English Homework

Department of Economics

Working Paper

College of Business Administration

Virtual Currency and the Financial System: The Case of Bitcoin

By

Abdur Chowdhury

and

Barry K. Mendelson

Working Paper 2013-09

VIRTUAL CURRENCY AND THE FINANCIAL SYSTEM: THE CASE OF BITCOIN

Abdur Chowdhury Department of Economics Marquette University

and

Barry K. Mendelson Senior Investment Analyst Capital Market Consultants, Inc.

Milwaukee, WI 53202

I. Introduction

Technological development and the increased use of the internet have led to the

proliferation of virtual communities. Some of these communities have created and

circulated their own currency for exchanging goods and services. Bitcoin is currently the

most popular among these virtual or digital currencies and has been in news recently

because of the wild fluctuations in its ‘value’ and also significant venture capital investment

in entities associated with it.1 Bitcoin is relevant in several areas of the financial system and

is therefore of interest to central banks, consumers and investors.

Digital currencies are part of a broader group of virtual currencies that include credit card

points, air miles, loyalty points and coupons (Chart 1). With the advent of the Internet,

mobile devices and detailed consumer information, companies are increasingly using

digital currencies as a marketing tool. As a result, there has been a sharp increase in the use

of digital currencies, particularly for app-based coins and tokens, mobile coupons, and

personal data exchanged for digital content. As these trends evolve, digital currencies have

the potential to become more popular and compete with traditional currencies.

This paper aims to provide some clarity in particular on Bitcoin, its role and potential

future use in the financial system and the risks associated with this form of digital

currency.. It will begin by providing a short introduction to the Bitcoin network as well as

describe the benefits of allowing the Bitcoin network to develop and innovate. It will

highlight concerns for consumers, policymakers and financial regulators. Next it will

analyze the role that Bitcoin could play in the financial system. The paper will conclude by

providing recommendations to address policymakers’ concerns while allowing for further

innovation within the Bitcoin network. An initial comprehensive overview of this kind is

absent from the existing literature. This paper intends to fill that gap in the literature.

1 Bitcoin is not the only virtual currency on the Web. There are others, such as Ripple, a new currency from a startup called OpenCoin.com

II. Bitcoin Network

Bitcoin is the world’s first completely decentralized peer-to-peer digital currency. A

software developer pseudo-named Satoshi Nakamoto published the Bitcoin Protocol

(Nakamoto, 2008) which outlined the theory of a decentralized currency. This was

followed in January 2009 by the release of the open-source Bitcoin software, and the

mining of the first Bitcoins. It rocketed to prominence in 2013, when the value of a Bitcoin

soared more than 10-fold in a two-month period, from $22 in February to a record $266 in

April (Chart 2).2 The price of a Bitcoin again rose to a record $710 on November 17, 2013,

before falling to $600 shortly thereafter. The nearly tripling of the price since early

November was fueled by rising expectations that the virtual currency will continue to gain

traction as an alternative to traditional methods of payment.3 At its peak, based on more

than 11.8 million Bitcoins issued, the digital currency boasted a market value of over $2

billion (Chart 3).4

Since its creation, Bitcoin has evolved from a mathematical proof of concept to a rapidly

expanding economic network. It is now being used in business transactions around the

world. Businesses big and small have shown interest in integrating the Bitcoin platform

into their operations and providing new services within the Bitcoin economy. The

momentum behind Bitcoin is coming from around the world, as amateur investors, venture

capitalists and technology enthusiasts pump money into businesses that are trying to

figure out how to use Bitcoin to buy and sell goods and (Chart 4).5 A growing number of

2 Bitcoins come in whole or in fractional form. Each Bitcoin is subdivided into 100 million smaller units called satoshis, defined by eight decimal places.

3 The prices are as of the writing of this draft on the Tokyo-based Mt. Gox exchange and on the Slovenia-based Bitstamp Exchange.

4 The Bitcoin economy exceeded $8 billion at one point in November, and investors and the U.S. Treasury are beginning to give the virtual currency legitimacy.

