Bitcoin: The good, the bad, and the ugly

prev
next

Dr. John F. Sase, Producer
Thomas A. Wilk, Guest Author
Gerard J. Senick, Senior Editor

"Too many people spend money they earned, to buy things they don't want, to impress people that they don't like.

"I am not so much concerned with the return on my investment as with the return of my investment."

Will Rogers, 20th-Century American Humorist

This month, we will examine the role of Bitcoin, an international currency that has become controversial in the last few years. Created by underground tech-enthusiasts in approximately 2008, Bitcoin is an electronic currency that incorporates encryption algorithms to create autonomy for its users and to preserve security within transactions. Bitcoin is a fiat-crypto currency (no intrinsic value/ using computer encryption) as well as a normally functioning form of money. We will consider the strengths of Bitcoin as a Medium of Exchange as well as its weaknesses as a Unit of Account and a Store of Value. In this context, we will discuss the rigid monetary policy, extreme volatility, and global fluctuations in the demand for Bitcoin. In addition, we will examine its role as a currency in certain failing economies.

Bitcoin rose to infamy with the Silk Road drug-trafficking bazaar. In the beginning of 2011, a daring entrepreneur with the tag name "Dread Pirate Roberts" kicked off the Silk Road, an underground, anonymous, and illicit drug-trafficking bazaar. Under this umbrella, criminals could sell all manner of drugs and illegal products with little exposure. All sales were financed by the recently formalized crypto-currency Bitcoin. At its peak, the Silk Road trafficked approximately $22 million in illegal contraband annually. The nature of Bitcoin's ledger and encryption system made the exchange of these products nearly frictionless (little to no cost or effort in a transaction), leaving no direct ties to the private information of its users. This secured and anonymous aspect drew in clientele from around the world, eventually attracting the attention of the FBI and other law-enforcement agencies. By 2012, the FBI had infiltrated the inner circle of Silk Road administrators and effectively shut them down with the arrest of the Dread Pirate Roberts. However, Bitcoin has continued to flourish as a major crypto-currency, though it remains associated with illegal activities.

Contrary to popular belief, the role of Bitcoin in major crimes such as terrorism may be less prominent than expected. Ultimately, its true value exists in its encryption-blockchain technology. (As transactions occur, they are consolidated into a block, which is attached sequentially to a chain of previously verified transactions.) This technology facilitates a more accurate and less costly system for recordkeeping. In these respects, Bitcoin has emerged as a new attempt to revolutionize the way that society values and views money. This cyber-money leads the field of many new forms of fiat-crypto currencies that have developed during the boom of our Internet/Information Age.

Throughout the centuries, money has developed to fit the needs and customs of various users in society. Before the age of large, complex societies, bartering for goods and services served as the norm. Money gradually replaced bartering systems as populations and trade grew. Initially, economies used various forms of money including carved seashells, large stone wheels, and semi-precious metal coins. Commodity-currencies always have had value in use beyond being that of a currency. However, commodity-money has been replaced by fiat-currencies in recent centuries. Fiat-money has little intrinsic value, as it only holds the value that society places upon it. Generally, fiat-money has been backed by sovereign governments or government-guided private-sector institutions such as our Federal Reserve Bank.

The performance of the three functions of money will determine the long-term viability and popularity of Bitcoin and similar currencies. Bitcoin handles electronic transactions in a different and far superior manner than most banks and businesses today. It has a triple-entry public ledger containing hash-encryption, which is broadcast within a distributed network. This helps to ensure that any possibility of double spending or fraud remains nearly impossible. Essentially, the blockchain constitutes the longest list of all transactions that have been verified to a certain degree of probability and that are accepted by the majority of users within the network. Blockchain technology helps users to maintain clear records of ownership, title, and registry. As a result, this technology may add value to multiple sectors of finance, banking, and law as well as to public and private recordkeeping.

