2013-14
Mitra FAMILY GRANT Recipient
Bit by Bit: An Economic Analysis of Bitcoin’s Viability as a Currency
Anisha Padwekar, Class of 2014
Bit by Bit:
An Economic Analysis of Bitcoin’s Viability as a Currency
Mitra Scholar
Mentors: Mr. Sam Lepler, Mrs. Lauri Vaughan April 14, 2014
Anisha Padwekar 2014With the advent of the Internet, financial transactions are increasingly occurring online. As physical interactions are replaced with digital ones, the concept of electronic currency has gained acceptance and has led to a proliferation of digital payment systems and virtual currencies. As more payments are made online, purchase patterns have become more susceptible to third party hacking and spying. Extensive data harvesting along with fears of cyber-attacks and backlash from the National Security Administration leaks has led to an emphasis on security and privacy. These factors, along with the recent global recession and European debt crisis, lowered the credibility of fiat currencies and created a demand for an alternative currency. Bitcoin is a modern electronic currency that relies on cryptography rather than a central authority to verify the validity of money and transactions. By facilitating electronic transfers and providing safety and anonymity, Bitcoin alleviates these fears and is heralded by many as the start of a currency revolution. However, there are also some major concerns about the currency’s viability posed by events like the collapse of Bitcoin exchange, Mt. Gox. In order to assess Bitcoin’s viability, it is important to understand its mechanisms. This paper analyzes Bitcoin in terms of the three functions of money to help determine how effective the currency will be. Current economic theory states that the functions of money are medium of exchange, unit of account, and store of value. In order for money to operate it must satisfy each of these functions.1 Underlying these three functions of money are six characteristics that are integral for a currency to function properly: durability, portability, divisibility, uniformity, limited supply, and acceptability. Ultimately, Bitcoin’s volatility, the threat of future regulations, and its lack of acceptability outweigh the potential positives like improvements in medium of exchange, freedom from inflation, and global nature and suggest that the currency is likely to fail in the long run.
Bitcoin: A Brief History
In a 2008 paper, Satoshi Nakamoto delineated the theory behind Bitcoin.2 Nakamoto’s intent was to alleviate the double-spending issue pervasive in electronic cash without relying on a central authority, which unnecessarily increases transaction costs and may act solely in its own interest. Double-spending is a problem faced by online merchants where a customer uses electronic money’s status as a string of characters to commit fraud by spending money twice. Nakamoto’s Bitcoin proposal alleviates double-spending by employing cryptography rather than a central authority.3 A year after Nakamoto’s paper was published the currency’s genesis block, which is a block containing the first transfer of bitcoins, was created and the currency grew from there. The first recorded financial transaction with the currency occurred in May 2010 when Laszlo Hanyecz bought a pizza for 10,000 BTC. At this time, bitcoins were worth approximately $0.0025 each.4 The low price of bitcoin caused many early adopters to mine and purchase large numbers of bitcoins in anticipation of the currency’s rise. Much of the current supply of coins is still owned by these early adopters. However, the number of Bitcoin users has been growing due to world events and media coverage, which have increased the demand for bitcoins and in turn the price. For example, fear of bank instability in Cyprus led investors there to seek refuge in Bitcoin causing the price of bitcoins to spike. Similarly, media coverage of Bitcoin following the bust of online black market, Silk Roads, introduced the general public to the currency.5
Benefits of Bitcoin
Even though some of the currency’s adoption can be attributed to hype, there are clear benefits that draw users to Bitcoin. Overall, Bitcoin fits into a trend towards alternative currency that is evidenced through the usage of currencies like airline minutes, mobile minutes (M-Pesa), and local currencies (Berkshares, Ithaca Hours, and the Brixton Pound).6 Alternative currencies,
like Bitcoin, are also supported by the ideas of well-known economist Frederick Hayek who argues that currency competition is beneficial, as it prevents any one currency from having a monopoly.7 Currencies of the local and alternative variety have a dated back to before national currencies. In fact, around 800 A.D, a variety of coins issued by local lords, bishops and abbeys were used in Western Europe.8 This long history of currency suggests that competitive currencies, which serve similar functions to regional currencies, have some merit.
One of the primary positive aspects of the currency is its advantage as a medium of exchange. Despite its many setbacks, Bitcoin performs well as a medium of exchange as it lowers transaction fees by practically eliminating double-spending.9 While reducing risk, it maintains the ease of online purchases, aided by services like Paypal. Unlike current credit card services like Visa which charge transaction fees, Bitcoin requires no fees, although they are optional. The lack of fees greatly benefits the community as it helps consumers save money and removes fees that can become large in proportion to smaller payments.
