bitcoin and the future of money

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Page 1: Bitcoin and the future of money

86 GlobeAsia July 2013

Technology

or the uninitiated, Bitcoin is a virtual currency created in 2009 that has of late exploded in popularity worldwide. Created by

a person or group of people known collectively under the pseudonym Satoshi Nakamoto, Bitcoins are slowly increasing in circulation and now have a market cap of over $2 billion.

While introducing currency had previously been the purview of nations, now it’s being taken over by a rag-tag group of monetary enthusiasts who refuse to let their government tell them what money is worth. Bitcoin effectively democratizes money, as anybody with a computer and an internet connection can create and spend their own Bitcoins.

Since the currency is free from any governing authority, it cannot be artificially manipulated. Recent occurrences such as the United States bank bailout, the LIBOR scandal or the crisis in Cyprus have left many questioning whether the governments and banking institutions in those cases are making prudent decisions. Considering the massive debt in the US and the instability in Europe as the EU struggles to stay solvent, it’s easy to see why Bitcoins have become so popular.

 Bitcoin is different One of the main ways central governments create money is by manipulating interest rates. The Federal Reserve, for example, routinely adjusts the interest rates in the US. When rates

are lowered, banks are incentivized to borrow money from the Fed, which creates that money out of thin air.

Ever since the US got off the gold standard in 1971, there is nothing substantial that backs this money. The bank in turn lends that money to its customers, thus increasing the total money supply.

While lowered interest rates are a boon to people looking for cheap loans, they are a nightmare for those living on savings who just saw the interest on those savings slashed. The only reason the Federal Reserve is able to raise

and lower rates at will is because it has a monopoly on issuing money that’s considered legal tender in the US.

Bitcoin, on the other hand, is very different. Bitcoins are created when a so-called Bitcoin “miner” or a team of miners are able to use their computer processing power to decode an unknown 64 byte number, at which point 25 Bitcoins are released into the system.

The software code that governs the creation of Bitcoins ensures each successive block of Bitcoins is mathematically more complex to create

Bitcoin and the future of money

Page 2: Bitcoin and the future of money

July 2013 GlobeAsia 87

By Jason Fernandes

then the last, and also that there will never be more than 21 billion Bitcoins in the entire system. 

While like many other currencies there is again nothing that backs Bitcoin, its method of creation provides a built-in safety net for its value. Unlike the US dollar whose supply can be increased by $1 million or $10 million just as easily at the stroke of a pen, each additional Bitcoin mined requires a steadily increasing amount of actual real world resources, such as time and processing power, to produce.

Why Bitcoin is the answerLately there is an increased concern that governments and large banking institutions have betrayed the public’s trust. Those following the crisis in Cyprus may be aware that the government there has essentially gone into people’s bank accounts and taken a portion of their money away. That which would have seemed inconceivable a few short years ago is now a reality these people must live with.

This is far from an isolated incident. The inter-connectedness of financial institutions worldwide and the US dollar’s status as a reserve currency have often led to ripple effects globally. The US bank bail-outs, for example, resulted in the influx of billions of dollars into the banking system and a downgrade of the US credit rating.

While the original rationale for the bank bailout was that the banking institutions were “too big to fail,” the banks have grown even bigger since the bail-out. In the three years immediately after the bail-out, the five major banking institutions have gone from managing $6.1 trillion in assets to $8.5 trillion – an increase amounting to 13% of the entire US economic output.

One shudders to think what would happen the next time one

of them makes a bad decision. The ramifications on the global scale could be catastrophic.

The US cannot be singled out for criticism, however, as even Europe has its own issues. The LIBOR (London Interbank Offered Rate) scandal has proved that major financial institutions in the United Kingdom were not above manipulating the interest rates worldwide for their own profit. The scandal revealed that traders would routinely manipulate the LIBOR upwards or downwards depending on their trades for the day.

An adjustment downwards would increase their credit score and promote a perception of better financial health, while an adjustment upwards would result in higher loan rates for customers. Since LIBOR is the most widely used interest rate in the world, its value also sets the rates of US derivatives and loans. Thus the ripple effects of the LIBOR scam were felt throughout the global financial marketplace.

Many view the banking institutions and governments that control, issue and manipulate currency as the proverbial fox guarding the henhouse. The machinations are too complex and opaque for the average person to understand and abuse is rife. Bitcoins offer a solution because they are capped at finite amounts and their functioning is completely transparent.

The code also happens to be open source and can be freely examined by

anybody so inclined. Bitcoin can never be manipulated by a sudden increase in supply and, instead, its supply increases in a measured, predictable manner.

