Posted in Finance Articles, Total Reads: 6011
, Published on 13 February 2014
Bitcoin is the first and most prominent cryptocurrency - an alternative digital currency which relies on cryptography for its creation and transactions. Prevailing electronic payment systems depend on third-party financial institutions to process transactions. This model increases transaction costs and still cannot eliminate the possibility of fraud. Hence Bitcoins, based on cryptography instead of trust, were proposed to allow people carry out transactions directly without a trusted third party.
Image Courtesy: freedigitalphotos.net, ddpavumba
Bitcoin is essentially an agreement amongst a community of people to use secure mathematical tokens, called bitcoins, as money. It’s peer-to-peer and is not controlled by any central authority. One can get started transactions in Bitcoin by installing software called Bitcoin Wallet on a computer or mobile device. The Wallet generates Bitcoin addresses which are used to send and receive bitcoins.
All the Bitcoin transactions are added to a large public ledger called the ‘Block Chain’ by a process called mining. The enormous amount of work needed to find valid blocks of transactions through hashing ensures the security of the network. Theoretically, an attacker can subvert the security by controlling more than 50% of the processing power of the network. But it’s practically impossible due to military grade cryptography and the fact that processing power of the miners is far greater than 500 fastest supercomputers together. The Bitcoin protocol and software is open-source enabling any developer to review its code.
One can acquire bitcoins either in exchange of goods and services or through competitive mining or purchase them at Bitcoin exchanges for other currencies. The payment mechanism is straightforward requiring only the recipient’s address and amount. One can obtain the address by simply scanning a QR code. For businesses, it’s far easier to secure Bitcoin wallets and payment requests as compared to compliance with PCI standard required for accepting credit cards. Irreversible nature of Bitcoin payments shields merchants from chargeback frauds. The payments can take place across borders at any time without any restrictions such as bank holidays or imposed limits. The processing fees are also much lower compared to PayPal and credit card networks.
Since becoming operational in 2009, the currency has gained increasing acceptance. Currently more than 12,220,000 bitcoins are in circulation with market capitalization of $11.53 Billion. On an average 60,000 unique Bitcoin transactions are taking place every day. More than 1,000 brick and mortar businesses and 20,000 online merchants, which include Wordpress, Reddit, Windows Phone Central Store, Zynga Inc. and Overstock.com, are accepting bitcoins.
Thus Bitcoin exhibits various characteristics of a currency –
Durability – It is protected using cryptography, distributed computing and other security practices such as backups and offline storage.
Scarcity – Total number of bitcoins to be in circulation generated is capped at close to 21 Million. This limit will be reached in year 2140.
Divisibility and Fungibility – One bitcoin can be divided down to eight decimal places. Thus over 2 quadrillion atomic units are possible in the system, enough to cover all the transactions in the world.
Medium of exchange – Bitcoins are gaining popularity every day as a medium of exchange
Standard of market value – Dynamics of demand and supply determine price of a bitcoin. Of late the price has been fluctuating between $600-$1000 per bitcoin.
So can Bitcoin replace conventional fiat currencies?
Controlled Supply v/s Deflationary Spiral
In 1971, the US government cancelled direct convertibility of US Dollar to gold. Since then, the world has operated on fiat money, which is a currency declared by government as legal tender but not backed by any physical commodity. It has allowed governments to run large, perpetual fiscal deficits, spending more than what they earn. When bills come due, governments simply create more credit and pay them off. This results in endless supply of money, massive buildup of debts and sustained inflation. Bitcoin is designed in such a way that no entity can unilaterally create a large supply of bitcoins leading to inflation. The bitcoin generation algorithm creates bitcoins at predetermined and gradually decreasing rate to reward miners. If Bitcoin becomes new standard in future, it could significantly curb the ability of the governments to follow loose monetary policies and run persistent deficits. However, detractors of the currency argue that its limited supply will cause deflationary spiral. Because the supply of the currency is capped but amount of goods and services is not, value of a bitcoin will increase in comparison to items available for purchase. It would incentivize bitcoin holders to hoard the currency. Consequently merchants will be forced to further reduce the prices causing even more hoarding and depression. A counter-example for deflationary spiral theory is the consumer electronics sector where prices have continuously fallen over the years but the sector has not experienced depression.
