Analysis: Understanding Bitcoin and crypto-currency

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In the beginning

Bitcoin and other "crypto-currencies" have been touted by their followers as the money of the future. However, the last 12 months have shown the pluses and minuses of the technology.

Crypto-currency is an attempt to replace money transactions with a digital medium of exchange using peer-to-peer networking. The first one, and still the most successful, was Bitcoin, which was created in 2009 by the mysterious developer "Satoshi Nakamoto."

• Bitcoin explained: what is Bitcoin?

It was first suggested in 1998 by Wei Dai on the cypherpunks mailing list and it was built around a philosophy that money is any object accepted as payment.

Virtual money, real impact

The idea is that you use cryptography to control the creation and transfer of money, rather than relying on central authorities.

Since the success of Bitcoin, there have been others which are starting to make names for themselves such as Ripple, Litecoin, Peercoin, Mastercoin, Namecoin and Quarkcoin. Even publications like Arstechnica have come up with their own crypto-currencies.

Many other crypto-currencies have just died because no one used them. Non-Bitcoin crypto currencies are collectively known as altcoins and they are more or less based on the same idea.

Their success depends on how much "cash" (the total value of transactions) they have running around the peer-to-peer network (i.e the virtual economy). Since Bitcoin is open-source, anyone can develop their own crypto-currency using the same technology.

A short lesson in scarcity

Bitcoins derive their value partly through their scarcity, which is defined by a cryptographic lottery. You can buy Bitcoins on online crypto currency exchanges or you can earn them through "mining."

Bitcoin mining programs compute an encryption function called a "hash" on a set of random numbers. Coins are awarded every 10 minutes to whichever miner happens to compute a number below a certain threshold.

A few years ago, Bitcoin mining was handled by standard PCs with powerful graphics cards, but as the hash difficulty has gone up, the only way to mine Bitcoins is to employ a Bitcoin ASIC, a chip that has been designed specifically for this task.

This lottery favors those with the biggest and fastest machines and by 2014, there will be about 12 million Bitcoins in circulation. Note that the total number of Bitcoins in (virtual) circulation will never exceed 21 million because of the way the system was designed.

As the Bitcoin network gets bigger, the hash gets more complex and miners, they get fewer Bitcoins for their trouble, hence they always need better hardware and higher Bitcoin prices to make it worthwhile.

The running of this lottery is what powers the financial transactions behind the network. In theory, it means that it is highly secure, untraceable, fast, and practically free.

Anonymity Guaranteed?

However, the few years that it has been running as a currency have revealed a few flaws which show that Bitcoin is an efficient proof-of-work for transactions which is cheaper and faster than any other method.

As a currency, it is not doing so well. For a currency to work, it needs to derive its value from efficiency and mainstream use. This is beginning to happen now with various online stores accepting Bitcoins and other crypto-currencies but is still widely regarded as a niche market.

Unfortunately, it also makes it possible to launder money and buy illegal products. Since Bitcoins can be spent on the Internet without the use of a bank account, they offer a convenient system for anonymous purchases. Since there is no money stored anywhere, accounts can't be frozen by police or PayPal administrators.

Nermin Hajdarbegovic, a freelance journalist and regular CoinDesk contributor, points out that Bitcoin should not be viewed as a currency, but rather as a low-friction payment technology that also happens to include its own currency.

"As a payment service, as a decentralized network for low-cost transactions, it's pretty clever and promising for micro-transactions, remittances, content monetization and so on," said Hajdarbegovic. "As an everyday currency and a mainstream alternative to national currencies, Bitcoin has a fair share of shortcomings, especially on the regulatory front."

Ideal for small transactions

This makes Bitcoin useful for small electronic payments for things like magazines and in-app purchases, since it is difficult to transmit small amounts efficiently using existing payment systems.

With a content monetization system based on the Bitcoin protocol, you could run up against a paywall, the site would display a WR code, and you would be able to scan it and pay $0.25 or even less to read to piece if you are interested. The same transaction with a credit card would cost a couple of dollars in fees.

Goldman Sachs, PriceWaterhouseCoopers and UBS have published reports saying that the technology works, but implementing it without regulation is next to impossible.

In its report entitled All About Bitcoin, Goldman Sachs said that crypto-currency was less vulnerable to cybercrime and was an "innovative payments technology but was unlikely to become a real currency unless it overcame some important problems."

The biggest problem was the volatility of Bitcoin prices which exceeded the volatility of other currencies and gold. Because its supply was ultimately limited, prices will need to vary to accommodate shifts in demand, not the other way round. Unlike gold, Bitcoin also has no intrinsic value from alternative uses that could anchor its price.

Goldman Sachs's view on the security of Bitcoin as a system also took a battering when in March, Mt. Gox, once the world's biggest Bitcoin exchanges, filed for bankruptcy after claiming it lost $400-million of its customers' Bitcoins following a hack attack. It turned out some were stored in an "old wallet".

Not fit for business?

As a currency, Bitcoin is not stable enough for most businesses. The value of a Bitcoin fluctuates dramatically and because there are no controls there is nothing to stop money vanishing if the price tanks.

Bitcoin payment processors offer a way of getting around this problem, as they convert the transaction to hard currency almost instantaneously. Many companies want regulation to provide them with some security that they are not going to lose a fortune on it.

The chief executive of the Bank of Montreal Bill Downe summed up the view of the financial industry that he would be open to dealing in Bitcoin transactions if the virtual currency becomes more clearly regulated.

In Europe Yves Mersch, Member of the Executive Board of the European Central Bank said digital currencies are still too small to have an impact on retail payments and central banks.

The only danger to the financial system is that they do pose a risk for users, particularly those who have been using them for speculative investments. For now, the ECB is just keeping an eye on things rather than calling for new rules, Mersch said.

European pressure for regulation appears to be coming from Europol, the European Union's top law enforcement agency. It wants greater powers to identify criminal activities online, including digital money laundering.

Irish lawmaker Patrick O'Donovan has also called for a parliamentary probe into digital currencies and their effect on illicit financial transactions.

Bitcoin's future

There are some signs that governments are starting to look at regulations and this is clearly proving difficult.

All these things will probably keep Bitcoin locked out of being a significant currency. Bitcoin's market capitalization currently stands at about $5.5 billion, which means the value of all Bitcoins on the market is less than the M2 money supply in Guatemala.

Goldman Sachs thought it was more plausible that Bitcoin could have a significant impact in terms of its innovation on payments technology, "by forcing existing players to adapt to it or co-opt it."

However, the report said that Bitcoin's "biggest hurdle" will be maintaining its cost advantage in the face of greater regulation, higher operating costs, and competition from entrenched players which are almost certain to come.

Fitch Ratings came to a similar conclusion as It found that Bitcoin stands to lose much of its appeal if Bitcoin companies are forced to deal with the added cost of regulation, rendering the near frictionless Bitcoin network much less cost-effective than it is today.

It seems that the sheer success of Bitcoin which seems to have jumped from a shadowy entity to an all-star one overnight has hurt its long term viability.

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