5 Sarah Needleman and Spencer Ante, “Bitcoin Startups begin to Attract Real Cash,” Wall Street Journal, May 8, 2013.

merchants accept Bitcoin, because the transaction costs associated with the currency are

generally lower than those for using credit or debit cards.

Instead of being made on a printing press or by a central authority, Bitcoins are generated

by solving complicated algorithmic searches by powerful computers, a process known as

mining.6 Most Bitcoin users do not mine, but purchase or trade for their Bitcoin. Mining

doesn't affect the average Bitcoin user much, but is still a very important part of the Bitcoin

ecosystem.

All newly mined Bitcoin, along with every transaction, are publicly recorded. This record is

known as the blockchain. While the blockchain records transaction details, it does not

record any personal identifying information about the senders or recipients. The

blockchain is a critical feature to maintain the transparency of the Bitcoin system, and

make counterfeiting or double spending impossible.

While Bitcoins are created through mining that pursuit is getting increasingly complicated

and expensive, as companies and technology fans race to build the powerful computers

required for Bitcoin production. There's a limit to the number of Bitcoins that can be

mined. After the year 2140, no more Bitcoins will be created, and the total amount ever

available is fixed at 21 million, more than half of which have already been mined (Chart 5).

The Bitcoin scheme is technically designed in such a way that its supply will increase at a

particular pace.

III. Theoretical Roots of Bitcoin

The theoretical roots of Bitcoin can be found in the Austrian school of economics and its

6 Mining is the calculation of a hash of a block header, which includes, among other things, a reference to the previous block, a hash of a set of transactions and a nonce (a 32-bit/4-byte field whose value is set so that the hash of the block will contain a run of zeros). If the hash value is found to be less than the current target (which is inversely proportional to the difficulty), a new block is formed and the miner gets 50 newly generated Bitcoins. If the hash is not less than the current target, a new nonce is tried, and a new hash is calculated. This is done millions of times per second by each miner.

criticism of the current fiat money system and interventions undertaken by governments

and other agencies, which, in their view, result in exacerbated business cycles and massive

inflation (ECB, 2012).

Friedrich A. Hayek of the Austrian School argued that governments should not have a

monopoly over the issuance of money. He instead suggested that private banks should be

allowed to issue non-interest-bearing certificates based on their own registered

trademarks. These certificates (i.e. currencies) should be open to competition and would be

traded at variable exchange rates. Any currencies able to guarantee a stable purchasing

power would eliminate other less stable currencies from the market leading to a healthy

and efficient monetary system. Following this line of reasoning, Bitcoin supporters believe

that, inspired by the former gold standard, Bitcoin could end the money-creating monopoly

of central banks. Although the theoretical roots of the scheme can be found in the Austrian

School of economics, Bitcoin has also raised serious concerns among some of today’s

Austrian economists.7

IV. Why People Might Want to Use Bitcoins?

According to the supporters of Bitcoin, it holds much promise as a way to lower transaction

costs for small businesses and global remittances, help alleviate global poverty by

improving access to capital, protect individuals against capital controls and censorship,

ensure financial privacy for oppressed groups, and spur innovation (Brito and Castillo,

2013).

Firstly, Bitcoin is attractive to cost-conscious small businesses looking for ways to lower

the transaction costs of doing business. Since Bitcoin facilitates direct transactions without

a third party, it removes costly charges that accompany say, for example, credit card

7 Their criticism covers two general aspects: a) Bitcoins have no intrinsic value like gold; they are mere bits stored in a computer; and b) the system fails to satisfy the “Misean Regression Theorem”, which explains that money becomes accepted not because of a government decree or social convention, but because it has its roots in a commodity expressing a certain purchasing power. See Matonis (2011).

transactions. And because transactions are cheaper, Bitcoin makes micropayments and

other innovations possible.

Secondly, as an inexpensive funds-transfer system, Bitcoin also holds promise for the

future of low-cost remittances. In 2012, immigrants to developed countries sent at least

$401 billion in remittances back to relatives living in developing countries (World Bank,

2013)8. The amount of remittances is projected to increase substantially in the near future.