Bitcoin’s implementation gives it significant advantages when it comes to its portability, divisibility, and uniformity, three of the six essential characteristics of money. The currency’s portability is derived from its nature as a string of characters. If a currency is portable, it should be easy to carry around and easily transferable. Both of these characteristics help the currency function as an effective medium of exchange. Since Bitcoin is digitally based, it can be accessed on a computer or a smartphone as long as the device has Internet access making the currency transferrable almost everywhere that cash is exchanged.10 In fact, it can be considered more portable than the dollar as transferring large amounts of bitcoins is easier than transferring the same value in cash.
Divisibility of a currency is important in allowing precise transactions to occur. In this sense, Bitcoin outperforms current fiat currencies. A Satoshi, the smallest Bitcoin unit, is as small as one hundred millionths of a bitcoin or about US $6.60 x 10-6 in March 2014, when this paper was written.11 This is much smaller than the cent, the smallest value of a US dollar. Since the dollar functions fine with little divisibility, it can be extrapolated that Bitcoin with its Satoshi meets the divisibility test. Even if bitcoin prices skyrocket, it is unlikely that the value will grow four magnitudes of ten greater. If this is the case, Bitcoin’s electronic nature allows for changes in its implementation protocol that can result in further divisions past the Satoshi, although they are not available now.
Uniformity-wise, Bitcoin surpasses other currencies, as well. Again, this advantage stems from its status as a set of numbers. Only from the code is one bitcoin distinguishable from the next. In fact Bitcoin is so uniform that it is difficult to find the identity of a participant in any given transaction.
Benefit: Addressing Unfulfilled Needs
Bitcoin’s structure allows it to be used where other money forms cannot be, namely as a conduit for the black market economy. Although criminal use is a moral negative, economically it is a benefit as it serves a need of the market that is not currently served. Bitcoin’s added degree of uniformity, which is attractive to those worried about their privacy, is also beneficial to black market criminals. With bitcoins, transactions occur anonymously and are only signed by private and public keys that are hashed with other characters. Since it is nearly impossible to discover the inputs to a hash, it is difficult to match a transaction with real world identities. For this reason, black market operations like Silk Road have proliferated through the use of Bitcoin. Silk Road, which was closed by the FBI in October 2013, was an online bazaar that allowed the
selling of drugs and murder-for-hire. Although this may be seen as a moral drawback of the currency, it actually benefits Bitcoin as it helps the currency gain users. An article on The Genesis Block, a website that specializes in information about digital currencies, outlined the correlation between Silk Road and the early success in Bitcoin. Jonathan Stacke depicts how news related to Silk Road correlated to upward and downward trends in the price of bitcoins. Stacke argues that between February 2011 and July 2013 transactions on Silk Road could account for approximately 12% of total exchange volume.12 Stacke’s analysis makes it evident that there is a correlation between the rise of Bitcoin and black market activities.
Benefit: Inflation Free
Bitcoin outperforms the dollar and other government issued currencies because it has a limited supply. Bitcoin’s code permanently caps the supply of bitcoins at around twenty-one million. This limit is part of the Bitcoin protocol set forth by Nakamoto, which specifies that new bitcoins will be created through transaction block creation at a decreasing rate until there are twenty-one million in circulation. The twenty-one million bitcoin limit effectively prevents inflation, which has caused many currencies to fail.
Inflation in Weimar Germany from the summer of 1922 to the autumn of 1923 provides an important historical example of how inflation undermines a currency. 13 In order to solve the simultaneous problems of war debt, increasing social welfare obligations, pay of government employees, and reintegration of soldiers into the economy after World War I, the German government resorted to printing money and keeping the interest rates low. 14 Already suffering from inflation, in August 1922 the inflation became much worse. Trying to keep up with the demand for more money due to price increases, the government continuously printed money resulting in hyperinflation. As the denominations on the bills skyrocketed, people were paid
daily and often rushed to spend their earnings as fast as they could in fears that their wages would become worthless hours later.15 Symptoms of failure included a return to the more trusted barter economy and the refusal of farmers to sell their goods for money.16 Ultimately, the German government realized the need to put an end to the staggering inflation by creating a new currency known as the Rentenmark, which was traded for one trillion of the inflationary Papiermarks.17
Due to inflation, the Papiermark had failed in its role as money, no longer fulfilling any of the three functions of money. As Bernd Widdig, director of International Affairs at MIT, notes, “[the Papiermark] had long lost its capacity to store value; its function of measuring and its exchange value had disintegrated as well.”18 Clear evidence of the currency’s failure as a unit of account is evidenced in the situation that Widdig provides where devaluation during the day could mean that a cup of coffee could cost 8,000 marks after being ordered an hour previously at 5,000 marks.19 Similarly, its inability to serve its role as store of value is proven by the staggering changes in the exchange rate when compared to the relatively stable dollar. For example, in September 1923 the exchange rate grew from 98.86 million marks to a dollar to 25.2 billion over the course of the month.20 At one point in October 1923, the daily inflation was estimated to be 20.9%.21 Both these factors, failure as unit of account and store of value, caused the currency to fail as a medium of exchange as well. Failure in this last function of money is evident from the fact that the barter economy abounded. Thus, the Papiermark’s inflation led to it to fail in all the three functions of money causing its overall failure.
