Historically, exchanges of value – barter systems – were done face-to-face so that participants could instantly verify the respective physical properties being exchanged. As purchasers and sellers became geographically distant, agents or trusted third-parties acting on behalf of the participants became necessary to verify the quantity or quality of the property being transferred. For example, credit card issuers are examples of a third-party standing in for a buyer, guaranteeing to the seller that the buyer’s funds are good.
The growth of the Internet and the proliferation of digital transactions have exposed many limitations to traditional currencies and exchange systems in the borderless, electronic world. Current limitations include high expenses, time delays, and security risks. These limitations are particularly egregious when the transactions involve parties on each side of the globe, different national currencies, and complex products.
The idea of an international currency – independent of a country or central bank and designed for a globalized economy – has fascinated economists, business executives, computer experts, and anti-government advocates for years. The ideal currency would provide anonymity to its holders, protection from inflation, and security from theft and fraud. These ideals led to the concept of a digital currency, enabling the concept of cash or cash equivalent to be used over the Internet.
Bitcoins (BTC), the latest and most popular outcome of efforts to create a practical digital currency, first appeared in 2009 with an initial issue of 2,625,000. As of December 7, 2013, there were 12,091,050 BTCs, each with a value of $736.61 USD.
The website Shopify recently listed 75 specialty retailers that accept bitcoins, and Forbes announced its “Top 10 Bitcoin Merchant Sites,” including website development software developer WordPress. Even Baidu, Inc., China’s biggest search engine, accepted bitcoins until the nation’s central bank banned the use or ownership of the currency by financial institutions.
Description of Bitcoins
According to Anthony Gallippi, CEO of Bitpay payment processor, “Bitcoin is a more secure, faster, and more affordable option for transferring funds.” In technical terms, bitcoins are a math-based, finite, verifiable, open-sourced, decentralized virtual currency that relies upon cryptography for security.
Proponents of the new currency claim that:
- Instant payment can be made to anyone, anywhere in the world
- Transactions cannot be reversed for any reason
- Third parties are unnecessary
- The supply of bitcoins cannot be manipulated by any government, bank, organization, or individual
Bitcoins are created in blocks of 50 bitcoins through a process called “mining” – what amounts to a payment for services provided to the decentralized network by processing transactions. In layman’s language, a transaction – one party transferring bitcoins to a second party – occurs electronically between each party’s bitcoin “wallet” – the name for the public digital files where the respective parties, or wallet owners, keep private encryption keys to prove ownership of the wallet.
The transactions are processed by network computers (bitcoin miners) into a shared public ledger called a “block chain.” The block chain is maintained over the entire network according to specific cryptographic rules, and each transaction must be verified by other computers (nodes) in the network before it’s confirmed. Once the network computers (the “miners”) complete the increasingly complex algorithms associated with each transaction, the owners of the mining computers earn a fixed number of bitcoins.
Essentially, the bitcoin transaction is audited a minimum of six times by different computers in the network before the transfer is confirmed to the wallet owners. This ensures that:
- The transferring bitcoin wallet has sufficient bitcoins to complete the transaction.
- The appropriate number of bitcoins are transferred from one wallet to the other, thus agreeing and confirming the total number of bitcoins outstanding remains the same.
- The bitcoin balance in each wallet is correct following the transfer, again confirming that the total outstanding bitcoins are correct.
Each computer verifying the transaction adds its own sequence of numbers to the block chain. As transactions increase, the computing power necessary to complete each transaction also increases due to the longer block chain and the greater complexity of the algorithms required to complete each operation.
Mining – processing transactions for the bitcoin network – is the only method by which new bitcoins are created. As the number of outstanding (unissued) bitcoins decrease, and the number of bitcoin transactions increase, the bitcoin miner must expend greater computer power to complete each transaction. This is the planned consequence of fixing the number of bitcoins issued to 21,000,000 BTC, thereby establishing the rate at which future BTC blocks are issued on a declining ratio based on the number of outstanding BTCs.
For instance, once there are 17,718,750 BTC outstanding, 6.25 BTC/block will be issued relative to the 50 BTC/block initially issued. According to Virtual Mining Corp CEO Kenneth Slaughter, “In 2009, people could mine 50 coins every 10 minutes. By the end of 2012, that amount was halved to 25 coins.”
The Potential of Bitcoins
While the number of bitcoins and their value has increased since their introduction, it may be helpful to compare bitcoins to other electronic payment methods.