Unfortunately, Bitcoin has acquired infamy through its role in underground drug-trafficking sites, the sex-trade industry, and global terrorism. The infamy has arisen in part because Bitcoin offers a certain level of anonymity within its transactions. This characteristic appeals to a variety of users. These include law-abiding citizens who value their privacy and freedom from government intervention as well as all degrees of criminals and terrorists who hide in the shadows of Bitcoin's encrypted registry in order to remain in business.

Bitcoin and the Functions of Money

Properly functioning money has three common attributes: Medium of Exchange, a Unit of Account, and a Store of Value. Bitcoin may not offer a better solution to how society handles money; however, its true value may lie in its own technology. Let us examine the functionality of Bitcoin as a form of money. In this context, we will discuss the monetary policies and rules for transactions of this currency, its technology and potential business-use, and the role of cyber-money in illicit activities around the world.

The primary function of money is to serve as a Medium of Exchange. This allows users to pay for goods or services quickly and easily, without dependence on a complex bartering system. The number of feasible trade combinations within a barter system increases exponentially as an economy evolves, becoming more complex.

The transaction costs for bartering in a large and intricate economy would be extremely debilitating without a simple medium used for transactions. This condition constitutes the primary reason why an advanced society prefers a commonly accepted form of money over a barter system. In this respect, an electronic crypto-currency should provide a well-functioning money that is secure, fast, and has minimal transaction fees. Serving as a Medium of Exchange, Bitcoin works very well, for the most part.

The security of Bitcoin is relatively strong considering its verification of transactions and confirmation of balances. This strength is based upon a hash-encryption system used by Bitcoin to encode transactions privately. Users sign their transactions with private keys that can be verified and tracked easily, using a public triple-entry ledger by anyone within the distributed network. Before being added to the main blockchain, these transactions go through an energy-consuming "proof of work" in order to verify the source and the sender. This feature means that, in order to add a fraudulent transaction or false funds into an account, one would have to replace the trusted blockchain that is publicly available and verified with another one that is fraudulent. The likelihood of this occurrence approaches zero. In addition, the cost of doing so would be astronomical.

In contrast, the mechanisms for the remote storage of personal vital information and a password to access a user's Bitcoin account are not secure. Though one user may create an account on his/her private computer, most users access their registered accounts through an online exchange or a remote server. This method allows for easy access to a personal account from any terminal or mobile device with access to the Internet.

Let us consider an example of what can go wrong with Bitcoin as a Medium of Exchange: In 2014, the Japanese Bitcoin exchange Mt. Gox handled 80% of Bitcoin's global-trade volume through its own website portal. In February of that year, it suspended operations and filed for bankruptcy after losing approximately $350 million worth of Bitcoins due to the hacking of its website. A drawback to the security coding of the currency is that it is too strong or too unforgiving. If a user loses his/her account information or password or sends funds to an invalid account, s/he never may regain control over those funds again.

In terms of processing power and time-to-settlement, Bitcoin excels in certain types of transactions. Bitcoin "miners" do not seem to care about the location or the destination of any individual transaction. Rather, they are concerned with the overall byte size of the transaction. This fee correlates with the additional time, energy, and computational power needed to add the transaction to the blockchain. Small fees given to miners who are able to attach the transactions to the blockchain successfully help to pay for some transaction costs. On average, an attachment of a transaction takes about ten minutes to process. Though the Bitcoin fees vary per transaction, the most common one is in the neighborhood of 0.50 bits per byte. This fee constitutes about 0.000129 Bitcoin or approximately $0.15 per transaction, on average.

Fees are based on both the size and the incentive to process a transaction rather than on the actual quantity of money transferred or its destination. For this reason, Bitcoin presents a cost-effective way to transfer large, low-volume sums of money across borders. According to the online banking-tool site Nerd Wallet (nerdwallet.com), international wire-transfers can cost between 15 and 50 dollars for most major banks to process. In addition, most banks take three to ten business days to settle their accounts fully on an international transaction due to a host of interrupting variables. Alternative online-payment and holding companies such as PayPal (paypal.com) and Square Inc. (squareup.com) charge a small, set fee plus a percentage of the amount transferred. Though it may not be ideal for small local transfers due to its per-charge fee and its rigid structure for approving transactions, Bitcoin performs much better than its traditional competition for large, one-time, international transfers.