Weimar Germany is not alone in its struggles with hyperinflation. In fact, fiat currencies that have failed due to inflation litter history. As recent as the late 2000s, Zimbabwe was facing staggering inflation to the tune of 79,600,000,000% monthly in the fall of 2008.22 On the other
hand, with Bitcoin there is “no possibility of monetary inflation,” because as Pierre Lemieux, writer for The Cato Institute, says, “creating new bitcoins will be a mathematical impossibility.”23 In other words, Bitcoin’s finite supply capped at twenty-one million by Bitcoin protocol prevents inflation from becoming a problem, as there is no central authority - no government or business - to indefinitely create new money. As opposed to fiat currencies where trust diminishes as the currency loses value, Bitcoin is relatively safe. A capped supply of bitcoins means that bitcoins are less likely to depreciate over the long run. In turn, less depreciation secures Bitcoin’s function as a store of value and a unit of account.
Benefit: Global Nature
Due to its global scale, Bitcoin also serves as a lubricant to global trade, as users can purchase goods denominated in bitcoins globally and not worry about currency conversion fees. By eliminating conversion fees and making it difficult for governments to apply tariffs, Bitcoin facilitates free trade. Additionally, Bitcoin’s acceptance globally is a boon to those deterred by the inconvenience of converting currencies to purchase foreign goods. These benefits can potentially have a large impact since the daily volume of the foreign exchange, or forex, market reached $5.3 trillion, making it the largest market in the world in September 2013.24
Potential impacts of a global currency on trade can be seen through the effect of the adoption of the Euro on trade since 1999. Research shows that sharing a currency had a positive impact on the trade of countries that joined the European Union.25 This can be attributed to the removal of exchange fees and the universal use of the currency for purchase. For example, by adopting the Euro, Germany gained a balance of payments surplus.26 Likewise, Greece, Finland, Portugal, and Spain have experienced increases in the real disposable income of their people while using the Euro.27
Bitcoin potentially offers these benefits as well. The traits that aid in replacing currency exchange also have other fringe benefits. For example, Patrick Murch, a general counsel for the Bitcoin Foundation, argues that the Bitcoin can be used as “a remittance lifeline for diaspora populations.”28 In other words, use of Bitcoin will facilitate the process of sending money to migrant workers’ families in their home countries. Through its role both as a borderless currency and a system for remittances, Bitcoin helps fulfill needs caused by increased globalization and unaddressed by the current system of national currencies.
Benefit: Counterfeit Free
Bitcoin’s role as a currency is further protected because the fact that a bitcoin is a chain of transactions makes it is impossible to counterfeit a bitcoin.29 By assuring users that each bitcoin is valid, Bitcoin’s freedom from counterfeiting stabilizes the currency’s acceptability and thereby its role as medium of exchange. For other currencies, like the dollar, creation of fake units is a serious threat. In fact, Richard Porter, who works at the Federal Reserve Bank of Chicago, approximated that 0.01% of dollars in circulation or $60 million were counterfeited in 2001.30 The creation of fake dollars is so large an issue that the Secret Service, which deals with the more pressing threats to the U.S. government, is used to investigate counterfeit dollars instead of the FBI or the CIA.31 Thereby, due to its freedom from counterfeiting Bitcoin has a significant advantage over other currencies like the dollar, since counterfeit notes undermine a currency’s acceptability. It is evident that Bitcoin possesses significant positive aspects. However, there are many outside forces that ultimately threaten the currency’s viability.
Threat: Volatility
The current volatility in Bitcoin’s value is a significant drawback. A fluctuating worth makes it hard for businesses to operate on bitcoins, as their assets will fluctuate with the currency
they are backed by. For example, if a business held only bitcoins when prices dropped in December 2013, that company’s value would have dropped approximately 40%.32 Although this is an extreme case, prices do vary daily, as shown by the following graph of bitcoin prices in US dollars on the BitStamp exchange (one of the many Bitcoin exchanges): 33
The graph depicts both the price of bitcoins and the volume of transactions from the week of March 1-7. In particular, March 3 to 4th, where prices rose roughly 20%, provides an example of relatively normal variations in Bitcoin prices that could prove destabilizing to Bitcoin-based businesses. A dollar equivalent of this spike is that a home valued at $500,000 on the beginning of March 3 would be worth $600,000 at the end of the day. The volatility of prices indicated in the graph undermines Bitcoin’s acceptance by weakening its function as a store of value. It also diminishes Bitcoin’s use as a unit of account since it becomes difficult to measure an object’s value when the price fluctuates rapidly.
Bitcoin instability is due to a variety of causes, but the most pronounced is the use of bitcoins as speculative investments rather than as a currency. According to the Initial Public Offering for The Winklevoss Bitcoin Trust, “there is relatively small use of Bitcoins in the retail and commercial marketplace in comparison to relatively large use by speculators, thus
contributing to price volatility.”34 Wild price fluctuations encourage speculation, which only makes volatility worse and precipitates Bitcoin’s value to fluctuate rapidly like that of a stock or commodity.
