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Does Bitcoin Have a Future?

Galen Stops reports on attempts to develop a new global currency.

Bitcoin is the virtual currency that
has taken the world by storm this
year. Recently, the number of
column inches devoted to Bitcoin have
been growing almost as rapidly as the
value of the currency itself. Without
wanting to indulge in some of the
hyperbole that has characterised much of
the media coverage of Bitcoin, its rise to
prominence has been incredible to
observe.

What started out as something being
discussed in Internet chatrooms made its
way onto the Twittersphere and other
social media outlets, from there into the
mainstream press, then large financial
institutions began putting out papers on it
and most recently its merits have been
under discussion in the US Senate and
amongst other government authorities
around the world.

There is no denying that there is a buzz
surrounding Bitcoin at the moment, but
thus far it has often polarised opinion. The
general debate centres around whether
Bitcoin will prove to be the new Tulip
mania – a speculative bubble that will
burst and then completely collapse – or
whether it represents a viable new
currency beyond government interference
and therefore beyond the traditional boom
and bust cycle of any fiat currency.

Mysterious Origins

Firstly, for those who have been hiding
under a rock for the last six months, a
brief explanation of Bitcoin.

Started in 2009 by Satoshi Nakamoto (it
remains unclear if this is an individual or
group), Bitcoin is a currency with no
physical form; it exists purely online.

Although Bitcoins can be purchased
online, the creation of new Bitcoins can
only be achieved through a process
known as “mining”. The people who
take part in this process, the “miners”
must use computers to verify any
Bitcoin transactions taking place online
while simultaneously trying to solve
complex maths problems. The first
miner to solve the problem is rewarded
with a Bitcoin. This is a simplification
of the process, but for the purposes of
this article it will do.

Although in theory anyone can become
a miner, the reality is that it takes an extremely powerful computer to solve the
maths problems which become
increasingly difficult with each bitcoin
mined. So there is a natural technological
barrier to entry.

One key element of Bitcoin is that the
open source code that it was created from
means that there can only ever be a
maximum of 21 million in existence. This
means that over time it will become
harder to mine a bitcoin, the increasing
number of miners makes it more
competitive and the dwindling amount to
be found means that the payoff will
decrease. This should effectively create a
Darwinian struggle amongst miners,
ensuring that only the most efficient ones
with the most powerful technology
remain.

The idea of verifying transactions
alluded to earlier is important in a virtual
world where people can never actually
hold their money. In an excellent piece on
Bitcoin, Franc?ois Velde, a senior
economist at the Federal Reserve Bank of Chicago, explains how this process works.
“It solves the two challenges of controlling the creation of a digital unit of
currency and avoiding its duplication at
once. Validation is hard to do, and those
who do it are rewarded for doing so by
being able to create new Bitcoins in a
controlled way,” he writes.

Each Bitcoin user will have a Bitcoin
“wallet” which is managed by an
application installed on their computer
device. When two users carry out a
transaction, this application broadcasts the
details of this transaction to a large
Internet network of nodes (the miners)
who then gather up this information every
10 minutes and add it to a universal online
ledger known as the ‘block chain’. Thus,
every Bitcoin transaction that takes place
is recorded online.

Evolutionary or Revolutionary?

With time mining becomes unprofitable,
but an additional incentive is offered to the miners. “Users can offer to pay a
transaction fee to ensure inclusion of the
transaction in the next block successfully
added to the block chain; this fee will be
allocated to the miner who adds that
block,” explains Velde.

The word “offer” is perhaps misleading
as in effect the users will be forced to if
they want any of their transactions
actually verified. This means that even
after all 21 million Bitcoins have been
created the system will, in theory, still
continue as before.

The logic behind a virtual currency is
in many ways less revolutionary than
evolutionary. Think how many
transactions and bank transfers are
already carried out online without anyone
physically holding the money at any
point. Looking at the historical moves
from trading precious metals to coins, to
paper money to wire transfers and it
doesn’t seem that illogical that online
currency would be the next step in this
evolutionary chain.

The revolutionary aspect of Bitcoin is in
its decentralisation. It exists independent
of any geographical jurisdiction and
because there is a finite number of
Bitcoins that can exist, there is no way for
a government or central bank to inflate or
deflate the currency.

