September 22, 2015

Summary

Editor’s Note: This foundational analysis on Bitcoin was originally published Feb. 28. 2014. In light of the U.S. Commodity Futures Trading Commission’s (CFTC) Sept. 17 decision to change its regulation governing cryptocurrencies, we are republishing it. We asserted that the underlying technology behind Bitcoin will have wide-ranging applications in a number of areas, including finance and computer science. The CFTC has decided to consider bitcoin a commodity rather than a currency, which means it will fall under the commission’s jurisdiction. While somewhat disruptive in the interim, this ruling does allow for bitcoin to be used as an asset class similar to gold or oil. From now on, companies seeking to operate as trading platforms for cryptocurrency derivatives or futures must register and comply with regulations laid out by the CFTC.

Bitcoin is a relatively new and unregulated electronic currency that enables the owner to buy, sell and trade anonymously without incurring high transaction charges. Since its creation in 2009, Bitcoin has become the most prevalent of a number of so-called cryptocurrencies. Some have heralded cryptocurrencies as potential challengers to financial institutions, especially in developing markets and regions where traditional banking infrastructure is underdeveloped. But despite a positive reaction to Bitcoin from the U.S. Federal Reserve Bank, multiple nations have refused to acknowledge the currency. Thailand, Russia, Iceland and Vietnam have all rejected or banned it.

Bitcoin experienced a tumultuous February as Mt. Gox, an exchange that converted conventional legal tender into bitcoins and vice versa, on Feb. 7 stopped withdrawals from accounts and ultimately shut down Feb. 24. Finally, on Feb. 28 it was revealed that most of the bitcoins deposited into the exchange — approximately $475 million worth — had disappeared. Electronic currencies such as bitcoin are susceptible to cyberattack, as the Mt. Gox incident shows. Chief among other concerns about electronic currencies is their existence beyond governments’ capital controls, making illegal activities such as money laundering relatively straightforward. Financial regulators and many observers say that cryptocurrencies are a speculative bubble waiting to collapse. But no amount of opposition can erase electronic currencies or the technology behind them.

Analysis

Central to the idea of currency is ownership, the fact that money can only belong to (and therefore be spent by) one person or entity at a time. In the digital era, electronic money is no different than any other computer file, which means that unlike physical money, it can be endlessly copied. Bitcoin is not the first attempt at creating an electronic currency, but it is the first digital tender to gain serious interest and backing. This is largely due to the efforts of Satoshi Nakamoto, a fictitious name or group, responsible for the “Bitcoin protocol.” Prior to Bitcoin, electronic currencies required a third party, such as PayPal, to determine if one party still owned the money or had previously spent it, thus transferring ownership to someone else. The Bitcoin protocol solved this problem by creating a publicly viewable global ledger, showing the sequential transactions of all accounts using bitcoin.

Bitcoins are bought and sold on the Internet at places known as exchanges. Bitcoins are generally stored in a digital wallet and transactions are recorded in a shared public ledger known as the “blockchain.” The currency is not controlled by a central bank but is instead managed by an online community. Members with powerful computers are encouraged to maintain the transactional register by “verifying the blockchain” — solving complex mathematical equations and adding another “block” of transactions to the existing chain. The process is known as “mining” because the verifier is rewarded with new bitcoins. The way the system works, new bitcoins will not be created after there are 21 million in circulation, which is projected to happen in the year 2140.

Bitcoin has both strengths and weaknesses as a currency. Accounts themselves are anonymous, but determining ownership through regulating exchanges or IP addresses is possible. Bitcoin also enables merchants to escape expensive transaction fees that are often the consequence of fraud protection. This is because bitcoin transactions are not reversible and, from the point of view of the merchant, there is little inherent risk of fraud. But due to skepticism and the fact that this is a relatively new concept entirely, few merchants accept bitcoins. Potential markets are also being shuttered by some countries that are fearful of the unique opportunities that cryptocurrencies offer compared to traditional state-sanctioned money.

Decentralized currencies such as Bitcoin remain in their infancy. To achieve mainstream longevity, cryptocurrencies will need to become popular and user friendly or find acceptance with a gigantic corporation such as Amazon. Governments have struggled to stop decentralized networks in the past, but with each evolution of government crackdowns on file-sharing programs, the programmers become more sophisticated. For example, when Napster became popular for file sharing and was taken down, Kazaa, another file-sharing application, was created instead. This has led to peer-to-peer networks that are so decentralized that they are nearly impossible to stop.

This will not prevent governments from trying to monitor, disrupt and partially regulate cryptocurrencies — in extreme cases governments could also physically move to shut down exchanges — so the programmers behind cryptocurrencies have to improve the reliability and security of their networks. Hardening exchanges against cyberattacks, or at least limiting their frequency, will be critical in instilling confidence.

Bitcoin as a Technology

Bitcoin is far more than a currency; it is a new technological platform. Currency is just one of many potential applications. While bitcoin itself may fail, its technological breakthrough — the Bitcoin protocol — can be used for other applications in computer science. Though observers have pointed to the Mt. Gox shutdown as proof bitcoin will fail, having one exchange shut down is not a big deal, and bitcoins’ value on other exchanges has yet to collapse since Mt. Gox’s problems began in early February.

