Thursday, 6 November 2014

Signs that Bitcoin is here to stay

GUEST POST

Special Economic Analysis
by Peter Warburton, Ph.D.

Virtual currencies, of which Bitcoin is the most prominent, offer a cheaper and more efficient online payments mechanism than debit or credit cards. The peer-to-peer transaction process reduces the risk of identity theft as fewer personal details need be disclosed. The appeal of Bitcoin is that it is in finite supply, and independent of any central bank or government body. This safeguards it against the debasement of the currency.

On these merits, Bitcoin has gained favor with both investors and advocates of financial disintermediation – pulling business away from the big banks. Its inability to function as a reliable store of value however, seesawing wildly in response to technological and regulatory developments, may limit its prospect as an alternative to fiat currencies.
Background

Created anonymously in 2009 under the pseudonym Satoshi Nakamoto, Bitcoin’s ascendancy has been tempestuous. Now the most prominent of the “virtual” currencies, its market capitalization is equal to $12.5 billion, with just over 12 million out of a maximum 21 million Bitcoins having been “mined” or discovered. This means that each Bitcoin is worth approximately $1,000, up from $13 at the beginning of 2013.

On the whim of their creator, Bitcoins are buried in a complex algorithm. These are released or “mined” as ever more powerful computers locate correct sequences of data, called blocks. An analogy is the search for prime numbers: the first few dozen were easy to identify, but the 5,000th requires a massive amount of effort and time – and electricity. The mining process is designed to suffer from diminishing returns as the number successfully extracted grows. Since it is so difficult, requiring complex computer software and calculations, the vast majority of people simply buy Bitcoins from online exchanges.

Fundamentally, Bitcoin is an electronic payment system based on cryptographic proof (complex algorithms) documenting each transaction. It allows any two willing parties to transact directly with each other, without the need for a trusted third party. Payments are made instantaneously over the Internet, with much lower transaction costs than normally encountered when paying by credit or debit card.

The notion of Bitcoin was introduced in 2008, when Satoshi Nakamoto issued a white paper outlining the system of exchange. Setting Bitcoin apart from its rivals was the use of public records documenting all Bitcoin transactions with a “timestamp.” This eradicated fraudulent attempts to “double spend” the virtual currency since the order of payments was made available for all to see, with only the first payment binding.

In 2011 Bitpay – a payment processing system developed especially for Bitcoin transactions – was unveiled. This facilitated e-commerce merchants’ acceptance of Bitcoin as a form of payment, enabling them to price products in local currency while consumers still pay using the virtual currency. Accordingly, retailers avoid any exchange rate volatility, with the Bitcoin price paid by the consumer adjusting accordingly.

One example of an online merchant transacting in Bitcoins is Bitmit. This is similar to eBay, with sellers auctioning unwanted goods and buyers bidding for them. Pizza, socks, mobile phones and much more can all be paid for using Bitcoin. A growing number of bricks-and-mortar institutions also accept the virtual currency. The University of Nicosia in Cyprus, for example, accepts the digital currency for tuition and other fee payments. A bar in Berlin also permits Bitcoin as a form of exchange, while a Canadian coffee shop introduced the world’s first Bitcoin ATM last October.

Analysis

Despite its growing popularity, the value of Bitcoin has remained turbulent, swinging wildly in response to regulatory developments, technical difficulties and general media coverage. In mid-2011, propelled by media attention, Bitcoin climbed to a value of $32 (figure 1). Thereafter it entered a period of free fall.

The formation in 2012 of the Bitcoin Foundation, a trade group focused on developing Bitcoin standards and improving its function as a medium of online exchange, put a stop to this downward trend, with the value rising throughout 2012.

In 2013 the value of the Bitcoin surged. It is believed that demand for an alternative, decentralized medium of exchange (independent of any government or central bank) was sparked by the Cypriot bank account freeze and the threat of government-imposed deposit taxes. In the two weeks following the freeze, the value of Bitcoin surged 98 percent – closing at $93 on March 31.

The rest of 2013 proved tempestuous, with Bitcoin’s value reacting to regulatory and technological hurdles. Trading was halted at the largest exchange in Japan, known as Mt Gox, as it became overwhelmed by trading volumes. A Ponzi scheme, promising huge returns, was identified and shut down in the United States. Silk Road – an Internet-based organization dealing in illicit goods and benefiting from the anonymity of Bitcoin – was also closed. Nevertheless, by December 2013, Bitcoin had climbed to a record high on the Mt Gox exchange, reaching $1,106. This was primarily driven by a surge in speculative demand from Chinese citizens (figure 2).

