Previous century have marked the arrival of machines while the 21st century is being called as atomic age. But calling this age solely an atomic age will be unfair to the other disruptive areas which have grown in the past. From hardware, we have grown to software; from software we have grown to internet; from internet we are growing towards big data analytics and cloud computing. And this is just a beginning. Internet is turning out to be a parallel universe. This is just a glimpse of the gigantic opportunities which these technologies hold. Not just internet, but the science of finance has evolved over time. From being mere single accounting book keeping to double entry system; from mere sale-purchase to derivatives; from historical accounting to fair value accounting. The world is changing, so as we.
One such disruptive phenomena which has immense potential to change the way we transact is Bitcoins. Technically speaking, Bitcoin is a decentralized electronic fiat currency implemented using cryptography and peer-to-peer technology. In simple words, bitcoin is a highly secure digital virtual currency in which complex and unique mathematical numbers are considered as coins which can be exchanged freely on internet. So, there was a time of commodity currency (gold / copper coins), fiat currency (paper currency backed by law), now we look forward to maths based currency.
What’s the need?
Bitcoins are offering many advantages over the traditional currency systems. Firstly, the entire bitcoin ecosystem is decentralized. So?? This means no one country / government / person will be in a position to dominate the currency. Pure market dynamics will be directing the prospects of the currency. No individual or organization can control or manipulate the Bitcoin protocol because it is cryptographically secure. Secondly, bitcoin architecture offers the facility to send/receive funds by being anonymous. Both the parties can choose a pseudonym (dummy name) to transact with each other. A pseudonym has a private (signing) key which can be verified by a corresponding public (verification) key. So, this offers privacy of the transactions. Thirdly, the open ecosystem provides freedom to transact. Anyone can transact in any amounts. No bank holidays. No borders. No imposed limits.
Rules of the Game – Key pointers to understand the system
- All bitcoins are unique unlike the dematerialized form like in case of shares, so each coin has specific identity and this leads to transaction being settled by exchange of “change”.
- A payer specifies himself, the amount of change which he will receive back after settling the transaction.
- A transaction is broadcasted into the system through various nodes.
- Bitcoin miners are the persons who verify the transaction between two parties and consolidates various nodes of the transaction.
- Bitcoin miners get “automatic reward bitcoins” in the form of newly generated bitcoins + “transaction fees”.
- The automatic reward bitcoins halves every 200,000th transaction block (~4 years) and will be eliminated by 2140 when all 21 million coins will be mined. After that, transaction fees will be the sole award available to the miners.
- The miners verify and create a block of various different transactions and add the block to transaction block chain.
- The transaction in turn also gets automatically added to the global ledger which keeps the record of all the transactions.
- A transaction block chain has the chain of all transaction blocks which were created since the inception of bitcoins.
How the system works?
- The system is very much open for all and the flow can be understood by a simple case below:
- Alice (payer pseudonym) has a balance of 50 BTC and wants to transfer 30 BTC to Bob (payee pseudonym).
- She will transfer 30 BTC and will specify the change of 18 BTC which she will get back from the ‘system’ net of transaction fees (assumed 2 BTC) using a bitcoin client (a software).
- The transaction is broadcasted into the peer to peer network (a kind of network topology – where there is no client-server relationship between two systems and all systems are equally capable) through various nodes.
- The transaction is verified by the miners & collated along with other transactions into a block and added to the previous longest transaction block chain available.
- The transaction also gets recorded into the global ledger.
What’s the risk?
The biggest risk which bitcoins face is acceptability – acceptability by governments, businesses and public at large. Acceptability is what makes a paper as currency. Paper currency has no intrinsic value but still it is valued because the law backs them. And since, law enforces it, people accept it. So, bitcoins acceptability will surely be deciding its fate.
Another major risk that bitcoins carry is that they are not regulated. Indeed, it’s true that regulations will limit the independence of bitcoin ecosystem. But regulations will bring some discipline in the system and will safeguard the interests of the stakeholders. A universal body should be created similar to World Bank / International Monetary Fund under international law so as to regulate the affairs of the new currency.
