Module 3

MODULE 3

DECENTRALIZED PAYMENT SYSTEMS

3.1. INTRODUCTION

With the advent of online transactions and online contracts, the concept of
digital currency was inevitable. As early as 2008, during the great financial
depression, together with the writings of Satoshi Nakamoto1, the mysterious
Bitcoin man who published white paper on Bitcoin in 2009, the concept of
cryptocurrency was envisaged. This was finally made true via the
Blockchain technology which overcame many drawbacks of online
databases such as security problems, the validation of transactions as well
as centralized ledgers. These concepts are further discussed as follows.

3.1.1. Digital Currency

Digital currency, as the name denotes, is money available in digital format
as compared to material and physical money like coins or banknotes.
However, digital currency has all the characteristics of traditional money
has. I.e., it can be transferred instantaneously and its ownership can also be
transferred across borders.

1 Satoshi Nakamoto is the name used by the unknown person or people who developed bitcoin, authored the
bitcoin white paper, and created and deployed bitcoin's original reference implementation. As part of the
implementation, they also devised the first blockchain database.

3.1.1.1. Crypto Currency

Crypto currency is only a variety of digital currency. It is an asset which is
considered as a reliable source of exchange because it is protected via
cryptography.2

Though, crypto currency is a type of digital currency, there are some core
differences between the two. These are3-

3.1.1.2. Structure

Digital currencies are centralized; there is a group of people and computers
that regulates the state of the transactions in the network. Cryptocurrencies
are decentralized, and the regulations are made by the majority of the
community.

Digital currencies require user identification where you need to upload a
photo of yourself and some documents issued by the public authorities.
Buying, investing and any other processes with cryptocurrencies do not
need require any of that. Nevertheless, cryptocurrencies are not fully
anonymous. Though the addresses don’t contain any confidential
information such as name, residential address, etc., each transaction is
registered, the senders and the receivers are publicly known. Thus, all the
transactions are tracked.

2 One of the cryptography’s primary objectives is communications and how to make them secure. It creates and
analyzes the algorithms and protocols so no information is changed or interrupted during the conversation by third
parties. Cryptography is a mix of a large number of different sciences, with mathematics as the basic. It’s math
that attaches the severity and reliability to algorithms and protocols.
3 Andrew Tar Digital Currencies vs. Cryptocurrencies, Explained (DEC 13, 2017) < https:// cointelegraph. Com
/explained/ digital-currencies-vs-cryptocurrencies-explained > last accessed on 1.12.2018.

3.1.1.3. Transparency

Digital currencies are not transparent. You cannot choose the address of the
wallet and see all the money transfers. This information is confidential.
Cryptocurrencies are transparent. Everyone can see any transactions of any
user, since all the revenue streams are placed in a public chain.

3.1.1.4. Transaction manipulation

Digital currencies have a central authority that deals with issues. It can
cancel or freeze transactions upon the request of the participant or
authorities or on suspicion of fraud or money-laundering. Cryptocurrencies
are regulated by the community. It’s very unlikely that the users will
approve the changes in the Blockchain, although there were some
precedents such as the hack of The DAO. However, the amount of money
was significant, and the decision was uncertain.

3.2. BITCOIN: DECENTRALIZED SYSTEM

As we already know, crypto currency is a type of digital asset that relies on
cryptography for chaining together digital signatures of asset transfers, peer-
to-peer networking and decentralization. In some cases a proof-of-work or
proof-of-stake scheme is used to create and manage the currency.4 Thus it
is Crypto currencies that enable electronic money systems to be
decentralized. The first and most popular system being Bitcoin. 5

4 Ian Steadman Wary of Bitcoin? A guide to some other cryptocurrencies WIRED.CO.UK <
https://arstechnica.com/information-technology/2013/05/wary-of-bitcoin-a-guide-to-some-other-
cryptocurrencies/ > last accessed on 1.12.2018.
5 A peer-to-peer electronic monetary system based on cryptography.

3.2.1. Legal Aspects: Regulation

§ European Union

Since 2001, the European Union has implemented the E-Money Directive
"on the taking up, pursuit and prudential supervision of the business of
electronic money institutions" last amended in 2009.6 Doubts on the real
nature of EU electronic money have arisen, since calls have been made in
connection with the 2007 EU Payment Services Directive in favor of
merging payment institutions and electronic money institutions. Such a
merger could mean that electronic money is of the same nature as bank
money or scriptural money.

