Bitcoin: A Future with Digital Currencies

Bitcoin: A Future with Digital Currencies

Visions of frictionless, secure and direct payments have for years inspired digital currency design. Now the distributed, cryptographic technology found in Bitcoin means they may be reality.

If proven successful, Bitcoin could mean dramatic changes to fund transfers, money inflation, financial privacy, payment verification and counterparty risk, as well as introduce a new categories of business and investment opportunity.

That is why this development, even at an early stage, merits a close look.

Transfers

Bitcoin transfers are broadcast, propagated and first confirmed after around 10 minutes. The network securely delivers funds-available to any recipient located anywhere in the world quickly and virtually free of charge. By contrast banks may take several days to complete international transfers while total global remittances exceeded US$ 500bn in 2012.

Money Inflation

The total number of Bitcoins ever to be created is limited to 21 million by design. Other digital currencies in the Bitcoin-family may have different money creation policies, but all allow a credible commitment in advance to limit money inflation.

This gives users of the currency protection against the value of their holdings being eroded through printing and improves it as a long-term store of value. Paper currencies give governments an incentive to print more, and it is difficult prevent this. The multi-trillion-dollar US “quantitative easing” programs are a case in point.

Privacy

The privacy of Bitcoin can range from near zero to near complete, depending on how well the identity behind an address is protected. This is like paper currencies, where cash transactions can offer a high degree of privacy but bank transactions will convey the names of sender and recipient.

There is a major structural difference between Bitcoin and cash, however: by design every single transaction which has taken place in the history of Bitcoin is logged in a public database. This means that if someone were able to map Bitcoin addresses to identities then all the transactions carried out using those addresses would be in the full view of the public.

Hence claims that Bitcoin offers anonymity is not really true. Bitcoin users need not worry that a central party such as a bank or financial institutions hands over their private information to third parties such as government agencies, because there is no layer of intermediation in the system, there is no one responsible for “account opening” who could be forced to gather and keep this information.

Verification

Because the entire history of Bitcoin transactions is logged publicly it is very easy to establish that a transaction has taken place by between the two parties as well as the time and amount. Users can prove that they control a Bitcoin address by signing a statement with a private key.

Hence any guniene flow of payments can be verified by third parties if sender and/or recipient want. On a larger scale this makes it possible to verify information such as:

  • How much income a business is making
  • Which customers a business has
  • Whether payment due under a contract has been made
  • What the cash flow profile of an account is like

Traditionally payment verification by third parties requires reliance on bank statements and possibly trusted parties such as accountants, lawyers or government agencies.

Counterparty Risk

Bitcoin payments are, like most cash payments but unlike credit card payments, irreversible. Since recipients need not worry about chargebacks, this means that goods and services can be delivered quickly, with light or no customer due diligence. At the same time, Bitcoin payments can take place using an escrow service if the risk of non-delivery of goods is too high.

Business and Investment

This introduces new types of business and investment opportunities such as:

  • Sale of micro-content (e.g. single articles or individual minutes of music), since micro-payments are viable due to the near-zero transaction costs
  • Goods and service providers with light or non-existent customer due diligence, since transfers are irreversible
  • Establishing exchanges where the users pay each other directly without your financial intermediation, due to the ability of third parties to easily verify cash flows
  • Buying shares in a Bitcoin based business, through fractional ownership of a pass through account into which customers make payments

The Issues

Bitcoin is still a marginal phenomenon which has gained some mainstream attention, and many potential weaknesses of the currency have been identified.

First, the system presents currency holders with an incentive to “hoard” coins. While the ceiling on money supply improves it as a store of value, it may make people predict that the price per coin will continue to rise indefinitely and therefore give them an incentive to hold the coins rather than spend them. Perversely this could have a calming effect on the circulation (velocity) of the currency. Some Bitcoin alternatives, such as Freicoin, have been established to address this.

Second, it does not offer complete anonymity like cash does. Every balance of Bitcoins can be be traced through its history from address to address. This means that if someone wishes to break the transaction link completely, they have to use a mixing service, which still implies a statistically determined risk of identification. Cash transactions are different in that every not has a unique serial number but there need to be any record of that note passing from one person to another. Extensions to the Bitcoin system, such as Zerocoin, have been proposed to address this weakness.

