Digital currencies, virtual currencies, in-game currencies, etc., have gathered a lot of attention, despite the difficulties of definition, from all corners of society for many years. Cryptocurrency has gained unprecedented attention since the birth of Bitcoin in 2009. Bitcoin is an online system of making and receiving payments in bitcoins. The system distinguishes itself by providing an open-source, cryptographically secure, confidentiality-preserving platform for transactions and/or making payments. The number of transactions as well as the number of accounts (held by individuals and businesses) is steadily increasing. A whole industry of service-providers has sprung up alongside. We consider the development of Bitcoin and its sister currencies as an important disruptive financial innovation which is here to stay unless throttled by ill-considered legislative or regulatory actions. Potential problems are analyzed and solutions offered. The overall assessment is that cryptocurrencies and variants of virtual currencies are a welcome development, they will offer competition to the existing modalities of money and governmental regulation, they will provide alternative means to economic agents for their transactions, and their innovative existence should be encouraged so that their beneficial features outperform any deleterious ones.
Money is a matter of functions four: a medium, a measure, a standard, a store. Traditionally, “money” is any object that is accepted in payment for goods and services as well as for repayment of debt. Historically speaking, the object has been tangible but as economies developed intangibles (such as written records) became increasingly acceptable. The concept of money has evolved1 such that it is defined in terms of its functions: “Money is what money does” ( [
What does the word “cryptocurrency” designate? Is it “hidden and secret” currency? If citizens, a central bank, agencies of governments and supragovernmental agencies know about it, is it hidden and secret? Is it electronic currency? Then, are electronic funds transfers (EFTs) and wire transfers not electronic currency? Is it digital currency? Then, are credit- and debit-card transactions not digital currency? The phrase “virtual currency”, however, has been defined by numerous agencies3. Among these various phrases, the phrase digital currency appears to be most general and encompassing the rest4, even though the agencies of the US government seem to prefer the phrase “virtual currency” 5. Recognize that a cryptocurrency is one type of digital currency and because it exists in the parallel world of computer network, it is also a virtual currency6.
In this paper we review the antecedents of digital currencies, both ancient and recent, and provide an economic/financial overview (instead of dwelling on technological aspects). The regulatory aspects are touched upon in the section on implications. The majority of discussion is in reference to bitcoin7, the preëminent cryptocurrency (an exciting version of digital and/or virtual currency) which has spawned fawning attention, copycats, regulatory frowning and governmental constraints. An immense literature, scholarly and otherwise, exists on the technical aspects of cryptocurrencies. Excellent sources such as Antonopoulos [
This paper is organized as follows. Section 2 reviews the roots of the “virtual” currency. Section 3 discusses Bitcoin, an ecosystem, which is the focus of the paper. Section 4 discusses the financial and economic aspects of Bitcoin. Section 5 discusses potential and perceived problems and offers an argumentative analysis and solutions. Section 6 concludes the paper.
Many forms of money exist. From the tangible forms of money (e.g., commodity to precious metal to base metal to paper) to traditional intangible forms of money (e.g., traveler’s checks to demand deposits to other checkable deposits) to modern intangible forms of money (savings deposits to other time deposits to deposits in money market funds of banks/thrifts and mutual funds). Aforementioned forms have the imprimatur of the state or the sovereign, thereby making it economy-wide money. For example, in the US, for January 2015, the currency stock (coins and Federal Reserve notes) is only $1266.3 billion; when other items are added, money stock measure M1 becomes $2927.9 billion. For the same period, money stock measure M2 is $11706.5 billion (http://www.federalreserve.gov/releases/h6/current/#t2tg1link). Thus, the coin and currency is 43.25 percent of M1 and only 10.82 percent of M2. Moreover, most of the money is not “real money”; it is in book-entry form (when we had physical account books) or in entries in a digital database (when accounts are kept on a computer). Thus, this digital money is as “virtual” as it gets. We have many other forms of money whose reach may not be economy-wide: 1) company money: commercial paper, stamps, coupons, points and rewards such as frequent flyer miles; 2) craft money: community currencies9 (http://www.communitycurrency.org/home); 3) play money: board games (e.g., Monopoly) and computer or online games (e.g., Gods, Gemstone III, Lineage, systems such as Second Life). Some of the online games allow creation of money or other rewards and a player can exchange the real money for play money10. When the games allow creation of money or spawn a currency to meet the demands of players, this currency is digital. Because an online game world is a virtual world, one can call the associated currency a “virtual currency” 11.
