Innovation or Hype? The Bitcoin Assessed

Is Bitcoin the innovative future of currency as we know it, or a hyped-up flash in the pan? Can stores of value underpinning global capital markets such as the US dollar (USD) and gold give way to Bitcoin on a wider scale? Will it become the pre-eminent medium of exchange among future societies? Financial pundits are divided over the revolutionary idea that is swiftly becoming much more than just an online craze. Regulators are beginning to move from outright dismissal to considered integration into wider payments and savings applications as a result of increased transaction and payments processing speeds, improved fungibility and lower transaction costs.

Bitcoin, or BTC, is fast becoming the most talked about subject in financial markets. Can a virtual, non-exchange backed currency depose long-held views on what constitutes wealth and the inherent process of exchanging goods and services using ‘money’? The core themes surrounding Bitcoin question the very concept of what ‘money’ is, while the value of the Bitcoin market now exceeds an estimated US$7.5bn.

The virtual currency was anonymously created by an individual using the pseudonym ‘Satoshi Nakamoto’, who disappeared in 2011 and has not been associated with Bitcoin since. Nakamoto is thought to have described Bitcoin as an electronic payment system essentially allowing one user to transfer ‘value’ to another user in a fast, secure method. Most importantly, the absence of a bank or intermediary underpinning the framework of Bitcoin leaves users to authenticate and keep track of transactions themselves.

Following the first recorded transaction using Bitcoin – a pizza delivery order on 21 May 2010 for 10,000 BTC (valued at £25) which, at current BTC rates, would be valued closer to a million US dollars – the concept developed a point of valuation and has continued to grow quickly. A residential developer in Shanghai, China is now accepting Bitcoins as settlement and a young couple successfully experimented by travelling for over 100 days using Bitcoins only for their purchases. The first Bitcoin automated teller machines (ATMs) are being unveiled across a number of countries and customers at the Old Fitzroy Hotel in Sydney, Australia can even purchase a beer for 0.05 BTC.

New Bitcoins are issued via ‘Bitcoin Mining’ – a process involving users working together to decipher complex mathematical equations, after which they are rewarded with 25 Bitcoins per unique problem. Every four years the amount a Bitcoin miner is rewarded with is halved, and total Bitcoins in circulation will eventually reach a limit of 21 million. Each Bitcoin can be broken down into denominations of eight decimal places however. Unlike sovereign currencies, which are reserve backed and highly regulated by a number of independent bodies to ensure transactional accuracy and stability, Bitcoin markets are managed solely by peer-to-peer (P2P) networks. Bitcoin miners provide the foundation of confidence in the system and core dispute resolution procedures.

Obstacles and Volatility

The relative anonymity of Bitcoin has resulted in criminal uses of the currency, including drug dealing through the now banned ‘Silk Road’ website, purchasing contraband goods, laundering of money derived from crime and funding of terrorist organisations and activities to name but a few. Critics have argued that without centralised oversight of any capacity, security concerns and the high level of sophistication required by P2P operators will limit its inclusion into mainstream transaction banking and payments markets that cannot conform to the new ‘crypto currency’ concept without fundamental changes.

Russia has gone as far as to label Bitcoin as illegal, declaring ‘money substitutes cannot be used by individuals or legal entities’. Governments from many other countries are following suit by closing Bitcoin exchanges and limiting the wider use of Bitcoin ‘wallets’. This reaction from authorities continues to place pressure on the main attraction of Bitcoin – its anonymity. Singapore has adopted a contrasting approach of regulation, declaring the old adage of ‘caveat emptor’.

Bitcoin has increasingly been utilised as a speculative asset, reflected in the ongoing threat of a ‘Bitcoin bubble’ and potential for the market to collapse. Bitcoin surpassed US$500 for the first time on 18 November 2013, rocketing in value by 16% in a single day. Following months of wild swings in value and price volatility that would make even the most grizzled Wall Street trader blush, it is no surprise for Bitcoin market participants to witness price swings of over 20% in a matter of hours. Record highs above US$1,200 were achieved after a surge in value from US$250 in less than a month. Having traded as low as US$96 in July 2013 and valued at less than US$1 in 2009, Bitcoin is currently valued at between US$600 and US$650.