The secondary function of money is to serve as a commonly understood Unit of Account. This second function helps to support it as a Medium of Exchange. In order to limit transaction costs, any properly functioning monetary system must be both popular and easily traded among a variety of users. This accounting function allows users to have a unit of measure that facilitates an accurate determination of production costs or the exchange value of a given good or service. These qualities explain why the U.S. dollar remains the most popular money in global use. Merchants and consumers around the world trust its measure of value, stability, and large user-base.

Unfortunately for Bitcoin, it is not as popular as the U.S. Dollar or other first-world currencies. The block-explorer service Blockchain (blockchain.info) estimates that seven million wallets are open within the Bitcoin network. However, it remains unclear as to how many of these wallets are held by separate users rather than by multiple wallets being held by a few users. In this respect, the real number of Bitcoin users has been suggested to be around two to three million wallet-holders globally. For a global currency, this statistic indicates a low user-base. Major online retailers such as eBay, Etsy, and Amazon have begun to "accept" Bitcoin for online payments. However, these companies are not performing the transactions directly. To date, no major company wants to assume the risk of adding an "asset," which may not be a legal one, to its books. Along with the extreme volatility of the medium, retailers remain afraid to accept Bitcoin as a valued, viable currency. These retailers resort to independent, third-party, Bitcoin-payment service companies such as BitPay (bitpay.com) and CoinBase (coinbase.com). These exchanges convert Bitcoins from any consumer into U.S. Dollars at the time of purchase.

In contrast to first-world countries, Bitcoin has grown in popularity in locations where political and economic uncertainty exists. Let us consider the recent example of Cyprus, which experienced a government-sanctioned bank heist in early 2013. The government of Cyprus removed money from the bank accounts of its private citizens without their consent. As a result, this action led many Cypriots to move their funds out of government-controlled banks and into Bitcoin wallets. Today, Cyprus University accepts Bitcoin as an official form of payment for its tuition.

Also, China has shown recent interest in Bitcoin. Since late 2013, advertising efforts from Baidu (the Chinese version of Google) promoted payments for services that could be made via Bitcoin. Along with its success in surviving the takedown of the Silk Road, Bitcoin also has experienced highly speculative investment pressures. These pressures have forced exchange rates to skyrocket, as Bitcoin is being touted as the next Facebook or Twitter. Nevertheless, the popularity of Bitcoin in China has died down substantially since mid-2014 due to its fading appeal as a novelty.

According to the law of diffusion of innovation, crypto-currency technology may still be stirring in its infancy. Bitcoin itself was one of the successful firsts. Its success has attracted users or "innovators" to develop a "proof of concept." In recent years, competitors such as Litecoin (litecoin.com) and Ethereum (ethereum.org) have entered the cyber-marketplace. These new virtual-currencies are taking hold among niche users--early adapters--who want to be part of the first wave of consumer use without taking on any of the associated risk of the innovators. Early adapters want to use the currencies while they still are considered cool and undiscovered. These recent-entry crypto-currencies may be popular with early adapters. However, they have a long way to go before entering the mainstream. Furthermore, Bitcoin may prove to be a better Unit of Account if its user-base grows and if other crypto-currencies become more widely accepted.

The tertiary function of money is for it to serve as a Store of Value. In this capacity, it is important that the users of a currency be able to maintain its purchasing power over a long period of time. The expected value of the asset should be determined easily with minimal volatility and without the expectation of insolvency in the future. Assets known to have a short shelf life such as fresh fish or other goods that are subject to rapid depreciation do not function well as a Store of Value. In contrast, fine art, classic automobiles, collector cards, and many other durable assets provide a good store of wealth because they hold their value over time. However, even these types of assets may not be quickly liquidated, easily traded, or generally accepted for other goods or services.

