What Is Bitcoin?
In 2009, Satoshi Nakamoto, whose identity remains unknown, wrote a paper called “Bitcoin: A Peer-to-Peer Electronic Cash System,” which proposed a new virtual currency. The idea was to have a currency that could be used by anyone with a computer and an Internet connection. Furthermore, Satoshi Nakamoto designed the system in such a way that the users of the currency would themselves be the ones who ran the system.
From those early days when bitcoin was more of a breakthrough in computer science, the digital currency has risen from a few cents a piece to over $1000 per bitcoin in 2013. Recently, bitcoin has become one of the most controversial and hyped topics lying at the intersection of finance and technology.
How Does Bitcoin Work?
Nakamoto designed bitcoin so that there is no central server that processes transactions; rather there exists a decentralized network of computers all over the world that allows the currency to function. Each bitcoin user possesses a wallet, which gives them a bitcoin address, a unique identifier similar to an email address. Whenever the user wishes to transfer them to someone else, the owner sends a message to all of the computers on the network. These computers then collect all of the transactions into a unit of data called a block, while protecting the integrity of the currency from such problems as double-spending and spending more bitcoins than one has.
The block chain is a sequence of blocks that is available to the public and contains every bitcoin transaction that has ever taken place. Any computer on the network that manages to add a block to the block chain is rewarded with a certain number of bitcoins. This process of adding a block to the block chain is called mining. The bitcoin protocol has a built-in mechanism that ensures that one block is added to the block chain approximately once every ten minutes. Thus, new bitcoins are released at a fixed rate. The system is self-sustaining because people are rewarded for adding their computers to the network and verifying transactions. Also, it is important to note that the reward for mining decreases over time, so that only about 21 million bitcoins will ever be in circulation. Online exchanges exist to convert between bitcoin and traditional currencies, charging a small conversion fee just like traditional exchanges.
Bitcoin vs. Traditional Currencies
One major difference between bitcoin and traditional currencies is the fact that bitcoin is decentralized. This means that bitcoin cannot be controlled by any single entity, unless that entity was able to control over half of the bitcoin network, which is very unlikely. The rate at which bitcoins are released is completely determined by an algorithm which has been released to the public. In contrast, the U.S. Dollar is controlled by Federal Reserve, an entity that can print money at any rate. Thus, there is no bitcoin-related monetary authority whose announcements might disrupt the bitcoin markets. On the other hand this also means that there is no possibility for a central authority to step in and take whatever extraordinary measures it may deem necessary to regulate the price or handling of the currency.
Another difference is that bitcoin users are essentially anonymous. This means that even though bitcoin transactions are tied to a particular bitcoin address, these addresses can be difficult to trace back to individuals if the user takes the proper precautions to ensure his or her privacy, such as using a different bitcoin address for each transaction. In this sense bitcoin is similar to physical cash, but preserve an even greater degree of privacy because the two parties involved in a transaction do not have to meet physically and reveal their identities to each other. However this has also created issues since the anonymity and untraceable nature of the digital currency makes it a prime candidate for illegal activities such as drug deals and money laundering.
Bitcoin transactions are also irreversible. Credit card transactions, on the other hand, can be disputed by customers and subsequently reversed by credit card companies. Thus, merchants must take into account the fact that some percentage of their credit card transactions will be disputed and reversed. In fact, some smaller merchants only accept cash payments precisely for these reasons. However, this is often an inconvenience for customers. Bitcoin could offer a happy medium between cash and credit cards.
Finally, bitcoin holdings cannot be frozen by a government. Since bitcoin is decentralized, there is no way for a government to dictate how the funds held in a particular bitcoin wallet will be dealt with by the bitcoin network. With funds held in traditional bank accounts, the government could force the bank to cease withdrawals from the account. Another challenge that bitcoin presents to governments is that the owner of the bitcoins might not be known. This is usually not a significant problem in the case of bank accounts.
Bitcoin for Speculation and Payments
Currently, bitcoin has two primary types of users: investors and those who actually use it for its unique attributes as a currency. The investors are generally speculators who are hoping to make money on the assumption that the price of bitcoins will increase. However, as an investment, bitcoins can be very risky because its price is extremely volatile. For example, over the course of 2013, bitcoins’ value ranged from $13 to $1,200. Moreover, due to bitcoin’s rapid increase in price, some believe that it may be a bubble whose future depends solely on its widespread adoption as a legitimate currency. With no government backing or support, the risk of complete devaluation is non-trivial, prompting some economic experts such as former Federal Reserve Chairman Alan Greenspan to caution, “It has no have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is.”
