Cryptocurrencies, Risks, and the Australian Financial System

This report provides an in-depth analysis of cryptocurrencies, focusing on their market risks and their impact on the Australian financial system. It begins with an overview of cryptocurrencies, tracing their history and highlighting key characteristics. The report identifies various market risks associated with cryptocurrencies, such as volatility, security vulnerabilities, and regulatory uncertainties. It then delves into the perspectives of key Australian financial regulatory bodies, including the Reserve Bank of Australia (RBA), the Australian Taxation Office (ATO), the Australian Prudential Regulation Authority (APRA), and the Australian Securities and Investments Commission (ASIC), examining their concerns and approaches to cryptocurrency regulation. The report assesses the implications of cryptocurrencies on financial securities and the overall stability of the Australian financial system. Finally, it concludes with recommendations for addressing the identified challenges and ensuring the responsible integration of cryptocurrencies into the financial landscape. The report references key academic articles and regulatory documents to support its analysis.

Running head: FINANCIAL MARKETS AND INSTITUTIONS
Financial Markets and Institutions
Name of the Student
Name of the University
Author Note

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Executive Summary
This report is mainly intended to discuss the concept of cryptocurrency in its present form.
However, it does not take all the aspects into account and is limited to identifying market risks
attached with cryptocurrencies and their impact on the Australian financial system. It starts off
with an introduction and provides a brief overview of the history of cryptocurrency. It then
identifies the market risks associated with them. After which, the report further proceeds to
discuss the effect of these cryptocurrencies on the financial system prevalent in Australia. In
order to understand this impact, the assessments of various important financial regulating bodies
like RBA, ASIC, ATO and APRA are taken into consideration. Finally, the report ends with a
conclusion providing an overview of the discussion and making some recommendations which
are deemed to be necessary.

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Table of Contents
Introduction..................................................................................................................................3
Cryptocurrency – An Overview...................................................................................................3
Cryptocurrencies and Market Risks.............................................................................................4
Concerns of the Central Bank......................................................................................................5
Concerns of the ATO...................................................................................................................7
APRA and Cryptocurrencies........................................................................................................7
ASIC and Cryptocurrency............................................................................................................8
References..................................................................................................................................12

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Introduction
In general, a cryptocurrency can be defined as a form of digital currency that is used in
place of the generally accepted currency like Australian Dollar and British Pound. Although it is
not backed or recognised by the central bank or any monetary authority in any particular country,
some people tend to use cryptocurrency as a mode of payment that is stored, transferred and
traded electronically. In the 10 years since it was first introduced, cryptocurrency has become
extremely popular. However, the problems of scalability and volatility still exist with these
currencies and hence they are still not recognised by the Central Bank in Australia. There are still
a few risks associated with them which have an adverse impact on the financial securities. They
also pose some concerns to the financial system prevalent in the country. In order to understand
the same, the role of various regulating authorities like Reserve Bank of Australia (RBA),
Australian Taxation Office (ATO), Australian Prudential Regulation Authority (APRA) and
Australian Securities and Investment Commission (ASIC) are first understood. The analysis then
moves on to the concerns posed by the cryptocurrency to the financial system as suggested by
the Reserve Bank of Australia.
Cryptocurrency – An Overview
Cryptocurrencies began in the year 2009. Since, their introduction the term ‘Bitcoin’ has
become synonymous with cryptocurrency. However, the reach of these currencies has been
limited to being regarded as a speculative high-risk investment and not as a payment system.
Bitcoin was launched in the year 2008 by a whitepaper report with the pseudonymous name of
Satoshi Nakamoto (ElBahrawy et al. 2017). The chief motive behind this currency was to create
a ‘peer-to-peer’ version of electronic cash which eliminated the need for depending on third
party financial institutions to complete a transaction. The transaction takes place through a

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network and depends on various established cryptographic techniques like hashing and digital
signatures for its verification. Throughout the network, a form of consensus mechanism is
developed which is necessary for a transaction to be validated. The technology on which a
cryptocurrency runs is known as a Distributed Ledger Technology (DLT). The DLT is
responsible for various aspects like who can see or keep a copy of the ledger of a transaction and
determining the mechanism for distributing the currencies (Dark et al. 2019). It also determines
the way in which the data in a particular platform is structured. Blockchain is one of the methods
of structuring and distributing the data. There are various other alternatives available for the
same. The DLT technology has not just been limited to the cryptocurrencies. It is also used in
other aspects like utility tokens and security tokens. These tokens, along with the
cryptocurrencies are known as the ‘crypto-assets.’ The chief benefit of using cryptocurrencies is
that it removes the necessity of middlemen and uses complex algorithms to complete a
transaction. Due to the anonymity available by using Bitcoin, it is used as a mode for money
laundering by criminals.
Cryptocurrencies and Market Risks
Initially when they were introduced, cryptocurrencies were meant to be used as a
payment mechanism by most of the parties. However, as stated earlier, this has not been the case.
They have become a high-risk speculative investment and not just continued to be a payment
mechanism. One of the main problems is that it is legally difficult to determine who the owner of
a particular cryptocurrency is. The private keys have been found to be not completely fool-proof
and can be compromised. This problem can be solved through the creation of a centralised digital
vault which stores all the private keys. However, storing these keys is a complicated process and
makes the concept of cryptocurrency redundant as the storage services can only be provided by