Rejecting the Status Quo

Since the 2008 financial crisis central
banks around the world have been
intervening on an unprecedented scale in order to try and help improve the
economies of their countries. This is
especially evident in the quantitative
easing program embarked upon by the
Federal Reserve in the US.

The democratic nature of Bitcoin and
it’s rejection of the traditional way of
conducting financial business and
government authority and interference
are in many ways reminiscent of the
“Occupy Wall Street” movement a
couple of years ago.

When questioned if they thought the
emergence of Bitcoin was in many ways a
direct response to the 2008 crisis and its
subsequent consequences, numerous
different sources agreed emphatically that
it was.

However, Walter Zimmerman, a senior
technical analyst from United-Icap, argues
that Bitcoin is also a response to a much
larger trend in currency pricing.

“The Federal Reserve, since it became
operational in 1914, has engineered a 98%
loss in the purchasing power of the US
dollar. There’s a reason why they have to
do this though.

“Because if consumers think that prices
are on an uptrend they will buy early and
buy frequently. And they will have to
work harder and harder to maintain the
same living. So what weakening the
currency does is it puts everybody on a
hamster wheel.

“It spurs economic activity, it spurs
spending, but it penalises savers,” he says.

Given that the dollar in your pocket is
always going to be worth less eventually, Zimmerman claims that Bitcoin, as a truly
free floating currency, is a natural
response from the market.

A True Capitalist Market

George Samman, COO of BTC.sx, a
Bitcoin trading platform, also believes that
Bitcoin’s rise in popularity can be
attributed to increasing anxiety about the
value of fiat money.

He says that the users of his platform
from Europe tend to be from Greece,
Spain and Italy and speculates that the
reason for this is that people in the these
countries are afraid that their government
could default on their debt and leave the
EU, drastically reducing the value of
their currency.

Similarly he says that BTC.sx has a
large user base in Argentina, which has
had a huge amount of inflation
problems, and thinks that Africa has the
potential to be a large market for them
in the future.

“I think that you can say that people are
sick and tired of the current system and
are starting to revolt against the old guard
and old ways that things were done.

“There’s a lot of fear. There’s all the
scandals going on on Wall Street that no-
one ever seems to pay for, people that are
in these power positions continue to get
richer while the gap between rich and
poor is getting wider,” he says.

The “occupy Wall Street” sentiment
alluded to earlier is clearly evident in this
rhetoric, however, Bitcoin is in many
ways actually the antithesis to this
movement.

“Bitcoin is a way to diversify assets and
I think that’s really something that people
are looking to do right now because
they’re scared that the next bomb is going
to drop behind them. People are getting
frustrated and trying to figure out how
they can make money here and protect
what they have,” says Samman.

Rather than the confused jumble of
disparate ideologies, demands and
vaguely anti-capitalist sentiment that
came to characterise the “Occupy”
movement, Bitcoin is capitalism in it’s
purest form. A free market where the
currency will thrive or crash based purely
on its own success, which is whether the
market will produce enough sustained
demand to keep it around.

And the demand for Bitcoin is surging
right now. On January 1, 2013, you could
buy a Bitcoin for $13.50. On October 1,
trading on Bitcoin closed at $140.3 and at the time of writing at the end of
November, it has closed at $1217.50 for
one Bitcoin. That’s an 8,918% increase in
value in under a year.

The Bitcoin Bubble

But of course such a meteoric rise in
value has lent credence to the theory that
Bitcoin is just the latest bubble.
Zimmerman’s research in Bitcoin
corroborates this theory [see chart] but he
argues that this doesn’t necessarily mean
that it is invalid as an asset class or that it
doesn’t have a future as a currency.

After all, there have been numerous
recent bubbles in housing, commodities
and the stock market itself, but this hasn’t
caused people to reject any of these assets.

The next question is of course: is this
growth sustainable?

“I’ve had a lot of people ask me if it’s
sustainable. Prices like that are generally
not sustainable in the short term, but I
think that the price rise overall will be
sustainable; I don’t think that it’s going to
drop anytime soon,” says Samman.

A market without regulators makes a
lot of people nervous though. After all,
they are there for a reason, and that is to
help protect market participants.
Zimmerman doesn’t agree with this
perspective though.

