I am writing this post a few weeks in advance, so – who knows – maybe this whole post will be outdated by the time its scheduled publication date comes around.
Update on the 6th of March 2014 – This whole article was written before the Mt Gox collapse.
What is Bitcoin?
Bitcoin (BTC for short) is, in effect, a globally shared ledger of transactions. BTC is commonly expressed as a currency and system for transacting the currency.
Conventional currencies are exchanged for Bitcoin using exchangers.
I have been keeping an eye on Bitcoin since around 2009/2010. At first, the reaction among most people in the online payments industry that it was just another Liberty Reserve with a cryptological twist. Its sole purpose could surely only be deep-web black-market ecommerce. And sure enough, for a long time, it remained almost exclusively in use for drug trade, copyright-infringement-friendly web hosting, and money laundering through anonymous prepaid cards.
Then Liberty Reserved was no more. In May 2013, it was shut down and a vacuum appeared for anonymous/high-privacy payment methods. Common Liberty Reserve alternatives – Perfect Money and such – didn’t jump in and take on Liberty Reserve clients, because they too feared being shut down.
Focus instead shifted to this now four years old cryptocurrency: Bitcoin. It was decentralized, so there was no risk of it being shut down.
More and more, gray-zone ecommerce adapted Bitcoin to attract customers who had previously used Liberty Reserve. The earliest adopters were web hosts. An industry made up of tech-savvy people and early-adopters of technology, it very quickly became expected of these hosts to offer Bitcoin.
Not wanting to fall behind, more and more regular web hosting companies started taking Bitcoin.
At the same time, it started going up in value and exchangers started going from being the kind of shady operations expected of digital currency converters.
Then another important event occurred. Notorious narcotics et al. market place Silk Road was shut down and its owners arrested. Now, clandestine websites are like hydras. If you cut its head off, there will be two new ones to replace it. Silk Road and similar sites are back in action. But what’s important here is that because of the way media portrayed Silk Road and Bitcoin, it effectively cleaned up Bitcoin’s reputation.
Today, Bitcoin is so big and influential, that it has spurred several governments to comment on it or plan for regulations.
Norway does not consider Bitcoin money, but as a taxable asset.
Sticking to its tradition of laissez-faire business-friendliness, Singapore decided not to interfere.
A big blow, however, fell on the currency when China said it was forbidding Chinese banks from trading in Bitcoin and declared it not a currency.
Malaysia does not recognize Bitcoin as a currency and cautions against using it.
Bitcoin ATMs have been blocked in Taiwan.
Slovenia says Bitcoin can be a taxable source of income.
There is a pending motion in the parliament of Switzerland to address it and potentially consider it a foreign currency.
Bitcoin Privacy and Anonymity
Wrongly, Bitcoin is often spoken of as an anonymous payment method. In fact, it is probably the most public of all means of payment in the world.
When you send money to someone using Bitcoin, that transaction is registered in the globally shared public ledger. Your and the recipient’s Bitcoin addresses are there for everyone to see.
Compare this to a bank transaction, which is only seen to the banks, the sender, the recipient, and SWIFT (or other such system). The only way to disclose further information will involve breaking banking secrecy, which is limited to authorized persons.
If you know someone’s Bitcoin address, you can see all transactions to and from that address. It is a time-consuming and resource-intense task to do, though.
While it’s easy to generate new Bitcoin addresses, in order to fund your new address, you need to either top it up from an exchanger or make a public transaction from your former or someone else’s address.
Exchangers are the next weak link in the chain. Since all transactions are public, transactions from an exchanger to you are public. These transactions can thus be used to compel an exchanger to disclose all information it has about clients. While in the past lax if any due diligence was performed on customers, exchangers are increasingly opting for or being forced into regulation. This means they have to collect certain information about you, which can be handed over to authorities.
A service called tumbling is frequently advertised as a way to launder Bitcoin. This is complete nonsense, since the tumbling, which is just a series of transactions, is public.
Bitcoin is not private, since all transactions are public. Bitcoin is also not anonymous, unless you earn your Bitcoins from within the Bitcoin system and make no connection between yourself and your personal finances.
