Bitcoin – Currency with a future or just a fad?

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Bitcoin is attracting people from all walks of life, from small entrepreneurs to global investors. But what is it really? And perhaps the most important question of all – is it reliable?

Bitcoin, unlike traditional currencies, is highly decentralised and functions without government regulation or central banks, underpinned by a peer-to-peer computer network made up of its users’ machines. Bitcoins are mathematically generated as computers in the network crunch numbers to find solutions to an algorithm, a procedure known as “mining”. The algorithm works in such a way that it becomes progressively harder to “mine” bitcoins over time1 . A useful analogy would be the search for prime numbers: it is fairly easy to find small prime numbers, but finding large prime numbers becomes progressively harder

When a solution is found, the miner obtains a transaction fee as well as a fixed amount of bitcoins, which progressively shrinks as more bitcoins around the world are mined2 . The twin effects of increased computational difficulty and a shrinking bounty awarded to miners combine to reduce the rate at which this crypto-currency is produced (or mined) over time. The total number of bitcoins that can ever be mined is limited to around 21 million (currently, 12.5 million have been mined) – a feature of the currency that was thought up to ensure that no central monetary authority can issue a flood of new bitcoins and devalue those already in circulation1 .

Being a math-based currency, Bitcoin is governed by cryptography. If you own a bitcoin, you also own a private cryptography key and an associated public address2 . Think of the public address as your bank account number and the private key as your PIN.

Together, the address and the private key enable you to make transactions. Using the math associated with these keys and addresses, the system’s public network checks every transaction that happens on the network2 . If the math doesn’t add up, the transaction is rejected, thus providing the necessary check and balance for the system to continuously operate.

Uses and abuses

Starting out as nothing more than a hardcore computer geek’s collectible item, Bitcoin is now turning the heads of notable investors from the likes of Wall Street. Many online merchants and even some brick-and-mortar stores are starting to adopt it as payment.

In the past four months, the number of companies accepting bitcoins has more than quadrupled from 669 to 2,827, according to Bitcoin Pulse, a service that tracks Bitcoin adoption3 . Since the first transaction in 2010 when a Florida-based programmer bought a pizza with 10,000 bitcoins, there have been close to 70,000 transactions per day on the Bitcoin network. Some of these transactions have been rather exotic, such as Richard Branson’s Virgin Galactic4 accepting bitcoins for outer space travel.

But like all global sensations, Bitcoin cannot help but raise a few (million) eyebrows along the way. It allows more anonymity than cash, since the network identifies recipients by their Bitcoin addresses as opposed to their individual names. Because of this feature, it is no surprise that the underworld market, the creative and resourceful creature that it is, has jumped on the Bitcoin bandwagon. In October 2013, the FBI shut down Silk Road, an online drug portal that shipped drugs to users’ doorsteps and accepted bitcoins as preferred payment5 .

Bitcoin’s wild ride at the end of 2013 also makes it look more like a speculative tool than a currency. The price of bitcoins hit a high of US$1,203 in November 2013, shooting up 800% from its base price of US$128 in October. This price surge, driven by Chinese investors stashing money offshore, is an indication of a classic bubble where prices unexpectedly surge before crashing, making multimillionaires out of the few who cashed in their holdings when the price peaked6 . A few weeks after its historical high, the price crashed to US$580, and it has been trading in the range of US$600-US$900 since the end of 20137 .

Extreme volatility of this nature is not the only risk that Bitcoin users face. Numerous hacks and heists have plagued the system, and one of the most recent and high profile hacks was Mt Gox. The oldest and largest Bitcoin exchange site halted all services on February 24, 20148 – the troubled company went offline, claiming to protect user accounts from a “transaction malleability” issue, but rumours are swirling. And they are not kind. Most are saying that there has been a heist at Mt Gox, comparable only to that of Bernie Madoff ’s ponzi scheme. The price tag? A cool US$426mil. Or 744,000 bitcoins, about six per cent of all bitcoins in existence.

Bitcoin in Malaysia

Although Bitcoin is quite an international sensation, in Malaysia it is still an obscure currency. However, many enterprising Malaysians are blazing the trail and easing Bitcoin into the Malaysian market9 . For the founder of Bitcoin Malaysia, Colbert Lau, the attraction of Bitcoin lies in its entire concept. Lau noted that marketing and awareness, as well as “viral apps on mobile adopting (bitcoins)” are needed to garner more support for Bitcoin in Malaysia.

Reuben Yap, founder of BolehVPN, and Arsyan Ismail, CEO of online retailer Ked.ai, have very similar views on Bitcoin and its implications on their local businesses. “BolehVPN’s business involves protecting users’ identities and privacy online, and being the closest thing to an anonymous form of payment, Bitcoin fits right into our business model,” explains Yap. For Arsyan, Bitcoin is perfect for his business: “Bitcoin transactions are easier to implement, pay and integrate, and transactions are fast and there are almost no fees.” He cheekily adds, “It just feels awesome to be a part of a disruptive ecosystem.”