The roots of digital currency for the real economy can be found as far back as 1967 when the Rand Corporation published Harrison’s ([
The movement toward [electronic funds transfer] EFT has met a great deal of resistance from the public, which fears that EFT would increase the risk of costly mistakes or theft, reduce privacy, encourage greater government intervention and control or be vulnerable to disaster or sabotage. Progress toward EFT has been hindered by the lack of low-cost, widely available transaction terminals, the high cost of reliable data communications lines, the lack of secure methods of identifying transacting parties, and the lack of adequate back-up systems.
For many purposes, a cashless, checkless society would be highly desirable. Most crimes of gain depend on the use of cash, and organized crime as we know it would probably become impossible if cash were eliminated. If all financial transactions could be monitored by the government, it might be able to intervene more effectively to control inflation and avoid recession. Tax collection could be made automatic and much less painful, both in impact and in the burden of bookkeeping imposed. Sound economic planning by business, government, and individuals might become possible in a way that it now is not. It could permit a more efficient allocation of resources and more accurate investment strategies.
Microcomputer technology and the advent of the [computer] will make the cashless, checkless society feasible and may answer the legitimate objections to EFT.… Trapdoor12 codes will provide secure communications and positive identification between transacting parties and banks. Low-cost non-volatile memory systems will make possible permanent, non-alterable records of all transactions.
Microelectronic technology makes trapdoor coding economically feasible for use in all kinds of communications and transactions, and trapdoor coding can make all kinds communications and transactions secure against eavesdropping and tampering.
Fast-forward to October 1995 when Alan Blinder, Vice Chairman of the Board of Governors of the Federal Reserve System, testified before the US. House Subcommittee on Domestic and International Monetary Policy [
First, the concept of [digital cash or] electronic money is not new. Electronic transfer of bank balances, for example, has been with us for years. Indeed, some of the new proposals simply make available to consumers and smaller businesses capabilities that large corporations and banks have had for many years.
Second, no one knows how the industry will evolve, either in form or in size. Some of us, for example, can still remember predictions made a generation ago that the United States was on the verge of being a cashless, checkless society. Those predictions, of course, did not come true. At least not yet.
This last point reminds us that, at present, we do not know which, if any, of the many potential electronic innovations will succeed commercially. My testimony this morning will concentrate on stored value cards and other types of so called electronic cash, because they seem to raise the most challenging public policy issues.
In particular, depending on their design, they could amount to a new financial instrument, an electronic version of privately issued currency. But even the concept of private currency is, of course, not entirely new. Travelers [sic] checks are familiar to everyone. And in the 19th century, the United States had considerable experience, not always happy experience, with privately issued bank notes. But widespread use of private electronic currency would certainly raise a number of policy questions.
On behalf of the entire Board, I want to state clearly at the outset that the Federal Reserve has not the slightest desire to inhibit the evolution of this emerging industry by regulation. On the contrary, the Board encourages innovations in payments technologies that benefit consumers and businesses.
Vice Chairman Blinder wondered “whether the Federal Government should issue its own electronic currency” in order to “probably stem seigniorage losses and provide a riskless electronic payment product for consumers. In addition, should the industry turn out to be a natural monopoly, dominated by a single provider, either regulation or government provision might be an appropriate policy response.”
The issues of privacy and risk of distrust of government were not addressed. These issues, however, have continually exercised the public. Szabo [
In next section we explore the salient features of Bitcoin and bitcoins. The convention is that Bitcoin refers to the ecosystem of the virtual currency whereas bitcoin refers to the digital currency itself.