The Real Costs of Accepting Bitcoin
A few middle-men service providers have popped up to facilitate the process of accepting Bitcoin. While the per-transaction and recurring fees are lower than most traditional payment methods, these middle-men are applying a spread of 10 – 20%. This means that if 1 BTC is sold at 1,000 USD on average from the major Bitcoin exchangers, the Bitcoin payment service providers will sell 1 BTC for 1,100 to 1,200 USD.
While Bitcoin is often touted as being cheaper than credit card payments, it is in fact vastly more expensive.
Since BTC is not considered a currency or unregulated in a lot of countries, companies in some jurisdiction may have to exchange BTC to conventional currencies for fiscal reporting. Exchanging adds another per-transaction cost.
Because the exchange rate for BTC varies enormously, something sold for 2 BTC – which at the time was 2,000 USD – can the next day be worth 1,500 USD. If you didn’t exchange when 1 BTC was 1,000 USD, you lost 500 USD or 25% of the sale value. The BTC shows no indication of stabilizing. It has, in fact, been more volatile in the six or seven months than all time before then. The only solution to this is for BTC to become an asset which is worth and possible to keep on its own, without the need to exchange to conventional currencies.
It is expected that in the future, transaction fees will also be incurred simply for sending money even without a middle-man service provider. In order to fully understand this part, I strongly suggest you watch at least the first video linked under Further Study below.
Bitcoin uses something called transaction chains (think of it as batch payments) which go into blocks. While currently all transactions go into a transaction chain, Bitcoin supports transaction fees and it is assumed that once Bitcoin is more established and more coins have been mined (when the amount of the so called block rewards is no longer an incentive enough), only transactions with a transaction fee will be processed and transactions will be processed from highest fee to lowest. Transactions fee is an optional value, but there is little reason to believe that anyone would spend their own technical resources – which are finite and cost money to maintain – would process transactions for free. If anyone does, it will be a small number of volunteers, and you can expect transactions to take far longer than the current average of 10 minutes.
Limitation of Bitcoin
The biggest limitation lies in that the currency has very little exposure outside of special interests. More and more merchants are starting to accept Bitcoin, though.
The aforementioned transaction cost is something that could potentially completely throw a wrench in the works and stop the Bitcoin machine. If the only way to transact in Bitcoin costs more than conventional payment methods and currencies, the only advantage to using Bitcoin is its (perceived) anonymity.
There is also a finite number of Bitcoins. There can never be more than 21 million Bitcoins and even though the Bitcoin protocol supports working with as small decimals as 0.00000001 BTC (often called a satoshi, named after the supposed BTC inventor), the entire BTC system is limited to 2,100,000,000,000,000 (2.1 quadrillion) units.
This, however, doesn’t account for lost BTC. Since Bitcoins are a purely digital concept and are stored in hard drives and memory sticks, any Bitcoin lost in a hard drive crash is lost from the entire Bitcoin system. It is unknown how many BTCs have been lost but over time, it will likely impact the overall financial ecosystem.
I won’t go into economic theories and political ideology here, but suffice to say that the opinions on a finite financial system vary greatly. While governments can print more money for conventional currencies, Bitcoin is locked to 21 million.
The Future of Bitcoin
Whether the future for Bitcoin is a bright one or not depends what you expect.
Its limitations are probably so great that it will never compete with other currencies on a large scale and, for example, replace any nation’s currency.
However, it may continue to thrive as an alternative currency and payment method. How well this goes depends on four things:
- Adoption. Large players need to start accepting Bitcoin as a form of payment.
- Independence. It must become attractive to hold and use Bitcoins on a daily basis and eliminate the need to exchange to conventional currencies.
- Regulation. Bitcoin runs the risk of being regulated to death. If governments decide to accept it or leave it be, Bitcoin will live on.
- Perception. While Bitcoin’s reputation is improving, it’s still unknown to most people and many that know it think of it just as a means to buy and sell illegal or covert goods and services.
Adoption and Independence are in a bit of catch-22. One can’t happen without the other. This requires some merchants to act as pioneers.
Regulation and Perception go hand in hand. If regulation is reasonable, Bitcoin will acquire a clean reputation and hence acquire improved public perception.