Third, Bitcoin prices against the dollar have been volatile, ranging from $13.50 per coin at the start of 2013 to a peak of $266 during the first half of year and currently trading at around $130. This could be due to the fact that Bitcoin is not convertible into any specific basket of physical or digital commodities. High daily volatility against reference currencies such as the US dollar will make it difficult to price goods and services and Bitcoin and expose users of the currrency to significant exchange rate risk, which they may wish to manage.

Fourth, it may in some circumstances be difficult to change and improve upon Bitcoin because the software that runs it is distributed amongst all the peers in the network. Hence any deep changes need to be agreed upon by users who voluntarily update their software. This may not be a problem if the project stays relatively focused with a cohesive team of core developers, but one can envisage so-called forks emerging. This is not exactly an issue we face with paper currencies because they are controlled by central government-mandated parties. As an example the proposed Zerocoin extension to Bitcoin mentioned previously would have to be accepted by virtually all peers in order to take effect.

Fifth, the regulatory status of Bitcoin is highly unclear and likely to be volatile for the foreseeable future. It was very recently recognized as a unit of account by the German finance ministry, being classified as a financial instrument rather than as a foreign or virtual currency. In other countries the regulatory status is even less certain. In the US FinCEN has offered some guidance about how US law affects the currency, but the practical implications for businesses using Bitcoin are unclear. It will no doubt take time before the regulatory status solidifies, and it is quite likely that approaches will differ between countries – leaving early adopters with significant, undiversifiable regulatory risk.

Prospects

Whether Bitcoin achieves general acceptance, becomes a currency mainly used in the digital economy, or fails due to regulatory responses or flaws in its design, the technology that it represents is a real breakthrough towards frictionless, modern payments system.

Due to the open nature of its design and the large amounts of experience and data being gained daily on Bitcoin usage, there will be plenty of opportunity for modifying and improving upon the concept.

We should expect a lot to change in the world of currencies.

Johannes Tynes, CFA, has more than a dozen years of investment experience from leading, global financial institutions dealing in both public and private markets. He is a Senior Advisor at Inpirical - an investment research and development company, and was educated at the London School of Economics and the Chicago Booth School of Business. Johannes believes that a solid grasp of financial concepts and data-driven analysis are the cornerstones of investment decision-making.

6 Responses to “Bitcoin: A Future with Digital Currencies”

  1. John says:

    Another concise but comprehensive article from Money Hacker. The Bitcoin is definitively an interesting experiment in our current market. Only time will be able to tell us more about the stability and true value of the currency.

  2. Tale says:

    Personally, I don’t like Bitcoin at its present value. It seems to variable, sure it has a lot of potential to rise, but I believe it also has a lot of potential to fail.

  3. sarah says:

    You have explained that very well but I do have a question. How can someone make money in Bitcoins? Is there a currency trading that is going on or how does it work?

  4. val yenko says:

    I don’t understand the function of bitcoins yet. Are they the next “big thing” for trading or more of a passing phase?

  5. Chris Romans says:

    Bitcoin as a currency is a strange phenomenon. I don’t even fully understand how new currencies are developed like this digital currency. Some days, I don’t even fundamentally understand why human beings have decided to take paper and physical coins as currency as well. I mean, I so often consider how much we tend to obsess over every dollar…every piece of paper. It can mean life or death in some instances, whether a certain amount of this paper can be secured or not.

    At this point, I’ve so far heard mixed reviews on Bitcoins and their usability. I think some people like that it is not particularly regulated at this point in time, though I’m not sure that lends itself to stability and value that will not inflate excessively.

  6. Aeru says:

    The hoarding is an interesting argument. Let’s say that one person in the world has managed to hoard all the bitcoins in the world. Therefore, he has absolute monopoly to set the price of the bitcoin to any value. Let’s assume infinite value. However, the true value of the bitcoin at this point is really only as much as any one person is willing to shell out. In other words, it is based on however much belief that any one person believes this coin is worth. If everyone thinks the coin is worthless, then the 21 million coins hoarded is equivalent to nothing.

    Of course, there will always be that one person who wants to evade his taxes, believes he can, and invests into bitcoins..

    Then..could we say that the intrinsic value of bitcoin is based on the belief that it can evade taxes and deal underground trades?

    If that belief were to be consequently and methodically proven false, then the price of bitcoin should drop, no?

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