Bitcoin – Threat to the Regulated Currency?

Posted in Finance Articles, Total Reads: 3346 , Published on April 20, 2014

In the month of November, a man named Satoshi Nakamoto published a research paper on an obscure cryptography mailing list describing his design for a new digital currency, Bitcoin that would also be able to solve the problem of double spending. And a new digital currency which is currently breaking the shackles of the regulated world was born. Satoshi himself may be a puzzle with his identity still unknown but his creation cracked a problem that has stumped cryptographers for decades. Bitcoin was able to sustain and made regulated environments to take notice of its existence which its early predecessors failed to achieve.

But what is the reason for its success and why the Central Banks are so averse to it? The answer lies in its independent mechanism. Bitcoin is decentralized electronic cash system with a distributed architecture. It is based on the assumption that majority of the nodes in the network are honest. Thus it resorts to majority vote mechanism for double spending avoidance and dispute resolution. Another pinch to the regulators is that Bitcoin is the freely traded currency and no exchanges are required for its trade. Participants just have to acquire a program known as bitcoin wallet and one or more bitcoin addresses. They are then used to receive the bitcoins, a concept similar to the emails received with the help of email addresses.

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The simplicity yet the ingenuity of the design is what makes the bitcoin successful. A core challenge in designing a digital currency is the multiple spending problems. If a digital cash is just information, (unlike the solid cash which changes hand) then what’s there to prevent people from just copying and pasting it and spending it as many times as possible. Conventional methods would be to have a central clearing house to keep a real time ledger of all transactions- ensuring that if someone spends the digital cash, he then can’t spend it again. The ledger though would prevent the fraud would require a third party who can be trusted to administer it. Bitcoins advantage was that it did away with this method by publicly distributing the ledger. The “Block Chain” users, “Bitcoin Miners”, who are willing to devote their CPU power to run a special piece of software and maintain the block chain collectively, helped in avoiding the third party interference. In the process these miners would also help solving the complex puzzles and thus, generating new currency.

The Central Banks all over the world are taking notice to this simplicity of the bitcoins and success it is marching towards. Some are adopting the wait and watch policy, and some are introducing strict actions. Our own RBI had issued an advisory on 24th December, 2013 against the use of bitcoins. In the advisory RBI said, “Since they are not created by or traded through any authorized central registry or agency, the loss of the e-wallet could result in the permanent loss of the VCs (virtual currencies) held in them.” This was immediately followed by an official raid by the India’s Enforcement Directorate (ED) on two locations in Ahmedabad. The first was the home of founder Mahin Gupta and second was the exchange office. The reason for the raid was cited as the violation of Foreign Exchange Management Act, 1999. A clear indication of the currency’s success that such an action was undertaken. Since its inception in 2008 bitcoin has gained enough value in the market and its exchange value runs in thousands of dollars as can be seen from the figure 1.

Figure 1

The value as on 5th Jan, 2014 is 930 US Dollars per bitcoin and 57972 Rupees per bitcoin. The very reason governments are sceptical about this currency and fraudulent activities it can be put to use into. Also, another question that is troubling the regulators is how to collect taxes for these traded currencies? The answer is they can't. Crypto-currency's strong protections on anonymity make it impossible for any state to know who is buying what, who is paying whom, who earns what, and who has what in savings. That poses a direct challenge to the power of states to levy taxes.

Figure 2

Figure 3

Figure 2 and Figure 3 indicates the rate at which the circulation of bitcoins has increased and number of transactions that occur on daily basis. The transactions and number of coins mined has increased at the blistering pace. The total number of bitcoins in circulation has increased by 106.67% in the past one year.

What are countries doing about this?

China was believed to have welcomed bitcoin with open arms when their major search engine, Baidu, began accepting bitcoins. However this love affair was short-lived because People’s Bank of China (PBOC) in December last year banned the financial institutions from dealing in this virtual currency. This dealt a major blow to the bitcoin surge as the Chinese exchanges were responsible for the two thirds of the worldwide traffic of the bitcoins. PBOC cited the risk of money laundering as the reason for the action. The Bank of France followed suit by issuing a statement, warning against the risk due to the use of bitcoin, “Even if Bitcoin is not currently a credible investment vehicle and therefore do not pose a significant risk to financial stability, they represent a financial risk for those who hold them”.

USA, on the other hand has changed its initial stance on the bitcoin. Bitcoin was coined by the USA authorities as the currency for the criminal activity and after the Silk Road seizure in October, 2013 it was widely believed that USA authorities are putting an end to the Bitcoin saga. However, the script changed sooner in the currency’s favour after the Senator Tom Carpe called it as a legitimate financial service. This was followed by a US court hearing asking the government officials to train themselves to use this currency. A stronger stance in support was seen when Bank of America released a report soon after the PBOC’s ban, calling Bitcoin as a major means of payment for E-Commerce.

Threat to the Card Industry

Though governments feel bitcoins to be a threat to the solid form of cash, whereas in fact, it is more of a threat to the credit and debit cards industry. Bitcoins will be preferable to the seller, due to the absence of transaction fee wherein they have to pay from their margins. Also, no credit limits and no buyers’ fee will make it even more attractive to consumers.

Running a dream

Bitcoins are capturing the market by taking long strides. It is quizzing the regulators to find out ways to tackle its unprecedented growth. The start has been phenomenal, we now just have to see whether it is going to sustain. For the countries like China and India, they should keep in mind Mark Twain’s saying, “The more things are forbidden, the more popular they become.” They are just helping the bitcoin to reach its star status.

Threat or not, Bitcoins have ensured the governments to rethink its stance on the digital currencies. Till then, bitcoins can enjoy the popularity it is gaining.

This article has been authored by Divya Roongta & Nishant Poojary from Sydenham Institute of Management Studies, Research and Entrepreneurship Education





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