Bitcoin is an online (therefore it is digital) virtual (because it does not have a real tangible existence) currency attributed to Satoshi Nakamoto [
Bitcoins (the currency) are created by payment processing work for transactions. Users provide their computing power to record a transaction and payment thereof into a public ledger. This process is called mining and the users who provide the computing power get 1) a fractional amount in bitcoins which are charged to the initiator of the payment as a transaction fee and 2) some newly created bitcoins. A transaction gets propagated to the network but not entered into the shared ledger until it is verified and recorded. Transactions are aggregated into blocks approximately every ten minutes. A block requires an enormous computation power to prove the legitimacy of transactions, but only a small computation power to verify. Mining is done competitively on the network and it creates trust by ensuring that transactions are confirmed transparently. This mining process creates new bitcoins for each block. The quantity of bitcoins per block is fixed and diminishes with time. The money supply is created via mining by a schedule of time and quantity. The process started with 50 bitcoins per block in January 2009 and the reward halves after every 210,000 blocks. New bitcoins were halved to 25 in November 2012 and are expected to be halved to 12.5 sometime in 2016. The rate of new bitcoin diminishes over 64 halving until block 13,230,000 when it reaches the minimum subunit of one satoshi. The mining rewards are expected to diminish until approximately 2040 when all bitcoins, about 21 million (strictly speaking, 20999999.9769 BTC or 2,099,999,997,690,000 satoshis, because the protocol uses fixed-point math where decimals are restricted to eight and the maximum is hard-coded) have been issued. Thereafter no new BTCs will be issued, but miners will continue to get transaction fees.
The Bitcoin ecosystem consists roughly of the following facets16. 1) A virtual currency with built-in trust- building safeguards via cryptography. 2) Peer-to-peer transactions without any centralized (governmental or regulatory or organized or individual) intermediaries. Transactions are irreversible, fast and negligibly costly. 3) Privacy and anonymity remain the driving force behind the concept and its implementation. 4) A volunteer group of developers provides open-source software for networked nodes (for mining) and for transactions (for wallets or personal accounts). Numerous APIs and interfaces have been developed for various applications. 5) Noncentralized computing network for encrypting (hashing) and for bookkeeping (blockchain). 6) Limited money creation, independent of governmental regulation, thereby limiting manipulation of the value of the currency. 7) National authorities are free to define the boundaries and regulate the use of the virtual currency. 8) A virtual currency with fluctuating exchange rates for major national currencies.
Many of the above are captured in the following table. The information is as of May 18, 2015, unless otherwise stated. This set of information is dynamic and thus gets updated every few seconds.
Description | Quantity | |
---|---|---|
I. | BTC Economy | |
1 | Total BTC | BTC 14,175,450 |
2 | Market capitalization | USD 3,340,019,529 |
EUR 2,952,214,089 | ||
GBP 2,137,117,634 | ||
3 | Transactions (last 24 hours) | 96,684 |
Transactions (average per hour) | 4028.50 | |
4 | BTC sent (last 24 hours) | 813590.43 BTC |
BTC sent (average per hour) | 33899.60 BTC | |
II. | Blocks | |
1 | Count | 357,017 |
2 | Blocks (last 24 hours) | 138 |
Blocks (average per hour) | 5.75 | |
3 | Difficulty level | 48,807,487,245 |
Next difficulty level (in 1831 blocks) | 49,162,985,405 | |
4 | Network hashrate (terahashs per second) | 351,922.36 |
Network hashrate (petaFLOPS) | 4,469,413.94 | |
III. | Nodes | |
Reachable nodes | 5850 | |
IV. | Transactions | |
Transactions (since inception) | 69,181,071 | |
V. | Accounts | |
Accounts (since inception) | 3,422,981 | |
VI. | Blockchain Size | |
Size | 33,765 MB | |
VII. | Businesses | |
Number accepting BTC | >100,000 | |
VIII. | Mining Cost | |
Total miners revenue (last 24 hours) | USD 854579.11 | |
% earned from transaction fees (last 24 hours) | 0.44 | |
% of transaction volume (last 24 hours) | 1.83 | |
Cost per transaction (last 24 hours) | USD 7.77 |
Sources: I and II http://bitcoincharts.com/bitcoin/. Hashrate is the unit of the processing power of the network. III. https://getaddr.bitnodes.io/. IV. https://blockchain.info/charts/n-transactions-total?timespan=all&showDataPoints=false&daysAverageString=1&show_header=true&scale=0&address=. V. https://blockchain.info/charts/my-wallet-n-users. VI. https://blockchain.info/charts/blocks-size. VII. http://www.ibtimes.co.uk/bitcoin-now-accepted-by-100000-merchants-worldwide-1486613. VIII. https://blockchain.info/stats, as of May 20, 2015.
