Posted in Finance Articles, Total Reads: 1726
, Published on 20 February 2015
Technology has changed the ways by which people buy products and services. People require faster and easier ways to exchange and use units of currency. In ancient civilizations, people primarily relied on metal coins, which was followed by paper currency. Then came credit cards. The smartphone revolution along with the presence of Digital wallets and near-field communication technology has ushered in even greater ease of use, allowing us to carry all of our credit card information in our phones. The last 5 years of this decade saw the rise of modern currencies that would eliminate the involvement of any third parties such as banks. These currencies are hinging upon the internet, the most widespread and omnipresent network ever invented. Of all these currencies, Bitcoin has gained the most widespread attention, for both good and bad reasons.
So what exactly is Bitcoin?? And how does it work?? Bitcoin is a type of electrical payment system. The entire idea of implementation of this system was laid out in a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” in 2008 by Satoshi Nakamoto . Nakamoto is the name of a person or group of persons who first envisaged this concept on the Cryptography mailing list on metzdowd.com . The first cryptography software was launched a year later in 2009. When it started trading in 2009, Bitcoin was worth only a few cents. Bitcoin peaked in value at $1242 in November 2013, and presently trades at $226.34. Bitcoin today boasts of a market capitalization of $8.5 billion, and approximately 12.9 million bitcoins are in circulation.
Exhibit 1: Bitcoin- A brief History
Bitcoin is the result of 20 years of research into cryptographic currency. It represents the solution to a problem commonly referred to as the Byzantine Generals Problem . The key idea is to establish trust between two unrelated parties over a largely unknown network like the internet. Another aspect that differentiates Bitcoin from other forms of monetary exchange is the fact that bitcoin transactions are peer-to-peer and do not require the presence of an intermediary. All Bitcoin transactions are recorded on a ledger also called a block chain. The ledger is maintained by a group of communicating nodes (e.g, many computers on a network). Each node maintains a copy of the ledger. A transaction between two parties X and Y are validated, added to each individual ledger and broadcast to the network by each individual node. Further, Bitcoin rewards ‘miners’ who seek to verify each transaction between a buyer and seller. To obtain this reward, miners need to have large computing abilities to verify the records into the block chain.
Every single new block created by the miners must contain information that links it to the previous block. This is achieved using a cryptographic hash. The difficult task for miners is to obtain an integer called ‘nonce’, jargon for “number used only once”. The nonce has to be such that the hash of this new block is smaller than the difficulty target . The process of repeated verification on the other hand makes Bitcoin much safer to use than conventional payment systems, where the release of information can help the attacker to conduct future transactions with little knowledge of the victim.
Exhibit 2: Variation of Bitcoin market cap with time
The greatest benefit that Bitcoin, offers is the absence of any intervening body between two or more parties conducting a set of transactions. In fact, the transfer of Bitcoins was envisaged as taking place between 2 peers, directly over the internet. Compare that to many other payment systems like PayPal which require an intermediary for authentication when you transfer or receive money. Bitcoin promises flexibility and speed, as it can be exchanged between individuals just like cash or paper currency. The essential difference between these payment systems and Bitcoin because of Bitcoin’s reliance on cryptography.
Exhibit 3: A Bitcoin Transaction
Issues and Controversy
Bitcoin’s rise to fame has stirred a fierce debate about its future. Many leading economists have voiced concerns against Bitcoin. Paul Krugman, the American Economist urges caution against Bitcoin in the article “The long Cryptocon” and “Bitcoin is Evil”. David Andolfatto, Vice President, Federal Reserve of St. Louis sees Bitcoin as a threat to establishment. Felix Salmon, a financial blogger, says of Bitcoin,” This is pure Silicon Valley utopianism” .
The volatility of Bitcoin continues to be a source of worry. Although the volatility seems to have declined in the recent past with increase in liquidity, Bitcoin has a long way to go before holding the asset in large numbers is safe. Essentially, Bitcoin is both a currency as well as an investment. To gain maximum benefit from Bitcoins, investors rely on speculation, which makes the prices go berserk. At the same time its performance as a currency relies upon how stable its prices are. Thus, the motives of its use are essentially in conflict.
Exhibit 4: As liquidity in Bitcoin markets decrease, the volatility has steadily decreased.
The year 2014 saw the collapse of Mt. Gox, the Japan-based exchange responsible for handling 70% of all Bitcoin transactions. In the absence of adequate security measures, Mt. Gox lost a huge amount of the money that it controlled, the second time such an attack occurred in the exchange’s four year history. Mark Kerpeles, the CEO of Mt. Gox remarked about the collapse, “We had weaknesses in our system, and our bitcoins vanished. We’ve caused trouble and inconvenience to many people, and I feel deeply sorry for what has happened.” Mt. Gox filed for bankruptcy protection in Tokyo in February 2014, and had liabilities of $68 million at that time. 
Different governments and authorities have classified Bitcoin differently. The People’s Bank of China says that Bitcoin is “fundamentally not a currency but an investment target”.  In December 2013, the Chinese Central Bank passed an order prohibiting financial institutions from handling any kind of transaction related to Bitcoin. The European Central Bank defines Bitcoin as a “convertible decentralized virtual currency” , a definition remarkably similar to that of the US Treasury.
The evolution of the Bitcoin system will present newer challenges and opportunities for the market, which means governments and regulatory bodies will need to fulfil newer roles. As a technology and a medium that can substantially ease the transfer of wealth, Bitcoin holds a tremendous amount of promise. However, concerns voiced by activist groups and governments worldwide, regarding the role and usage of Bitcoin are serious. Anonymity of this system has already been misused in the technology’s short lifespan to fund illegal trading. The shortcomings of the system need to be thoroughly investigated, and the entire process may need to be regulated by the central monetary authorities before Bitcoin finds widespread application.
This article has been authored by Samyaraj Das from IIM Bangalore