In the fiscal year ending October 2013, there were $8 billion in transactions in bitcoins. By contrast, Bank of America, PayPal, Western Union, Automated Clearing House (ACH) Network, and Fedwire collectively processed 132 million transactions for a total of $599 trillion in 2012, as testified to by Jennifer Shasky Clavery of the United States Department of Treasury in November 2013.
Gallippi, also testifying before the Senate Banking Subcommittee at the same time as Clavery, contrasted the difference between the existing capacity of processors to handle bitcoin transactions as compared to credit card processing. He noted that the Visa credit card network can handle 20,000 transactions per second worldwide, while Bitcoin has the capacity to handle seven transactions per second, and currently averages just one transaction per second. He also stated that the global money supply of bitcoins is around $5 billion today, compared to $70 trillion in the global M2 money supply.
Bitcoins have a way to go before becoming a serious alternative to existing electronic transaction systems, but they do provide real advantages to users:
1. Protection From Payment Fraud
Bitcoins are digital and cannot be counterfeited or reversed arbitrarily by the sender, as with credit card charge-backs.
2. Reduced Possibility of Identity Theft
When you give your credit card to a merchant, you give him or her access to your full credit line, even if the transaction is for a small amount. Credit cards operate on a “pull” basis, where the store initiates the payment and pulls the designated amount from your account. Bitcoins use a “push” mechanism that allows the bitcoin holder to send exactly what he or she wants to the merchant or recipient with no further information. Furthermore, bitcoins do not require names – just digital wallet IDs.
3. Direct Transfers for Immediate Settlement
Purchasing real property typically involves a number of third parties, delays, and payment of fees. In many ways, the bitcoin block chain is like a “large property rights database,” says Gallippi. Bitcoin contracts can be designed and enforced to eliminate or add third party approvals, reference external facts, or be completed at a future date or time for a fraction of the expense and time required to complete traditional asset transfers.
4. Access to Historically Inaccessible Markets
There are approximately 2.2 billion individuals with access to the Internet or mobile phones who don’t currently have access to traditional exchange systems. These individuals are primed for the bitcoin market. Kenya’s M-PESA system, a mobile phone-based money transfer and micros financing service recently announced a bitcoin device, with one in three Kenyans now owning a bitcoin wallet.
5. Lower Fees
There aren’t usually transaction fees for bitcoin exchanges because the bitcoin miner is compensated by the network with newly issued bitcoins. Even though there’s no bitcoin transaction fee, many observers expect that most users will engage a third-party service, such as Coinbase, in lieu of creating and maintaining their own bitcoin wallets. These services act like Paypal does for cash or credit card users, providing the online exchange system for bitcoin, and as such, they’re likely to charge fees. It’s interesting to note that Paypal does not accept or transfer bitcoins.
Limitations & Risks of Bitcoins
Critics of bitcoins range from noted economist and “New York Times” writer Paul Krugman, to MarketWatch’s David Weidner, who claims advocates for bitcoins are essentially gold bugs: “The most paranoid class of investors. They’re hoarding it to ward off what they believe is hyper inflation. They don’t trust the Fed. They don’t trust the government. They don’t trust central banks.”
They, and others, raise a number of concerns, some of which are substantial obstacles to the online currency, while others may resolve as the system matures.
1. Financing Illegal and Immoral Activities
Some believe the appeal of bitcoin is that it can be used anonymously for illegal or antisocial acts. According to Mercedes Kelley Tunstall of Ballard Spahr LLP, “Bitcoin has built its reputation and structured its virtual currency around being both anti-government and anti-establishment.”
On October 2, 2013, the FBI closed the notorious website Silk Road, seizing more than 144,000 BTC worth $28 million. According to Paul Smocer, president of BITS (the technology policy division of The Financial Services Roundtable), Silk Road was “an operation that was allegedly used to anonymously buy or sell drugs, offer guns or assassins for sale, and provide tutorials for hacking ATM machines. The operation was completely reliant on digital currency for transactions.” He went on to say, “Digital currencies are being used to assist a broad array of criminal activities including illegal drug sales, stolen identities, child pornography, prostitution, human trafficking, and illegal weapons sales. It is also being used as a favorite of cyber criminals to pay for services such as developing and distributing malicious software to the movement of stolen funds resulting from account takeovers.”
Proponents of bitcoins, with the agreement of federal currency regulators and enforcement officials, respond that any financial institution, payment system, or medium of exchange has the potential to be used for money laundering and other illicit activities.