High levels of volatility of is also a cause of concern. The currency is traded on exchanges, Mt. Gox, being the major ones. The currency has shown immense fluctuations in the past, which makes it even more difficult to gain the trust of users. Currency volatility can be easily figured out from the chart below. Presently (as of Mar 31, 2014), the currency trades at $458.6 per bitcoin.
Although the currency allows for anonymous payments by anyone with the use of dummy names which gives privacy to the users but this gives rise to the risk of money laundering. The audit trail is created in the form of transaction block chains and recorded automatically in the global ledger of bitcoins. But the concern is how to track the money launderers as the transactions can be done with pseudonyms.
Bitcoins are also being looked as creating a bubble in the markets as they don’t have any underlying asset. But, in a way, bitcoins do have a strong concept underlying them. Whether fiat currencies have anything underlying them? No – they are just backed by law and public acceptability. So, Bitcoins also needs acceptability in order to bear the currency’s real fruits.
Safeguards of Bitcoin Ecosystem
Despite many concerns, there are inbuilt mechanisms in the bitcoin system which gives hope that the currency is here to stay. The concern of volatility will decrease over time as the system has been designed in such a way that money supply of bitcoins is restricted to 21 million bitcoins. However, all 21 million coins will take time till the year 2140 to come entirely into money supply. So, the stability of the currency will improve gradually over time.
Another safeguard of the system is that the bitcoin ecosystem provides economic incentive to act honestly. For a person with malafide intention to make money by double spending the bitcoins, he will need computing power GREATER THAN the combined computing power of all other honest bitcoin miners, which is a meagre possibility. Even if someone has such immense computing power, still it will be more profitable for that person to use the computing power to mine bitcoins instead of trying to double spend.
Bitcoin Mining – A rush for money
Bitcoin mining is being considered as a lucrative business by the software experts as they get into mining bitcoins and earn good returns. Although the transaction fees per transaction are low in the beginning years but the real punch is the automatic rewards which the miners get on successful generation of “proof of work”. “Proof of work” is basically an acknowledgement of successful transaction which gets generated after the miner successfully solves the transaction puzzle. However, the automatic rewards, which started as 50 new bitcoins for every transaction verified, will be halved every four years and will finally be eliminated. Post that, transaction fees will be the mainstay for the miners.
Current Scenario of Bitcoins – US and India
US Government viewpoints on Bitcoin
Government entity
|
View on Bitcoin
|
Securities and Exchange Commission
|
Considering options on Bitcoin as a security.
|
Commodities Future Trading Commission
|
Considering options on Bitcoin as a commodity, or a “marketable good produced to satisfy wants or needs.”
|
Internal Revenue Service
|
Clarified that for federal tax purposes, virtual currency is treated as property.
Under currently applicable law, they cannot treated as currency.
|
Treasury
|
Companies deemed to exchange Bitcoin for traditional fiat currencies and vice versa as a business must register as money transfer businesses.
|
Congress
|
Considering the effect of Bitcoin on the Federal Reserve and weighing consumer protection options.
|
In India, RBI is keeping a close watch on the progress of currency and has cautioned the public against the use of Bitcoins. Income Tax department is expected to come up with their stand once RBI examines the issue completely.
The road ahead
Bitcoins are in very early stage of their adoption and many countries are reluctant to allow bitcoins. There are many concerns as well as many opportunities for bitcoins. The currency will mature over time with wider adoption. More & more issues will come into light over time and will get resolved. The important thing is that the currency has much more to offer than its shortcomings. The shortcomings can always be overcome by putting in place a regulatory system and a proper audit mechanism. We need a world unbiased towards the currencies of developed world and bitcoin provides a common platform for all. Yes! Bitcoin is here to stay.
References / Bibliography
- Khan Academy – Bitcoin Module
- Congressional Research Service, “Bitcoin: Q+A and Analysis of Legal Issues” (2013)
- https://bitcoin.org
- Joshua A. Kroll et al, “The Economics of Bitcoin Mining or, Bitcoin in the Presence of Adversaries” – Princeton University (2013)
- www.bitcoincharts.com
- “Major VC Declares That Bitcoin Represents The 3rd Great Era Of Currency” – Business Insider (Mar 28, 2013)
0 comments:
Post a Comment