“I thought that the whole idea of a
free market is that it’s self-regulating?”
he asks.

“Besides, these regulators are really
paper tigers. What risks have they
protected us from? What big swings have
they warned us about? Regulators didn’t
protect anyone against the Internet
bubble or the credit bubble. They’re very
good at guarding against a repeat of a
crisis that has already happened, but
that’s it,” he says.

Advocates of Bitcoin argue that there
currently isn’t anyone really regulating the
US dollar, that is to say no one who is
protecting the consumer, the basic end
user of the dollar, from the continuing
printing of money in order to help prop up
banks’ balance sheets.

Government Reaction

Speculation has mounted about how
governments will react to Bitcoin and
other virtual currencies. China has become
the biggest Bitcoin market in the world
and while its government hasn’t openly
endorsed the currency it has said that its
people are free to use it.

Meanwhile, US Federal Reserve
chairman Ben Bernanke commented in a
letter recently that Bitcoin “may hold
long-term promise, particularly if the
innovations promote a faster, more secure
and more efficient payment system.”

The fact that the currency remains
outside of their control must worry
regulators though. If Bitcoin does
continue to grow and gain mainstream
acceptance it would mean a scenario
where this currency could have a major
and significant impact on the economies
of their respective countries and they
would be unable to influence or control
activity. At this point in time this is
almost an unthinkable scenario.

Consider the extraterritorial reach of
Dodd-Frank in its definition of what
economic activity could impact the US
and therefore comes within its scope and
it seems unlikely that the US would allow
this currency to gain real traction in its
economy without oversight.

However, as soon as regulators try to
implement oversight of the currency it’s
raison d’etre is largely gone. Additionally,
the idea of them to try to ban it is
ludicrous given its virtual nature. Even if
they wanted to get rid of it, it’s an open
source encryption that was put together
with extreme skill. It would require an
agency with the recourses and skill set available similar to the NSA to actually
break the encryption and destroy it.

One major criticism of Bitcoin as a
currency is that, especially once all 21
million Bitcoins are out in the market,
there will be little incentive to spend
them. Supply is finite so if demand
continues to go up, then Bitcoins will be
traded and spent fractionally. But what
incentive would there be to actually use a
Bitcoin for a transaction? If people just
hoard the currency this restricts its ability
to trade frequently and be used as a
medium of exchange.

Zimmerman points to the fact that
before the Fed, the US had a currency for
75 years that was finite and it was a
stable store of wealth that no one
hoarded because they knew it wouldn’t
lose its value.

“To say that a currency has to be
capable of deflating in order to be useful
is absolutely ludicrous. You can’t gut its
value and therefore it can’t be used as a
currency?” he argues.

The Silk Road Legacy

The security of Bitcoin has become an
issue recently as the currency has
attracted more interest. Both in terms of
whether money that is held and exists
purely online is safe from hackers and whether virtual money provides criminals
with an easier channel to make illegal
transactions.

“That’s a problem and something that
needs to be fixed,” admits Samman,
referring to the hacking of Bitcoin
accounts online.

“That’s something that we watch all the
time on our site and security is one of the
biggest expenses that we have. You hear
these stories all the time about money
being lost, people taking money from
other people and there are just some bad
actors out there,” he adds.

Of course this is not to say that regular
banks haven’t been robbed, meanwhile
identity theft has grown significantly in
recent years, with a common aim of this
crime being to defraud people. But
because there is no regulatory body
ensuring the security levels at Bitcoin
exchanges, those who choose to invest
must do the proper due diligence
themselves on where they choose to trade
in order to ensure that it has adequate
security in place.

Because they are anonymous in nature,
virtual currencies are often viewed as an
easy way for criminals to make illegal
transactions. The website Silk Road
grabbed a lot of media attention in this
regard. It was an online black market set
up in 2011 that was later shut down by the
FBI after evidence was found that virtual
currency was allegedly being used to pay for the trafficking of narcotics and to
contract murder for hire services.

“As to the claim that criminals use
Bitcoin, well, I hate to say it but the
global reserve currency of criminals is not
Bitcoin, it’s the US dollar. What do they
find at every drug bust? They certainly
don’t find a little pile of paper Bitcoin
receipts, they find $100 bills,” counters
Zimmerman.

