Virtual Currency

Bitcoin became a fixture in world financial news in late 2013 and early 2014. The
'virtual currency' had been launched five years earlier by computer hobbyists, and in late 2013
the U.S. dollar exchange rate for one bitcoin rose more than fivefold in the space of a few weeks.
The market value of one bitcoin, which had begun trading at less than five cents in 2010, briefly
exceeded $1,200.00. Two days of hearings were held by the U.S. Senate Committee on
Homeland Security and Governmental Affairs, and government regulators testified that
algorithmic, stateless currencies like bitcoin had the potential to play useful roles in the
commercial payment system.1 Stories appeared in the media about travelers subsisting for
lengthy periods by spending only bitcoin, and various businesses, some of them exotic such as
Richard Branson's Virgin Galactic space travel, attracted publicity by accepting bitcoin as
payment.
The euphoric news surrounding bitcoin at the end of 2013 gave way to catastrophe in
2
February 2014, when the Mt. Gox exchange, once the leader in worldwide bitcoin trading,
imploded in a spectacular bankruptcy. Hundreds of millions of dollars worth of bitcoins went
missing in connection with the failure of Mt. Gox, yet the value of bitcoins on other exchanges
remained surprisingly high at around $450 each at the time of this writing. Figure 1 shows the
daily closing dollar-bitcoin exchange rate on the Mt. Gox exchange up until February 2014, and
thereafter on the Bitstamp exchange, which took over the top spot in trading volume after Mt.
Gox folded.
In this paper, I examine whether bitcoin should be considered a currency, an issue that
has drawn increasing attention from market regulators concerned about the tax, insurance, and
other consequences of how bitcoin is treated legally. I argue that bitcoin does not behave much
like a currency according to the criteria widely used by economists. Instead bitcoin resembles a
zspeculative investment similar to the Internet stocks of the late 1990s.
Money is typically defined by economists as having three attributes.
Bitcoin somewhat meets the first of
these criteria,especially in online markets, appear
willing to accept this as the form of expense. However, the worldwide commercial use of bitcoin
remains minuscule, indicating that few people use it widely.
Bitcoin requires merchants to quote the prices of common retail goods out to four or five
decimal places with leading zeros, a practice rarely seen in consumer marketing and likely to
confuse both sellers and buyers in the marketplace. Bitcoin exhibits very high time series
volatility and trades for different prices on different exchanges without the possibility of
3
arbitrage. All of these characteristics tend to undermine bitcoin's usefulness same the unit of account.
As a store of value, bitcoin faces great challenges due to rampant hacking attacks, thefts, and
other security-related problems.
Therefore bitcoin's
value is almost completely untethered to that of other currencies, which makes its risk nearly
impossible to hedge for businesses and customers and renders it more or less useless as a tool for
risk management.
Bitcoin lacks additional characteristics that are usually associated with currencies in
modern economies. Bitcoin currency can't be saved in any bank, and instead it must be possessed
through a system of 'E_wallets' which is verified both costly to maintain and vulnerable to
predators. No form of insurance has been developed for owners of bitcoin. Bitcoim can't be deposit from any bank. Bitcoin as the
unit of account for standard consumer finance credit, auto loans, and hypothecations, and no credit/debit card have been denominated in bitcoin.