Need for Regulation
A significant challenge for Bitcoin is lack of clear rules and regulations from the governments and monetary authorities. One of the most critical questions is how will bitcoins be taxed? If treated as capital assets, gains and losses from bitcoins would be subject to capital gain tax. If they are treated as currency then profits from sales would incur income tax. Bitcoin investors such as Winklevoss twins, who have applied for an exchange traded fund to track Bitcoin prices, are in favor of capital gain tax treatment. Some analysts have opined that as currently bitcoins have limited use as real money they could be viewed as capital asset but if they attain wide acceptance then they can be treated as actual currency. Apart from taxation, various laws related to foreign exchange management, currency convertibility and capital controls will have to be revised to regulate Bitcoin. A few governments like Canada, Germany and Singapore have published their approach towards bitcoin taxation. The US authorities are still contemplating over various aspects of Bitcoin regulation. China’s central bank banned financial institutions from conducting transactions in Bitcoin in December 2013. Some regulators including RBI have issued advisories cautioning people that though virtual currencies are not illegal yet, their users are exposed to significant financial and legal risks. As majority of the current Bitcoin community consists of speculators, any important announcement regarding Bitcoin regulation causes sharp movements in the exchange rate of bitcoins.
Another major concern is that bitcoins can be used for illegal activities such as money laundering, drug trade and terrorism. Though Bitcoin transactions are publicly logged, only a flow of bitcoins from address to address can be determined. The address cannot be directly mapped to actual identity of the user but with other tools such as network analysis and surveillance, the owner of the address can be found out. Hence the law enforcement authorities in various countries will demand compliance to certain norms and cooperation in stopping illegal activities using bitcoins.
Ease of Use?
While Bitcoin network is protected by nearly impregnable cryptography, individual wallets have to be secured by sound security practices. There have been instances when hackers gained access to Bitcoin users’ machines and stole bitcoins worth millions of dollars. To circumvent this problem, people store their wallets on machines or memory-sticks not attached to the Internet and with additional encryption protection. But this reduces ease of access and speed. Also there is a chance of memory-stick or hard-drive getting stolen or discarded in garbage. Many users prefer to maintain their wallets with companies providing exchange services between bitcoins and conventional currencies. However in April 2013, Mt.Gox, one of the largest bitcoins exchanges was also targeted by malware. Moreover, this introduces a trusted third-party which Bitcoin was intended to remove. Large-scale adoption of Bitcoin is possible only if tools that make it easy to manage and safeguard bitcoins become available.
Competition and Technology
Soaring demand for Bitcoin has caused proliferation of multiple competitors like Litecoin, Namecoin and Peercoin. While Bitcoin is the top cryptocurrency currently, we cannot ignore that many of today’s most popular products and services such as Facebook, BitTorrent and Google Chrome were not the first in their respective categories. Finally, any cryptocurrency and other applications of cryptography must keep an eye on progress of revolutionary technologies like quantum computing that can potentially break the strongest cryptographic barriers.
Is Bitcoin truly the next generation in evolution of currency or just a clever payment system backed by mathematics? Two former top central bankers of US have differing opinions. Alan Greenspan is unable to fathom how something not backed by any tangible asset or government became so valuable. But Ben Bernake thinks that virtual currencies hold long term promise if such innovations promote fast, secure and efficient payment system. The security and stability of Bitcoin are still questionable. If the system fails, one will be left with no digital fortune and no authority to complain to. If Bitcoin continues to be mainly used for speculation, instead of purchase of goods and services, then its growth potential is limited.