Wild swings in Bitcoin prices are one of the few traditional aspects of the revolutionary method of conducting transactions. The Bitcoin price relies upon supply and demand factors between the speed of ‘Bitcoin’ market and the rate at which market participants are exchanging Bitcoins. In the absence of any regulatory intervention from central banks and other institutions, there is no method of manipulating or controlling the market. Market participants are divided over the prospect of speculative price action eventually smoothing out as more users engage with the crypto currency.

Uncertainty and instability among Bitcoin markets, coupled with a well-publicised association with criminal transactions in the now banned ‘Silk Road’ network has limited the wider application of the virtual currency – until now.

A Way Forward

One suggestion for the legitimate use of Bitcoin, or ‘crypto currencies’ in general that do not require personal details as credit card providers necessitate, is for its use in foreign exchange (FX) services. Characteristics such as low cost and high speed are distinct advantages for FX conversions and transfers, but the need to ‘know your customer’ (KYC) would require a number of changes to the underlying protocol. Without a reduction in volatile price action and lack of security however, Bitcoin would have difficulty in becoming a viable risk management or business FX alternative. It must be stated that the potential is clear.

Fewer than 1,000 Australian merchants currently accept Bitcoins as a form of payment; however this number is growing fast. Such a small percentage indicates Bitcoin has not moved beyond a method of P2P payment. This number is expected to rise rapidly however, given the increased focus placed by Bitcoin operators on merchant payment sectors. Bitcoin now has a market capitalisation approaching US$5bn, with large scale interest from numerous investors, most notably a commitment of over US$1.5m by internet entrepreneurs Cameron and Tyler Winklevoss, early investors in Facebook.

The Winklevoss twins have even created the ‘Winkdex’ – an index that provides a constantly updated Bitcoin price. The exchange traded fund (ETF) allows traders to speculate on the underlying price of Bitcoin markets, potentially adding further volatility to an already alarmingly fast-moving market.

Online marketplaces such as eBay are also open to the potential benefits of Bitcoin, recently releasing a ‘virtual currency’ category among classified ads to provide an avenue for customers to settle transactions themselves. The site cannot itself process Bitcoin transactions due to legal restrictions, yet it signals a defined consideration by large companies to incorporate the system in some capacity.

The transactional and payments processing application of Bitcoin may not appear to be necessarily ground breaking; however the challenge it poses to traditional centres and modes of currency and goods exchange, and the revenues banks derive from acting as an intermediary, is clear to see.

Bitcoins essentially shift data from one location to another, but when they are converted to underlying currency such as pounds sterling (GBP) or USD, they re-enter the banking system. The conversion is carried out at ‘Bitcoin Exchanges’ that remain highly unregulated and open to criminal activity such as hacking and identity fraud.

It is these exchanges that provide a clear entry point for regulators and banks seeking a method of incorporating themselves into the burgeoning Bitcoin community. However, most cases of bank involvement with the virtual currency so far have involved the shutting down of deposit accounts linked to the virtual currency. Many businesses are even seeking to associate themselves with the ‘trendy’ nature of Bitcoin, reporting distinguishable PR exposure that would not otherwise be readily available.

Corporate treasuries have predominantly dismissed the closer interaction of Bitcoin, especially following the sudden closure of one of the largest virtual currency exchanges, Tokyo-based Mt.Gox, earlier this month. Customers were prevented from executing withdrawals, causing significant concern among the Bitcoin community. Apple recently removed the main Bitcoin wallet ‘Blockchain’ from the app store, preventing thousands of users from accessing Bitcoin markets. Uncertainty and variability in conducting Bitcoin transactions involving sudden limitations on depositing and withdrawing Bitcoins is a major impediment to the wider use of crypto currencies by corporate treasuries.

As ‘crypto currency’ continues to become more prevalent, evidenced by the creation of other mediums such as Litecoin, Mastercoin and Dogecoin to name a few, banks around the globe will be faced with a challenge – ‘if we can’t beat them…join them’

17 views

Related reading