The future of Bitcoin

Virtual currencies have grown significantly in the last few years and are now beginning to attract the interest of financial institutions, venture capital investors, and payment providers. As digital and mobile wallets are well placed to expand these new technologies to more mainstream, day-to-day use, many are now asking if they will be the next big thing to hit the payments world.

Current hype about open loop virtual currencies ignores the many risks and potential challenges that these currencies pose to providers. Although these currencies are unregulated, recent developments suggest they are not outside the realms of control by the authorities. Also, pricing volatility makes it unlikely that they will become a real mechanism of exchange for most consumers in the near future.

Not cut from the same cloth

Virtual currencies are not a single type of product, but instead fall into different categories. Closed loop currencies such as Microsoft Credits, Amazon Coins, and the now defunct Facebook Credits are operated by specific corporate entities, with mixed levels of uptake. However, most of the hype and attention being paid to virtual currencies today is focused not on these platforms, but on unregulated open loop currencies such as, most famously, Bitcoin, and others such as Litecoin and PPCoin.

Although each currency is slightly different, Bitcoin provides a template of how most open loop currencies work. Virtual currencies such as Bitcoin are technically known as peer-to-peer crypto-currencies. Created through the combined processing power of coin “miners,” the process is designed to produce only a finite amount of “bitcoins,” and the rate of production will slow over time as a means to help limit inflation. Using a block chain (a public record of all Bitcoin transactions) in a peer-to-peer network, bitcoins, which are divisible up to a millionth of a bitcoin, can be exchanged for goods or services or exchanged on currency markets, much like standard currencies. A digital wallet is central to Bitcoin for storage purposes, and mobile wallet platforms in particular will likely be critical to any future use of Bitcoin at the point of sale (POS).

Initially widely used for illicit purposes, open loop virtual currencies are now more commonly used by libertarian evangelists at the consumer and merchant level, and by providers of some mainstream sites such as WordPress and Reddit. Bitcoin providers and services are now growing, with many racing to be legally recognized processors and payment providers, and, in many instances, attracting significant levels of start-up investment. Interest is even growing among more mainstream payment providers, with PayPal executives, for instance, publicly suggesting that PayPal could accept Bitcoin on its platform in future.

No escaping the regulatory noose

Although virtual currencies may seem like an unstoppable force in digital payments, they can still be impacted, sometimes severely, by regulatory authorities, depending on the nature of the platform and the point at which virtual currencies interact with real-world currencies.

The recent high-profile arrest and blocking of payment processor Liberty Reserve highlights the challenges faced by virtual currencies. Liberty Reserve operated what is alleged to be the world’s largest-ever money laundering operation, processing over $US6 billion since 2006. The service operated by users exchanging money via intermediaries for “Liberty Dollars” and then exchanging these back to a local currency elsewhere. The actual system of exchange of Liberty Dollars was not itself illegal, but its complete lack of Know Your Customer (KYC) and anti-money laundering (AML) protocols made it a prime conduit for criminal activity. In this instance, the virtual currency itself was legal, but the operations built around it were not.

In March 2013, the US Financial Crimes Enforcement Unit (FinCEN) announced that businesses acting as brokers or transmitters for virtual money services must be registered as Money Service Business (MSBs). More recently, two separate accounts held by Mt. Gox (the world’s biggest Bitcoin currency exchange), one with Wells Fargo and one with online payment provider Dwolla, were seized by the Department of Homeland Security, reportedly due to Mt. Gox remaining unregistered as an MSB with FinCEN.

These moves highlight the fact that while trade for goods and services in virtual currencies cannot be directly regulated, the point at which these currencies interact with real currencies remains directly under standard financial controls. These legal challenges and instances of fraud also deal a blow to the image of Bitcoin and other virtual currencies as legitimate alternatives. If PayPal or any other established payment providers were to begin accepting Bitcoins, the regulatory hurdles would remain high, if not higher than they are for standard currency forms.

Price volatility a key factor

Although the criminal potentials of virtual currencies will attract some users, the volatility of prices of virtual currencies means most mainstream consumers will be unwilling to use them as a means of exchange in the near future. Their inclusion in other digital payment platforms may eventually become more common, but the day-to-day use of new virtual currencies in an open loop environment remains unlikely. The growth of these currencies in recent months is being driven more by their use as investment assets being hoarded by speculators than by their use as full means of exchange.

Between January 1, 2013 and May 30, 2013, the value of one Bitcoin grew by 880 per cent, from a closing price of $US13.30 to a closing price of $US130.55. In that time, Bitcoin went through a price bubble, starting roughly around the time of the financial bailouts in Cyprus and hitting an intraday peak of $US266 and a closing peak of $US230. Although the peak has since been corrected, the value of Bitcoin continues to increase at a steady rate.

This rise in prices has inevitably led to the creation of numerous Bitcoin millionaires, and it has attracted the attention of some institutional investors. As more rush to cash in, the use of Bitcoin as a legitimate means of exchange becomes more unlikely. For merchants, it becomes difficult to assess how to price items, while for consumers, buying everyday items such as a pizza or a coffee becomes an increasingly expensive proposition.

Gilles Ubaghs is a Senior Analyst in Ovum's financial services technology team