The potential for Bitcoin to be a good Store of Value over the long run appears to be very low due to its short-term volatility. In this respect, Bitcoin is much more price-volatile than gold, an asset that remains a preferred substitute for government-backed fiat currencies during times of economic or political uncertainty. Underscoring this relationship, Bitcoin has experienced extreme swings in value that are nearly four times greater than the fluctuations of gold prices have been over the last three years. In effect, this extreme volatility makes Bitcoin better as a speculative investment than as a solid Store of Value. The overall growth of Bitcoin as an investment instrument has skyrocketed over the past few years with growth of several thousand of a percent over the last decade. Such behavior in itself is indicative of a high-risk speculative investment.

Further compounding the volatility of Bitcoin's value is the uncertainty of its legality as well as its acceptance by world governments and global corporations. Bitcoin has been outlawed or limited in its recognition as a currency or an asset in numerous countries. As a result, Bitcoin's volatility can be observed through its exchange rate when the U.S. Congress classified Bitcoin as a convertible virtual-currency in late 2013 and when it classified Bitcoin as a commodity in late 2015. These classifications have increased the speculative potential of Bitcoin because it now must contend with global shifts in asset demand. In addition, FBI forfeitures of Bitcoins from the closure of the Silk Road have reduced its supply substantially, causing further volatility and upward pressures in the commodity-price.

Bitcoin's Monetary Policies

Bitcoin remains a distributed global-fiat currency that does not conform to the rules of any central bank or to the particular monetary policy of any country beyond what has been coded and accepted by the majority of users within its own network. The monetary policies of Bitcoin are limited to a predetermined money-supply growth rate and a self-imposed maximum quantity. These policies are internally rigid and offer no direct tools to any central governing body for combating severe fluctuations in global demand or discrepancies across borders. In addition, no compensation exists for lost or forfeited Bitcoins. Lacking the tools that a normal central bank may enjoy to influence inflation, unemployment, and overall economic stability means that Bitcoin is highly susceptible to attacks from other currencies. This susceptibility leads to increased instability in its pricing, a weakness that further decreases Bitcoin's viability as money.

The U.S. Federal Reserve Board has three tools to help to control the rates of inflation: The discount rate as a lender of last resort, reserve requirements for member commercial banks, and open-market transactions for the buying and selling of Federal securities. These three tools modulate the supply of money and influence interest rates within our economy, either directly or indirectly. Furthermore, implementation of such actions can influence the costs of conducting economic activity in the private sector. Unfortunately, Bitcoin has no such tools at its disposal. Its money supply is perfectly inelastic and essentially fixed. Bitcoin increases its total quantity by a small amount with every transaction-block added to the blockchain. This leaves its price directly impacted by any shift in the demand for Bitcoin.

In respect to the Store of Wealth function, Bitcoin's money supply grows along a fixed and predictable schedule. Its growth occurs from rewarding miners for successfully attaching a transaction block to the main blockchain. Initially, the reward for the time, energy, and computing power needed to process a block was 50 Bitcoins. Given an average processing-time of 10 minutes, this reward is scheduled to be halved by every 210,000 blocks or by every four years. Currently, the reward is 25 Bitcoins per block. This reward is expected to halve to 12.50 Bitcoins by July 2016. As more blocks are added to the blockchain, the reward for processing becomes substantially smaller. Scheduled growth will be capped at approximately 21 million Bitcoins (21 trillion bits). By the year 2140, processing rewards will be virtually zero. Given a limit to its growth, approximately 99% of the Bitcoin supply will be mined within the next ten years. As the Bitcoin reward decreases, the fees for processing a single transaction will increase in order to balance out the costs associated with processing. This may affect Bitcoin's competitive edge in respect to transaction fees. In addition, one bit only would be worth about 0.045 cents considering the current U.S. Dollar exchange-rate values. In order for Bitcoin to function in the future as a world currency, severe appreciation of Bitcoin will be needed due to its arbitrarily restricted supply.