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large scale financial institutions like custody banks. This also compromises the peer-to-peer
technology used by the cryptocurrencies. The other risk attached to the cryptocurrency markets is
the different legal frameworks present across the world. Due to the differing nature of these legal
principles, any country can choose to impose legal and regulatory measures on the functioning of
a cryptocurrency. This uncertainty leads to a wide swing in the values of the cryptocurrency on a
regular basis and significantly impact their values in the market (Harwick 2016). It had also been
found that this volatility causes significant risks in trading in cryptocurrencies and is also
responsible for the formation of price bubbles. While they are considered to be a good source of
investment by speculators, their inability to retain the value for a long time causes the underlying
financial securities to quickly lose their value (Bucko, Palová and Vejacka 2015). Another
reason for this price surge was found to be the lack of knowledge of speculators about the actual
functioning mechanism of the Bitcoin or other cryptocurrencies. One of the key functions of
money is to act as a store of value. However, the fluctuating price levels of Bitcoin suggest its
inability to operate as a currency and hence it also remains another form of investment and not
become a widely accepted payment mechanism. Unlike traditional financial securities, the value
of a cryptocurrency does not merely depend on the value but also on the aspect of security. As
some of the websites in which the cryptocurrencies are traded have been found to be vulnerable
to hackers. Hacking the coin itself is much more difficult than hacking the cryptocurrency
exchanges (Jabotinsky 2018). There have also been speculations about rampant insider trading,
competitor collusion and unethical market manipulation practices in the cryptocurrency trading.
An estimated $1.7 billion dollars was stolen from the cryptocurrency market in the year 2018.
This puts the credibility of the entire market into jeopardy. The lack of a robust fiscal policy
developed by the central banks and other monetary authorities also increases the uncertainty

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aspect. The legal and economic changes that may occur in this area may happen on an overnight
basis and the value of the financial securities in which they are traded tend to fall drastically.
Concerns of the Central Bank
In any country, the efficient functioning of the financial system is essential for the benefit
of the economy. Financial system includes all the financial regulatory bodies and important
financial institutions which have a major say in the important decisions related to the country.
Chief amongst them is the Reserve Bank of Australia (RBA). Established under the Reserve
Bank Act 1959, the main objective of the bank is to contribute towards maintaining stability in
the currency of Australia and to ensure the economic prosperity amongst the people of the
nation. The bank maintains the inflation levels in the economy and controls all aspects related to
the currency supply which it considers to be necessary. However, as stated by the Central bank,
Bitcoin is extremely volatile in nature to be considered as the main currency of a particular
country. Another problem with it is its inability to store value like gold or the traditional
currencies used worldwide. One of the main concerns of crypto currency payments is the
requirement of a strong network for processing the payments. This necessitates the presence of a
constant network on a regular basis. This makes the cryptocurrency into something that is
accessible to only a selected group of people. Another concern identified by the RBA is the lack
of scalability in cryptocurrencies. The information that can be obtained by a Bitcoin block is
limited. Due to this, the time taken to validate an individual Bitcoin block is much more than that
taken by the normal currency transaction. This is the reason why the number of cryptocurrency
transactions that happen in a second are less than 10. In comparison, the Australian Payments
Platform called the Fast Settlement Service undertakes and settles 1000 transactions in a second.
Adopting to a cryptocurrency as the main currency would significantly slow down the speed at

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which transactions take place and thereby negatively impact the financial system as a whole.
Another problem is related to the validation of the blocks. If two miners compete to validate a
block and do it at the same time, only one of those gets validated and the other remains as an
orphan block. It takes more time to validate this block and add it to the chain of existing
transactions. The lack of promptness in completing the transactions is a major problem with the
cryptocurrencies. One of the major functions of the RBA is to maintain stability in the economy.
Cryptocurrencies act as a major hindrance to this stability that is essential for the functioning of
the financial system. Another problem is the decentralised nature of the functioning of the
payments system. Due to the anonymity provided by Bitcoin and other currencies, there need to
be stricter regulations to ensure that the currency exchange does not take place for funding
money laundering and terrorism practices. The cost of maintaining a cryptocurrency network is
very high and the power consumed by them is also much higher than usual. It had been reported
that the power consumption involved in maintaining the consensus in the payments system was
equal to the power consumption of Switzerland. This brings in a lot of environment related
problems which impact the country as a whole (Dark et al. 2019).
Concerns of the ATO
The Australian Taxation Office (ATO) is responsible for collecting taxes from
individuals for the gains made by them in a particular year. However, due to the anonymity
provided by a cryptocurrency transaction, it becomes extremely difficult to identify the parties
who have entered into a transaction and hence levying tax on an individual almost becomes
impossible. However, the ATO has recently stated that it would seek the identity of the people
involved in a cryptocurrency transaction thereby effectively putting an end to the anonymity
aspect. The confusion caused by these currencies in the Australian taxation system is also very