Most of these remittances are sent using traditional brick-and-mortar wire services such as

Western Union and MoneyGram, which charge steep fees (9.0%) for the service and can

take several business days to transfer the funds. In contrast, transaction fees on the Bitcoin

network tend to be less than 1% of the transaction.9 This entrepreneurial opportunity to

improve global money transfers has attracted investments from big-name venture

capitalists. Bitcoin allows for instantaneous, inexpensive remittances, and the reduction in

the cost of global remittances for consumers could be considerable.

Thirdly, Bitcoin also has the potential to improve the quality of life for the world’s poorest

by improving access to basic financial services.10 According to one estimate, 64 percent of

people living in developing countries lack access to these services, perhaps because it is too

costly for traditional financial institutions to serve poor, rural areas.11 Because of the

impediments to developing traditional branch banking in poor areas, people in developing

countries have turned to mobile banking services for their financial needs.12 Mobile

banking services in developing countries can be further augmented by the adoption of

8 World Bank Payment Systems Development Group, Remittance Prices Worldwide: An Analysis of Trends in the Average Total Cost of Migrant Remittance Services (Washington, DC: World Bank, 2013), 9 In the first quarter of 2013, the global average fee for sending remittances was 9.05 percent (World bank, 2013). See, also, Andrew Paul, “Is Bitcoin the Next Generation of Online Payments?,” Yahoo!Small Business Advisor, May 24, 2013, 10 Muhammad Yunus, Banker to the Poor: Micro-lending and the Battle againstWorld Poverty (New York: Public Affairs, 2003). 11 Oya Pinar Ardic, Maximilien Heimann, and Nataliya Mylenko, “Access to Financial Services and the Financial Inclusion Agenda around the World” (Policy Research Working Paper, World Bank Financial and Private Sector Development Consultative Group to Assist the Poor, 2011). 12 The closed-system mobile payment service M-Pesa has been particularly successful in countries such as Kenya, Tanzania, and Afghanistan. See, for example, Jeff Fong, “How Bitcoin Could Help the World’s Poorest People,” PolicyMic,May 2013,

Bitcoin. As an open-system payment service, Bitcoin can provide people in developing

countries with inexpensive access to financial services on a global scale.

Fourthly, Bitcoin might also provide relief to people living in countries with strict capital

controls. The total number of Bitcoins that can be mined is capped and cannot be

manipulated. There is no central authority that can reverse transactions or prevent the

exchange of Bitcoins between countries. Bitcoin therefore provides an escape route for

people who desire an alternative to their country’s devalued currencies or frozen capital

markets. For example, people in Argentina have adopted Bitcoin in response to the

country’s dual burdens of a 25% inflation rate and strict capital controls.13

Additionally, one of the most promising applications of Bitcoin is as a platform for financial

innovation. The Bitcoin protocol contains the digital blueprints for a number of useful

financial and legal services that programmers can easily develop. 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.14 Some of the features that are built into the Bitcoin

protocol include micropayments, dispute mediations, assurance contracts, smart property,

etc.

V. Challenges Facing Bitcoin Users

Despite the benefits that it presents, Bitcoin has downside risks potential users should

consider.15 Firstly, Bitcoin has weathered at least six significant price adjustments since

2011.16 These adjustments resemble traditional speculative bubbles: overoptimistic media

coverage of Bitcoin prompts waves of novice investors to pump up Bitcoin prices.17 The

exuberance reaches a tipping point, and the value eventually plummets (Brito and Castillo,

2013).

13 Jon Matonis, “Bitcoin’s Promise in Argentina,” Forbes, April 27, 2013,

14 Jerry Brito, “The Top 3 Things I Learned at the Bitcoin Conference,” Reason, May 20, 2013. 15 It is also important to note that many of the potential downsides of Bitcoin are the same as those facing traditional cash. 16 Timothy B. Lee, “An Illustrated History of Bitcoin Crashes,” Forbes, April 11, 2013 and authors’ calculation. 17 Felix Salmon, “The Bitcoin Bubble and the Future of Currency,” Medium, April 3, 2013,

If Bitcoins were only used as stores of value or units of account, the currency’s volatility

could indeed endanger its future. It does not make sense to manage business finances or

keep savings in Bitcoin if the market price swings wildly and unpredictably. When Bitcoin

is used as a medium of exchange, however, volatility is less of a problem. Merchants can

price their wares in terms of a traditional currency and accept the equivalent number of

Bitcoins. Customers who purchase Bitcoins to make a one-time purchase don’t care about

what the exchange rate will look like tomorrow; they simply care that Bitcoin can lower

current transaction costs.

