Bitcoin Currency and Business

Like many technological concepts, digital currency emerged slowly into the recognition and daily language of society.   Similar to trying to explain the concept of the internet to the masses in the 1990’s, explaining digital currency, or specifically, a Bitcoin to the masses is a daunting task.   Even more daunting is the idea of how to use, save and rely upon this cryptocurrency as a means of currency.

A Bitcoin is a peer-to-peer payment system created in 2009. It is the first open source digital currency, and Bitcoin is managed by an open source software algorithm that uses the global internet network both to create the bitcoins as well as to record and verify transactions. (Ciaian, Rajeaniova, Kancs 2014). It is a currency that differs from standard currency in that the quantity of units in circulation is not controlled by a person, group, company, central authority, or government. A bitcoin is a public key that is produced as a result of the solved algorithm. The idea of the Bitcoin digital currency and how it functions has been described as technical elegance. The use relies on three types of consensus. Participants must maintain consensus on the rules that determine validity of transactions, on which transactions have occurred and finally that the currency has value.   These concepts are intrinsically connected in the sense that the lack of consensus on any one point will cause the entire currency to fail.   Bitcoin is an intangible currency that can be and is used for the purchase of tangible goods. Not only does it not have a tangible existence, the use of same by a person either as a buyer or a seller of goods is anonymous.   There is no way to track the ownership of a Bitcoin back to a person or entity. The production of the Bitcoin creates the public key, the ownership of the Bitcoin is by whomever holds the corresponding private key to said coin. The validity of the coin is verified through its development line, called the blockchain.

Bitcoin emerged in August of 2008 with the registration of bitcoin.org. What followed was an internet based release of a white paper on the program shortly followed by the registration of the project with SourceForge.net. On the 3rd January of 2009 the source software was released through a cryptography mailing list with the first transaction on the blockchain completed on January 12, 2009.   Bitcoin was given its first valuation on October 5, 2009 by the New Liberty Standard at one dollar equaling 1,309.03 bitcoin. It is commonly accepted that the first transaction using bitcoin currency occurred May 22, 2010 when 10,000 bitcoin were paid to another private individual who called in and paid for delivery of a pizza to the buyer. By November 6, 2010 bitcoin was valued at $.50 per bitcoin.   Over the course of the next several months, the development of upgrades to the software to access bitcoins were made. The increase interest in acquiring the currency lead to mention of the currency in trade magazines during 2011. The added interest put a strain on the bitcoin.org site and caused some to speculate the site would fail.   It recovered. The value of bitcoin continued to rise and became equal with the dollar on February 9, 2011. Bitcoin’s value bobbed up and down over the next several months steadily climbing in value. To date, at its highest valuation on November 29, 2013, it reached $1,242 per coin. The value rapidly plummet to around $220 and has hovered near that mark for the past year.

The production of Bitcoin is done by mining. Within the mining process lies the system of checks and balances for the currency. Mining is the action of solving the software algorithm upon which the creation of a Bitcoin is the payout.   The action of mining is done now within cloud computing, however that is not where it started.   A potential miner must build a computer to function as the algorithm solving system which works in cooperating with other systems within the cloud based network.   The mining system will download the mining program and begin the process of mining and may work for hours before solving the first piece of any algorithm. As pieces of the algorithm are solved, the process creates a chain of solved pieces that act to verify the creation of the Bitcoin. This chain can branch into other links of the solve algorithm; however, it is in the miner’s best interest for payout to stay on the longest existing branch of Bitcoin creation. Miner’s often pool their resources so that a number of miners are all working on solving the same block and then split the payout.   This type of mining produces more blocks faster than a single miner. The payout for successfully solved blocks, although split, has proven to be larger as well. At the time a Bitcoin has been successfully mined, that transaction is recorded in the Bitcoin Log which is how the validation of the public key is validated. The algorithm itself is designed to fluctuate in its level of difficulty based on how many mining systems are working at any given time. In doing so, it creates an environment that controls the output of bitcoins based on the level of participating mining systems. In doing so, the currency protects itself from cartels of miners forming for the purpose of bombarding the system with thousands of miners in a sneak attack to gain a large payout. When there are more miners, the algorithm is more difficult. Likewise if a scare were to create an atmosphere where a large percentage of the existing miners stop mining, the algorithm would become less difficult. In doing so, the system achieves an atmosphere of consistent production. Another unique factor of the bitcoin algorithm is the termination number.   There are 21 million bitcoins that can be mined. Not only does the design of operation achieve consistent mining, it also provides for validating a Bitcoin as real and for preventing the possibility of double spending any coin. “To prevent double spending Bitcoin players engages in a peer-to-peer protocol that implements a distributed timestamp service providing a fully-serialized log of every Bitcoin transaction ever made. Transactions are organized in the log into blocks, which contain a sequence number, a timestamp, the cryptographic hash of the previous block, some metadata, a nonce and a set of valid Bitcoin transactions.” (Kroll, Davey, Felton Princeton University 2013). In the construction of the creation and spending of the currency, bitcoin has covered all basis of making it a securely generated, but ungoverned currency.

