefore, the blockchain technology is decentralised or distributed in nature (i.e it is not controlled by a central server or central party), but decentralised blocks.  

 Stella: Thank you, Yash, for the insight on the operation of blockchain technology and how it functions. Could you now explain how cryptocurrency is derived with the help of blockchain?

3.      How is cryptocurrency derived from the blockchain technology?  

 Consensus protocols: 

a.       Sure Stella. 

b.       Now having understood the blockchain technology, let us understand how cryptocurrency is derived from this technology.  

c.       As Nishant explained earlier, cryptocurrency is a reward for the effort put in for validating a transaction. 

d.       Now, where does this effort come into play? 

e.       To explain this better, let me take you all one step back to the process involved in blockchain technology. A mentioned earlier, under blockchain technology, each transaction is first encrypted that is to say that it is turned into a cryptographically secured hash. Once the transaction is hashed or encrypted, it is grouped together with other transactions into a block. Then it is thereafter validated.   

f.        Therefore, the computing systems who undertake the process of validation of a block are actually performing the function of “mining” and “solving complex mathematical algorithms or equations” – which we all have heard and read a lot of times when trying to understand the derivation of cryptocurrency. 

g.       To explain this further, encryption as a process involves coding a transaction with alphanumerical codes, which naturally is much more complex in blockchain technology, and that’s why it involves encrypting and decrypting through such alphanumerics which exist in the form of mathematical equations or algorithms.

h.       As a result of the said method of mining or validating transactions of a block, a lot of computing power is invested and ultimately the process of mining ends up using immense amount of electricity.   

i.         At this stage, there are two methods of validating, one is proof of work, used by major cryptocurrencies like Bitcoin, Ethereum and Litecoin, which actually involves miners solving the mathematical algorithms, and the other is proof of stake, which is at present not so popular. 

j.         Overall, as a reward to solve the mathematical problem or algorithm i.e  validate transactions in a block, a digital coin or asset is awarded to the miner by the blockchain network, and as result, a cryptocurrency is derived from the blockchain technology. 

Stella: Thank you, Yash, for the explanation on how cryptocurrencies are derived under the blockchain technology. Now, having understood the genesis and purpose of cryptocurrency, we can more rationally try envisaging the manner of regulation and taxability. In light of this, let me once again invite Nishant for his final comments on how the regulation and taxability can be carried out. 

Nishant: Thank you Stella.  

·         As we have seen in the discussion so far that the technology based on which the virtual currency or the crypto currency is derived or as we now come to term it as a digital asset is derived is not very simple 

·         However, one thing is clear that obtaining of a crypto currency as we've seen in the initial discussions is as a result of the effort and skills of either an individual or a group of persons or entity which results in the awarding of a crypto currency either as a price or as a value for the efforts and resources put in 

·         Now keeping this concept in mind, it would be appropriate to suggest that the regulation should be developed, or the taxation of cryptocurrencies should be considered in relation to such an asset or an outcome that has been derived 

·         I was trying to draw an analysis to a similar concept and that the effort and skill of an artist which results into a piece of art; now if we see a work of art has been considered as a capital asset under section 2(14) of the Income Tax Act. In view of this, can one say that the derivation of a crypto currency or a Bitcoin or any of these virtual currencies is also a similar effort or skill which results in the awarding of these, in which case this digital asset can be treated in a similar manner 

·         Having said so, I think it's not that simple and would require a lot more deliberation before thorough regulations can be developed 

·         However, to conclude, I would like to just highlight one important point and I think our Honourable Prime Minister also mentioned that in the recent talk that he gave that at the World Economic Forum where he is very clearly highlighted and stated that the world will have to come together to give a uniform treatment to cryptocurrencies and only then will the nations be able to identify develop and implement regulations which are specific effective and do not allow any abuse especially considering the fact that these deal with complex situations and being digital in nature can be conducted from any part of the world 

·         I think the think-tanks of various nations are currently deliberating on and discussing to arrive at some such uniform basis which will help in regulating and taxing the cryptocurrencies as well as the value derived, or the income generated therefrom. 

  Stella: Thank you Nishant for these final comments. We can now conclude this podcast, we thank you all the listeners.