In fact, Mark T. Williams, a risk management specialist, notes that “although Bitcoin was purportedly designed as a virtual currency, it is a highly-speculative virtual commodity.”35 This analysis of Bitcoin is interesting as the word “commodity” suggests that bitcoins have an intrinsic value.36 However, it is more important to note both the idea that Bitcoin is “highlyspeculative” and that it might not be a currency. The latter idea is validated by the 2014 U.S. Internal Revenue Service ruling that treats bitcoins as property instead of a currency for tax purposes. 37 Although Bitcoin prices may stabilize in the future due to diminished speculation and a fading of media attention, the current volatility provides a significant threat to Bitcoin’s role as a currency.
Threat: Bitcoin Loss
Although a bitcoin is inherently durable, since the unique string of characters that represents its value will remain the same overtime, its weakness also lies within these characters. Since Bitcoin relies on strings of characters to identify the public and private keys and define each bitcoin, a loss in any of these strings results in an irretrievable bitcoin.38 Once the characters are discarded or misplaced, it is nearly impossible to retrieve them again. Unlike fiat currency, where more money is created to replace lost currency, Bitcoin has a fixed number that will be minted, so the loss of a bitcoin will directly relate to contraction of the money supply. Ironically, it was this freedom from central authority that enticed Nakamoto to create Bitcoin.
A notable example of bitcoins loss is when James Howells, a British IT worker, inadvertently threw away a hard drive containing 7,500 bitcoins worth roughly £4 million in
November of 2013. The hard drive, which now sits in a landfill in South Wales, was never found.39 Unfortunately, Howells is not alone, as passwords to online wallets containing bitcoins are commonly misplaced. Unlike the theft of bitcoins where bitcoins simply switch ownership, the irretrievable loss of bitcoins poses a threat to the entire Bitcoin system as it results in the gradual diminish in the supply of bitcoins. Since no new bitcoins will be created after twenty-one million, a constant gradual erosion of bitcoins into the distant future could bring the supply of the currency towards zero. However, it is likely that the loss of bitcoins will decrease, since Bitcoin is currently young. Just like other early industries, for example banking, it will mature and proper practices will be put in place to secure bitcoin wallets. However, it is not clear how effective new techniques of saving bitcoins will be or when they will come, so bitcoin loss still represents an obstacle to Bitcoin’s success as a currency.
Threat: Regulations
Although the regulations on Bitcoin are limited so far, the potential for over-regulation threatens the long-term viability of the currency. The lack of widespread extensive regulation shows that governments are still reacting to the phenomenon rather than governmental approval of Bitcoin.40 If there were to be government opposition to the currency, the potential repercussions of conducting illegal actions would lead to diminishing use of Bitcoin.
An example can be taken from the Austrian town of Wörgl. In July 1932, in order to deal with the ongoing depression and rampant unemployment the town created a stamp scrip currency that was known as “labor notes.”41 The currency was inspired by the accelerated money theories of German economist Silvio Gesell.42 Backed by the Austrian shilling, the currency was paid out to government employees by the town’s government as part of their wages. These “labor notes” were redeemable for real shillings as long as a two percent duty on the shillings was paid at
conversion. Each stamp scrip was only valid if it received a stamp costing one percent of its value monthly.43 The results of the experiment were largely positive stimulating the local economy by increasing the circulation of currency. Unlike Bitcoin, which currently has limited acceptance, the stamp scrip was widely accepted in the city of Wörgl.44 Ultimately, the Wörgl experiment was terminated when the Austrian government, feeling threatened by the local currency, placed a ban on local currencies in September 1933.45 The brevity of the Wörgl experiment makes it difficult to truly assess whether it would have been successful on its own, but it is important to note that government actions ultimately led to its downfall. Government intervention interfered with the currency’s ability to be a medium of exchange and a store of value by making the currency unacceptable. As a result, usage of the “labor notes” stopped. The takeaway is that the government approval has a major effect on the long-term stability of alternate currencies. Presumably, the same is true for Bitcoin.
There are many reasons why governments are interested in regulating Bitcoin. Some of these reasons include money laundering, black market use, and tax evasion. In fact, there has already been some movement from governments on the currency. Motivated by fear of interference with its monetary policy, the Chinese government forced financial institutions to stop trading in bitcoins, calling the crypto-cash “not a currency in the real meaning of the word.”46 Similarly, the Russian government stated in February 2014 that use of bitcoins as currency is illegal.47 Regulations like these are detrimental to Bitcoin as they make it inconvenient for consumers in China and Russia to participate in the Bitcoin economy. However, it is important to note Bitcoin’s global scale making any one government’s regulation largely inconsequential to the entire system.