As a fiat currency, one that is not backed by any physical commodity, bitcoin’s value lies solely in the idea that it has value. “The price formation of Bitcoin cannot be explained by standard economic theories, because supply-demand fundamentals, which usually form the basis of currency price formation, are absent on Bitcoin markets. First, Bitcoin is not issued by a specific central bank or government and thus is detached from the real economy. Second, the demand (and supply) for Bitcoin is driven also by investors’’ speculative behavior, because there is no interest rate for the digital currency and thus profits can be earned only from price changes.” (Ciaian, Rajcanivoa, Kancs 2014). One has to wonder how then bitcoin’s are spent for goods. First one has to understand where bitcoin’s are stored. Every created bitcoin is recorded in the bitcoin block chain and the public key recorded.   The miner awarded the coin is given the private corresponding key. These keys can be transferred to bitcoin holding software, which acts as wallets or bank accounts in some sense. Like providing the services to cloud mining, there are companies that provide the service of holding bitcoins within electronic wallets.   Third party providers as well as within the original BitCore software used for mining can provide the owner of the coin with a wallet.   Through the wallet software, a Bitcoin can be transferred to a person that also has an operational wallet. When a transaction occurs and a Bitcoin is transferred, the peer-to-peer network is flooded with the request and through the transfer, the identity of the key for the Bitcoin is validated.  The good is transferred and the transaction completed.

There are also Bitcoin Exchanges that operate as a clearing house for trade of bitcoins. Exchanges rose early as a third party player in the Bitcoin currency.   Exchanges acted something like a stock market exchange.   Holding deposited bitcoin keys for clients and assigning them a cash value based on the supply-demand theory.   Clients could let their bitcoins sit in the exchange until the market price was desirable and then redeem them for the currency of their respective country.  Due to the anonymity that accompanies the use of bitcoin, the exchanges were vulnerable to thieves who could hack the exchange and steal the currency. There’s no tracing of the bitcoin key and the newness of the technology meant to secure it’s holding the exchanges would have to be one step ahead of hackers.  The largest theft of bitcoin from an exchange happed to the MtGOX exchange that operated out of Japan.   More than 850,000 Bitcoin were stolen, most of those still remain unaccounted for. Many early exchanges were marred with financial and legal troubles as well.   Although the bitcoin itself is not governed by any entity, the banks that would provide the currency for the exchange business were.   As a result, banking investigations created money flow issues for some exchanges. Another early exchange, BitInstant saw its demise after the CEO was charged with money laundering as a result of selling another person several million in Bitcoin to be used for purchases through the website Silk Road. Silk Road only accepted Bitcoin payments and sold illegal goods including drugs. The role of U.S. currency to purchase the Bitcoin was the portion of the transaction that was governed.   As long as the public involved in Bitcoin use desires to exchange Bitcoin for currency of a country, there will be some sort of governing entity overseeing the transactions.   However, those who mine, keep and then use their bitcoins directly for purchases of goods go unregulated and remain anonymous in the transaction.

