Michael Faraday on being asked about the use of Electricity in 1837

Introduction

Virtual Currencies such as Bitcoin (or BTC) are generating greater attention and scrutiny as more and more interest is generated in them. Virtual currencies are being designed primarily for use in e-commerce. What separate Bitcoin from other virtual currencies is that while other virtual currencies such as “Amazon coins” or those issued by Facebook are to be used in the particular network only, Bitcoin is the first “decentralized” digital currency, i.e., it is the first peer to peer currency which is meant for use across various platforms and is not just tied to a particular one such as Amazon or Facebook.

Bitcoin was launched in 2009 by a person (or group of persons) that is known by his pseudonym as Satoshi Nakamato. The idea behind launch of Bitcoin was to have a digital currency which can be used for payments across various e-commerce platforms without the reliance on financial intermediaries and which will not be affected by supply side problems currently affecting fiat money, which is of more and more printing of such currencies. In essence Bitcoin is a decentralized peer to-peer payments network and a virtual currency that essentially operates as online cash. Unlike traditional currencies, which are issued by central banks, Bitcoin has no central monetary authority.

Before Bitcoin the major obstacle in using digital currencies were the problem of double — spending, which in real world are being taken care by the trusted intermediaries such as a bank or credit card payment gateways such as Visa or MasterCard. For example if a person A transfers 100 rupees to another person B, the financial intermediaries such as a bank or Visa, use to debit the account of person A to the tune of 100 rupees and credit the account of person B to the same amount. Since Bitcoins are meant to be used for boundary-less internet transactions as there is no single intermediary who is there to take into account the ledger keeping across the globe. And the cost of such intermediary is humongous. Western Union Money transfer and MoneyGram charged fees of around 9% of the total transactions value for sending remittance in the first quarter of 2013 as estimated by the World Bank, which in some ways is similar to the idea of distributing cash like Bitcoins.

Bitcoin solved the problem of double-spending without the need for a third party and this is its unique feature. Bitcoin does this by distributing the necessary ledger among all the users of the system via a peer-to-peer network, akin to the networks that underpin BitTorrent, a file-sharing system, and Skype, an audio, video and chat service. Every transaction that occurs in the Bitcoin economy is registered in a public, distributed ledger, which is called the block chain. New transactions are checked against the block chain to ensure that the same Bitcoins haven’t been previously spent, thus eliminating the double-spending problem. The global peer-to-peer network, comprising thousands of users, takes the place of an intermediary. Bitcoin solved other major problems in using online currencies i.e. that of online theft and hacking by using advances in cryptography which keeps Bitcoins more secured compared to other such currencies. Bitcoin system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes. This makes Bitcoin network more robust to any hacking attack though it does not make it completely fool proof, just like theft of physical cash.

How does a Bitcoin get generated?

Bitcoins are mathematically generated as the computers in this network execute difficult number-crunching tasks, a procedure known as Bitcoin “mining”. The actual mining of Bitcoins is by a purely mathematical process. For Bitcoins the search is to find a sequence of data (called a “block”) that produces a particular pattern when the Bitcoin “hash” algorithm is applied to the data. When a match occurs the miner obtains a bounty of Bitcoins (and also a fee if that block was used to certify a transaction). The size of the bounty reduces as Bitcoins around the world are mined. The difficulty of the search is also increased so that it becomes computationally more difficult to find a match. These two effects combine to reduce over time the rate at which Bitcoins are produced and mimic the production rate of a commodity like gold. At some point new Bitcoins will not be produced and the only incentive for miners will be transaction fees. The mathematics of the Bitcoin system were set up so that it becomes progressively more difficult to “mine” Bitcoins over time, and the total number that can ever be mined is limited to around 21m. There is therefore no way for a central bank to issue a flood of new Bitcoins and devalue those already in circulation. This reduces the problem of supply side problem for Bitcoins and reduces the chances of long term inflationary pressure for Bitcoins, which is currently adversely affecting fiat currencies being used across the globe. However since supply is limited, theoretically the value of a Bitcoin, should there be significant unstated demand, could be significant.

Price discovery of Bitcoins

To transact in Bitcoins, one has to download a software that follows the Bitcoin Protocol was released that uses a network to effect the digital transfers. This software is commonly called the Bitcoin wallet software. Alternatively, some websites offer a web based online wallet allowing one to conduct transactions without downloading a client. These websites essentially are connected via the same Bitcoin protocol.

Bitcoins get traded on the basis of the underlying currency and each underlying currency has its own set of exchanges. The most active currencies are USD, EUR, AUD, CAD, GBP, HKD, SEK and NZD.

There are more than 10 exchanges for USD and EUR each the most used being Mt. Gox with sales of more than $14mn/month.

“Nobody can stop an idea, whose time has come” -Victor Marie Hugo

Advantages of Virtual Currencies like Bitcoins

The first question which comes into mind while using Bitcoin is why one should use Bitcoin when one can use fiat currencies like INR or USD or Euro. Bitcoin is still a new and fluctuating currency that is not accepted by many merchants, so the uses for Bitcoin may seem mostly experimental. But using Bitcoins have advantages, some of which are

A. True Global Currency — As of now there is no currency which can be used across the globe freely, though USD can be used across the globe for some of the transactions but it is not freely available and cannot be used across that freely. With the advent of internet, the concept of globe as one village is turning out to be truer. This calls for the designing of institutions and currencies which can be used across the world as freely as possible. The entire genesis of virtual currencies like Bitcoin is this idea — One globe, one system, one currency. Bitcoin has emerged as the first and the foremost currency, which is close to the above mentioned ideal.