§ USA

In the United States, electronic money is governed by Article 4A of the
Uniform Commercial Code for wholesale transactions and the Electronic
Fund Transfer Act for consumer transactions. Provider's responsibility and
consumer's liability are regulated under Regulation E. 7

Digital currencies pose challenges for central banks, financial regulators,
departments or ministries of finance, as well as fiscal authorities and
statistical authorities. In May 2014 the U.S. Securities and Exchange

6 Directive 2009/110/EC of the European Parliament and of the Council of 16 September 2009 on the taking up,
pursuit and prudential supervision of the business of electronic money institutions amending Directives
2005/60/EC and 2006/48/EC and repealing Directive 2000/46/EC OJ L 267, 10.10.2009, p. 7–17 (BG, ES, CS,
DA, DE, ET, EL, EN, FR, IT, LV, LT, HU, MT, NL, PL, PT, RO, SK, SL, FI, SV) Special edition in Croatian:
Chapter 06 Volume 011 P. 94 – 104.
7 In Introduction to Electronic Money Issues < https://www.occ.gov/topics/bank-operations/bit/intro-to-
electronic-money-issues-appendix.pdf> last accessed on 1.12.2018.

Commission (SEC) "warned about the hazards of Bitcoin and other virtual
currencies". 8

Bit License, the most comprehensive regulation of virtual currencies to date
proposed by the New York State Department of Financial Services in July
2014.9 Unlike the US federal regulators it has gathered input from bitcoin
supporters and the financial industry through public hearings and a
comment period until 21 October 2014 to customize the rules. The proposal
per NY DFS press release “sought to strike an appropriate balance that
helps protect consumers and root out illegal activity". It has been criticized
by smaller companies to favor established institutions, and Chinese bitcoin
exchanges have complained that the rules are "overly broad in its
application outside the United States".10

3.3. ADOPTION BY GOVERNMENTS

As of 2016, over 24 countries are investing in distributed ledger
technologies (DLT) with $1.4bn in investments. In addition, over 90 central
banks are engaged in DLT discussions, including implications of a central
bank issued digital currency.11 Some of the major adoptions by governments
in this regard are-

§ Hong Kong: Octopus card system which was launched in 1997 as an
electronic purse for public transportation. It is the most successful and

8 See Bobelian, Michael SEC Warns Investors To Beware Of Bitcoin (Forbes 9 May 2014); Securities and
Exchange Commission guidance.
9 Digicash files Chapter 11 (January 2, 2002).
10 Sydney Ember More Comments Invited for Proposed Bitcoin Rule ( Deal Book, NY Times, 21 August 2014).
11 BoE explores implications of blockchain and central bank-issued digital currency
(EconoTimes.com.,9/9/2016).

mature implementation of contactless smart cards used for mass
transit payments. After only 5 years, 25 percent of Octopus card
transactions are unrelated to transit, and accepted by more than 160
merchants.12

§ Canada: The Bank of Canada have explored the possibility of
creating a version of its currency on the blockchain where the Bank
of Canada teamed up with the nation’s five largest banks — and the
blockchain consulting firm R3 — for what was known as Project
Jasper. In a simulation run in 2016, the central bank issued CAD-
Coins onto a blockchain similar Ethereum.13 The banks used the
CAD-Coins to exchange money the way they do at the end of each
day to settle their master accounts.

§ India: Unified Payments Interface (UPI) is an instant real-time
payment system developed by National Payments Corporation of
India facilitating inter-bank transactions. The interface is regulated by
the Reserve Bank of India and works by instantly transferring funds
between two bank accounts on a mobile platform. UPI is built over
Immediate Payment Service (IMPS) for transferring funds. Being a
digital payment system it is available 24*7 and across public holidays.
Unlike traditional mobile wallets, which take a specified amount of
money from user and store it in its own accounts, UPI withdraws and
deposits funds directly from the bank account whenever a transaction
is requested. It uses Virtual Payment Address14, account number with

12 Ibid.
13 Central Banks Consider Bitcoin's Technology, if Not Bitcoin (The New York Times).
14 A unique ID provided by the bank.

IFS Code, mobile number with MMID (Mobile Money Identifier),
Aadhaar Number, or a one-time use Virtual ID. An UPI-PIN15 is
required to confirm each payment.