Secondly, Bitcoin presents some specific security challenges.18 If people are not careful,

they can inadvertently delete or misplace their Bitcoins since the currency is virtual and

not physical. Once the digital file is lost, the money is lost, just as with paper cash. Because

of the pseudonymous nature of Bitcoins, it could also be used for illegal transactions. In

October 2013, the U.S. Government accused Silk Road of making available a vast digital

marketplace where one could mail-order drugs and other illicit objects.

Another concern is that Bitcoin can be used to launder money for financing terrorism and

trafficking in illegal goods. Although these worries are currently more theoretical than

evidential, Bitcoin could indeed be an option for those who wish to discreetly move ill-

gotten money.19

VI. Is Bitcoin Money?

In its simplest form a traditional currency serves three purposes- medium of exchange, unit

of account and store of value. Bitcoin serves a role as a peer-to-peer network and a digital

currency. However, it is not a traditional currency in the strictest sense. As a medium of

18 Most of the security challenges concern wallet services and Bitcoin exchanges. The protocol itself has proven to be considerably resilient to hacking and security risks.. See Dan Kaminsky, “I Tried Hacking Bitcoin and I Failed,” Business Insider, April 12, 2013, 19 Concerns about Bitcoin’s potential to facilitate money laundering were stoked after Liberty Reserve, a private, centralized digital-currency service based in Costa Rica, was shut down by authorities on charges of money laundering. However, note that unlike Bitcoin, Liberty Reserve was a centralized currency service created and owned by a private company.

exchange, Bitcoin satisfies the condition of coincidence of wants; however, it lacks liquidity

because it has not been widely accepted. Its high-volatility makes it hard to predict and

thus can be a risky instrument to store value.20 Finally, Bitcoin’s role as a unit of account is

still confined to a small group of businesses and individuals.

VII. Bitcoin Versus Conventional Currencies21

Bitcoin differs from conventional currencies in some very fundamental ways, as noted

below (BBVA, 2013).

1. All functions such as Bitcoin issuance, transaction processing and verification are

carried out collectively through peer-to-peer technology (P2P) by the Bitcoin

network, without a central supervisor or agency to oversee operations. In contrast, a

conventional currency is issued by a central bank as part of its mandate to manage

national monetary policy. It is also the central authority that conducts monetary

policy, supervises banks, maintains financial system stability, and provides financial

services to depository institutions.

2. Although physical Bitcoins are available from companies such as Casascius and

BitBills, Bitcoin has been designed primarily to be a digital currency. Conversely,

conventional currencies exist primarily in physical form; the balances that an

individual holds at a bank or online brokerage can be converted into physical units

within minutes if so desired.

3. The total number of Bitcoins that will be issued is capped at 21 million and that limit

will not be reached until 2040.22 While Bitcoin critics argue that the maximum limit is

not large enough, supporters maintain that since each Bitcoin is divisible to eight

20 In fact, the sharp buying and selling due to the Cyprus bail-in showed bitcoin’s vulnerability to speculation and highlights how unpredictable its value can be.

21 This section is based on BBVA, 2013.

22 The Bitcoin “mining” process presently creates 25 Bitcoins every 10 minutes (the number created will be halved every four years), so that limit will not be reached until the year 2040.

decimal places, the number of fractional Bitcoins (called “satoshis”) – at 21 x 1014 – will

be more than enough for all conceivable applications. Conventional currencies, on the

other hand, can be issued without limit.

4. Bitcoin has limited acceptance so far and cannot be used at brick-and-mortar

storefronts, although that may eventually change if it continues to gain traction.