Part III on the Bitcoin network; Part IV on transactions; Part V on Accounts; Part VI on Blockchain size; Part VII on Businesses using BTC; and Part VIII on the mining cost.
The next section discusses the financial and economic aspects of this cryptocurrency.
The introductory section discussed the essential functions and concomitant attributes of money. In this section we discuss how well a cryptocurrency such as Bitcoin performs as money. Recall that Dai, as mentioned above, caught on to the fundamental financial concept that money is any object or any record accepted as payment in exchange of goods and services and as future payment for debt or for future goods and services. Miller, Michalski and Stevens [
As the previous sections delineated, here we demonstrate that a cryptocurrency such as bitcoin fulfils the functions of money splendidly.
Bitcoin as a medium of exchange. Given the data in
Bitcoin as a unit of account. Much debate rages on blogosphere whether BTC fulfils the function as a unit of account (i.e., a measure and a standard). Not many goods and services are quoted in BTC. Not many contracts are denoted in BTC. Whether one would promise to deliver or pay in BTC in the future is open to question.
Nevertheless we must remember that BTC can be exchanged for approximately 40 national fiat currencies (http://bitcoincharts.com/markets/). Exchanges (money-changers) exist in many countries and many currencies. Thus, one can buy BTC to start an account (wallet in Bitcoin parlance). We expect the possibilities of exchange to increase steadily.
As the innovation diffuses into various populaces, the adoption will improve the functionality as a numeraire. The importance of BTC is not diminished just because it is not a numeraire yet. There is no BTC-as-a-fiat-cur- rency economy and therefore it has not found the use as a numeraire. It can, however, still function as an exchangeable currency and owners will learn to manage the exchange risk.
The criticism that BTC is not a numeraire because of its volatility against USD and Euro is to miss the point of being a numeraire. Volatility and unit-of-account are two different and separable issues. A commodity with one of the largest global markets is crude petroleum and it is common knowledge that crude is quoted in US dollars. The market still functions quite well for non-USD currencies18. All the great trading centers of the world ―ancient, medieval or modern―are accustomed to trading in multiple currencies while the prices of merchandise are quoted in a currency of convenience. Koning [
Bitcoin as a store of value. Scarcity makes money and scarcity lets the money hold its value for a longer period. The supply of bitcoin is limited, both theoretically (about 21 million BTC) and actually (about two-thirds has been mined/minted/issued by May 2015). Despite the exchange rate fluctuations, BTC indeed functions as a store of value. We recognize that the functions of medium of exchange and store of value are complementary. As the adoption grows the currency will grow in value (intrinsically and perhaps in exchange) and be more stable.
Often the volatility of BTC’s exchange rate is said to militate against its function as a store of value. Once again such an argument misses the point about a function of money. Commodity-backed money holds a stable value until the value of the commodity changes. In our opinion, fiat-money has never held a stable value because the governing authority manipulates the money supply to suit its own political and economic objectives. Inflation is recognized as the worst enemy of stable value! Volatility, its causes and consequences are discussed later in the context of motives for holding cash.