The remainder of this paper is organized as follows. Section II describes the history and
background of bitcoin. Section III analyzes whether bitcoin fulfills the classical criteria of a
currency. Section IV discusses obstacles faced by bitcoin and concludes the paper.
4
II. History and background of bitcoin
For much of the 19th and 20th centuries, the world's most successful currencies were
convertible into fixed amounts of gold or other precious metals, and for thousands of years prior
to that, many currencies were minted directly from gold or silver specie. This direct connection
between money and gold, secured by sovereign inventories such as the Fort Knox depository in
the U.S., created public confidence in a currency's value. The gold standard collapsed in most
economies between the 1920s and 1970s, partly due to the pressures of financing two World
Wars, but probably even more because worldwide production of gold did not keep pace with
economic growth. Since then, nearly every major economy has issued paper fiat currency, the
value of which relies on public belief that a nation's government or central bank will not increase
the supply of new banknotes too rapidly. Multinational consortia have issued currency like the
euro on similar terms. Fiat currencies have circulated for thousands of years, and sooner or later
nearly all of them have been inflated down to worthlessness by governments confronted by
strained public finances.
Bitcoin attempts to overcome the weaknesses of both fiat and gold-based money,
functioning as an algorithmic currency with a deterministic supply and growth rate tied to the
rigor of mathematics. No government or other central authority can manipulate the supply of
bitcoins. Instead the currency is governed by cryptographic rules that are enforced by
transparent computer code in a decentralized manner. While some enthusiasts have suggested a
connection between bitcoin's algorithmic growth rate and the monetary orthodoxy espoused by
Milton Friedman, the bitcoin protocol appears to give little or no attention to any optimal rate of
monetary growth. Instead, it provides for the rate of seigniorage to slow asymptotically to zero
2 A controversial Newsweek story on March 6, 2014, claimed to have located and identified Nakomoto, but the
magazine's claim was denied by the subject of the story and has been subject to continuing uncertainty. See
http://mag.newsweek.com/2014/03/14/bitcoin-satoshi-nakamoto.html.
5
by the year 2140, when the last bitcoin is scheduled to be released and the final total will be
fixed at 21 million units.
While the limited supply of bitcoins seems to be a critical aspect of the currency's appeal,
whether the supply is truly fixed has become a matter of some disagreement. The case against
this view is stated by bitcoin entrepreneur in a recent interview with Goldman Sachs (2014):
If you needed to create more, you could. That would require 51% of the computing
power of the network to switch their software to adopt the change. Changes to the
software have occurred a couple of times in the past. There are developer forums where
such types of changes are typically discussed and a consensus is ultimately reached
across the mining community that maintains the network.
If Ersham's interpretation is correct, it implies that the growth of bitcoins could be adapted for
reasons of monetary policy, with this macroeconomic policy decisions controlled by an online
discussion forum or blog rather than by an expert agency such as the Federal Reserve
Bitcoin originated using a scheme outlined in Nakamoto (2008), a nine page proposal for
a 'peer-to-peer electronic cash system.' The author or authors of this document have not been
identified,but their system was designed in a way that gave them no royalties or residual
property rights to benefit from bitcoin's adoption. According to the algorithms proposed by
Nakamoto, new bitcoins are created and awarded to computer users who solve pre-specified
mathematical problems. These problems become more difficult and less frequent over time. A
transparent, decentralized registry tracks the ownership and subsequent transfers of every bitcoin
after it is 'mined' by its initial owners. All of the quantities and growth rates of bitcoins are
known with certainty by the public, so its circulation cannot be affected by monetary policy in
6
the way that the Federal Reserve controls the growth rate of the public supply of U.S. dollars.
Wallace (2011) reviews the early history of bitcoin and states that Nakamoto mined and
introduced the first 50 units into circulation in 2009, essentially to demonstrate the method to a
group of online observers. Bitcoin's circulation at first took place among volunteers and
enthusiasts from the computer world. Interest grew to the point that bitcoin began to trade in
2010 on a Japanese-based online exchange, Mt. Gox, which had originally been created as a
platform for exchanging trading cards from the fantasy game Magic. On the first day of trading
on Mt. Gox, 20 bitcoins changed hands at a price of 4.951 cents, for total volume of slightly less
than one U.S. dollar.
The first purchase of goods and services using bitcoin is said by Wallace (2011) and
other sources to have been two pizzas procured at a cost of 10,000 bitcoins in 2009. The pizza
parlor did not accept bitcoins directly, and instead a third-party broker was enlisted who agreed
to procure the pizzas using a credit card (based on a real currency) and accept the bitcoins, worth
almost $5 million at recent prices, as consideration. Much of the commerce involving bitcoins
continues to take place using middlemen who facilitate immediate exchanges of bitcoins into
conventional currencies.
The Silk Road marketplace, an Internet portal for the sale of illegal narcotics which
accepted only bitcoins for payment, was sometimes reported to account for as much as half of
the early bitcoin transaction volume although this estimate is subject to considerable dispute.