Conventional currencies, on the other hand, have near-universal acceptance.

Moreover, a Bitcoin transaction can take as long as 10 minutes to confirm.

Transactions are also irreversible and can only be refunded by the Bitcoin recipient.

These limitations do not exist with conventional currencies, where debit and credit

transactions are confirmed within seconds; certain transactions can also be

reversed for valid reasons by the originator, without having to rely on the

recipient's largesse.

5. If you lose your Bitcoins for any reason – for example, your hard drive

crashes, or a hacker steals the digital wallet in which your Bitcoins are stored or the

Bitcoin exchange where you held a balance went out of business – you have little

recourse. Currency balances held at banks, on the other hand, are insured against

certain events such as bank failure by legal agencies.

VIII. Bitcoin and the Financial System

Because of its drawbacks as a currency, Bitcoin’s insertion in the financial system has not

been smooth. The supply of Bitcoins cannot be controlled, regulated or supervised by any

public authority and although businesses using Bitcoins can be regulated, Bitcoin

transactions and mining cannot. It derives its value from decentralization and anonymity.

Anonymity makes it difficult to manage credit, counterparty, liquidity, market, operational

and legal risks. Therefore, Bitcoin, in its current format, is not compatible with banks and

regulators’ quest for transparency and accountability.

Consequently, the involvement of banks in the Bitcoin environment has been marginal and

confined to banks servicing businesses that operate with Bitcoin. In most countries, banks

are required to know their customers and comply with anti-money laundering regulations,

which are difficult to comply with in the Bitcoin network.23

Ultimately, lack of government support and vulnerability to money laundering make it very

difficult for Bitcoin to become a true competitor of benchmark currencies. Without the

backing of governments and monetary authorities, Bitcoin’s role in the global financial

system will be limited to a niche currency or a digital commodity.

Despite its shortfalls to become a widely accepted currency, Bitcoin’s limited supply and

anonymity is an attractive option for supporters of a decentralized monetary policy system

and people that have lost trust in the financial system after the recent global crisis. In

addition, it could be attractive for individuals looking to hedge against unstable local

currencies.

From an institutional perspective, even though today's money is increasingly moving in an

electronic environment, it is still managed by the banking industry. However, in its purest

form, digital peer-to-peer currencies eliminate the need of banking intermediation and

sovereign guarantees. A decentralized digital currency challenges the entire monetary and

banking system (BBVA, 2013).24

23 For example, the U.S. Department of Homeland Security seized Mt. Gox’s bank account at Wells Fargo, alleging violations of anti-money laundering regulations. Likewise, Barclays and Royal Bank of Canada have frozen or shut down bank accounts tied to Bitcoin businesses.

24 Ripple, created by a private company, was designed to serve a dual function as a currency and a payment

system, allowing for faster processing times and lower fees.

For digital currencies to succeed they have to be trustworthy and that necessarily implies

the recognition of governments and financial institutions. This is going to be hard for digital

currencies like Bitcoin that are by design anti-establishment.25

IX. Bitcoin and Monetary Policy

As discussed earlier, the Bitcoin scheme is designed as a decentralized system where no

central monetary authority is involved. Bitcoins can be bought on different platforms.

However, new money is created and introduced into the system only through mining

activity, i.e. by rewarding the “miners” who perform the crucial role of validating all

transactions made, with new Bitcoins.

Therefore, the supply of money does not depend on the monetary policy of any virtual

central bank, but rather evolves based on interested users performing a specific activity.

According to Bitcoin, the scheme has been technically designed in such a way that the

money supply will develop at a predictable pace. The number of Bitcoins in existence will

reach 21 million in around 2040. From this point onwards, miners are expected to finance

themselves via transaction fees.

The fact that the supply of money is clearly determined implies that, in theory, it could not

be changed by any central authority or participant wanting to “print” extra money.