“But with Bitcoin you have the block
chain which means that the visibility
versus the anonymity issue is just
something that can be upgraded with the
latest piece of software. You could make
the block chain so that it’s virtually
impossible to be anonymous, it’s very
easy to do,” he says.

Whether this will ever actually be done
is unclear, but because of the block chain
it should certainly, in theory at least, be
possible for the exchange to maintain the
history of each Bitcoin buyer to seller and
therefore make the currency extremely
traceable.

Volatility Remains High

In his Fed letter, Verde highlights
some of the more technical
complications surrounding the use of
Bitcoin. One such involves the
possibility of “forks” in the verification
of transactions. These forks occur when
one part of the Bitcoin network accepts a transaction as valid and adds it to the
blockchain, but another part of the
network rejects it.

“These incidents happened for
accidental reasons but a fork could
someday be the result of malicious
action,” he observes.

According to Velde, these forks
highlight another problematic element to
Bitcoin. The protocol is based on open-
source software created by the
mysterious Satoshi Nakamoto and any
improvements, fixes, repairs or removal
of bugs has been carried out by
programmers from the community of
Bitcoin users.

As a result of this he argues, “It is hard
to imagine a world where the main
currency is based on an extremely
complex code understood by only a few
and controlled by even fewer, with
accountability, arbitration or recourse.”

One barrier towards the mainstream use
of Bitcoin that remains insurmountable is
its sheer volatility. The huge changes in
the value of Bitcoin that are occurring
almost daily mean that it simply isn’t a
currency that merchants can use in
transactions yet.

The process of price discovery is a
natural process that a new currency must
grow through, but until the price is more
stable it cannot effectively be used in
transactions. The money that merchants
would lose by not accepting Bitcoin is
nowhere near the level of currency risk
that they would be incurring if their
timing was even slightly off and they got
hit by one of the huge swings in
valuation against other currencies that
Bitcoin is undergoing.

The volatility of Bitcoin is still an
unknown factor in the equation. It could
be that the market finds a trading range
as arbitragers dampen volatility and then
merchants that have been following it
might be more willing to expose
themselves to the currency as the risk of
a value change diminishes. Or
alternatively, it could mean that the
purely speculative aspect of the market
continues to grow and the bubble bursts
before a stable platform can ever be
achieved.

Bitcoin Enters Mainstream Markets

Call it speculation or investment,
Bitcoin is continuing to garner interest,
especially from the financial industry.

The first Bitcoin hedge fund has started
up in Malta. Owned by Exante Ltd, the fund was actually set up in late 2012, but
has only begun to receive a high level of
attention following the dramatic rise in the
value of Bitcoin. Called the Bitcoin Fund,
it currently has assets under management
totalling over $35 million. The rising
value of Bitcoin recently allowed Exante
to release a press statement claiming that
its Bitcoin Fund “is the best performing
hedge fund year to date (2013) with a
return of 4847%”.

Also grabbing media attention recently
was the news that Cameron and Tyler
Winklevoss, the twins made famous due
to their dispute over the invention of
Facebook, have filed with the Securities
and Exchange Commission to launch an
exchange-traded fund, called the
Winklevoss Bitcoin Trust, that holds
bitcoins.

Although these are just two examples,
they are indicative of the interest and
financial investment that Bitcoin is
beginning to receive.

And while the number of shops or firms
accepting Bitcoin as payment remains
negligible, individual cases of this
happening are appearing with increasing
regularity.

There is a Subway restaurant in Russia
that accepts Bitcoin and even offers a 10%
discount to those who pay with the
currency. The University of Nicosia in
Cyprus will accept the digital currency as
payment. Richard Branson has announced
that his commercial space flight venture,
Virgin Galatic, has already accepted its
first purchase with Bitcoin.

But it will require much more than
isolated cases if Bitcoin is ever to be used
in mainstream consumer stores.

Will Big Firms Adopt Virtual
Currency?

“There are a lot of hurdles that need to
be addressed and the initial investment to
make it work would be huge, it’s not
something that a small start up could
handle. But if a company like Google or
Amazon takes that on and invests then
you have something,” says Guido Schulz,
Global Head of Strategic Management at
AFEX.

