Featured Financial Technology

Bitcoin: The Next Step in Money’s Evolution


By: Jack Roth

Bitcoin is an elegant implementation of a digital currency that is gaining in popularity and value and may soon rival or replace existing currencies.

Bitcoin, launched in 2009, is a cryptocurrency, a digital asset designed to work as a medium of exchange that uses cryptography to control its creation and management; therefore it does not rely on central authorities. Tyler Winklevoss, co-creator of Facebook, said about bitcoin: “We have elected to put our money and faith in a mathematical framework that is free of politics and human error.”

A diverse range of factors has made bitcoin one of the most volatile currencies in the world, and it means different things to different people. For some, it is the future of freely-moving currency untied to any central bank. To others, it is a digital entity of questionable value and dubious origin. Simply stated, bitcoin is a digital currency, but, in truth, it has the potential to become a world currency and a viable way to pay for things and transfer assets.

Bill Gates, founder of Microsoft, has called bitcoin “a techno tour de force.” Peter Thiel, co-founder of PayPal, said “bitcoin is the first encrypted money that has the potential to do something like change the world.” And Al Gore, the 45th vice president of the United States, said, “I think the fact that within the bitcoin universe an algorithm replaces the functions of the government is actually pretty cool. I am a big fan of Bitcoin.”

Digital Currency and Bitcoin

Francois Velde, senior economist with the Federal Reserve Bank of Chicago, described money as a medium of exchange — something that is accepted in exchange for a valuable good or service, not for itself but to be exchanged later for another good or service. For thousands of years, he said, that medium has taken the form of a physical object whose supply is scarce, either naturally (precious metals) or artificially (a token issued by a monopolist). Today in the United States, base money takes the physical form of coins (tokens issued by the United States Mint under authority of Congress) and notes (which used to be circulating claims on the Federal Reserve but are now in the nature of paper tokens), as well as the electronic forms of reserves, which are claims held on the books of the Federal Reserve by depository institutions (claims to notes and coins).

The concept of money or currency, however, continues to evolve. Individual traders, seeking to circumvent the volatility and unpredictability of national currencies tied to political decision making, have experimented with new digital currencies such as the bitcoin, traded entirely in an online electronic environment.

Bitcoin came to be when a person (or group) under the pseudonym Satoshi Nakamoto introduced a platform (Bitcoin, uppercase) that hosts a digital currency (bitcoin, lowercase).

Bitcoin the platform is built on the concept of “proof of work” data that is expensive and time-intensive to produce but can be easily verified. This proof of work is created through the process of “mining.” According to Bitcoin Magazine, in order to mine a bitcoin, a computer must complete a complicated algorithm, essentially going through the work of an extensive calculation in exchange for some newly minted currency. That piece of digital currency is worth whatever the market decides through supply and demand.

Transactions are connected to a user’s Bitcoin address, which is stored on its general ledger, known as the blockchain. Transactions on the blockchain are verified by the consensus of every member, offering security and trust without a third-party overseer. Bitcoin Magazine states that the essential power of blockchain technology is its ability to distribute information. The network automatically verifies itself at certain intervals, creating a self-auditing system that guarantees the accuracy of the data it holds. Companies such as Microsoft and Deloitte are developing new uses for the blockchain because they believe its decentralized and verifiable nature give it a huge potential beyond digital currencies.

“We have elected to put our money and faith in a mathematical framework that is free of politics and human error.” – Tyler Winklevoss

To Bitcoin or Not to Bitcoin

People are betting on bitcoin because they believe it will turn into a full-fledged currency, but some are more skeptical.

“Bitcoin is not a claim to a physical object or to a currency; it aims to be itself a currency and replace the physical object with a computer file,” explained Velde in an essay in the Chicago Fed Letter. “When a physical object is exchanged, there is little doubt the giver owns it and the recipient receives it. A digital file is easily created and duplicated, so how do we avoid doubts about its authenticity as currency?”

Velde added that bitcoin is a fiduciary currency, meaning that unlike commodity-based currencies (such as gold coins or bank notes redeemable in gold), it has no intrinsic value and derives its value in exchange either from government fiat or from the belief someone else may accept it.

“They are inherently fragile; government orders can be ignored or doubted, and a currency that has value only because of the belief it will have value may have no value at all,” he cautioned. “Once created, the bitcoin has no value other than in exchange, contrary to a gold coin.”

Velde questioned whether bitcoin can truly rival or even replace existing currencies — particularly in the form of cash. “A dollar bill in my hand cannot be anywhere else at the same time, my ownership of it is undoubted, and it can be exchanged immediately and finally,” he wrote. “A fiduciary currency like bitcoin is useful only insofar as others accept it broadly.”

That said, he gave credit where credit was due, stating that Bitcoin represents a remarkable conceptual and technical achievement that may well be used by existing financial institutions (which could issue their own bitcoins) or eventually even by governments themselves. We are seeing glimpses of this already, with the European Central Bank and European Banking authority having both released detailed reports on digital currencies and suggested regulation of the industry by the EU to further control price fluctuation. An HM Treasury report introduced anti-money laundering, consumer protection and technical standardization for digital currency companies in the United Kingdom, which has encouraged traditional financial services to engage more with digital currency businesses and accelerate the integration of blockchain technology within financial services.

” A fiduciary currency like bitcoin is useful only insofar as others accept it broadly” – Francois Velde

Bitcoin enjoys the backing of no government or third-party entity like a bank.

• Every Bitcoin address has a private key, which allows users to take bitcoins from a bitcoin wallet or send them to others. It must be protected to keep bitcoins safe.

• Bitcoin wallets grant users access to their public Bitcoin address and allow them to sign off on transactions.

• Desktop wallets allow users to create an address for sending and receiving bitcoins and provide a place to store the private key for doing so.

• Mobile wallets, accessed through apps, allow users to transact
on the go.

• Custodial wallets, which store Bitcoin keys on the Internet through a third-party website, also allow users to access their bitcoins from almost anywhere.

• Bitcoins are mined by a network of participants who chronologically order transactions by including them in the Bitcoin blocks
they find.

Besides mining for bitcoins, you can earn them by providing goods and services in exchange for the digital currency.

Bitcoin is not anonymous, at least not entirely. Bitcoin transactions are linked to a specific address, and, thus, an identity, which is why it is often described as “pseudonymous.”

• In the United States and other countries, authorities fear that Bitcoin could be used for money laundering and the purchase of illicit goods without being traced.

• According to the U.S. Treasury Department’s Financial Crimes Enforcement Network, using bitcoin to purchase well-natured goods and services is not illegal.

• The IRS views bitcoin and other virtual currencies as property for federal tax purposes, similar to stocks and bonds, and federal tax law dictates that purchasers and/or sellers must treat it as such.

• Bitcoin is illegal in some countries, including Iceland, Bolivia, Ecuador and Bangladesh.

An Initial Coin Offering, also commonly referred to as an ICO, is a fundraising mechanism in which new projects sell their underlying crypto tokens in exchange for bitcoins.

• The U.S. Securities and Exchange Commission (SEC) has determined that certain ICOs must be treated as securities and are subject to certain restrictions.

• In the first half of 2017, one bitcoin surpassed the spot price of an ounce of gold for the first time, and subsequently broke its all-time high, reaching $1,402.03 on
May 1, 2017.

• On August 1, 2017, bitcoin split into two derivative digital currencies, the classic bitcoin (BTC) and the Bitcoin Cash (BCH).

• On August 14, 2017, the price of one BTC hit a record high of $4,400 for the first time.

Source: Bitcoin Magazine (bitcoinmagazine.com)