Bitcoin and motives to hold a (cash) balance. We have learned that conventionally individual economic agents have three motives to hold a currency, viz., 1) transactions, 2) precautionary, and 3) speculative. BTC is a new currency in a new format. The impetuses for its creation and use are different than those for a national fiat currency. The goals of privacy and trust over a public network for transactions drive the large global community of adopters and innovators to continue to use, develop and refine this virtual currency. To quote Andreessen [
Although not widely spread, BTC is indeed used for transactions as is shown in
The volatility of BTC exchange rate has been commented upon earlier. The holdings of unspent BTC is considered quite high (Ron and Shamir [
In sum, it would not be an exaggeration to assert that BTC fulfils the essential functions of money adequately, if not fully, for the ecosystem designed. Whether BTC can fulfil the essential functions admirably for a general economy remains to be seen. It will need to overcome many pitfalls and perceived problems before it could do so. The next section provides an exposition of problems and likely solutions.
This section discusses the real and perceived problems of cryptocurrencies, exemplified by Bitcoin. The section provides an exposition of issues and argumentative analysis while suggesting solutions and recommendations. The essential functions of the cryptocurrency as money were discussed in the previous section; the attributes of the cryptocurrency as money were mentioned an earlier section. This section, therefore, discusses problems and solutions in the context of functions of money, of attributes of money, of technology and of socio-politico environment.
Bitcoin is a very good (alternative) payment system with low cost of transaction, inclusive of electricity and computing costs of mining and blockchain. It would compete quite well with payment system such as PayPal, debit cards and the Kenyan system M-PESA (http://en.wikipedia.org/wiki/M-Pesa). Note, however, that these systems are in the fiat currency arena whereas Bitcoin is a virtual currency.
We recognize that whoever “owns” the wallet (account) via a private key owns the bitcoins. Thus, BTC becomes a “bearer” instrument, just as cash is in a fiat money world. This instrument needs to be enhanced as a store of value for credit purposes.
Bitcoin transactions are irreversible. This may make correcting a mistake difficult. We feel confident to aver that this is a minor inconvenience. For all practical purposes, cash transactions are difficult to reverse because once cash changes hands, the transaction is for all practical purposes finished.
Bitcoin will need to be enriched by adding the functionality of credit. The credit-granting, denominated in BTC, can be done by BTC exchanges or wallet-service providers. The credit transactions of granting loans and repayments thereof can be easily accommodated, regardless of the intrinsic worth of BTC.
The ecosystem already provides for group ownership of an account (i.e., a wallet or an address), thereby increasing the currency’s viability. Thus, it is possible to pool the currency for larger transactions.
Bitcoin is considered to be a deflationary currency. And, this has to do with the value of a unit of the currency. The minting of money is part of the reference software code. The money supply is limited and thus debasement is prevented. With unspent bitcoins and loss of bitcoins, explained below, the money supply is extremely limited. Whether Bitcoin is truly deflationary and whether it is a good or bad model for macro-finance are subjects of contention. It remains unclear whether the open-source code developers and user community can, or would be willing to, change the money supply by agreeing to a change or accepting a change in the system.
Take for example the use of hundi (often used incorrectly synonymously with hawala20). An easy way to understand the essential nature of a hundi21 is to consider it as a bill of exchange or a promissory note, and of a hawala as a swap contract22. Note also that both bills of exchange as negotiable instruments and financial swaps contracts are unquestionably legal in the US. Much has been written about them since the terrorist attack in the US. Under the prodding of the US the developed countries have pushed for and made illegal the transactions on hundi and hawala. That is indeed unfortunate because these instruments were part of business environment and cultural practices of many countries for many centuries23. That these countries and their citizens are deprived of a traditional and well-functioning way of making payments across time and distance is quite unfortunate because now both individuals and firms must use more expensive methods of remittance.
BTC is a digital currency accessible from anywhere, as long as one has access to 1) a computer, 2) an Internet network and 3) one’s wallet (or account). We accept that the access to computers and the Internet is not universal. Yet among the economic agents who have the access, portability of BTC approximates that of cash.
With the sole exception of loss of bitcoins, discussed below, BTC is as durable as any currency made out of commodity or specie and surely more than paper.
Bitcoin ecosystem is secure against forgery and counterfeiting. The system is not amenable to mischief by miscreants and hostile governments.