As Americans hold a large proportion of bitcoins, regulation within the United States is another issue. Major ruling by the United States federal government, other than the IRS, seems unlikely since Federal Reserve Chairman Janet Yellen stated, “the Fed doesn't have authority to supervise or regulate Bitcoin in anyway.” Although the federal government is hesitant to regulate Bitcoin, state governments like New York’s are in the process of creating legislation to safeguard consumers.
Regulation to protect consumers will make the currency seem more legitimate and lower risk for mainstream adopters. This type of regulation, as long as it does not become overregulation, can be beneficial to Bitcoin. According to lawyer Joshua Doguet, “an ultimate finding of legality should have a positive impact on the demand for bitcoins because legal uncertainty tends to inhibit economic growth.”48 In the United States, the Financial Crimes Enforcement Network (FinCEN) under the United States Department of the Treasury considers Bitcoin exchanges as “money transmitters.”49 As “money transmitters,” Bitcoin exchanges are required to provide documentation that can help the government find instances of crime or tax evasions. 50
However, laws aimed at protecting consumers may go too far. Currently, further regulations are being considered and by the New York Department of Financial Services held a hearing on Digital Currencies at early 2014.51 The New York County District Attorney, Cyrus R. Vance, Jr., plans on making Bitcoin exchanges obtain BitLicenses and identify their customers in order to safeguard against crimes committed using the currency.52 However, many Bitcoin proponents are wary of any interference to the currency. Barry E. Silbert, founder and CEO of a Bitcoin Investment Trust, SecondMarket, argued that regulations to individual merchants and consumers in the Bitcoin market could make transactions “grind to a halt.”53
Fears of overregulation are rational as many politicians who are opposed to the currency like senator, Joe Manchin of West Virginia, can influence these regulations. Manchin argues that the currency should be banned because it is "highly unstable and disruptive to our economy."54
The recent media spotlight and losses associated with the failure of the biggest Bitcoin exchange, Mt.Gox, only increase the likelihood of regulations intended to protect the customer that can potentially stifle the currency.55
Threat: Deflation
Another, albeit less immediate, issue is that of a deflationary spiral. Bitcoin’s algorithm specifies that bitcoins will be created at a decreasing rate, with a cap at twenty-one million. Although the short-term growth in money supply might suggest modest inflation to some, scholars including those from the Palo Alto Research Center argue that Bitcoin will face deflation. Their argument rests on the fact that as the currency gains acceptance and as the supply dwindles each coin will continue to gain value.56 This idea is supported by the Fischer Equation of Exchange, which states that MV=PY, where M is money supply, V is velocity of money, P is price level, and Y is aggregate income. Since V is typically considered constant, P is dependent on M and Y. In this case, Bitcoin supply, which is capped at twenty one million, will grow much slower than aggregate income, which is continually increasing. Therefore, price levels will drop, otherwise known as deflation. Reality also supports these deflationary claims as there are already signs of hoarding, a direct result of anticipated deflation. Research into Bitcoin transactions by Israeli computer scientists reveals that a majority of Bitcoin’s money supply is being saved instead of spent.57 Not only does this behavior imply an expectation in a rise of bitcoin prices in terms of dollars, but it will also result in further depreciation of bitcoins, since V and P are inversely related.
Extensive saving, or hoarding, has many negative side effects that could ultimately prove detrimental to Bitcoin. Hoarding will undermine Bitcoin’s role as a medium of exchange, as no one will be willing to spend money if the goods they buy will be at lower prices in the future. Not only does saving bitcoins raise economic concerns, but it raises technical concerns as well. Bitcoin protocol relies on transaction fees being awarded to bitcoin miners to provide incentive for solving the proof-of-work problem once new bitcoins stop being created.58 Thus, a low transaction rate and the resulting decrease in quantity of transaction fees would make it less worthwhile for honest nodes (bitcoin miners who support only authentic transactions) to participate in solving proof-of-work problems. Therefore, in the future hoarding could lead attacking nodes (bitcoin miners who intend to create fraudulent transactions) to hold a majority of the CPU power and make it possible for double-spending to occur.59 Double-spending is possible since the longer of two conflicting versions of transaction histories is taken to be correct, as it required more CPU power in order to create. According to Nakamoto, this assumption works as long as a majority of the CPU power is controlled by nodes that are not working against the system (accepting double-spent transactions).60
Threat: Banking
The problem of hoarding ultimately relates to another problem Bitcoin faces, namely banking, or the lack thereof. The Bitcoin system is based off of preventing double-spending without use of a central clearinghouse. However, according to Brian P. Hanley, the only way for loans and banking to work in Bitcoin is if there was a virtual-bitcoin analogous to bank-notes, which are only partially backed by real currency. A virtual-bitcoin would be difficult to implement without use of a central authority to check its authenticity; thus, creating loans would go against the very nature of the Bitcoin system.61 More deterrents to Bitcoin banking include
anonymity of borrowers and irreversibility of payments.62 In addition, Bitcoin’s inherent deflationary nature promotes hoarding. For the same reason, the appreciation of bitcoins will also disincentivize borrowing. Hanley argues that this is a major pitfall of the currency as loans allow businesses to expand capital in order to grow. In other words, “debt is the engine that leads to more wealth.”63 A secondary effect of banking inconveniences is that there is no rate of return from savings in Bitcoin banks since banks cannot lend money easily. Therefore, since the nature of the Bitcoin system makes banking difficult users of Bitcoin lose all the benefits associated with banking.
