A romp through the Bitcoin phenomenon

1 April 2014

The ultra-secretive founder of an alternative currency is supposedly discovered in California prompting a media-frenzy, a major exchange suddenly closes with £210 million worth of the currency lost (before suddenly finding £72 million of it), and the first UK ATM dispensing this new currency opens in a coffee shop in London’s Shoreditch.

We are of course talking about Bitcoin and this is an average month for the new payments method that generates more column inches than it does transactions at the moment. Despite the low volume of usage the global interest in Bitcoin is not surprising because its impact on the financial industry is predicted to be widely felt – although at this stage it is not known how exactly.

Many industry commentators including Dave Birch, director at Consult Hyperion, regard the technology as a “genuine breakthrough” that utilises the power of the internet to create a novel solution to an old problem of storing value in a secure but open ledger environment.

So what exactly has been created?

The story of Bitcoin begins with its founder the shadowy Satoshi Nakamoto who introduced what is a peer-to-peer payment system in 2009 with the aim that it would deliver a border-less digital money not overseen by any government or central database tracking the transactions.

It consists of two key components – the first is the public ledger (block chain), which is shared across the internet and holds all the transactions. This visibility enables the validating of all Bitcoin transactions thereby eliminating counterfeiting and double-spending.

Every transaction can be seen by everyone running the open source Bitcoin software and some of these individuals are essential to the second component of the technology – verifying each transaction through the ‘mining’ of bitcoins. And for their efforts in maintaining the block/ledger they are rewarded with bitcoins.

Cleverly this system ensures that the transactions are verified and that the supply of the currency continues to expand in a controlled way. The army of miners around the world have to date received 25 bitcoins per block processed but in 2017 this will be halved to 12.5 and again four years later. Through this formula there will ultimately be 21 million bitcoins mined and the last is not expected to be in circulation before 2140.

Although there is no disputing the elegance of the Bitcoin technological infrastructure there is no shortage of critics to it developing into an alternative global payments method. Jean-Pierre Landau, professor of economics at SciencesPo, says it has two key limitations.

Firstly, she points to the limited supply of bitcoins hitting the market, which will over the next century and a half increase by an average of only 0.6% per year: “If the Bitcoin economy grows faster than this then the currency will grow scarce.”

The second is that since the supply will expand slower than that of physical currencies then its exchange rate will rise significantly leading to people holding on to their bitcoins in the expectation that they will increase in value. This lack of spending reduces liquidity and its validity as a currency.

Although the value of bitcoins has fluctuated wildly they have still retained much of the 5,580% increase that they enjoyed in 2013. This has led to much speculating and it gaining a get-rich-quick tag that has knocked its credibility.

Despite the deficiencies Birch believes there is scope for its usage and that the real driver of its widespread adoption as a method of payment is very much in the hands of merchants: “If they felt it was cheaper than other forms of payment then they’d do it. If bitcoins were vastly cheaper then they’d take them.”

Jessica Einhorn, senior adviser at Washington-based Rock Creek Group, reckons its greatest potential is as an efficient way to transact over the internet – that could result in reduced costs for retailers and consumers.

“People will buy more bitcoins to bypass the fees charged by traditional payment processors such as PayPal and the credit card companies. This is Bitcoin’s clearest advantage,” she suggests.

This has undoubtedly been the attraction to the likes of Overstock.com – one of the most high profile merchants to accept bitcoins – that expects to transact up to $15 million worth of bitcoin sales this year. It sits alongside a wildly varied array of organisations at the vanguard of acceptance that include UK media law firm Sheridan’s, hardware re-seller Core4Solutions, and the University of Cumbria.

What links these organisations, according to Birch, is the desire to gain publicity and to this end they have all undoubtedly been successful. The Old Shoreditch Station Coffee shop, which recently installed the first Bitcoin ATM in the UK, has also attracted publicity as well as early Bitcoin adopters visiting it from around the country to load bitcoins into digital wallets on their phones.

What would no doubt attract wider acceptance is greater security. But this is one of the dichotomies of Bitcoin. Payment cards have lots of other things bundled in with them such as insurance, regulations, and consumer protection that have made them attractive. If you added these to Bitcoin then it would not only push it closer to the existing currencies that it fights against but also add costs – thereby limiting its appeal to merchants and consumers.

To really add security to Bitcoin there is the possibility that it could be hooked up to the Visa and MasterCard infrastructure and be treated as a new transaction type rather than a complete replacement for the incumbent card schemes.

While this will be a step too far for all Bitcoin devotees, if regulations are in fact on the way then Birch believes the guidelines put in place by the Financial Action Task Force for new payment methods could be good for Bitcoin and its low value transactions.

“They say you should go easy on regulating the low value end of the market and instead focus the efforts on high value payments. Should you have to fill out forms for a payment of a millionth of a bitcoin? No.”

Supporting this argument is his view that money laundering predominantly involves cash and therefore Bitcoin should not be of great concern for the authorities. However, hacking and illegal activity have never been too far away from Bitcoin, which fundamentally makes it harder to trace the owner of transactions than traditional card payments.

In October 2013 the US FBI closed down the black market website Silk Road and found bitcoins worth $28.5 million, and in December a McAfee survey found that a ten-fold surge in the last quarter in the number of cyber attacks – particularly ransom-ware where data cannot be accessed until a payment is received - had been driven by rise of Bitcoin usage.

The biggest blow came in February when one of the largest Bitcoin exchanges (where bitcoins can be bought and sold for cash) Tokyo-based MtGox suspended withdrawals following reports that as much as £210 million worth of bitcoins had been stolen over several years because of flaws in its payment software. Although £72 million of the currency has since been found it is still not accessible to MtGox customers.

This clearly has had a devastating effect on the credibility of Bitcoin but Birch says this should not reflect negatively on the underlying Bitcoin technology as the MtGox debacle is wholly down to weaknesses of third-parties such as the exchanges who are bolting on their services. One study found that as many as 45% of exchanges have failed and taken clients’ bitcoins with them.

It is only with these third-parties that he believes regulations should be introduced: “With [Bitcoin] money that is this smart it needs no regulations. It’s at the edges where you need regulations. It’s the exchanges where the problems occur.”

These providers are clearly delivering an essential service if Bitcoin is to realise its ambitions of becoming an alternative currency but they remain a weak link in the chain at present. For Birch this is not of too much of a concern as he believes the focus of Bitcoin has been far too much on it as a new payment method and not enough light has been shone on its technology.

“The conversation has been about the currency but this is wrong. This is less interesting than the technology and it is time we focused on this and cut back on the currency chat,” he says adding that its clever open public ledger platform enables it to become an exchange for various digital contracts.

This could include the trading of bonds and corporate paper as well as shares and also the registering of land. “Let’s say you create shares or bonds on Bitcoin and then use the platform to buy and sell them. Now you have a public ledger for people to see [the transactions] and a whole layer of the financial services industry infrastructure would then go,” says Birch.

It seems clear that there are places where Bitcoin has the potential to cause some serious disruption to the financial industry but it is not necessarily as an alternative payment method or currency. As Birch suggests - credit cards are under threat from all over the place but Bitcoin is not really the main threat to their ongoing existence.

 

By Glynn Davis, freelance business journalist.

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