A satoshi (10−8) is the smallest subunit of a bitcoin. Thus, the divisibility of BTC is in acceptable range. Note that some 401(k) accounts are reported up to eight decimal places. If this fineness of divisibility is deemed unacceptable, then perhaps the reference software can be changed by the community.
We expect that liquidity of BTC will improve, but it will never equal that of fiat currencies whose supply and value (via inflation-targeting) are managed at the national and international levels.
This relates to point 5.1.4 and the concept of the store of value. Availability and general use of credit have become indispensable to the orderly and smooth functioning of economies. If credit markets based on bitcoin are developed and they function well, then Bitcoin will be entrenched further.
Because the cryptocurrency is not widely used as a numeraire, it faces exchange-rate risk. This risk can be mitigated in derivatives market if such a market is developed. Considerable progress has been made for both derivative contracts24 and derivatives exchanges25. Nevertheless note that exchange-rate risk exists anytime a currency needs to be exchanged. If an individual wishes to avoid this risk, he needs to forgo exchanging BTC for another currency. And, if he wishes to mitigate this risk, he needs to undertake hedging transactions.
This is an economy-wide necessity. What role BTC will play in this and what influence the economy will have on Bitcoin is unclear. Because Bitcoin is not limited to a single economy, the implications are quite exciting.
BTC exchange operators will need to be monitored for honesty and transparency. In the absence of strict monitoring, they have incentive for charging higher fees and spreads. But, in this case, they would not be any different from stock exchanges or banks engaging in transactions for foreign currencies.
Critics of virtual currencies argue that BTC is not a legal tender and that raises doubts about its viability. Such an argument misses the point of creating an independent ecosystem. In the US, for example, only the coins and currency issued by the Department of the Treasury and notes of Federal Reserve Banks and national banks are legal tender for all debts, public charges, taxes, and dues. The statute is silent about payments between private parties26. In other words, an individual or a private business or an organization is free to develop his own or its own system for accepting payments in exchange of goods or services or repayment of debt.
The US regulators have tried to classify BTC as a financial asset (i.e., a security) and IRS has said so explicitly (see below). It is quite likely that US’s lead will be followed by other countries. Any regulatory regime would impose compliance cost on the currency. We are afraid that regulatory regimes in the developed world are unlikely to be kind to Bitcoin because of fears of illicit transactions and money-laundering.
Many US regulatory agencies have been studying existing laws and regulations to figure out whether their jurisdiction extends to virtual currencies and to what extent. The regulatory regime in the US consists of federal, state-based and some industry’s own self-regulatory organization-based (SRO) authorities, in at least three areas, viz., 1) Prudential (e.g., anti-money laundering27, consumer protection, financial protection) via agency of FinCEN, CFPB, FINRA, 2) Taxation via agency of IRS and state tax authorities, and 3) Market-operations- oriented via agencies of SEC, CFTC, FRB, OCC, etc.
Federal Bureau of Investigation (FBI) [
claimed that “Whether a virtual currency is a security under the federal securities laws, and therefore subject to our regulation, is dependent on the particular facts and circumstance at issue. Regardless of whether an underlying virtual currency is itself a security, interests issued by entities owning virtual currencies or providing returns based on assets such as virtual currencies likely would be securities and therefore subject to our regulation.” SEC is likely to deem an investment in BTC as an “investment contract” and thus be a security under the Supreme Court’s Howey decision28. SEC brought its first bitcoin-related enforcement action in 2013 July when it sued Trendon T. Shavers and his Bitcoin Savings and Trust for allegedly running a Ponzi scheme29. SEC has taken action against a software developer, Imogo Mobile Technologies Corp., and a bitcoin exchange, MPEx. Commodity Futures Trading Commission (CFTC) claims jurisdiction in bitcoin markets because it approved TeraExchange’s bitcoin swap as an example of a virtual currency derivative30. State securities regulators have taken a keen interest in bitcoin investment. The Texas State Securities Board took enforcement action against Balanced Energy LLC31. The State of New York has proposed [
While Bitcoin as a system is encrypted and therefore extremely safe so that trust can be engendered, the client side (i.e., wallet or account or address side) remains quite vulnerable. Major thefts of bitcoins from exchanges have been reported. A user can lose the private encryption key or forget it or lose the storage device where the user’s wallet is kept or lose the key due to theft32. Under all these circumstances, the owner’s access to his digital asset is compromised. In our view, this is little different than the loss of cash.
