Bitcoin : The upcoming International Monetary system?

Abhinav Chauhan | MBA-IB 2012-14

Anurag Sharma | MBA-IB 2012-14

This article has been published in "The Financial Bulletin” Vol. 2 Iss:2 pp.7-9 of ICFAI Business School (July 2013 edition)

The ever globalising business operations and their plethora of long distance transactions are representative of the face of modern trade. Internet has been a harbinger of welcome news for facilitating such transactions. The costs linked to such transactions though are humongous, owing to the involvement of third party financial institutions that validate and thus reduce the risk of fraudulency. What is significant is that this current model is trust-based. The transactions have a possibility of reversal, and thus high trust requirements. Also, with transactions crossing borders more often than not, a standardised currency medium that brings homogeneity is invariably required.

Bitcoin, seems to be a welcome solution to the world. This experimental peer-to-peer technology has gained abundant popularity recently while grabbing hold of significant investor base as well as the attention of major economists around the globe. It has resulted into a billion dollar market. Cryptocurrencies have been speculated to be the future of transactions. Bitcoins have managed to give those speculations a face worth trusting. The system gives users the ability to mine, buy, sell or accept “Bitcoins” from around the globe.  

The existence of dubious analysts challenging the working of this system is not surprising. They have raised some significant issues and marred the potential showcased by bitcoins. Does Bitcoin hold a real future, or is it another bubble waiting to explode?

Bitcoin : The technicalities

To understand Bitcoin, we need to delve into its technicalities. New bitcoins are generated via mining. The generation rate of bitcoins is limited, and the net bitcoins ever to be released have been capped at 21 million.

Mining a Bitcoin: There are freewares available on the internet that can be downloaded by anyone willing to mine bitcoin. The software lets user allocate his hardware for solving complex mathematical problems or facilitating the ongoing transactions. In return, the user is compensated in the form of prevalent rate of BTC(Bitcoin) or the transaction fee as the case may be. Thus, a huge pool of bitcoin miners helps bring new bitcoins in supply.

The bitcoins may also be secured by buying them at the prevalent exchange rates. Mt. Gox is one such renowned exchange which enables users to trade Bitcoins in return for US Dollars, or vice versa. These rates are driven by the buyer-seller speculation or the demand-supply of Bitcoins in the system.

A bitcoin is essentially an electronic chain of digital signatures to which, when transferred to the new owner, the previous owner adds a coded hash to the pre-existing chain of codes. In order to avoid double selling of a bitcoin, timestamping is inculcated in the system. The processes of timestamping and verification of non-fraudulent transactions require huge hardware capabilities and thus the mining nodes are incentivised.

Is The Bit-risk worth taking?

There is absolutely no doubt about the huge promises that the Bitcoin system holds. The presence of huge investor base further strengthens this perception. But like any other upcoming trend, Bitcoins also have certain innate issues worth addressing.

The imminent deflationary nature of the currency lends it lower practicability. The deflationary nature has its onus to the cap on the maximum number of bitcoins ever to be eleased. With expected 21 million bitcoins into the system and an expected steady demand, the exchange rate of bitcoins is bound to increase.  Possible hoarding of bitcoins as well as non possibility of external influence to govern circulation of this currency can be detrimental to its utility.

 Also, what has been causing a crucial point of concern for the system, is its highly volatile nature. The good news however is that with wider acceptance, the system might tend towards stabilisation.

The immense variability is substantiated by the data released by Mt. Gox showcasing the rapid fall of bitcoin value from nearly 230 in April’13 to close to 78 in July’13.

The transactions offered under this system can be subjected to complete anonymity. While this might be considered as a positive aspect that is safeguarding the user’s interest, it lends vulnerability by increasing the scope of money laundering and illicit transactions. Recent case in point is the freezing of accounts of Mt. Gox by the US department of homeland security alleging money laundering on its part. Also exists is a portal called Silk Road, an online black market that only accepts bitcoin as a medium of exchange for illegal/smuggled items.

So, is it a downhill?

Looking at the downsides of Bitcoin system, any investor would feel the need of careful consideration before investing. What cannot be ignored is the ease of life that this system has to offer.

The relevance of transaction costs in business operations is second to none. What bitcoin does is diminishes these costs monumentally.  This striking feature of the system has probably been one of the driving forces to the wide surge in acceptance witnessed in the last few months.

Also what works for the currency is its decentralised nature, with the value of currency solely being controlled by users. There has been a huge scepticism regarding the centralised banking system around the globe.. The net debt for developing countries, which stands close to $5 trillion as per International Debt Statistics report 2013, published by world bank, substantiates the concerns.

Where does Bitcoin stand then?

With an exceptional amount of interest that has gone into understanding the system, sprouting up of strengths and weaknesses is not a surprise. To invest or not to invest in the system is then rooted in the risk taking capacity of investors, as it is with any investment. The system does have huge potential, and if not more, it definitely lays down a strong foundation for future cryptocurrencies. It won’t be an exaggeration if Bitcoins are referred to as “The Father of Cryptocurrencies”. Investors with the backbone to support this system may end up being a part of a great legacy in the making.