What exactly is Bitcoin and should we care?
What to make of Bitcoin, the digital currency which has been all over the news recently, and should we take it seriously?
Invented by one Satoshi Nakamoto, whom nobody has ever met and who has now disappeared, Bitcoin is an experimental digital currency which uses a decentralised, peer-to-peer network, open-source software and sophisticated public key cryptography to enable anyone to pay anyone else, securely and anonymously, over the internet. The supply of bitcoins and the secure processing of transactions is controlled by the network itself via a process called “mining” which essentially involves using massive amounts of computer power to solve immensely difficult cryptographic problems. This process is designed in such a way that the supply of bitcoins is steady but gradually decreasing so that by about the year 2140 there will be an absolute maximum of 21 million bitcoins in circulation. In other words, Bitcoin is also a type of scarce commodity like gold with a limited supply and like gold, is a hedge against inflation. Also like gold, the value of bitcoins is highly volatile and has recently appreciated massively (then collapsed somewhat) in what some see as a classic bubble.
Not much the wiser? Me neither! But Bitcoin is real, it works, and it is actually being used by real people. For the record, as of today (April 16) there are about 11 million bitcoins in circulation, each worth about $60, representing a market capitalisation of about $600 million, (down from about $2.5 billion earlier in the month) and a transaction volume of about 60,000 per day. Moreover, Bitcoin has a couple of very interesting features.
The first is the decentralised, anonymous nature of the Bitcoin. Unlike most currencies, Bitcoin involves no banks, is not owned or controlled by any government, and there is no central point which can be manipulated or shut down (unlike PayPal for example). Not surprisingly therefore, Bitcoin appears to be very popular with arms dealers, drug barons, money launderers and other unsavoury characters. On the other hand, Bitcoin is also attractive to those who are fed up with indebted governments all over the world devaluing our savings through quantitative easing or simply stealing our bank deposits as in the case of Cyprus. In between are those who wish to avoid paying taxes or who believe that “big brother” style eavesdropping on their personal transactions has gone far enough.
The second attractive feature of Bitcoin is that currently, transaction fees for users appear to be zero, or close to zero. For reasons involving the mining process which I don’t fully understand, it is expected that transaction fees will increase slightly over time, but it seems reasonable to suppose they will always be a small fraction of the fees typically charged by banks and payment schemes for any other type of cross-border payment. In other words, Bitcoin is a relatively frictionless payment system, and just as digital media have wrought havoc with industries such as book publishing or the music business, it is possible that Bitcoin or another digital currency will seriously undermine the existing bank-based global payments industry.
This last point is an important one. Whatever we might think of Bitcoin itself, and even if it eventually collapses or turns out to be a massive Ponzi scheme or whatever, the genie is now out of the bottle as it were and the principles of a new, digital currency are unlikely to go away. Indeed, similar schemes such as OpenCoin are being launched and the whole digital currency ecosystem is attracting significant levels of interest from major venture capital firms. So yes, I do think Bitcoin should be taken seriously, and the incumbent banking and payments industry and governments worldwide should be afraid, very afraid!
Nick Collin, Banking Automation Opinion Article, May 2013