Other significant failings of Bitcoin's monetary policy are due to the lack of its ability to rectify any lost or forfeited Bitcoins resulting from either transaction errors, wallet seizures by government entities, or hacked accounts. Purportedly, the FBI has one of the largest wallets of Bitcoin after capturing nearly $28.5 million worth during its shutdown of the infamous Silk Road drug-trafficking website. This action further decreases the overall reliability for self-regulated monetary and price controls by Bitcoin users. This weakness may cause further upward price pressures and uncertainty of value. If Bitcoin plans to emerge as a global currency, it will need to find a way for its users to rectify innocent mistakes within the system. If not, the theoretical limit of 21 million Bitcoins may continue to be lowered every year.

In addition, no coding exists in Bitcoin to allow lending or borrowing of funds in any form. Bitcoin's ledger system requires that all Bitcoins be accounted for and transmitted as a balanced input and output per transaction. At this time, no factor exists for distinguishing between an owned or borrowed Bitcoin. This shortcoming severely limits its use by a business seeking to leverage its company's value or a consumer in need of a loan in order to buy a car or to pay for college.

A Princeless Bride

There are criminal elements that use Bitcoin as a means by which to exchange goods that may help to finance some criminal actions. However, Bitcoin's involvement in illicit markets is a very small drop in the global drug-trafficking bucket. According to the U.S. Department of the Treasury, $64 billion are generated annually from drug-trafficking within the U.S. alone. Bitcoin-associated drug-trafficking enterprises only account for roughly 0.04% of this market, which is exclusive to the U.S. Considering that the Silk Road was a globally served bazaar, Bitcoin's role in the drug-trafficking market of the world is essentially nonexistent.

Criminals always will find new and innovative ways to hide and obscure their tracks from law enforcement. For its part, law enforcement always will adapt and improve. High-denomination cash offers the same level of anonymity as Bitcoin but is more readily accepted, less volatile, and literally leaves no digital trail. The Hong Kong and Shanghai Banking Corporation (HSBC) has faced numerous suits and settlements for its involvement in laundering billions of U.S. Dollars in cash from Mexican cartels and other terrorist groups. If cracking down on criminal anonymity and frictionless trade is a priority, then the 100 USD and 500 Euro notes should be discontinued. Cash still is king for the majority of criminals, since the business structure and investment needed in keeping a complex operation afloat usually needs physical cash-financing. Bitcoin just does not offer the immediacy and presence that a bag full of $100 bills does.

However, certain criminal industries have substituted Bitcoin for the standard electronic-payment systems of credit and debit cards. Recently, major credit-card companies stopped processing payments for the advertising of illegal sex trades that were openly advertised on public "classified" websites such as Craigslist and Backpage. Public outcry against child prostitution led these companies to stop processing what they believed were illegal ads. In response to this change in policy, pimps and prostitutes alike moved their financing to Bitcoin in an attempt to remain anonymous and to continue advertising.

Cyber-technology crimes have increased steadily over the last 15 years with the recent use of Bitcoin as a method of payment for various illegal acts. Hackers who partitioned a part of a company's hard drive typically would demand ransom in the form of Bitcoin. This type of crime is a byproduct of technological evolution. However, the method of payment is made frictionless and more secure than an in-person exchange of cash. Bitcoin may not be the focus of crime, but it does allow for easier transactions in certain cases.

This frictionless attribute of Bitcoin brings concern to its role in financing terrorist groups across the world such as ISIS. The latter has gone on record asking for supporters to send Bitcoins through pro-ISIS websites. At first glance, this would place Bitcoin on a high-priority list for the Department of Homeland Security to investigate and to track. However, it is unlikely that ISIS or any other terrorist group would be successful in turning large amounts of Bitcoins into physical cash for financing their activities. War-torn countries would need a certain level of technology and functioning exchanges to use Bitcoin effectively, which they generally do not have.

