Bitcoin, the mysterious money of the internet, has captured the imagination of many investors over the last couple of years. There are three main reasons behind this interest in the cryptocurrency: it’s raw as a form of payment; there has been a substantial rise in value since Bitcoin’s creation less than a decade ago; and there is a perennial surge in demand for (perceived) long-term stores of value when geopolitical risk is heightened. Now, public opinion is widely split between people who think cryptocurrencies are revolutionary, with some suggesting that they will do to the banks what email did to the postal industry, and others who believe that cryptocurrencies may be showing similarities to historical market bubbles.

In essence, Bitcoin is an electronic cash system which is fundamentally different from existing payment systems owing to the lack of third-party mediators, central banks, credit-card companies and so on. It was initially intended to solve the problem of lack of trust on account of fraud between counterparties making and receiving transactions. In established payment systems, we are reliant on a central third party to verify transactions and keep a record of them, as well as to protect individuals from fraud. We pay for this verification, record-keeping and protection through transaction costs, but also lose privacy, with third parties and credit-card companies keeping a record of our identity. Bitcoin is based on a different, decentralised system which offers far more anonymity to participants.

Bitcoin solves the transaction cost and trust issues by creating a distributed ledger – a ‘block chain’ – which is a full public record of all transactions, providing the history but also the proof of ownership of every single Bitcoin in circulation. Computers called nodes keep a record of this distributed ledger; there is no requirement for a central third party to maintain the ledger, thus removing the power of that single institution.

Then we have individuals and companies called ‘miners’ who are responsible for maintaining the ledger, which they do by verifying transactions. For the time, effort and computational power they contribute to the system, they receive rewards in the form of Bitcoins, which are intended to keep them using the system. 

A real alternative to traditional currency?

One consideration is whether Bitcoin can be thought of as money in the traditional sense and whether it could replace traditional currency as the most prevalent form of payment. To be able to answer that question, we really need to look at the role of money in an economic sense. Cash/money remains as a medium of exchange and a form of value for goods and services. While some companies do now accept Bitcoin as payment, it is still not being actively used by many retailers so it doesn’t really tick this box. Neither does Bitcoin really yet have the ability to act as a unit of account and measure of value of goods and services owing to its extreme volatility. Instead, it is currently used largely as a long-term store of value – unlike traditional currencies, Bitcoin is not backed by physical assets, but there is an expectation that it is going to be around for a while.

One interesting fact about Bitcoin is that the first Bitcoin transaction was made to purchase a pizza. At the time, this was a big deal because not many retailers accepted Bitcoin for goods and services. In fact, initially Bitcoins were almost worthless – it cost a couple of cents to buy a Bitcoin. The first officially documented purchase was in 2010 when someone bought two pizzas for 10,000 Bitcoins (10,000 Bitcoins were worth about £20 at that time). By January 2018, the worth of 10,000 Bitcoins was closer to a hundred million pounds.

Mining difficulty

Another interesting fact about Bitcoin is that mining the currency is very energy-intensive. The ability to mine Bitcoin is dependent on a few main factors: computational power, the ‘hash rate’ (the processing power of the Bitcoin network), and the level of mining ‘difficulty’. One might think that with a rise of computational power it has become easier to mine Bitcoins, but in fact it has become more difficult as computational power is not improving fast enough. The computational power needed to mine new Bitcoins is so intensive that individuals can no longer mine Bitcoins and need to pool resources across different computers.

Regulatory challenge

A major issue with Bitcoin is regulation, with the legal status of the cryptocurrency varying significantly from country to country. In many cases it has been banned or restricted owing to concerns that it is being used to fund criminal activities or to transfer value out of countries where capital controls exist. For example, the key funding currency of Bitcoin used to be the Chinese renminbi, but when individuals used Bitcoin to transfer value out of the country, the regulators shut down Bitcoin trading in China; the same thing happened recently in India.

While we think regulation is a key problem, and there are dangers that the Bitcoin currency itself may have entered bubble territory, the potential future uses of the underlying distributed-ledger technology are wide-ranging. One such application could be the issuance of digital cash by central banks. For example, in Sweden, where cash has been declining rapidly over the last couple of years, the central bank has actually been assessing the concept of issuing digital cash and how this might affect the financial system. Another potential use could be in share trading, which has always involved significant layers of intermediaries. Distributed-ledger technology could cut out some of these layers and simplify the process, making settlement quicker and improving trade accuracy. Smart digital contracts are a further area where the technology could help to execute transactions and agreements and enforce obligations across all parties without the involvement of middlemen. 

 

This is a short extract from a BNY Mellon ‘Agents of Change’ podcast episode. To hear more about Bitcoin, you can listen to the full podcast here.

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