Then there are those who believe that bitcoin will serve as the primary digital currency of the future, essentially acting as the U.S dollar for an economy that is more and more based on bits and bytes rather than physical nickels and dimes. A growing set of online and physical vendors who view it as an alternative to traditional payment systems have already taken advantage of bitcoins’ unique attributes. For example, two vendors who have recently begun accepting bitcoin payments are Overstock.com and the Sacramento Kings. As mentioned previously, since bitcoin transactions are irreversible, sellers do not have to worry about canceled transactions. Moreover, the conversion costs associated with using bitcoins are much lower than the transaction fees that credit card companies charge businesses. By using bitcoin instead, vendors can retain a larger percentage of their revenue. For similar reasons, bitcoins could become very useful in the remittance market, allowing migrant workers to send money back home without paying large transaction fees that eat away at their hard-earned wages. Finally, bitcoin, as a digital currency, holds the unique potential of being programmable. This could be useful, for example, in limiting the ways a group of bitcoins can be spent, potentially eliminating corruption in 3rd world countries where often foreign aid is diverted into the pockets of corrupt political leaders.
Supporters and Detractors
The reaction to bitcoin from the financial industry has been mixed. According to Offit Capital Advisors LLC, a wealth-management firm, “Saying that a currency is a store of value implies that it is a relatively stable value…Without that stability, the costs of normal commerce far outstrip any credit-card or bank transaction fees. Bitcoin fails miserably on this important measure.” On the other hand, Barry Silbert, the leader of a brokerage called SecondMarket Inc., said, “There is very little debate, I think now in Wall Street, and certainly as it relates to Silicon Valley and venture capital, that Bitcoin technology and the protocol have the potential to radically disrupt and transform the financial-services space.” Some are skeptical of bitcoin’s future, while others are hopeful due to its potential.
The reaction from world governments has also been mixed. Both the Bank of Finland and the People’s Bank of China have expressed skepticism that bitcoin meets the definition of a currency. China has gone even further and actually has prohibited financial companies from making transactions in bitcoin. In the U.S., regulators seem to be taking a more measured approach in considering bitcoin’s potential. For example, Ben Bernanke has stated that the Federal Reserve has no plans for regulating any virtual currencies.
There seems to be three plausible outcomes for the future of bitcoin. One possibility is that bitcoin will simply fall into disuse or will become extremely niche. Another possibility is that bitcoin will become so widespread that it will be a viable alternative to traditional currencies. In this scenario, people would store a substantial portion of their wealth as bitcoins and use them to for purchases and investments, and governments and corporations would universally accept bitcoins. In order for this to happen, the value of bitcoin would have to become relatively stable because otherwise it would not be able to function effectively as a currency.
The third scenario is one in which bitcoin will become widely used as a payment system, but not as an alternative currency. Consumers would only store a small amount of their wealth as bitcoins in any given moment. They would use these to buy goods and services, and convert traditional money to bitcoins as needed. Producers would receive bitcoins and immediately convert them to local currencies. In this way, the risk of fluctuating bitcoin prices is mitigated. Also, as mentioned previously, bitcoin is advantageous for a payment system, due to its low cost and irreversibility. Bitcoin is already seeing a small amount of use in this capacity.
The Implications of Bitcoin
Bitcoin has the potential to fundamentally change our conception of currencies. For example, currencies are usually regulated and managed by governments. The government performs important functions such as printing new money and protecting the integrity of the currency from counterfeits. With bitcoin, these analogous functions are performed by the computer network and protocol. However, there is a key similarity between many modern day currencies such as the U.S. dollar and bitcoins: both lack physical backing and thus their value is derived from faith in a system and general acceptance of worth between users. The dollar requires faith in the stability of the U.S. Government, while bitcoin requires faith in the bitcoin network.
Given all of the excitement, skepticism, and fear surrounding bitcoin, the future of bitcoin is uncertain. Opinions on its prospects are sharply divided. The enthusiastic hopes of the early adopters are matched by the pessimistic forecasts of the skeptics. Only time will tell whether investing in bitcoin today will be more like investing in Apple in 1980 or investing in Dutch tulips in 1637.