Overall, Bitcoin's involvement in the global crime-market is minimal at best. Bitcoin's functionality as a medium of exchange among criminals is a cause for concern as Bitcoin gains popularity. However, it is a very small portion of the sheer amount of illegal activity being financed by cash every year. Bitcoin's technology offers initial anonymity, but law enforcers always will have a public record to trace and time to unravel any suspicious activity. The majority of Bitcoin users just want to have freedom from government regulation or monetary policies that may devalue their net worth. Some of these users just want a greater level of anonymity. The first Bitcoin ATM, Coin Vault, was established in Houston, Texas, in 2014. It still requires more documentation for identification verification than most formal investment-accounts. However, some proponents for Bitcoin are criminals and desire anarchy, but they are not representative of the population.

Conclusion

As properly functioning money, Bitcoin has not reached the threshold of viability. It has too much volatility to be considered a secure Store of Value, as it is better suited as a high-risk speculative investment. Likewise, Bitcoin may become a better Unit of Account as it gains widespread popularity and as governments make conclusive, positive decisions in respect to its legality and operative definition within major markets. It may take several years before the majority of the population accepts any crypto-currency as common business practice. Bitcoin's monetary policy as a standalone currency is not conducive to generating wealth, growth, and stability within a large global economy.

Nevertheless, the real value of Bitcoin lies within its hash-encryption blockchain technology, which allows it to exist as a relatively fast, secure, and low-cost recording system with a short-term anonymity and no financial intermediary. This technology makes Bitcoin an excellent Medium of Exchange. This system could help to prevent fraud and the loss of registered receipts and to reduce the time that it takes to settle ownership among high-value assets. Ultimately, only time will tell whether or not Bitcoin will be successful beyond that of a rigid, fiat crypto-currency or as a tool that major global businesses choose to adopt as a preferred technology that could help them to reduce costs and to eliminate transaction uncertainty.

The problem with Bitcoin revolves around how it is recognized legally. It can be considered a commodity, an asset, or a currency. For attorneys, this technology and the currency derived from it remains of questionable legality in many countries. This matter needs to be thoroughly addressed on a global basis. Closer to home, there are currently nine Bitcoin ATMs in the Metropolitan Detroit area. In respect to attorneys and their practices, Bitcoin technology could help to reduce the risk of fraud in matters concerning contracts, titles and deeds, and registry of various assets. Bitcoin can streamline the process of any registry. Therefore, there may be a time when attorneys may not be needed as much in the process. Since crypto-currencies appear to be here to stay, attorneys are advised to take a closer look as to how Bitcoin may affect their practices, either positively or negatively.

--------

Many of our articles are posted at www.saseassociates.com. In addition, we post original and curated videos related to Economics on www.Youtube.com/VideoEconomist.

Dr. John F. Sase has taught Economics for thirty-five years and has practiced Forensic and Investigative Economics since the early 1990s. He earned a combined Masters in Economics and an MBA at the University of Detroit, and a Ph.D. in Economics at Wayne State University. He is a graduate of the University of Detroit Jesuit High School. Dr. Sase can be reached at 248-569-5228, www.saseassociates.com, and www.Youtube.com/VideoEconomist.

Thomas A. Wilk is a Doctoral student in Economics at Wayne State University. Mr. Wilk can be reached through the Economics Department at 313-577-3345.

Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a Supervisory Editor at Gale Research Company (now Cengage) for over twenty years. Currently, he edits books for publication and gives seminars on writing and music. Senick can be reached at 313-342-4048 and at www.senick-editing.com. You can find some of his writing tips at www.YouTube.com/SenickEditing.

Published: Wed, Jun 15, 2016

Comments

  1. No comments
Sign in to post a comment »