According to Roberts (2015)”Last year was an annus horribilis for bitcoin. Its price, once up above $1,200, sunk below $250. The second-largest bitcoin exchange had to temporarily suspend operations after a large-scale hack. And there have been two high-profile criminal prosecutions of bitcoin entrepreneurs. It was enough for some commentators to dub 2015 a make-or-break year for the currency, with experts saying it needs to find a purpose or face extinction. But that’s only one side of the story. There’s also been a flood of venture capital and bitcoin startups, as well as interest from legitimate bodies such as the New York stock exchange, all of which suggests bitcoin is here to stay.” This statement and many like it have the finance industry looking differently at bitcoin in 2015. Banking institutions have had on-again-off-again relationships with the currency.   It hasn’t been until in the last twelve months that financial institutions have really started to investigate and weigh their involvement with the currency. Oliver Bussmann, the group chief information officer of Swiss bank UBS feels that the blockchain technology of bitcoin has the potential to trigger “massive” simplifications of banking processes and cost structure. He added that he believes this will happen when somebody with a strong brand and security level validates it’s use as a reliable service (Duivestein 2015).   Banks however, are not going to move quickly to embrace the move to digital currency.  The huge swings in the valuation of the currency has kept banks and hedge manage manager away from participating in bitcoin. The downside for these institutions is if digital currency does become the way of the future. Banks will be left behind as their focus on products which enhance customer experience and increase conveniences is just not needed.  Some feel that banks may follow the Shirkey Principle: “Institutions will try to preserve the problem to which they are the solution.” Companies that have started focusing on stripping down the service offerings by banks are called “FinTechs”. FinTech companies have seen a large increase in global investment as they strive to rebuild the system of financial transactions. The acceptance in 2015 of bitcoin by major online resellers such as Dell, Microsoft and Overstock.com all lend to a move toward the reliable secure companies validating the worth of the currency.

The business around bitcoin developing is huge despite negative press regarding hacking, use for purchase of illicit goods and CEO’s going to jail for money laundering through bitcoin use. Startup companies and technology that focuses on development of interfaces for use by the masses of the currency have seen great increases in investment to their product ideas.   In 2012, bitcoin startups raised 2.13 million. That figure increased to $95.81 million in 2014 and then to $347.29 million in 2014.   In the first two months of 2015 already 105.84 million has been invested in bitcoin startups. (Duivestein 2015). The idea that bitcoin is a resource for criminals as prosecutors in recent lawsuits allege seems to not be the consensus of financial community. “The technology is technology, it’s neutral in character”, says Jerry Brito, executive director of the non-profit Coin Center. “Someone’s going to use it, if its good, which I think it is.” (Roberts 2015). Developers are not concerned with the bad press or with the volatility of bitcoin’s day-to-day valuation either.   Many of the developers that are in the expansion of bitcoin technology feel that the public does not need to understand the currency yet. This currency is often put on a parallel to the internet in the 1990’s in the idea that at its introduction, the public did not understand what the internet was or how it would impact and become such a large part of daily life. Likewise, this currency and the expansion of digital currency is on its way of having the same impact.   Until the products can deliver a general use application of bitcoin, the public will largely remain outside the circle of awareness and use.

When it comes to the industries around bitcoin, it is hard to imagine that the currency can exist in developed markets without the existence of the third party to make it available to the masses.   The concept of bitcoin is one that is meant to have no reliance on other currency.   The only certification that it has any value is the idea that a person or group of persons sees it as having value.   Third party players in this currency can and are reaping rewards by charging a fee to turn bitcoin into fiat currency. Another group of players are those that create hardware to support the mining of bitcoin. “Called ASIC mining machines, the systems sell for thousands of dollars. One of the most powerful machines on the market, the Neptune from Stockholm, Sweden-based KnC miner retails for almost $10,000.” (Hill 2014). The hardware market for mining machines is still highly competitive and has caused companies such as Terrahash to go bankrupt for failure to be able to deliver their prepaid custom mining computers to anxiously awaiting clients.

