Bitcoin is the best-known and most established of the new ‘crypto-currencies’, having a current global market-cap value of billions of US dollars. Launched in 2009, Bitcoin is an experimental, decentralized digital-only currency that is not guaranteed or managed by any central bank or authority, but rather by the collective network of users. It enables instant peer-to-peer (P2P) payments to anyone, anywhere who has a bitcoin address – the virtual post-boxes where each bitcoin is stored. Bitcoins are created or ‘mined’ by users’ computers through solving complex algorithms with the reward being the ‘coins’ that are then stored in a virtual wallet of bitcoin addresses. Bitcoin is proposed by its creators as a safe alternative, free from the concerns of today’s economy such as inflation, sovereign debt and monetary policy.
So in theory at least, those who deal in bitcoin can reap a number of benefits, not least a reduction in transaction fees or commissions. Bitcoins are stored and traded online for other market currencies through FX exchanges such as MtGox in Japan. There is no requirement for a bank account, which ultimately reduces many of the costs of doing business.
Bitcoin Already In Use
Many of these benefits, particularly cheap and rapid payments, are already being exploited by both individual speculators and businesses involved in retail or consumer-facing industries. As an example, Overstock.com, the online retailer, took US$126,000 in bitcoin payments on the first day it started accepting them, and to date has received thousands of orders totalling over US$600,000 in revenue. Coinbase, an American bitcoin exchange already has more 21,000 merchants using its service to receive payments from consumers. This highlights the rapid growth in use and acceptance of bitcoin as a payment medium – although, without exception bitcoin is accepted alongside traditional currencies.
However, as can be expected from any new technology or system, bitcoin is not without its share of problems. The biggest question currently hanging over bitcoin is its price volatility, which is largely due to its limited liquidity. Bitcoin’s detractors argue that the built-in scarcity of the currency (the number of new bitcoins issued each year is strictly limited) fuels price volatility and rewards hoarding and speculators dumping coins when prices are high. Indeed, currently estimates suggest that speculators account for 50% to 90% of bitcoin owners. Furthermore, unlike other government-backed fiat money, there is no obligation for anyone to use or accept bitcoins. Consequently, its apparent worth rests solely with its users and on the goodwill of the multitude of programmers involved. Bitcoin could still be described as being at the level of social experiment and it is promoted, moderated and used by those who truly believe in it and the benefits it supposedly brings. However, as it becomes more mainstream and widely accepted it could become open to more ‘individually minded’ and less-scrupulous people in the absence of formal regulation. Without a central bank to back it up, bitcoin could rapidly fail should these perceptions change.
While speculators welcome volatility and the opportunities to make a quick profit, businesses generally don’t like such risks. The large fluctuations in the value of bitcoin mean that companies using it could see their receivables and profits on goods or services wiped out when bitcoin depreciates and prices listed in bitcoin have to be monitored and updated frequently. Conventionally, businesses manage their currency risks by hedging using derivative instruments, such as forwards and swaps, but these are not widely available for bitcoin – virtual currency markets are too small and immature. And given this market immaturity and the volatility of bitcoin prices these devices would be prohibitively expensive.
Currently, relatively small events, trades, or business activities can significantly affect the bitcoin price. However, this volatility will decrease as bitcoin markets and technology matures. The most significant price fluctuations to date have been caused by governments, including those of China and Russia, announcing restrictions on the use of bitcoin as a payment method. The Russian prosecutor general’s office announced a strengthening of regulations governing the use of virtual currencies as they could be used for money laundering or financing terrorism due to the anonymous nature of the payments – this is one of the main concerns for bitcoin detractors.
Russia maintained that the official rouble was the only currency in Russia and it is illegal to introduce others: “Systems for anonymous payments and cyber-currencies that have gained considerable circulation – including the most well-known, Bitcoin – are money substitutes and cannot be used by individuals or legal entities.” Similarly, China has declared bitcoin a ‘virtual good’ and thus it has no legal status and cannot be handled by banks.
Future Prospect as a Payment Method
All non-cash payments, such as online shopping, could potentially be duplicated to let people spend the same money twice – known as ‘double-spending’. This weakness in the system is typically prevented by operators in the payment system, such as Visa, from being exploited but this service adds costs on top of the transaction. The design of the bitcoin system inherently tackles this issue. By using a publicly held ledger of anonymized ownership data, the network of users’ computers validates all transactions across the network and cross-checks with each other that they are correct and recorded, eliminating the need for a third party and the additional costs. Further, users don’t leave a record of their details that would enable fraud, such as bank details and PIN numbers. Retailers and other recipients of your payments never receive any information other than the bitcoin address from which you sent the payment, which on its own is useless.
This secure and ‘fee-free’ characteristic of bitcoin means that it is a very attractive payment method and way of moving money around – and crucially banks are dis-intermediated from the process. Bitcoin, however, is not going to replace traditional transaction banking any time soon. It has an over-reliance on a single exchange, MtGox, which can slow down payments and the exchange has more than once stopped withdrawals. All the same, bitcoin is increasingly on the radar of financial institutions as a potential future disruption to their dominance of payments infrastructure.
Use for Corporates?
One of the main barriers to the use of virtual currencies, and biggest risk, from the perspective of the corporate is the lack of liquidity. This dearth of ‘coins’ – as of August 2013 there were approximately 12.3 million bitcoins in existence worth nearly $7 billion at current rates – ultimately means that bitcoin cannot be thought of or used as a reasonable substitute for existing market currencies. This low volume means it is difficult for companies to leverage it for anything but small transactions.
For corporations, the disconnect with banks in how bitcoins are exchanged and traded limits the options available when they are looking to transact. With a variety of online portals and exchanges to choose from, little standardisation and often a disparity in the prices quoted, the time and resources required increases in order to execute transfers and maintain suitable diligence and regulatory compliance.
Further to the diversity of the exchanges available, their immaturity can cause serious issues to all users. MtGox handles 70% of all bitcoin trading but had to suspend US dollar (USD) cash withdrawals for two weeks as it was unable to process and satisfy the volume of USD-denominated orders. Further issues arose recently as withdrawals were again suspended after a
flaw in the programming
was discovered that could allow transactions to be fraudulently altered after having been completed. The announcement of this situation caused the price of bitcoins traded on MtGox to fall by 27%. Incidents such as these pose a significant threat to the liquidity planning of any corporation using bitcoin.
While bitcoin represents a significant and exciting technical development, when evaluated against the needs and responsibilities of large corporate treasury departments it is not a realistic currency option for any use. Although, on a small scale, it has potential value in protecting against sovereign risk and other factors described above, bitcoin itself carries unacceptable levels of additional risk for a corporate user. Until there is more integration and maturation of the exchanges combined with an increase in the liquidity of bitcoins and the number of established counterparties, bitcoin will stay on the sidelines and will only be adopted by the most risk-hungry and adventurous of corporates.
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