§ South Korea: South Korea plans national digital currency using a
Blockchain.16 The chairman of South Korea’s Financial Services
Commission (FSC), Yim Jong-yong, announced that his department
will "Lay the systemic groundwork for the spread of digital currency."
17South Korea has already announced plans to discontinue coins by
the year 2020.

§ Switzerland: In 2016, a city government first accepted digital
currency in payment of city fees. Zug, Switzerland, added Bitcoin as
a means of paying small amounts, up to 200 SFr., in a test and an
attempt to advance Zug as a region that is advancing future
technologies. In order to reduce risk, Zug immediately converts any
Bitcoin received into the Swiss currency. Swiss Federal Railways,
government-owned railway company of Switzerland, sells Bitcoins at
its ticket machines.18

§ UK: The chief economist of Bank of England, the central bank of the
United Kingdom, proposed abolition of paper currency. The Bank has
also taken an interest in Bitcoin. In 2016 it embarked on a multi-year
research program to explore the implications of a central bank issued

15 UPI Personal Identification number that one creates on the UPI app of the bank.
16 South Korea plans national digital currency using a Blockchain (Brave New Coin, 26.9.2016).
17 Ibid.
18 Uhligje, Christian Alpine 'Crypto Valley' pays with Bitcoins (DW Finance, 1.7.2016).

digital currency.19 The Bank of England has produced several research
papers on the topic. One suggests that the economic benefits of issuing
a digital currency on a distributed ledger could add as much as 3
percent to a country's economic output. The Bank said that it wanted
the next version of the bank’s basic software infrastructure to be
compatible with distributed ledgers.

3.4. DIGITAL CURRENCIES AND DECENTRALIZED PAYMENT
SYSTEMS - PROS AND CONS

3.4.1. Pros

In a centralized system, there is a group of people responsible for the state
of the whole system. If you made a mistake in a transaction, you can make
a request to the company and rely on the successful outcome. You cannot
do this in the decentralized system. On the other hand, centralized networks
keep a lot of confidential information about the users. This data may get
lost, hacked or be transferred to law enforcement agencies at court request.
Decentralized networks do not have these problems. The same goes for a
transaction cancellation. If the system is revocable, you can make changes
to a transaction. At the same time, it opens room for fraudulent activities.

3.4.2. Cons

Bitcoin itself “is always one big hack away from total failure”.20 One of the
major problems of decentralized system is hacking. Whilst decentralization,

19 Ibid.
20 Popper, 2015, p 13.

in its response to a perceived threat, has facilitated certain elements of
electronic communication it also opens a new problem: the computer virus.
21 The decentralized multiple and weak nodes are now made vulnerable to
viruses, worms, hacking, cyber-terrorism, anomalies, accidents,
assemblages, contagions, and so forth. The “solution” of decentralization
creates its own new problems and threats. The very nature of a decentralized
network with multiple weak nodes and packet-switching produces the
perfect environment for a virus to spread and hacking to occur. Packet-
switching is a mode of data transmission in which a message is broken into
a number of parts which are sent independently, over whatever route is
optimum for each packet, and reassembled at the destination. This is
championed in Baran’s network, and introduces local intelligence to
communications. Instead of being controlled from above from a centralized,
hierarchical position, network communications decentralized control into
small packets which find their own way from sender to recipient.22

Other than this, the risk and volatility involved, the affect on the monetary
policy of countries are also major drawbacks which need to be smoothed
over by the governments in their adoption of decentralized systems of
payment and digital currencies.

The question now stands is it possible to combine the benefits of both
centralized system and digital decentralization payment?

21 Ivan Leshko Decentralized Payment Models Changing Tradition (Financial Services Oct 09, 2017).
22 Ibid ; See also Paul Baran, On Distributed Communications Networks, (1962, p-18).

Adopting centralized systems for the decentralized network might work.23

As reported by Forbes, more than two billion people are unbanked or do not
have access to bank services. There are over five billion people that use
mobile phones, and this number is growing rapidly. Thus, the banking
system can be implemented into the mobile network to provide services to
more people. Using crypto currency and Blockchain, you can enjoy all the
benefits of transparency, security and decentralization. With digital money,
you get controlling body, a number of digital wallets and regulation base.