Bitcoin does have drawbacksSome of the biggest advantages of Bitcoin could also prove the biggest barrier to its mass adoption. Bitcoin is unregulated and completely anonymous. While many herald this as a major benefit, it puts Bitcoin squarely in the sights of regulatory authorities of various governments in whose jurisdiction these transactions occur.

US prosecutors recently shut down Liberty Reserve, the second largest Bitcoin exchange, for alleged criminal links and money laundering. This is the sort of risk that’s part and parcel of the anonymous currency concept.

People have used Bitcoin to purchase everything from guns to drugs, all anonymously via a website known as the Silk Road that accepts payment solely in untraceable Bitcoins. It’s unlikely that the currency will be allowed to survive in its present form without heavy attempts by governments to regulate it.

The other problem with untraceable Bitcoins is that one’s entire Bitcoin portfolio is stored on one file in one’s PC (known as a Bitcoin Wallet) and is thus susceptible to theft. While some have chosen to store their Bitcoins in services that provide essentially the equivalent of an online vault, these too have been targeted by hackers in the past.

Many view the banking institutions and governments that control, issue and manipulate currency as the proverbial fox guarding the henhouse. Bitcoins offer a solution because they are capped at finite amounts and their functioning is completely transparent.

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Technology

The problem is that there is no remedy for theft because even the Bitcoins obtained through theft are as valid and untraceable as those obtained through other means. If a credit card was lost, one could just call and cancel it – but there is no way to do that with Bitcoin.

On the other hand, one could say the same is true for actual currency. If you lose your wallet, you have little means at your disposal to track that money down and reclaim it. That said, at least Bitcoiners do not have to be concerned with the government

deciding it can reach into your digital wallet and help itself to some of your money, as was the case in Cyprus.

Another concern is the volatility of the currency. Over the course of their existence Bitcoins have cost anything from $5 to a high of $266 and everything in between. This makes it difficult for businesses to feel stable in accepting it in lieu of payment.

Since there is no central regulatory authority, the buffer role that central banks play in stabilizing currency fluctuations just does not exist in this case. On the other hand, services have slowly been emerging that would ease this sort of volatility.

Websites like Bitpay, for example, allow merchants including those on Amazon to accept Bitcoins and have the funds transferred to their bank accounts in real currency at the close of the business day. This eases risks somewhat for business owners, because

the currency is unlikely to have a massive negative fluctuation simply over the course of the business day.

Also, as more people begin to use Bitcoins, the currency will automatically stabilize as, with increased usage, the market will figure out how to price them reliably. There are currently a little over 11 million Bitcoins in circulation and there is quite a bit of mining left before Bitcoin hits the hard limit of 21 billion Bitcoins. That means of course, that many more Bitcoins will be introduced

into the system. More Bitcoins in circulation will mean more people with a vested interest in maintaining its value.

Many have suggested that since the system is designed to become progressively harder after every Bitcoin is released that miners will lose interest in the currency once it is no longer economical to mine. They predict that deflation is a real possibility with Bitcoins because increased scarcity would change the economics of the system.

These naysayers fail to consider Moore’s law which, if applied to Bitcoin, suggests that the computing power will likely increase at such a rate so as to offset the increasing complexity needed to make more Bitcoins.

 How will this all play out?Bitcoin will likely face extreme resistance from both the financial

services industry and government regulatory agencies. Bitcoin represents disruptive change in the way these two groups do business and they are not likely to take it lying down.

The financial services industry, for example, will have to completely revamp its business strategies. Credit card and money transfer companies will have to drastically drop their rates to compete with the much lower rates that govern Bitcoin transactions.

Governments, too, will push back and lobby for increased regulation to prevent things like money laundering, but will likely be more concerned at losing their monopoly on determining what constitutes money.

The future for Bitcoin is wide open. The genie has been released from the bottle, never to return. While Bitcoin itself may not survive long-term, the concept itself is here to stay: record companies were able to shut down Napster, but file sharing lives on in the dark corners of the internet.

Ultimately, the government cannot prevent an otherwise legal transaction between two parties from happening, simply because it doesn’t like what is being bartered. Bitcoin has value because several people the world over mutually agree that it does. The most recent exchange rate has one Bitcoin hovering at $109 and, while it has come down off its high from several weeks ago, it still retains quite a bit of its value.

As the world financial markets remain in flux, Bitcoin will continue to be an attractive option for many looking to diversify their cash holdings to guard against sudden fluctuations. Bitcoin represents a change in the way we earn, spend and think about money. Bitcoin is Money 2.0.

Jason Fernandes is a tech commentator

and the founder of SmartKlock.

Ultimately, the government cannot prevent an otherwise legal transaction between two parties from happening, simply because it doesn’t like what is being bartered.