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high. These currencies are treated as a property for Income and CGT purposes. There was also
the problem of charging double taxes from the businesses who accepted cryptocurrencies as a
form of accepting payments. In June 2017, changes were made to the definition of digital
currency under the GST Act and taxation rules again became more complex (Cassidy et al.
2018).
APRA and Cryptocurrencies
The main purpose of the Australian Prudential Regulation Authority (APRA) is to
regulate bodies in the financial sector in accordance with the other rules of the Commonwealth
that are related to prudential regulation and retirement income standards. Other responsibilities
of the bodies include maintaining efficiency, balance and competition in the financial system of
Australia (Apra.gov.au. 2019). However, the volatile and uncertain nature of the
cryptocurrencies poses a serious threat to the objectives of APRA. It has also been found that the
behaviour of the cryptocurrencies is significantly different from that of the fiat currencies and
their analysis needs to be specialised in nature. The models that are needed to measure the
fluctuations in the cryptocurrencies need to be much more dynamic than those related to the
regular models and hence the chances for error in this regard are much higher (Phillip 2018).
ASIC and Cryptocurrency
The Australian Securities and Investment Commission (ASIC) released a set of
guidelines in 2017 in which it considered cryptocurrencies to be a legitimate form of currency.
Emphasis was also laid on the misleading conduct involved in cryptocurrencies and the time
from when the regulations under Corporations Act 2001 would become applicable. The
Commission also stressed the fact that anything which carried the label of a crypto-asset did not
necessarily constitute a financial product. The changes that were made by the ASIC to its

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regulations very plenty. These were done to accommodate the concept of cryptocurrencies in the
general business guidelines followed by other corporations (Anthony, Prasad and Sadique 2018).
However, the business model has still not been able to be brought under a predetermined set of
rules like the traditional corporations.
Conclusion and Recommendations
In conclusion, it can be said that the cryptocurrencies have come a long way since they
were first introduced in 2019. Initially, there were concerns about the primary key which was
responsible for the storage of a transaction as it could have been easily hacked. At present,
hacking the actual Blockchain or the transaction has become extremely difficult. However,
concerns still remain about the security aspects of these currencies. This is specifically true in the
case of the websites handling the currencies. The uncertain legal and security aspects cause high
fluctuations in the value of a cryptocurrency and ultimately lead to huge capital losses to the
people who have invested in them. The cost of maintaining a network of cryptocurrency is much
higher than the normal currency. The power consumption and the speed of processing a
transaction is also much higher in case of the currency. Hence, adopting them in place of the
existing currencies is an impracticable move in the current market conditions. Any future
developments which make the currencies more environmental friendly and increase the
processing speed are essential for a wider usage of the currencies. The regulations governing the
cryptocurrencies should also be more dynamic and take their uncertain nature into consideration.
This will enable the governing bodies to run the financial system more efficiently than before.

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References
Anthony Das, C., Prasad, K. and Sadique, M.S., 2018, July. Cryptocurrency a Bit unregulated?
In International Conference on Business and Banking V (ICBB V).
Apra.gov.au. 2019. Accountability and reporting | APRA. [Online] Available at:
https://www.apra.gov.au/accountability-and-reporting#targetText=In%20providing%20this
%20regulation%20and,financial%20system%20stability%20in%20Australia. [Accessed 5 Oct.
2019].
Bucko, J.O.Z.E.F., Palová, D. and Vejacka, M., 2015. Security and trust in cryptocurrencies.
In Central European Conference in Finance and Economics (pp. 14-24).
Cassidy, J., Cheng, M.H.A., Huang, E. and Le, T., 2018. A Toss of a (Bit) Coin: The Uncertain
Nature of the Legal Status of Cryptocurrencies. In Proceedings of Asia Conference on Business
and Economic Studies (ACBES) by University of Economics Ho Chi Minh City on 8th–9th Sep
2018 at Ho Chi Minh City, Vietnam. (pp. 254-264). UEH Publishing House.
Dark, C., Emery, D., Ma, J. and Noone, C., 2019. Cryptocurrency: ten years on. Australia:
Reserve Bank of Australia.
ElBahrawy, A., Alessandretti, L., Kandler, A., Pastor-Satorras, R. and Baronchelli, A., 2017.
Evolutionary dynamics of the cryptocurrency market. Royal Society open science, 4(11),
p.170623.
Harwick, C., 2016. Cryptocurrency and the Problem of Intermediation. The Independent
Review, 20(4), pp.569-588.

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Jabotinsky, H.Y., 2018. The Regulation of Cryptocurrencies-Between a Currency and a Financial
Product. Hebrew University of Jerusalem Legal Research Paper, (18-10).
Phillip, A., 2018. On Gegenbauer long memory stochastic volatility models: A Bayesian Markov
chain Monte Carlo approach with applications.