An unanswered question, practical and legal, is the passing of the BTC “property” through an individual’s will or probate proceeding.
We are unable to give much credence to the argument that cryptocurrencies could make the work of monetary authorities more difficult. Until the currencies have large volumes and large values, monetary authorities can rest easy. Finance has taught us that under the conditions of perfect markets, investors are able to do as well as undo the actions of managers of firms. We know from the financial press that on average investors are able to work around the policies of their government. The addition of a virtual currency is unlikely to change the dynamics. As governments and monetary authorities impose imperfections in the market place, the cost of transactions will rise, but the transactions will continue one way or the other.
We are unable to give much credence to the argument that cryptocurrencies would deprive the government of revenue. Until the currencies have large volumes and large values and start substituting the fiat currency in a significant quantity, the loss will be negligible and therefore the fear is unfounded.
Transactions take approximately ten minutes or so to be verified and included in a block for inclusion in blockchain. This delay should not be considered a hindrance, however. While transactions through credit/debit cards and cash are almost instantaneous, transactions through checks are often delayed. Even wire transfers at a greater cost take longer.
If Bitcoin gains widespread adoption and regulatory approval as a currency and payment mechanism, it is possible that the system cannot grow commensurately with the demand. The network of nodes will need to become larger and cryptographic hashing will become more computation-intensive. The blockchain is already multi-gigabyte. Multiple linked-blockchain will need to be invented to confirm transactions. On the other hand, there is the fear of concentrating computing power in a few hands. This is called “51 percent attack” in which an entity (an individual or a group of individuals) can control more than half of computational power, then that entity can wrest control of the system [
We saw in Section 3 how Bitcoin ecosystem has evolved to where it is now. The foundational principles, the money supply, protocols for proof-of-work, hashing, cryptographic levels, etc., are fixed by Satoshi and subsequent developers. These features are firmly established in the structure of the system. While this architecture represents the “constitution” of the ecosystem, it might actually become a constraint in the future. As global economies evolve, participants learn and demand more functionality, regulation of one sort or another intrudes, the current architecture may not prove to be flexible enough to adapt to changing circumstances. The volunteer developers will necessarily have to plan for and implement flexibility in the system and its software.
The software is open-source, presenting an ease of improvement and innovation on one hand and ease for copy-cats on the other. Numerous alternative virtual currencies have appeared. Some of them are offshoots of Bitcoin and others are variations33. Among the more important ones are: Litecoin, Peercoin, Primecoin, Namecoin, Ripple, Sexcoin, Quark, Freicoin (with a “demurrage” fee of five percent34), Mastercoin, Nxt, Auroracoin, Dogecoin). A discussion of these competing cryptocurrencies and their similarities with Bitcoin is beyond the scope of this paper.
An attack on cryptography of the currency could kill not only Bitcoin but all cryptocurrencies. This attack could originate in one of two ways, viz., 1) The government could actually break the cryptologic protection of a cryptocurrency. Schneier [
Because privacy and anonymity are easy, it is often claimed that a virtual currency will become useful for illicit purposes. As mentioned earlier, what is legitimate and what is not depends on one’s philosophic viewpoint. We already saw how a perfectly innocent practice of alternative payment system of Hundi and Hawala has been declared criminal under the leadership of the US. Despite the current regulatory and policing structures, major thefts have occurred (the bitcoin-exchanges of Mt. Gox35, BTER36, Bitstamp37), illicit transactions have occurred (the bitcoin-marketplace of Silk Road38), fraudulent practices by specialized computer hardware manufacturer (the manufacturer Butterfly Labs39) have occurred and a variety of sundry crimes, small and large40 have occurred. These crimes, however, should not be attributed to Bitcoin ecosystem or BTC or any other cryptocurrency. The conclusion simply is that criminals are resourceful and they will find a way to commit crimes; a government can increase the cost of committing a crime, but the government cannot prevent all the crimes. It is not clear at all that these crimes would not have occurred if there were no cryptocurrencies.