Indeed Amazon has just announced the
launch of it’s own virtual currency,
‘Amazon coins’ in the UK and Germany.
It deposited 400 Amazon coins (worth £4)
into the digital wallets of Kindle Fire
users and those customers who buy the
coins in bulk will receive a 10% discount.

At the end of his paper, Velde concludes that Bitcoin “represents a
remarkable technical and conceptual
achievement, which may well be used by
financial institutions (which could issue
their own Bitcoins) or even by
governments themselves”.

Amazon launching its own virtual
currency is clearly an example of what
Velde was referring to, although what
Amazon is doing feels suspiciously like a
PR stunt designed to profit from the high-
profile status of virtual currency at the
moment. Given that the Amazon coins
can’t be used elsewhere, must be
purchased with fiat currencies and
seemingly can’t change in value, it is hard
to see the difference between purchasing
them or purchasing store credit online.

Perhaps a far more interesting
development in the growth of Bitcoin
would be if one of the major banks started
trading it. However, there has been a lot
of comment in the distinct generation gap
that exists between those who are
accepting and using Bitcoin and those
who remain sceptical about its value as a
currency.

As one person put it: “One of the
reasons why you won’t see a Goldman
Sachs trading group for Bitcoin anytime
soon is that they would have to educate
and convince the entire decision chain
about it.”

Impact on Financial Services

But if Bitcoin did become widely
accepted it could have significant
implications for the banks.

“You won’t need banks, you’ll only
need encryption, you won’t need credit
cards you’ll only need encryption, you
won’t need a checking account, you’ll
only need encryption,” says Zimmerman.

He clarifies this by adding that there
would still be a role for the banks as
people would still need to borrow, but the
fees they could charge wouldn’t be as
good because they’d have to compete with
this electronic option.

Schulz argues that it could also have a
significant impact on payment methods.

“A potential benefit of virtual currency
payments is that they are usually verified
within 10 minutes. Compared to
bankwires which can take two days to
clear, this is incredibly quick. So this
could provide a huge windfall in terms of
cashflow management for companies.

“If somebody could take this principle
of that instantaneous delivery, put some
technology around it and actually create that audit trail, then they’d have an
extremely powerful value proposition on
hand,” he says.

The Real Value of Bitcoin

As a concept Bitcoin is intriguing and,
in many ways, ingenious. As a reality it
remains problematic. This is not to say
that the problems with it as a currency are
insurmountable, but without any
government backing or direction, it is
difficult to predict how or if it will be able
to overcome the obstacles to mainstream
adoption.

One thing is clear though and that is
that many of the criticisms of Bitcoin are
in fact wide of the mark and often either
stem from a lack of understanding about
the virtual currency or about how fiat
currencies have actually developed and
function.

Most Bitcoin users will even admit that
they aren’t certain if Bitcoin will be the
definitive version of virtual currency that
becomes popularly accepted. However,
they all maintain the virtual currencies
represent the future of the currency market
and, for the time being, Bitcoin is way
ahead of its competitors.

But competitors are growing, albeit
largely on the back of Bitcoin’s
popularity. But even with these, it isn’t
necessarily an “either or” scenario. For
example, Charles Lee, a former
programmer at Google, developed
Litecoin. He has publicly said that he
wasn’t aiming to oust Bitcoin, but was
aiming to be the silver to Bitcoin’s gold.

Given the rapid expansion of the
Bitcoin bubble the next 12 months are
likely to prove crucial for the fledgling
currency. If it can stablise at a price range
and maintain interest then it could have a
real chance of expanding into other areas
of the market, particularly if regulators
don’t try to obstruct its growth somehow.

It might be though that the real value of
Bitcoin is that it has opened the wider
public’s mind to the concept of virtual
currency, provided a template for how it
could work and forced people to think
about what it could mean for the world at
large. And for other programmers and
entrepreneurs, it has laid down the
gauntlet for any future attempts at a new
currency.

Whether it works out or not, the Bitcoin
story definitely has further to go. And
regardless of its success or failure it seems
increasingly likely that virtual currency, in
one form or another, is here to stay.

Paul Gogliormella

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