2. High Risk of Loss
Timothy B. Lee, adjunct scholar at the Cato Institute and regular contributor to Forbes.com, identifies four reasons to be cautious about bitcoins:
- Lack of Security. There is no safety net or perfect way to protect your bitcoins from human error (passwords), technical glitches (hard drive failures, malware), or fiduciary fraud. According to an article in the UK edition of Wired, 18 of 40 web-based businesses offering to exchange bitcoins into other fiat currencies have gone out of business, with only six exchanges reimbursing their customers. The authors of the study estimate that the median lifespan of any bitcoin exchange is 381 days, with a 29.9% chance that a new exchange will close within a year of opening.
- Increased Regulation. While relatively benign guidelines are currently in place, law enforcement agencies could decide that bitcoins are a “giant money laundering scheme,” and enact more stringent regulations that would diminish the currency’s value.
- Limited Scaling. The design of the system limits the speed and number of transactions processed, making it unlikely that bitcoins will replace conventional credit card transactions.
- Lack of Applications. While acknowledging bitcoins’ popular use for illegal transactions, Lee questions how useful bitcoins really are. To be truly disruptive to existing fiat currencies or electronic payment systems, Bitcoin would need applications for low-cost international money transfers, the creation of complex electronic contracts, or use in Kickstarter-style fundraising campaigns or micropayment transfers.
James J. Angel, associate professor of finance at the McDonough School of Business at Georgetown University, noted in an article on CNN that one of the largest Bitcoin exchanges is a former online site to trade cards used in the popular card game MAGIC: “An exchange based on trading kiddy cards does not seem like a sound foundation for a monetary system.”
Many financial experts would concur that the issues inherent in currency and monetary exchange systems are considerably more complex than the artificial limits established in game software. Angel also predicted that Bitcoin mining software would become a magnet for computer viruses since there is no government regulating the participants within the system.
On December 8, 2013, the Financial Times reported that “Bitcoin has fueled a surge in the number of cyber-attacks,” with more than 300,000 known incidents occurring in the preceding quarter. According to the article, cyber-attackers demand ransoms paid in bitcoins from owners of the computers that have been attacked, steal bitcoins by deciphering the long codes, and hack the coining computers used to maintain the public ledger of bitcoin ownership.
Furthermore, Mr. Smocer, testifying before the Senate Subcommittee, noted that bitcoins are not broadly accepted by the established financial services industry, limiting their overall application and use.
3. Excessive Volatility
According to an analysis published in The Wall Street Journal by Campbell Harvey, a finance professor at Duke University, bitcoins have been 7.5 times as volatile as gold, and more than eight times as volatile as the S&P 500 over the last three years. This coincides with the analysis of Marie Brière, associate professor of Universiteé Paris Dauphine in France, who calculated an annualized return of 370% for bitcoins with 175% volatility. Such violent price movements within short time periods are not consistent with an ideal exchange medium for buyers or sellers, limiting bitcoins as a significant vehicle for businesses.
Many believe that bitcoins are speculative bubbles, similar to the Dutch tulip bulb mania of the 1600s. The evidence to date definitely suggests that the current market is mainly speculation, with three-quarters of mined bitcoins being hoarded, waiting for prices to rise.
Raoul Pal, head of Global Macro Investors, recommended “Buy Bitcoins” on November 1, 2013 when a BTC was at $210, saying, “It’s either zero or it’s worth a truly outstanding amount of money.” He likened the purchase to a lottery ticket.
SecondMarket CEO Barry Silbert, whose company offers the Bitcoin Investment Trust to accredited investors, agrees with Pal’s assessment, saying, “There will either be a total loss of principal or a very, very high return.”
Cameron and Tyler Winklevoss, who came to fame in their legal controversy with Facebook founder Mark Zuckerberg, filed a proposal in June 2013 that would allow investors to acquire an exchange traded fund to track the performance of bitcoins. This has yet to be approved.
On the other hand, many financial advisors are staying clear of the investment. Phil Christenson, an advisor of Philip James Financial, stated, “If Bitcoin was a stock, I’d seriously consider selling some of it. I wouldn’t be buying it.” The governments of China and France have issued public advisories to warn against potential risks in bitcoins, and the government of India is expected to make a similar warning.
In a short time, Bitcoins have captured the attention of financial speculators, con-men, and cyber punks alike. Are bitcoins a real solution to the need for a transaction system suited to the Internet Age, or just another way for unwitting sheep to be sheared of their assets as they’re led to slaughter? The concept is intriguing. The demand for a suitable virtual currency is real; however, it’s simply too soon to project whether bitcoins are the answer, or just another speculative boom.
If you decide to buy bitcoins or take them in exchange for your goods or services, limit your risks. Remember that the risks of engaging in virtual currency transactions are entirely your own.
What do you think about bitcoins? Do you own any? Will you buy them as an investment or speculation?