A decentralized system such as Bitcoin makes arbitration and adjudication of disputes between transacting parties difficult, if not nearly impossible. Where should one go and to whom should one complain? The Bitcoin ecosystem will need to resolve this juridical problem rather quickly if Bitcoin wants to play a major role in the financial life of people. This in turn raises a problem discussed next.
Since Nakamoto released the concept, the implementation and reference software code of Bitcoin and then ceded the control to a volunteer group of developers of open source code, the development of the ecosystem has proceeded in the mode of decentralized public participation. Only time will tell what kind of governance structure is necessary for long-term survivability.
Whether participants trust Bitcoin and its governance structure should be ideally speaking independent of government-imposed regulatory structure. The transparency and openness of the system have been hallmarks of Bitcoin. If they are not injured, the trust in the system will not be shaken.
Money, hundi, hawala, credit over time and space, fiat money, central banking, fractional-reserve banking system all have been truly disruptive financial innovations. In that tradition, we must add virtual currencies of which a cryptocurrency such as Bitcoin is a prime example. Bitcoin is a complete private transaction- and payment-oriented ecosystem with built-in trust-building and account-keeping features. Interestingly enough, these features intrinsically preserve confidentiality of parties. It may not be considered a perfect system. Which system has been perfect ab initio? And, which system has remained perfect after some use? Until the participants of the system gain experience in using a system, it is quite impossible to effect changes in the system. The attention gathered by Bitcoin is proof that participants consider it to be a system with which they can work. In general, most of the regulatory structures are not anticipatory in nature; therefore it is no surprise that legislatures and regulatory authorities of the US and other developed countries are trying to figure out the costs, consequences and interrelationships of the new cryptocurrencies. Supranational monetary authorities are facing similar quandaries.
Bitcoin ecosystem, and other cryptocurrencies, will prove to be a disruptive innovation in the financial world. We expect Bitcoin to maintain its advantages as the first mover. Competing cryptocurrencies might offer an advantage in one feature or other, but a radically distinct cryptocurrency is not on the horizon. There is only one foe Bitcoin must tame: The government. The government’s ill-considered regulation could kill not only Bitcoin but also the whole idea of cryptocurrencies41. The real issue is one of centralized authority exerting control versus a decentralized operation of a system. We hope that the modern governments and monetary authorities will show wisdom by not killing a competing decentralized system in its infancy. Secondly, the government’s insistence on surveillance and its uncontestable, unchallenged cryptographic prowess will vitiate the trust of people in a system they have built on their own to steer clear of the government’s heavy hand of control.
The implications for financial services marketplace are many and some of them beyond imagination. First, a major effect will be felt on the payment systems of the world in terms of ease, confidentiality, cost and time. Second, a major effect will be the development of concepts and tools for using Bitcoin for purposes not envisaged by Nakamoto or the volunteer team. Third, more and more individuals and organizations will become comfortable dealing with a decentralized system in which they participate but nobody controls directly. That the system has been able to overcome the problems of trust is a signal achievement. As more experience is gathered and solutions to the inherent problems such as scalability, lost coins (for whatever reason), money supply, and interfaces with regulatory regimes are found, the system will be enhanced. In this enhancement, we expect more disruption, especially in the regulation of financial activities.
The overall assessment is that cryptocurrencies are a welcome development in the financial field. They are here to stay. It may never become a universal currency, although it might become close to it. The disruption they cause to monetary system, banking system, financial system, regulatory system, political and government system, etc., is expected to be more beneficial than deleterious to the functioning of the economy.
GautamVora, (2015) Cryptocurrencies: Are Disruptive Financial Innovations Here?. Modern Economy,06,816-832. doi: 10.4236/me.2015.67077