The Silk Road association helped give bitcoins an early reputation for lawlessness, and this
outlaw cachet may not have harmed its appeal at all. Bitcoin usage spread into the bricks-andmortar
7
in San Francisco in October 2013. Far from hurting bitcoin, this event generated publicity that
may have boosted its popularity. Later in the same month, the first bitcoin ATM went into use in
a Vancouver coffee shop.
Trading of bitcoins grew rapidly on the Mt. Gox exchange and other platforms. Many
online exchanges have now opened to trade bitcoin alongside other virtual currencies that have
sprung up as rivals,3 though some of these platforms are thinly capitalized and trading can appear
episodic at best. As bitcoin's value has increased, exchanges have become targets of hackers;
Mt. Gox in April 2013 reported three denial of service attacks that sharply reduced trading
volume on various dates, though in each case the exchange appeared to recover in a matter of
hours. A number of investment funds have opened to cater to bitcoin speculators, including one
that attempted to register with the Securities and Exchange Commission in July 2013 under
sponsorship of the Winklevoss twins, who have became famous in the world of digital
entrepreneurship due to their legal battles with Mark Zuckerberg over ownership of Facebook.
Bitcoin appeals to two distinct clienteles. One group consists of technology enthusiasts
who embrace bitcoin for online commerce. As more and more routine business transactions
migrate online, these users believe bitcoin's value should increase due to transaction demand,
and they also cite its cost advantages over credit cards and other payment systems for routine
bricks and mortar retail shopping. A separate group with pseudo-Libertarian political beliefs
finds bitcoin attractive due its lack of connection to any government. Some of these adherents
openly distrust the world financial system, and the timing of bitcoin's introduction, coinciding
8
with the very bottom of the global financial crisis in 2008-09, probably helped swell their ranks.
The technology and libertarian clienteles are united by their enthusiasm for bitcoin but
not much else. Discussions about the merits of bitcoin can attract odd mixes of entrepreneurs,
academics, and polemicists. An example occurred at a March 2014 panel discussion moderated
by a New York Times reporter. In response to a conjecture that up to 10% of the bitcoin supply
has already been pilfered by computer hackers, bitcoin entrepreneur Andreas Antonopoulos
called the 10% theft 'a vast improvement over the rest of our economy, where 80% is in the
hands of criminals ' and that's the banks.'4 As the audience applauded in approval, the famous
Stanford economics professor Susan Athey looked on from the other side of the stage with a mix
of exasperation and bemusement.
The daily transaction flow of bitcoin trades suggests that the large majority of worldwide
demand originates in two countries, the U.S. and China. While China has taken various steps to
ban the use of bitcoin, U.S. regulators have had a more benign attitude. The relative tolerance of
bitcoin by American regulators may stem from their recognition that a universal online audit trail
exists for bitcoin transactions. Although services such as 'tumblers' exist on the Internet that
purport to cloak bitcoin transfers in anonymity, confidence in the security of these protocols
appears to be naive. The arrest of Silk Road's operator in October 2013, which took place amid
widespread publicity of Internet data monitoring by the U.S. National Security Agency,
disabused many about the possibility of keeping any bitcoin-related information anonymous.
Tax evasion, money laundering, purchases of contraband, and other illicit activities using online
transfers become far riskier when the use of a virtual currency like bitcoin can be reconstructed
9
by governments that have sufficient technical skills.
III. Bitcoin's weaknesses as a currency
This section presents analyses of ways in which bitcoin fails to conform to the classical
properties of a currency. A successful currency typically functions as a medium of exchange, a
unit of account, and a store of value. Bitcoin faces challenges in meeting all three of these
criteria.
A. Medium of exchange
Because bitcoin has no intrinsic value, its worth ultimately hinges upon its usefulness as
a currency in the consumer economy. Evidence of bitcoin's footprint in daily commerce is
mostly anecdotal, consisting of newspaper stories about people living only by spending bitcoin
or estimates of large numbers of businesses that are willing to accept bitcoin. To date, only one
established business of any size has begun to take bitcoin, the online retailer.

Source: Essay UK - http://ntechno.pro/free-essays/finance/virtual-currency.php


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