Threat: Hacking and Theft
A substantial concern voiced by many is the widespread hacking and fraud prevalent in the Bitcoin system. The recent theft of $474 million bitcoins and resulting failure of Mt. Gox, previously the largest bitcoin exchange, is testament to the risks associated with Bitcoin.64 Although the scale of Mt. Gox’s loss is unprecedented, it is not the lone victim of larceny. The frequency and media coverage of these events has done much to destabilize the system by inspiring fear in Bitcoin users. In particular, the theft of bitcoins undermines the currency’s status both as a store of value and as a medium of exchange. Concern over the ability of bitcoin wallets to protect money from hackers conflicts with Bitcoin’s perceived ability to store value. Likewise, fear of fraudulent transactions can erode Bitcoin’s status as a medium of exchange. The nature of this threat, however, does not lie in the system itself, where it is nearly impossible to doublespend or create fictitious bitcoins. Rather, it lies with the bitcoin wallets, as evidenced by the Mt. Gox failure. Hackers can gain access to consumers’ bitcoins by breaching the security of the wallets in which these bitcoins are stored. Therefore, as the companies that offer these wallets
increase their security and governments look towards regulation to protect the consumers, issues with hacking and theft in the long run may greatly diminish.
Threat: Acceptability
Currently, only a few businesses accept the Bitcoin. Of the businesses using Bitcoins some are major retailers like Overstock.com and TigerDirect, but the majority are smaller.65 That being said, the number of Bitcoin vendors is increasing daily.66 One caveat to this trend is that many of the merchants that allow payments in bitcoins are immediately converting the bitcoins to dollars using services like Bitpay and Coinbase. Although these vendors claim to be using bitcoins, they really just function in dollars to mitigate risks associated with Bitcoin volatility.67 In order for Bitcoin to be a fully functioning currency, more vendors need to accept bitcoins as a form of payment. If this does not occur, it will be difficult for Bitcoin adopters to use the currency to purchase anything and the currency will become more of a speculative investment. Ultimately, Bitcoin’s acceptability is yet to be determined. The unfortunate fate of DigiCash provides a potential preview to the future of Bitcoin.
DigiCash, which was used in 1994 to 1998, is a crypto-currency that was hauntingly similar to Bitcoin. DigiCash, which was created by cryptographer David Chaum, promised its users anonymity, security, and ease of transactions. Its goal was to become the cash of the Internet.68 These promises are similar to the boons that Bitcoin purportedly offers. Unlike Bitcoin, DigiCash offered retrieval services in the event that access to the accounts storing the money was lost. Another difference is that DigiCash was a company, which looked for commercial success by partnering with banks.69 Despite its supposed benefits, the currency ultimately struggled to gain both customers and merchants willing to use the service.70 In other words, DigiCash never fulfilled the acceptability role of currency, and as a result, failed to gain
traction as a currency. The parallels between the Bitcoin and DigiCash make this precedent important. Apart from the speculators, Bitcoin has a similar user base to DigiCash: a writer for The Guardian noted that the only users of DigiCash were “libertarians and encryption fanatics.”71 Since time has made crypto-currencies more acceptable, DigiCash’s failure does not necessarily preclude Bitcoin’s demise, but the currency’s failure does demonstrate the danger low adoption by consumers and merchants poses to a currency.
By facilitating transactions, Bitcoin establishes itself as an innovative medium of exchange. However, it faces serious threats that stem from acceptability, legislation, and volatility. Due to these factors, Bitcoin’s future remains at risk. Whether or not it survives, Bitcoin sets an example for future decentralized and peer-to-peer currencies. Since the creation of Bitcoin, there has been a proliferation of such currencies like Ripple, Litecoin, and Namecoin. Aside from using the idea to create new crypto-currencies, many scholars have proposed using Bitcoin’s infrastructure to create “colored coins,” which can represent commodity certificates, stocks, or small properties. No matter the future of Bitcoin itself, the technologies that underlie the currency are gaining traction and have a promising future.
If new implementations of Bitcoin-like crypto-currency fix issues with deflation, volatility, acceptability issues, and potential regulation, they are likely to revolutionize the financial system and prove viable as currencies. Deflation can be fixed in future currencies by having a source code that continually, but gradually, increases the money supply instead of capping it at twenty-one million. If deflation is fixed, Bitcoin’s problems with volatility will diminish, as bitcoins become less of a commodity. As volatility diminishes, acceptability will follow suit, since bitcoins are more useful when their value is stable. Bitcoin’s issue with regulation could then potentially be solved since government’s will be forced to allow bitcoins if
they gain popularity. Regardless, due to its innovations in working as a medium of exchange
Bitcoin provides a sizable contribution to the financial system despite its potential failure.
