Posted in Finance Articles, Total Reads: 3165
, Published on 06 March 2014
Discovery of electricity was a revolution. This was followed by another astounding revolution - The Steam Engine. Internet - yet another. Now it's time for Bitcoin.
Bitcoin is a digital currency that enables an individual to transfer money and make payments to anyone across the globe. However, the first thing to understand about Bitcoin is that it is not just money transfer or upgraded money. It is only a component that gives Bitcoin great value. Bitcoin is rather a programming environment, a publicly audited ledger which accounts for all transaction in terms of property, ownership and contracts. Developed by Satoshi Nakamoto in 2009, it uses advanced encryption technology whereby users transfer money by sending digitally signed messages to a network. The encryption also helps to keep the identity of both sender and receiver private.
In the past four years, Bitcoin has seen tremendous growth as more and more businesses and small merchants are shifting from conventional modes of payment. Companies like WordPress and Overstock.com and many small brick and mortar stores have already started accepting bitcoins as payment. Even some not for profit organisations and advocacy groups like Electronic Frontier Foundation have also started accepting donations in bitcoins.
Image Courtesy: freedigitalphotos.net, samuiblue
Case for Bitcoins
The proponents of Bitcoin network argue that the advantages of this technology outweigh the risks involved. They argue that Bitcoin incorporates all the benefits of online funds transfer without the associated costs. Transacting on a Bitcoin platform is easy and hassle-free. The user can start as soon as he/she obtains a Bitcoin wallet which takes only a few minutes. As compared to fiat currencies, Bitcoins offer several advantages:
Bitcoin environment uses Peer-to-Peer (P2P) exchange so there is no bank or intermediary acting in between. This, in addition to minimising the cost of transactions by reducing commissions, also leads to less labour involvement in financial transactions, heavy duty accounting and conflict resolution.
No Counterfeit Currency
Every time a Rs. 500 note changes hands, people check for its authenticity by holding it against a light source. This is because 2 out of every 3 bank notes in India are fake. This surge in volume of counterfeit currency has led to increase in prices and a reduction in the value of real money as more money is into circulation than is required. With bitcoins however, such a scenario is less plausible as they can be created only by miners after doing certain amount of work for each block.
With fiat currency the government always has the option of printing more money. If a monetary instrument works properly, the supply changes as the quantity demanded changes. In other words, when there is more demand, it goes up, and comes down when there is less demand. This leads to increased money supply followed by inflation. However, since the maximum value of Bitcoins is capped at 21 million, Bitcoins are partially if not entirely inflation-proof. Thus, many inflation hit countries like Argentina and Cyprus are seeing an increased use of Bitcoins.
Not Based on Debt
Many governments including India are hugely burdened by the loads of debt financing that they have raised for government spending. With increasing amounts of debt also comes the increased cost of rolling over debt and accumulating interest. With bitcoins however, the concept of debt totally vanishes. This also reduces the cost of insurance.
Currently, credit and debit card companies charge very high commissions for their services. This seems fit as these companies spend approximately 30%-40% of their profits fighting lawsuits on fraud. This commission cost is transferred to end consumers leading to high prices. However, since Bitcoins cannot be impersonated, if there is a way of transferring these kind of transactions to Bitcoins - through smartphones or Bitcoin cards - the costs would reduce substantially.
When making a transfer using Bitcoin network, both the sender and receiver are required to agree on the terms set by them. Only then the transaction can go through. This means that there is no unnecessary fees that the seller can impose on the buyer without his approval.
Case against Bitcoins
Currently, 25 bitcoins are created every 10 minutes. Although still in its nascent stage, the Bitcoin network has consistently faced criticism from the proponents of age old fiat currency system. This criticism can be explained in part by the fact that the fiat system is the monopoly of the respective governments with vested political, financial and military interests. Nevertheless, some criticism stems from genuine concerns expresses by economists.
The acceptance of Bitcoins as national currency would render many professions out of date. These would include accountants, forex professionals, credit and debit card companies, clearing houses and other financial intermediaries. Since most of these jobs are dream jobs for many and are very well paying, it will be difficult to find alternate means of employment. Not to forget the substantial lobbying power this soon-to-be-unemployed community has.
Many critics view Bitcoin as a bubble that will soon burst. They argue that the value of a bitcoin in terms of fiat currencies has been extremely volatile with the price rising from US$0.30 to US$200 in just one year. Also, many speculative and arbitrage opportunities exist within this niche market further fuelling this volatility. However, since the concept is still in its embryonic stage, there are no hedging contracts available in terms of forwards or futures. Thus, there are serious questions on its viability as a currency.
Bitcoin network is seen as a haven for money laundering and many other criminal activities. Recently, Silk Road, an online market which used bitcoins as a medium of exchange was closed under the federal law. It turned out that this clandestine currency was being used for many nefarious purposes. What further aggravates the situation is the fact that it is not possible to trace the source or the destination of money, much less what is being traded.
With regard to national currencies, a government is required to back the money supply with assets like gold. However, the same does not apply to Bitcoins. They are neither backed by hard assets nor by faith of the government. This makes them a risky proposition during bankruptcy. Some analysts however argue that Bitcoins are backed by the “processing power”. This seems illogical as there is no fundamental means of repayment in case the process crashes.
What lies ahead
As Bitcoin is gaining popularity, more and more governments are taking a stance either for or against it. The Reserve Bank of India for example has issued a warning that use of bitcoins for money transfer is highly unsafe due to potential security and money laundering risks. The Government of China has taken a stricter stance by prohibiting payment and financial institutions from accepting them as payment. The European Banking Authority has also issued a warning that Bitcoin lacks consumer protection. Many more governments and central banks have also banned the use to prevent black marketing and alleged drug dealings that are using bitcoins.
The future of Bitcoin is still clouded as the entire economic and financial community has mixed opinions about its viability as a currency. However, going by the current trends of growth in their use, the potential of Bitcoins as a currency seems to be rising. One should however ask this question “If the Federal Reserve creates more money in 2 hours than has been created by Bitcoins since its inception 4 years ago, what is more riskier?.”
This article has been authored by Mukul Gupta from IMT Ghaziabad