Bitcoin’s rally proved short lived, however, a consequence of the Chinese National Bank banning Bitcoin exchanges (institutions that exchange money into the virtual currency and vice versa) from accepting new inflows of cash and financial institutions from facilitating transactions. Following the clampdown, which took place in early December, it appeared that the Bitcoin bubble had burst (figure 1). Remarkably, it has since recovered nearly 70 percent of its value. In the past month, the number of businesses on CoinMap, a website showing physical (as opposed to online) companies and vendors accepting Bitcoin around the world, has tripled to more than 2,300.

The degree to which the Chinese were viewing it as a medium of exchange, as opposed to a form of investment, is arguably questionable. Indeed, rampant speculative demand for the currency was cited as one of the Chinese authorities’ primary concerns.

Elsewhere, such as Germany, virtual currencies have been recognized as a legitimate unit of account. The first ever U.S. congressional hearing on virtual currencies took place on Nov. 18, 2013, in which Bitcoin’s “potential to promote more efficient global commerce” was discussed. This bolstered the value of Bitcoin by 48.7 percent on the day.

Bitcoin’s decentralized nature, meaning that it is not declared or issued by any government or central bank as legal tender, is similar to gold. Unlike gold, however, Bitcoin and other virtual currencies lack intrinsic value. Moreover, Bitcoin can be replicated by other cryptographic currencies. Litecoin, for example, retains Bitcoin’s finite supply characteristic but offers even faster transactions and tries to avoid resource intensive “mining” to release additional supply. Peercoin has no supply limit but builds in price inflation of 1 percent. Other alternatives, Anoncoin and Zerocoin, aim for complete anonymity.

Despite being the first prominent virtual currency, Bitcoin’s longevity is highly uncertain. Indeed, as pointed out by John Authers of the Financial Times, there have been many firsts which have drifted into insignificance: AltaVista, an Internet search provider, was quickly superseded by the likes of Google. MySpace, a social networking site, has been displaced by Facebook.

Ultimately, therefore, Bitcoin’s success is dependent on its use as a medium of exchange, its ability to maintain its value and to act as a unit of account. Indeed, these three criteria define any sound currency. Over the centuries, money has taken many different forms; from shells, to agricultural commodities, precious metals and now (most commonly) fiat money – all of which meet the three criteria to differing degrees. Virtual money is simply the latest incarnation.

Bitcoin is becoming a more widely accepted method of payment, facilitated by Bitpay and other exchanges that enable transactions into and out of the currency. That being said, no one is legally obliged to accept the virtual currency and countries like China and Thailand (which has ruled it illegal) are limiting its geographical reach.

As a store of value it certainly compares favorably to some agricultural products which are prone to rot. Some also argue that despite its volatility, Bitcoin is preferable to fiat currencies because these can be debased by central banks printing money. Put simply, inflation erodes the purchasing power of money over time.

The creation of money to facilitate asset purchase programs in the United States, UK and Japan since the eruption of the global financial crisis (also known as quantitative easing) has enhanced Bitcoins’ relative attractiveness as a store of value. This is also true of other commodities which are finite in supply and independent from central banks, such as gold.

It is its performance as a stable unit of account in which Bitcoin falls down, with speculative demand amplifying the currency’s volatility. While merchants pricing in U.S. dollars are insulated from this, the consumer (who still pays using Bitcoin) suffers the full brunt.

Conclusion

Despite its pitfalls, the virtual currency is here to stay. While it will evolve over time, just as tangible forms of money have done over the centuries, its merits as a low-cost, virtual payment system in a world in which Internet sales are rapidly gaining market share are encouraging to its survival. Like any new innovation, it will not be without its blips and the Bitcoin premium may not last forever.

The ascent of the virtual currency is also part of a bigger movement whereby banks and other financial institutions are eliminated from the transaction process. This transition, known as financial disintermediation, has grown in favor since the eruption of the global financial crisis. Perhaps the most prominent example is the proliferation of peer-to-peer lending websites. On this merit alone, digital currencies have gained stalwart supporters.

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