Disrupting the Currency Market

My column that originally appeared in the Duke Political Review.

The advancement of the digital age has transformed financial transactions, both in high powered trading and in everyday use. According to Nilson Reports, some $4 trillion in purchases occurred using credit, debit or prepaid credit cards in 2012. Online shopping is omnipresent, and smartphones have even rendered trips to your local bank unnecessary, as checks can be deposited directly into your account from wherever you are. The one area of payments that remained undisrupted by the digital age was the concept of currencies themselves.

This, however, would change in 2009, when Bitcoin was introduced into the market as the first cryptocurrency. Borrowing technology from peer-to-peer networks and public key cryptography, cryptocurrencies are a new digital form of payment that allow for decentralized control and anonymous transactions. Untraceable, like cash, but with the accessibility of a credit card, cyrptocurrencies and Bitcoin in particular, have revolutionized the currency market in a way that prior virtual currencies had never achieved.

Today, we are witnessing a new era of digital money where virtual goods are no longer simply an extension of real money, but rather a replacement of traditional currencies altogether. There are still many issues that Bitcoin, and other virtual currencies, have yet to address. Is a currency backed by a distributed network even technically feasible? Is it really safe to trade with? What sort of infrastructure needs to be in place? If technical challenges are overcome, can such a currency survive economically in a dynamic world market? What policy options do governments have with virtual currencies, and what actions should they take?

With new technology, especially when it concerns money, security is a prime concern. Bitcoin is still relatively new, so it is possible that there are unknown security holes in the code. However, the source is open and transparent, allowing cryptography experts to scrutinize its inner workings, and, furthermore, all transactions require large distributed computer networks, meaning many individuals are involved in verification. Bitcoin is generally as secure as you are; access to your money requires a private key, a number you keep secret on your computer. The FBI recently seized Ross Ulbricht, the founder of Bitcoin market Silk Road and has yet to gain access to his 600,000 coins—that’s $120 million at today’s prices. Like digital banking, the lack of physical money does not preclude the existence of secure transactions.

Infrastructure is a separate challenge that is still in the process of being addressed by the market. This past April, Mt. Gox, the most popular Bitcoin exchange at the time, had to shut down its transactions for several weeks as it upgraded its infrastructure. For some time, there had been a substantial backlog of orders, especially during the April bubble, when Bitcoin demand soared and prices reached over $200. Since that time, Mt. Gox has run into other troubles, and users continue to report very slow dollar withdrawals. Consequently, a new exchange, called Bitstamp, has risen as the new most popular trading market. This development may prove to be the long term solution to Bitcoin’s infrastructure problem; however, we will not know this for a few more months. Regardless, with a $2 billion market cap and growing, Bitcoin needs a stable conversion platform, and the market opportunity is real; it seems inevitable that technical capacity will not limit Bitcoin for long.

But beyond the infrastructure, can a currency with no backing from any government survive economically? National—or international—currencies, likewise have had no asset backing since 1971, but are guaranteed by law to be accepted in their home country and can otherwise rely on their central bank’s reputation. Bitcoin has no guarantee to be accepted in any country, but in some ways, its reputation is infinitely more valuable than that of any central bank, as monetary policy is completely transparent in an open source algorithm. It is unknown whether currencies can exist on reputation alone, but, so far, this particular currency has succeeded—to a degree. Since Bitcoin’s value relies solely on how liquid investors perceive it to be, it has been fairly volatile, especially in 2013, during which prices have ranged from under $20 to $250. Bitcoin’s massive instability with relation to other currencies is related to its small market size (in relative financial terms), as demand for use of trading Bitcoins is only a part of the desire to own them. Speculation became a large part of the demand for the currency as more websites began to accept them in 2013. Bitcoin faces a unique problem as a commodity. Unlike most real world commodities, Bitcoins cannot be consumed, only traded. While economic activity may raise the demand for and, thus, the price of physical goods, such as oil, the only real determinant of the demand for Bitcoin is how many people want to trade their current goods for it, believing they can, in turn, trade Bitcoins for other goods later on. This will lead to deflation as Bitcoin gains wider use and increases in value, something which could prove lethal to Bitcoin’s long term viability.

Nonetheless, the general trend is towards greater mainstream acceptance, and many prominent websites now accept Bitcoin including WordPress, reddit, Etsy, The Pirate Bay and even non-profits like the Electronic Frontier Foundation and Khan Academy. The full list is much longer, and includes many types of internet and Bitcoin related services. With growing use comes a larger market base, which could see prices stabilize. Then again, larger markets could bring in more speculators as well. But the more places that accept Bitcoin, the higher their intrinsic value independent of speculation.

Long term, Bitcoin may not even be the final iteration of virtual currencies. Other algorithms with different restrictions on currency growth may compete with Bitcoin and perhaps prove more stable; only time will tell. This brings up a final interesting aspect of Bitcoin in relation to policy, namely the inability of policy to control it. Economically speaking, Bitcoin is a digital commodity and possibly even a currency, but legally, it is mercurial and amorphous. This is because Bitcoin is emphatically neither a legal entity nor a currency; rather, it is a distributed computer network. Bringing down or removing sections of Bitcoin’s network does little to thwart its existence. Like BitTorrent, it is virtually impossible to find these computers, but unlike BitTorrent, the fewer computers on the network, the bigger the incentives for more computers to come online. From a policy standpoint, this means Bitcoin is virtually untouchable. Indeed, since Bitcoin’s value is determined by what people believe it to be worth, there may be no single entity on the planet that can control its trajectory—not even those who first invented Bitcoin, even if they felt another algorithm might ultimately be superior.

As a way to avoid taxes and trade illicit goods, Bitcoin’s value to the black market is obvious (see The Silk Road). So despite government’s inability to control Bitcoin, it will continue to attract attention. However, some observers, including The Economist, recommend that policymakers let digital currencies take their course. They rightly point out that current illegal transactions and tax evasion already occur in cash, and a digital currency provides a fascinating new market which could revolutionize digital payments. Taking policy actions to thwart Bitcoin is not the best interest of the market’s development. Others disagree, noting that every other financial area is a heavily regulated in the world, despite what the libertarian supporters of Bitcoin might want. But the choice may not be regulators’ decision to make.

While Bitcoin is likely to survive for a time, its long-term future is less certain. Even so, it has set a precedent for digital currencies, which is likely to be copied in the future. Virtual currencies are here to stay, and money markets must prepare for their growing influence, whatever impact they may have.