While so many are investing vast amount of money into products that can make the digital currency a general use currency, some are still skeptical of the ability to secure the currency which has no financial backing. The 2011 hacking of MtGOX which has been valued at $400 million and the 2015 hacking of the Slovenian exchange, Bitstamp valued at $5 million, is strong argument for the security critics of bitcoin.   It adds to another level of business developing around the currency.   In February of 2015, the bitcoin exchange, Coinbase, announced an insured exchange.   The first step of its kind for the currency.   The previous summer, the New York Department of Financial Security announced BitLicense, a dedicated set of regulations for bitcoin companies.   These two major developments may be the reassurances that institutional investors and hedge fund companies need to get onboard with bitcoin use.   Investments from the New York Stock Exchange and the United Service Automobile Association to the development of the insured bitcoin exchange are yet another step in validating the currency for use and investing by larger entities.   The venture, at its very base though, must remain profitable for those in the business of mining for bitcoin.   If the valuation would drop and then continue to only get lower, it becomes dangerous to the security of bitcoin as a viable currency. It becomes exorbitantly expensive for the miners in that scenario.   As long as there is incentive to continue to mine, most investors in the field are not overly concerned about the lack of mining operations. Currently there are 14,242,250 mined coins in circulation at the current projected rate, most analysts have mining for bitcoin projected to last into the year 2140.

The finite number of bitcoins possible to be mined; however, for some again adds to the feasibility of the bitcoin really moving into the realm of fiat currency with the banking of major institutions and banks. “Bitcoins finite supply means that its price should go up, and keep going up. So if if you have dollars that are losing a little value to inflation every year and Bitcoins that are gaining it, which one are you going to use to buy things with? The question answers itself, and it raises another. Why would this ever change? Unless you can’t buy something online with dollars – like drugs – you’d always want to use your dollars instead. Buying things with Bitcoin would be like cashing out your Apple stock in 1978 to go grocery shopping even though you have plenty of actual cash lying around.” (O’Brien 2015).   This possible reality creates a cycle that would mean the value of the bitcoin could never actually increase, because no one really wants to spend them.   Instead, bitcoins are always being held pending a huge valuation due to the lack of supply. The lack of spending them in turns lessens their value. The theory works directly against the concept of the bitcoin as a currency.

Within the vein of this theory also lies a question that other industries are looking to borrow from the design behind bitcoin currency.   If the fundamental idea behind the currency is to transfer an item that has a perceived monetary value to another through the blockchain system which validates the transaction, thereby removing the need for financial institutions to be involved, then why could the system be used to transfer other types of assets?   That is exactly the question that is pushing some financial institutions to look at developing their own blockchain system so as to not become the dinosaur of the financial realm, but rather to cut service costs and still keep customers involved through cheaper services, but probably not free services. Like the security questions involved in keeping bitcoin held safely by a third party, the stealing of the formation of blockchain technology for asset transfers via the internet raises concerns for the long-term viability of the emerging currency.   “The future might not be in Bitcoin, but it should to its technology.” (O’Brien 2015).

The inception of the idea is agreed genius by admires of software design, economic theory and free money libertarian politics.   The money invested into the pursuit of the intangible currency is real money and has generated huge profits for hardware developers. Likewise the money venture capitalists have put forth to back companies that may be able to bring the bitcoin to the masses in an easy-to-use though likely not understandable way is very real money as well.   With all the money, time and effort poured into the currency, proponents would say it cannot fail.   However, the infancy of the developing technology and underlying support of this as a currency leaves many in the financial and economic industry still too skeptical to bet on the currency to be in existence for the long term. One thing is certain, the technology that is at the core of bitcoin will forever change how all players involved in the world of finance look at how money and other assets are moved from one owner to another.

 

- Villamonte