Posted in Finance Articles, Total Reads: 1205
, Published on 12 January 2015
In Chile a society has emerged inspired by Ayn Rand’s Atlas Shrugged which speculates the crumbling of world economy over next few decades. The group of self-descried anarchists have founded the Galt’s Gulch in order to protect themselves from the economy going ‘side-ways’. This self-sufficient, gated community will bud over a large area of 6874-hecters and will be based entirely on bitcoins.
While the idea of economic anarchy might sound too extreme to many of us, it attracts our attention to the crypto-currency rapidly gaining importance in the online transactions- the bitcoins.
Image Courtesy: freedigitalphotos.net, kasahasa
The Rise & Rise-
Bitcoins, which were conceptualised in 2008-09, have gained a lot of value against the traditional currency starting from a few cents in early 2009 to over US$1200 in 2013. Over these 4 years the virtual currency has seen many fluctuations arising from events like Hungarian central bank crisis and ban on transaction in bitcoins by China crashing its values several folds within a few days to the US Federal bank recognising it as a legitimate mode of transaction, giving it an added confidence in the minds of traders.
Bitcoins, which were introduced by a group of programmers named Satoshi Nakamoto have an in-built mechanism which puts an upper cap on the mining of the coins. As the number of coins mined by solving a complex computer program increases the level of computation power required to mine more coins increases exponentially. This mechanism puts an upper limit on generation of this currency at 21 million till 2140 and helps the crypto-currency from losing its value. It has also fixed the rate of inflation and made the currency resistant to uncontrollable inflation making it inflation-proof.
Bitcoins like most other virtual currencies, were initially traded only in online gaming and lotteries. Zynga, the online gaming giant started accepting bitcoins for the payment of the online games. As the confidence of traders increased over this currency, more and more e-commerce sites including Wordpress and Reditt started accepting it. The rising popularity encouraged businesses as diverse as the Virgin Group in airlines and University of Nicosia, Cyprus to accept this currency as a form of payment.
So far, the retail traders are exchanging and gathering this currency for speculative purpose as they see the exponential rise in the price of currency against US dollar over the past few years. Many of them intend to exchange the virtual currency for physical currency at some point of time for appreciation. However, as more and more businesses start accepting this currency, especially for cross-border transactions bitcoins will see a wider use for purchases of virtual as well as physical goods.
Bitcoins are superior to payments from credit cards as there is very less transaction cost associated with it. As it is a form of peer-to-peer payment, it bypasses any bank and avoids the additional charges levied by the banks for processing.
The currency also becomes a convenient mode of payment for cross-border transactions as it is not affected by the fluctuations in currency rates. It becomes the only mode of payment for people who do not have access to credit cards and online banking facilities in developing as well as developed nations.
The transactions in bitcoins are recognized by the wallet key which is generated by the program itself. Using the public key, anyone can view the account transactions of any wallet, provided they known their public key. However, as the wallet does not hold the identity of the person holding its private key, the identity of person remains completely secret. The transactions are recorded in an online log to track the ownership of each bitcoin.
The Dark side of the Shining Coins
Similar to output of any computer program, the mined coins are stored in a wallet which is protected by a private and a public key. This wallet and the key is stored in the computer and is susceptible for permanent loss if the data over this computer is lost. Further, this wallet is also open to hacking from programmers worldwide. Cases of theft and loss due to malware attacks are not uncommon. But see it as a risk associated in holding any form of currency.
Another argument which is put forward by the critics is that since the transactions made by bitcoins are not traceable, they can be used for illegal activities to a large extent. Guns, drugs, pornography and all similar illegal activities find an easy gateway for conducting their businesses. This became evident when a web portal called the Silk Road was raided and shut down by the authorities which traded in illegal weapons and drugs. It was found that bitcoins formed a large part of their transactions made over the website.
Since the virtual currency is not fully regulated by any central bank or government, concerns are that this currency can be used for money laundering from international bank accounts.
Additionally, since they are not backed by any underlying asset, they do not have any intrinsic value as such. This gives wide scope to speculations and bitcoin-bubbles as seen in the past, which tank the value of the currency dramatically. It is this volatility which creates concerns among the prospective users of the currency.
The Regulatory Side-
As of today, none of the central banks of the world regulate bitcoins. While some authorities like Chinese government have fully banned the use of currency for trading, many regulators like the US Federal bank have given accepted the use of bitcoins as a legitimate way of payment. Some countries like Austria, Finland and Canada treat bitcoins as normal incomes for regulatory purpose; some countries like Norway collect taxes on bitcoins without recognising it as a form of currency. The general opinion of all the central banks is that since these are highly speculative and unregulated instruments, there is high financial, legal, operational and security risk associated with it.
Compared to their status only a couple of years ago, bitcoins are experiencing high awareness in financial markets. As more and more transaction will occur using them, we expect the markets to come up with more regulations and guidelines. We also expect many governments to treat them a legitimate payment options and provide security for them.
We also expect financial markets to come up with innovative derivative products for bitcoins. This will provide an option of hedging against the volatility in the prices of bitcoins. As a result, the users’ confidence will increase and the bitcoins will see a surge in their use.
As is the case with many paper currencies including the US dollar, bitcoins are not backed by any physical underlying having an intrinsic value. These currencies gain their value form the confidence and trust in the minds of users and thus their purchasing power. So as long as the retail users and businesses have confidence in them, they will retail their purchasing power.
This will also encourage financial entities to come up with different methods to secure this payment mode and offer more services in exchange of bitcoins.
Further, mechanisms built in the mining method regulate the generation of new currency and provides a cover from depreciation of the currency due to inflation.
The advantages of using bitcoins over the existing currencies outweigh the disadvantages so much that we can expect them to come to mainstream very soon. Though they will not completely replace the paper currency and credit cards as a mode of payment, they can certainly create a niche for themselves in financial transactions. In future we can only see an upside for the use bitcoins.
This article has been authored by Vaibhav Tyagi & Chinmay Ingole from NMIMS