Over the last year, venture capitalists have been quick to invest money in startup businesses that approach bitcoin with unique ideas. One company envisions “colored coins,” essentially a Bitcoin-like cryptocurrency where each individual coin represents another physical commodity. Colored coins would then act as a surrogate to trade anything from stocks to securities, traditional money or anything else. Other companies are attempting to connect Wall Street to digital currencies, planning to trade bitcoins or derivatives based on them. To do so would require oversight from the U.S. Securities and Exchange Commission. There is an ongoing movement to get the Securities and Exchange Commission to approve an exchange-traded fund for bitcoins, which are being looked at not just as a currency, but as an asset class all by themselves. Unlike gold, however, Bitcoin is also a currency in the sense that it is easily divisible as well as relatively fluid.

Geopolitically, the use of Bitcoin by financial institutions and venture capitalists is of secondary importance, but they do provide a growing user base. The first five years of Bitcoin saw an exponential growth in value as well as popularity. Like any new, free-floating currency, the worth of bitcoins has remained volatile. In order for Bitcoin — or any other cryptocurrency — to be widely adopted, there will need to be an increase in the number of outlets and potential users, and there must be overall confidence in the value and stability of the tender. All of this can come only with time.

Cryptocurrencies in the Developing World

The relative ease of moving bitcoins in and out of countries with harsh capital controls was demonstrated during the recent financial crises in Cyprus, Argentina and Russia. Even more recently, Bitcoin addresses have been used on protesters’ posters in Ukraine as a way to find financial support from abroad. Banking sectors can impose restrictions and limit the movement of conventional funds, but no such regulatory system exists for digital currencies. For frontier and developing markets, digital currencies provide a way for individuals to gain access to dollars and other more stable currencies. The underlying volatility of national currencies is a driver toward alternative tender.

Digital money has already revolutionized local economies in some developing countries, providing a functional way to escape capital controls or bypass technologies. M-Pesa is a mobile money transfer system that has become popular in several African countries. The system debuted in Kenya in 2007, and to date roughly one-third of all Kenyans have an M-Pesa account. As a result, the equivalent value of about one-third of Kenya’s gross domestic product is now spent via phone. In July 2013, a technology known as Kipochi was developed to connect M-Pesa accounts with Bitcoin accounts. Currently, anyone in the world can send bitcoins directly to a third of people in Kenya with zero transaction costs. This becomes important when considering the number of workers employed outside their home country. Traditional remittances — when foreign workers send money home — are very expensive, with transaction costs upward of 30 percent. Cryptocurrencies such as Bitcoin provide a significantly cheaper alternative.

Kenya’s successful adoption of mobile payment methods is a reminder of the fact that bitcoins can be transferred as easily as sending an SMS message on a phone. Much of the developing world does not have access to financial institutions or traditional bank accounts, but even the poorest countries invest in robust telecommunications network architecture, and almost everyone has a cellphone. The proliferation of cellphones and a digital tender such as Bitcoin could enable societies to skip technological phases, such as the need to construct a massive and intricate network of landlines.

On top of the impact on remittances, cryptocurrencies encourage innovative financial markets, for both the developed and the developing world. Cryptocurrencies enable a mechanism for global peer-to-peer lending, a concept made popular through companies like Kickstarter. Digital transactions can be used to finance projects anywhere on the planet. This is especially important for developing countries because it allows access to informal capital markets in the developed world. Securing enough credit through traditional channels to start a small business in Zambia is difficult, but obtaining multiple instances of smaller amounts from the fringes of a developed economy is achievable.

Cryptocurrencies in the Developed World

Most countries that eschew stringent capital controls (such as the United States and Japan) are adopting a wait-and-see approach to Bitcoin, monitoring the currency but not yet taking strong action to regulate it. Other governments with more restricted financial systems are moving to regulate Bitcoin more severely. However, should cryptocurrencies gain prominence in a country’s economy to the point that they undermine a central bank’s monetary policy, the government of that country would have a problem. Jeopardizing one of the primary methods a nation-state uses to direct its economy — and finance its government — is unacceptable to any authority. By then, assuming a broad citizen investment in the new currency, any attempt to outlaw it or affect the exchanges would be politically difficult, leading to social tension, even unrest.

A more likely government strategy to circumvent the impact of digital currencies and preserve the integrity of the treasury would be to employ pre-emptive action at the emergence of cryptocurrency, most likely through regulating the online exchanges. Such regulation would enable government officials to identify online accounts, make connections and thus limit or monitor tax evasion and other illicit activity. Bitcoins are incredibly transparent. Tracking money-flow using the blockchain is just one method agencies may already be using to monitor illegal activities.

Bitcoin was initially popularized by libertarians, who saw a digital currency as a way to avoid central banks and state control of the financial sector. As Bitcoin’s popularity has grown, so has the interest of venture capitalists, attempting to bring cryptocurrencies into legal and regulated circles. Although Bitcoin may not survive, cryptocurrencies will. While there are enough residual problems to prevent them from going mainstream in the short term, digital currencies are likely to remain popular in specific niche markets.

Examining the Future of Bitcoin is republished with permission of Stratfor.