One of the examples of how to combine the two is being realized by Telcoin.
The main idea is to combine mobile companies over the world with the
banking system. The banking system is represented by the symbiosis of
digital money and a new crypto-currency, that will provide different
services, like mobile money, prepaid credit and postpaid billing platforms.24

3.5. REGULATION OF CRYPTOCURRENCIES IN INDIA

The Government of India (GOI) constituted a high-level Inter-Ministerial
Committee (“IMC”) on November 02, 2017 to study issues related to
cryptocurrencies. The IMC was given the mandate of examining the policy
and legal framework required for the regulation of cryptocurrencies in India.
In view of recommendations by the IMC, the GOI proposed the introduction
of a legislation banning the use of cryptocurrencies in India. A draft of the
‘Banning of Cryptocurrencies and Regulation of Official Digital Currency
Act, 2019’ (“Crypto Bill”) was included with the report of the IMC and

23 Andrew Tar Digital Currencies vs. Cryptocurrencies, Explained (DEC 13, 2017) < https:// cointelegraph. Com
/explained/ digital-currencies-vs-cryptocurrencies-explained > last accessed on 1.12.2018.
24 Ibid.

prohibits any person from mining, generating, holding, selling, dealing in,
issuing, transferring, disposing of or using cryptocurrency in the territory of
India. A cryptocurrency has been defined to mean “any information or code
or number or token not being part of any Official Digital Currency,
generated through cryptographic means or otherwise, providing a digital
representation of value which is exchanged with or without consideration,
with the promise or representation of having inherent value in any business
activity which may involve risk of loss or an expectation of profits or
income, or functions as a store of value or a unit of account and includes its
use in any financial transaction or investment, but not limited to, investment
schemes.“

The Crypto Bill prohibits the direct or indirect use of any cryptocurrency (a)
as a payment system under the Payments and Settlements Systems Act,
2007; (b) to buy or sell or store cryptocurrency; (c) to provide
cryptocurrency related services to consumers or investors; (d) to trade
cryptocurrencies with Indian currency or any foreign currency; (e) to issue
cryptocurrency related financial products; (f) as a basis of credit; (g) as a
means of raising funds; and (h) as a means of investment. The draft
legislation proposes imprisonment for a term of up to ten years for anyone
involved in the above-mentioned activities in relation to cryptocurrencies.

The RBI ban imposed on cryptocurrency exchanges and related businesses
from having access to banking channels in India has already resulted in a
number of entities closing down their operations over the course of the last
year. This, coupled with the release of a draft bill which proposes to

criminalize the use and trade of cryptocurrencies in India, has resulted in a
drop in cryptocurrency trade, holding and interest in India.

3.6. CONCLUSION

Thus it is concluded that despite its drawbacks, they can be overcome
eventually over a period of time. The technology is as yet developing, but
one thing is for sure known, that with the ongoing progress of market and
technology, online transactions are inevitable and as a result for the ease of
working, digital currencies are indispensible. This is where Blockchain
comes in. it creates a database which makes it possible to have a
decentralized system of payment which ensures secure validation of
transactions and prevents fraud from any party.

Virtual currencies, depending on the nation, have different legal elements to
consider. Some nations classify them as cash and legal, some classify them
as assets and legal, while some nations like India do not classify them as
illegal or legal, without legal frameworks. Cryptocurrencies related legal
issues are as follows:

1. Decentralized nature: Cryptocurrencies are decentralized in nature,
making it difficult for them to be regulated by the government.

2. Absence of a well-defined legal framework: Most nations lack an
adequate legal framework to regulate the value and flow of virtual
currencies both inside and outside the nation, creating additional hurdles to
regulate a decentralized currency.

3. The volatility of Virtual Currencies: Virtual currencies follow a
volatile track of ups and downs that further bring market and economy
instability.

4. Independent Wallets: Wallets holding cryptocurrencies and engaged
in transactions are established and managed by private companies that have
no control over any organization owing to the lack of any binding
international laws in place. They, therefore, have no liability for the loss of
the customer as well as for any form of financial crime committed by and
through the use of these wallets.

5. Taxation: Taxation issue is one of the major cryptocurrencies issues.
Because of their pseudo-anonymity, if properly used, they can readily be
used by hiding the property for tax evasion purposes. Loopholes current in
some countries ‘legal and tax scheme allow an individual to use
cryptocurrencies features such as anonymity and lack of or outdated or
improperly enforced cryptocurrencies schemes.

6. Money Laundering: Money laundering is typically taken into account
when developing a country’s legal framework when discussing
Cryptocurrency. Due to the ease of their motion between nations with little
or no oversight, money laundering is a main legal complication with such
currencies.