Arsyan Ismail, CEO of online retailer Ked.ai.

Both Yap and Arsyan acknowledge that there aren’t many Bitcoin users in Malaysia yet, but the numbers are growing. BolehVPN, for instance, gets an average of one to two bitcoin transactions every day. To gauge the market’s reaction towards Bitcoin as a form of payment, Arsyan’s company organises events and does testing with merchants.

Yap is more concerned about government intervention in the Bitcoin market than about price fluctuations. Thailand and Russia have already banned the usage of bitcoins. For him and Arsyan, Bitcoin’s transparency is one of its allures. “Transparency is what gives credibility to Bitcoin. That’s how Bitcoin relates to everyone, not just our business,” says Arsyan.

But herein lies a problem. Yap gives a concise explanation of what this lack of government recognition means for Bitcoin users in Malaysia: “The risk is more on people who use bitcoins to buy things, as opposed to those who accept bitcoins. Bitcoin’s system on verification is pretty secure and is not subject to fraudulent chargeback requests. So in that sense, it’s better than credit cards from a vendor’s point of view. However, from the purchaser’s point of view, in the event that the vendor doesn’t deliver the goods or services, it’s hard to get legal recourse, so the purchaser really needs to trust the vendor.”

Bitcoin as a global currency

Even though Bitcoin has become a big hit – particularly with online retailers – economists and central banks continue to urge caution, especially in the wake of the Mt Gox disaster. Bank Negara Malaysia stated that “Bitcoin is not recognised as legal tender in Malaysia” and advised the public to be “cautious of the risks associated with the usage of such a digital currency”10.

Economists such as Paul Krugman11 have been more vociferous in their censure of Bitcoin, arguing that, if adopted globally, the crypto-currency could spell periods of deflation. With a fixed supply of bitcoins, set to be reached at around 2030, the cost of mining will become increasingly expensive. As the cost of mining rises, the value of bitcoins relative to goods and services also rises, leading to a downward spiral in prices and wages. This in turn could lead to higher debt burdens, prolonged unemployment and slower economic growth.

Paul Krugman, an American economist, has been more vociferous in his censure of Bitcoin.

Furthermore, it remains unclear how bitcoins can be effectively saved for future consumption12, as there is no central authority acting as a sink to buy up the currency in the event that its value crashes. Unlike bitcoins, conventional currency is backed by central banks that are committed to maintaining the stability of their respective currencies. Without some authority committed to buying back the currency should its value fall, there can be no real or psychological price floor for the currency, enabling periods of extreme volatility and diminishing the currency’s ability to act as an efficient mechanism to save income.

The heists, drug scandals and continued Bitcoin bashing by economists do not help its cause, and many opined that the recent closure of Mt Gox would be the final nail in the coffin. But Bitcoin lives on despite these scandals. SecondMarket13, an American online market place, is also in the process of setting up a new and improved exchange to replace Mt Gox as Bitcoin’s main trading platform, while the US$/bitcoin trading volume surged to an average of US$40mil in March, up from US$10mil in September 2013.

In a promising development, the Chicago Board of the US Federal Reserve opined: “Should Bitcoin become widely accepted, it is unlikely it will remain free of government intervention. That said, it represents a remarkable conceptual and technical achievement, which may well be used by existing financial institutions or even by governments themselves”14. While it is still largely considered a new play thing for libertarians, speculators and drug dealers, this could yet be the genesis of an important new financial innovation.

1 www.businessinsider.com/how-bitcoins-aremined- and-used-2013-4?IR=T
2 www.economist.com/blogs/economistexplains/ 2013/04/economist-explains-howdoes- bitcoin-work
3 www.bitcoinpulse.com
4 http://blogs.wsj.com/moneybeat/2013/11/22/ richard-branson-now-takes-bitcoins-for-spacetravel
5 http://money.cnn.com/2014/02/14/technology/ security/silk-road-bitcoin
6 www.economist.com/news/leaders/21590901- it-looks-overvalued-even-if-digital-currencycrashes- others-will-follow-bitcoin
7
www.coindesk.com/price
8
www.wired.com/2014/02/bitcoins-oldestexchange
9
http://bitcoinmalaysia.com
10
 www.bnm.gov.my/index.php?ch=en_announcement&pg=en_announcement_all&ac=275
11
http://krugman.blogs.nytimes.com/2013/12/28/bitcoin-is-evil/?_php=true&_type=blogs&_r=0
12
www.economist.com/blogs/freeexchange/2014/03/bitcoin#sthash.kEBi8LsC.dpbs
13 http://finance.fortune.cnn.com/2014/02/25/secondmarket-bitcoin-exchange
14 www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2013/cfldecember2013_317.pdf

Dheepan Ratha Krishnan is a research analyst at the Penang Institute.
Yap Jo-yee is a research assistant at Penang Institute, and will be pursuing a degree in Economics at University College London this September.



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