Notes
1 Campbell R. McConnell, Stanley L. Brue, and Sean Masaki Flynn,Economics: Principles, Problems, and Policies, 19th ed. (New York, NY: McGraw-Hill/Irwin, 2012), 637.
2 Satoshi Nakamoto is actually a pseudonym for the creator of the Bitcoin system. Despite the currency’s rise in popularity, it is still not known who actually created the system. The public does not even know whether Bitcoin was created by a person, organization, or a government. Surprisingly, this has not had a major impact on use of the currency.
3 Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System (n.p.: Bitcoin Project, 2008), 1, accessed April 13, 2014.
4 Timothy B. Lee, "Five Years of Bitcoin in One Post," The Switch (blog), entry posted January 3, 2014, accessed March 3, 2014.
5 Omar L. Gallaga, "Silk Road Arrest Puts Bitcoin in Spotlight.," Austin AmericanStatesman (Austin, TX), October 4, 2013, accessed March 9, 2014.
6 Eric Garland, "The Next Money: As the Big Economies Falter, Micro-Currencies Rise," The Atlantic, last modified May 16, 2012, accessed March 24, 2014.
7 Anthony M. Endres, "Currency Competition: A Hayekian Perspective on International Monetary Integration," Journal of Money, Credit & Banking 41, no. 6 (September 2009), accessed March 24, 2014.
8 Margrit Kennedy, Bernard Lieater, and John Rogers, "An Old Idea in New Clothes," in People Money: The Promise of Regional Currencies (Devon, UK: Triarchy Press, 2012), 42, accessed March 9, 2014.
9 Nakamoto, Bitcoin: A Peer-to-Peer Electronic, 1.
10 Steve Patterson, "Is Bitcoin a Viable Currency?," The Freeman, last modified December 11, 2013, accessed March 9, 2014.
11 "BitStamp(USD)," chart, Bitcoin Charts, March 9, 2014, accessed March 9, 2014.
12 Jonathan Stacke, "Analysis of Silk Road’s Historical Impact on Bitcoin," The Genesis Block, last modified October 3, 2013, accessed March 9, 2014.
13 Bernd Widdig, "Flirting with Disaster," in Culture and Inflation in Weimar Germany (Berkeley, CA: University of California Press, 2001), 36, accessed March 9, 2014.
14 Ibid., 41
21 Steve H. Hanke, "R.I.P. Zimbabwe Dollar," Cato Institute, last modified February 5, 2009, accessed March 9, 2014.
22 Ibid.
23 Pierre Lemieux, "Who Is Satoshi Nakamoto?," Regulation, 2013, 14, accessed March 9, 2014.
24 Neal Armstrong and John Detrixhe, "Currency Trade Reaches $5.3 Trillion a Day amid Yen Turnover," Bloomberg News, last modified September 5, 2013, accessed March 30, 2014.
25 Georgios Fotopoulos and Dionysios Psallidas, "Investigating the Effects of Euro on Bilateral Trade: A Kernel Matching Approach," Journal of Economic Integration 24, no. 4 (December 2009): 682-83, accessed March 31, 2014.
26 Floyd Norris, "Euro Benefits Germany More than Others in Zone," New York Times (New York), April 23, 2011, Late (East Coast) edition, accessed April 2, 2014.
27 Brad Plumer, "Who Gained the Most from the Euro? And Does It Matter?," Wonkblog, accessed April 2, 2014.
28 Timothy B. Lee, "Five Years of Bitcoin in One Post," The Switch (blog), entry posted January 3, 2014, accessed March 3, 2014.
29 Michael Sivy, "The Real Significance of the Bitcoin Boom (and Bust)," Time, last modified April 12, 2013, accessed March 20, 2014.
30 Richard Porter, "Estimating the Volume of Counterfeit U.S. Currency in Circulation Worldwide: Data and Extrapolation," Federal Reserve Bank of Chicago, last modified March 1, 2010, accessed March 20, 2014.
31 "Know Your Money," United States Secret Service, accessed March 20, 2014.
32Andrea Peterson, "Bitcoin Value Drops 40 Percent after More Bad News from China," The Switch (blog), entry posted December 18, 2013, accessed March 9, 2014.
33 "BitStamp(USD)," chart.
34 Stephen Grocer, "Beware the Risks of the Bitcoin: Winklevii Outline the Downside," MoneyBeat (blog), entry posted July 2, 2013, accessed March 9, 2014.
35 Virtual Currencies: Hearings Before the New York State Department of Financial Services, 2014 Leg. (N.Y. 2014) (statement of Mark T. Williams). Accessed April 13, 2014.