According to Bitcoin supporters, the system is supposed to avoid inflation, as well as the

business cycles originating from extensive money creation. However, critics have suggested

that the system leads to a deflationary spiral. The total supply of Bitcoins is expected to

grow geometrically until it reaches a finite limit of 21 million. If, however, the number of

Bitcoin users starts growing exponentially for any reason, and assuming that the velocity of

money does not increase proportionally, a long-term appreciation of the currency can be

expected. This would imply a depreciation of the prices of the goods and services quoted in

25 In March, 2013 the U.S. Financial Crimes Enforcement Network (FinCEN) clarified rules set in 2008’s Bank Secrecy Act (BSA) which governs digital currencies. Under the BSA, exchanges and administrators of digital currencies are considered money-services business (MSB) which requires federal and state registration.

Bitcoin. People would have a great incentive to hold Bitcoin and delay their consumption,

thereby exacerbating the deflationary spiral.

Brito and Castillo (2013) have, however, pointed out that the extent to which this could be

a problem in reality is not clear. Firstly, as highlighted by the Economist (2011a), the

deflation hypothesis entails an assumption which is not realistic at this stage, i.e. that many

more people will want to receive Bitcoin in return for goods or in exchange for paper

money. However, Bitcoin is still quite immature and illiquid which is a clear disincentive

for its use. Secondly, Bitcoin is not the currency of a country or currency area and is

therefore not directly linked to the goods and services produced in a specific economy, but

linked to the goods and services provided by merchants who accept Bitcoin. These

merchants may also accept another currency (e.g. U.S. dollars) and therefore, the fact that

deflation is anticipated could give rise to a situation where merchants adapt the prices of

their goods and services in Bitcoin.

X. Concluding Remarks

Successful virtual currencies must reach a balance between convenience and compliance

(BBVA, 2013). Trust in the U.S. dollar comes from the strength of the U.S. economy and its

institutions. Would people trust a currency that is backed by a private entity or an

unknown developer? Would the average person hold their savings in a digital wallet rather

than a bank account that is insured by a deposit guarantee fund? Who will be accountable

for a failure in the systems that create the digital currencies? These and other serious

questions will need to be considered by future developers of virtual currencies

On the other hand, governments and financial institutions should also recognize the fact

that it is only a matter of time before new models of virtual currency like Bitcoin become

more mainstream. So the challenge for policymakers will be to foster Bitcoin’s beneficial

uses while minimizing its negative consequences.

We conclude with some recommendations to help policymakers meet this future but fast

closing challenge.

• Monitor market developments of Bitcoin, provide analyses, including payment statistics,

act as “catalyst”

• Facilitate a social dialogue between Bitcoin stakeholders to:

– develop a payments strategy and set work priorities,

– set business requirements for specific payment instruments,

– identify harmonization and standardization needs.

• Set challenging payments security requirements

• Regularly update the legal framework to:

– provide clarity on responsibilities and liabilities,

– remove obstacles that hinder innovation or competition,

– facilitate market entry for new, innovative types of providers.

References

Banco Bilbao Vizcaya Argentana (BBVA), “Bitcoin: A Chapter in Digital Currency Adoption,”

July 31, 2013.

Brito, Jerry and Andrea Castillo, “Bitcoin: A Primer for Policymakers,” Mercatus Center,

George Mason University, 2013.

Economist, “How Does Bitcoin work?” The Economist, April 11, 2013.

European Central Bank, Virtual Currency Schemes, October 2012.

Grinberg, Reuben (2011), “Bitcoin: An Innovative Alternative Digital Currency”, Yale Law

School Working Paper Series, April.

Hayek, Friedrich A. (1976), Denationalisation of Money, 3rd edition., The Institute for

Economic Affairs, London.

Investopedia, “How Bitcoins Works? June 29, 2011; available at

http://www.investopedia.com/articles/investing/072913/how-bitcoin-works.asp

Matonis, Jon (2011), “Why Are Libertarians Against Bitcoin?”, The Monetary Future, 16

June.

Nakamoto, Satoshi (2009), “Bitcoin: A Peer-to-Peer Electronic Cash System”, available at

http://bitcoin.org/bitcoin.pdf

Chart 1

Chart 2

Source: http://blockchain.info/charts (accessed on November 20, 2013)

Chart 3

Chart 4

Chart 5: Total Bitcoins over Time