With cryptocurrencies building stable ground in the currencies markets, and ICOs hitting headlines globally, here Richard Tall, Partner and Head of Financial Services at DWF, discusses the challenge of counterfeiting problems within the crypto markets.

As we have experienced in the post-2008 era, the value of a currency depends on the market's perception of its security. People want to hold assets, including currencies, which are generally recognised as being safe and fungible, and which they can swap for something they need - whether that be food, shelter or something else. Currencies that are recognised by others are of benefit to the holder. But the moment there is any doubt as to their heritage, they become less so.

Counterfeiting has long been a thorn in the side of any currency’s heritage. But now, with cryptocurrencies coming to the fore, will counterfeiting continue to exist? And if so, what could the repercussions be?

Counterfeiting capabilities    

Some of us may be familiar with Operation Bernhard, in which Nazi Germany sought to destabilise sterling through the printing of £5 notes. Aficionados of the film The Eagle has Landed will recall the significant amounts of forged £5 notes carried by the paratroopers.

Now, the passing of an individual forged note does not undermine faith in a currency. But, if a retailer were to receive a number of these which were later rejected by their bank, it follows that the retailer would be unwilling to continue to accept that note. This is still the case today and naturally, retailers are wary of high value notes which open them up to the risk of loss.

Exponents of true cryptocurrencies will tell you that they are incapable of counterfeiting - and the short history of cryptocurrencies bears that out. However, there have been scandals - for example, Mt Gox and the ethereum DAO attack - which have given rise to significant losses.

Let me elaborate. Mt Gox and similar cyber-attacks follow the same sort of pattern as normal cyber-attacks with the hacking of accounts and removal of the contents. The ethereum DAO attack took advantage of a bug in the system, which it seems quite a few people knew about. And as blockchain is open source and anybody can get to it, there will always be some brainbox out there who can do something befitting of a James Bond film.

In contrast, if you instruct your stockbroker to buy you shares in XYZ plc, you rely on your stockbroker to actually buy real shares in XYZ plc, and not something which they think is XYZ plc shares. Afterall, as a regulated entity, the stockbroker has obligations, and if they breach those then they have a regulatory problem. They will therefore trade via particular systems with certain counterparties to keep themselves, and your trade, safe.

Structural weaknesses

If you go onto a cryptocurrency trading platform, you are relying on that platform being keyed into the right blockchain to deliver to you what you ordered. A blockchain itself should be impenetrable to the malintent. However, the whole point of the blockchain is that it is a public peer to peer network. If I were a James Bond villain, I would look at nefarious means by which I could convince everyone that my blockchain was the right one.

In a way, this happens when a cryptocurrency undergoes a hard fork, which is the mechanism by which a hacked network can "roll back" to the pre-hack period or when a network needs updating. Hard forks can take various forms, but the basic premise is that when one happens, a new blockchain is created, and usually there will either be disruption to the service; preventing transactions between peers, or gross instability introduced to the system; leading to equally gross price fluctuations.

So, if I were an incredibly clever, evil mastermind and was bored of hacking crypto wallets or wallet providers (a bit like hacking a bank account) and wanted to head to the top of the criminal mastermind league table, all I would need to do is to convince trading platforms and wallet providers that my blockchain is the right one. In Operation Bernhard, the premise was the same; the enemy simply wished to convince the UK populace that their fivers were the right ones, so nobody would trust the real ones. The desired effect? Chaos and economic uncertainty.

Could this possibly happen with cryptocurrencies? Yes. But it has little to do with the sanctity of a cryptocurrency's blockchain, and much more to do with the security systems of the cryptocurrencies' platforms and wallet providers, and the extent to which they are able to verify that they are dealing with the right counterparty.

Reducing the risk

One of the straplines for using cryptocurrencies is that, as peer to peer networks, they remove the overheads associated with credit and banking. However, the overheads for credit and banking arise because those entities provide a particular type of service, and a user of that service is able to rely on being made whole if it all goes wrong for any reason - such as when a system is hacked.

Blockchains have huge numbers of applications, but one of their overwhelming threats is their public nature. It's why sophisticated networks of users deploying the blockchain for commercial purposes will most likely do so through private networks, with a view to security enhancement. Yes, this might defeat the point of cryptocurrencies for many - but it'll also reduce the risks associated with cryptocurrencies for many more, enabling them to become the functional currencies most of them seek to be.