36 "Commodity," in Merriam-Webster, accessed March 31, 2014.
37 Donna Leinwand Leger, "IRS: Bitcoin Is Not Currency," USA Today, last modified March 25, 2015, accessed March 31, 2014.
38 Simon Barber et al., "Bitter to Better: How to Make Bitcoin a Better Currency," in Financial Cryptography, by Angelos D. Keromytis, Lecture Notes in Computer Science (Berlin, Germany: Springer-Verlag, 2012), 7397: 9, accessed March 1, 2014.
39 "James Howells Searches for Hard Drive with £4m-worth of Bitcoins Stored," BBC News, last modified November 28, 2013, accessed March 9, 2014.
40 Kashmir Hill, "Bitcoin's Legality Around The World," Forbes, last modified January 31, 2014, accessed March 9, 2014.
41 Ibid., 50
42 Jérôme Blanc, "Free Money for Social Progress: Theory and Practice of Gesell's Accelerated Money," The American Journal of Economics and Sociology57, no. 4 (October 1998): 475, accessed March 9, 2014.
43 Ibid., 476
44 Kennedy, Lieater, and Rogers, "An Old Idea in New Clothes," in People Money: The Promise, 50.
45 Blanc, "Free Money for Social," 476.
46 Neil Gough, "Bitcoin Value Sinks after Chinese Exchange Move," New York Times, December 18, 2013, accessed March 3, 2014.
47 Gabriela Baczynska, "Russian Authorities Say Bitcoin Illegal," Reuters, last modified February 9, 2014, accessed March 9, 2014.
48 Joshua J. Doguet, "The Nature of the Form: Legal and Regulatory Issues Surrounding the Bitcoin Digital Currency System," Louisiana Law Review 73, no. 4 (2013): 1131, accessed March 9, 2014.
49 "FinCEN Issues Guidance on Virtual Currencies and Regulatory Responsibilities," FinCen, last modified March 18, 2013, accessed March 9, 2014.
50 Doguet, "The Nature of the Form," 1148.
51 "NYDFS Virtual Currency Hearing," New York State Department of Financial Services, last modified February 3, 2014, accessed March 9, 2014.
52 Virtual Currencies: Hearings Before the New York State Department of Financial Services, 2014 Leg. (N.Y. 2014) (statement of Cyrus R. Vance, Jr.). Accessed April 13, 2014.
53 Virtual Currencies: Hearings Before the New York State Department of Financial Services, 2014 Leg. (N.Y. 2014) (statement of Barry E. Silbert). Accessed April 13, 2014.
54 Declan McCullagh, "Sen. Manchin Demands Complete US Ban on Bitcoin," CNET, last modified February 26, 2014, accessed March 9, 2014.
55 Craig Timberg, "Mt. Gox Collapse Spurs Calls to Regulate Bitcoin," Washington Post, last modified February 28, 2014, accessed March 9, 2014.
56 Barber et al., "Bitter to Better: How to Make," in Financial Cryptography, 7397:6-7.
57 Dorit Ron and Adi Shamar, Quantitative Analysis of the Full Bitcoin Transaction Graph (n.p.: n.p., 2012), 13, accessed April 13, 2014.
58 "Bitcoin: Proof of work," video file, 10:32, Khan Academy, accessed March 9, 2014.
59 Barber et al., "Bitter to Better: How to Make," in Financial Cryptography, 7397:6.
60 Nakamoto, Bitcoin: A Peer-to-Peer Electronic, 3.
61 Brian P. Hanley, The False Premises and Promises of Bitcoin, 13, February 25, 2014, accessed March 9, 2014.
62 Pamela J. Martinson and Christopher P. Masterson, "The Hazards of Lending to Bitcoin Users," American Banker (blog), entry posted January 2, 2014, accessed March 9, 2014.
63 Hanley, The False Premises and Promises, 16.
64 Tim Hornyak and Jeremy Kirk, "10 Things You Need to Know about Mt. Gox's Bitcoin Implosion," PCWorld, last modified March 6, 2014, accessed March 9, 2014.
65 Entrepreneur, "More Major Retailers Are Getting Ready to Accept Bitcoin," Reuters, last modified January 29, 2014, accessed March 9, 2014.
66 Reuben Grinberg, "Bitcoin: An Innovative Alternative Digital Currency,"Hastings Science & Technology Law Journal 4 (December 9, 2011): 198, accessed March 9, 2014.
67 Virtual Currencies: Hearings Before the New York State Department of Financial Services, 2014 Leg. (N.Y. 2014) (statement of Mark T. Williams). Accessed April 13, 2014.
68 Robert Guttmann, "Three Generations of Cybercash," in Cybercash: The Coming Era of Electronic Money (New York: Palgrave Macmillan, 2003), 115, accessed March 9, 2014.
69 Ibid.
70 Ibid., 116
71 Steve Bowbrick, "Past Currency," The Guardian, last modified February 25, 2003, accessed March 9, 2014.
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