B. Lower Transaction Cost –Because there is no third-party intermediary, Bitcoin transactions are substantially cheaper and quicker than traditional payment networks. Since Bitcoin facilitates direct transactions without a third party, it removes costly charges that accompany credit card transactions. Not having to pay merchant fees means that merchants who accept Bitcoin have the option to pass the savings on to consumers. That is the business model of the Bitcoin Store, which sells thousands of consumer electronics at discounted prices and only accepts Bitcoins. One of the biggest advantages of Bitcoins is in fund remittance, where the cost of fund transfers using Bitcoins is estimated to be much shorter and cheaper around 1% of total transaction amount unlike a delay of more number of days and cost of transactions of 9% as charged by the most established players like MoneyGram or Western Union Money transfer.

C. Providing liquidity in times of capital controls and high inflation — Since Bitcoins can be freely moved they have been used in past in Cyprus for movement of capital in times of capital restrictions and are widely used in countries like Argentina where the annual inflation rate is high. Technically speaking, any currency which takes the risk of devaluation or its citizens perceives a threat could effectively use Bitcoins as a safe alternative.

D. New Innovations — The Bitcoin protocol contains the digital blueprints for a number of useful financial and legal services that programmers can easily develop. Bitcoin is thus the foundation upon which other layers of functionality can be built. The Bitcoin project can be best thought of as a process of financial and communicative experimentation. Since Bitcoins are, at their core, simply packets of data, they can be used to transfer, not only currencies, but also stocks, bets, and sensitive information. Some of the features that are built into the Bitcoin protocol include micropayments, dispute mediations, assurance contracts, digital notarisation and smart property. These features could allow for the easy development of Internet translation services, instantaneous processing for small transactions (like automatically metering Wi-Fi access), anonymously and securely store a “proof of existence” for private documents and Kick-starter-like crowd funding services.

Disadvantages of Virtual Currencies like Bitcoins

Like all digital currencies and platforms which try to keep transactions to be used across the internet and anonymous Bitcoins also have disadvantages and some of them are

A. Online theft and hacking — Since online community is much larger compared to people living in one’s vicinity there are greater chances of people hacking into Bitcoin network to steal the Bitcoins. Bitcoin has fuelled a surge in the number of cyber-attacks where computers and personal data are held hostage in return for ransoms paid in Bitcoins, the almost-anonymous virtual currency.

B. Criminal Uses — Since Bitcoin transactions can be used freely across the internet and there is still no authority to track the payments done across Bitcoin networks, Bitcoin can be used for illegal activity such as online drug payment (such as the Deep Web black-market site known as “Silk Road”, which has been recently shut down by US authorities), money laundering and trafficking in illegal goods.

C. Volatility — Bitcoin has weathered quite a number of significant price adjustments since 2011. These adjustments resemble traditional speculative bubbles: overoptimistic coverage of Bitcoin prompts waves of novice investors to pump up Bitcoin prices. The exuberance reaches a tipping point, and the value eventually plummets. Newcomer investors eager to participate run the risk of overvaluing the currency and losing their money in a crash. Bitcoin’s fluctuating value makes holding Bitcoins tough for people who want to store Bitcoins as store of Value.

“Governments will always play a huge part in solving big problems. They set public policy and are uniquely able to provide the resources to make sure solutions reach everyone who needs them. They also fund basic research, which is a crucial component of the innovation that improves life for everyone.” Bill Gates

Economic Implications of Virtual Currencies

Historically money had two functions

i. To act as medium of exchange &

ii. To be store of value

After the advent of banking and financial institutions in medieval period the money added the third function as well, this was the credit creation, i.e., the transfer of money from one who has it to one who needs it. This has been made possible by the evolution and innovations in the banking which include

a) Cashless intra bank and interbank transactions , thus reducing the needs for coins and other such resources

b) Fractional reserve banking (the policy to hold a fraction of loans as reserves against loss making provision) &

c) Central Bank monopoly on note creation, as this induced faith in the currency in use and have imparted stability in the system and thus has made fractional reserve banking possible

In modern times the aspect of credit creation has become more and more important aspect of monetary phenomenon, as evident by the increasing nature of Marshallian k (the ratio of monetary base to nominal GDP).

For any virtual currency like Bitcoin to establish itself as an alternative to fiat currencies all three functions of money are equally important.

Policy Concerns

Historically human life has been mostly impacted by technological evolution from hunter gatherers to agricultural settlers to an industrial society and now to an ever connected society via internet and other means of communication. This makes it impossible for regulators and other governing bodies to ignore virtual currencies like Bitcoin, which for the first time make it possible to have a unified medium of exchange in internet, as these can and will greatly influence people’s behaviour both socially as economically in future in the same way introduction of physical money had done in the past. So it is imperative for government and policy makers to have a critical examination and study of virtual currencies, their impact on greater economy and society, and to be prepared for any eventuality brought by the technological disruptions will be the first step in understanding and providing the stewardship for ushering the society in next age.

Conclusion

The idea of virtual currencies like Bitcoin is catching up. The legal status of Bitcoin is unclear, as is evident from the fact that recently big governments have started to warn off the people against the use of digital currencies, since money is an integral part of how a society operates and a stable monetary system is one of the pillars of functioning of stable society. Also at the same time given the technological evolution and process the idea of a virtual currency for use in virtual economy in which the current human generation is moving has also got a fundamental case in favour of virtual currencies. Bitcoin may go bust due to resistance from various governments and technological flaws but the chances are that some form of digital money will make a lasting impression on the financial landscape. Given the socioeconomic impact and implications this calls for a greater understanding and development of necessary frameworks and institutions on part of policy makers and government to deal with this phenomenon.