With cryptocurrencies in the news, Professor Pedro Gomis Porqueras tackles some of the questions.
Bitcoin is an online communication protocol that facilitates the use of a virtual currency, including electronic payments.
It began in 2009 by an anonymous group of developers. Anyone can create a Bitcoin account – without charge, without any centralized vetting procedure and without a real name. The “Bitcoin core” software can be freely downloaded at https://bitcoin.org/ en/choose-your-wallet.
While Bitcoin is by far the most widely-used cryptocurrency, by November 2017 at least 11 other cryptocurrencies had market capitalisations over US $1 billion and another 49 between US$100 and $999.99 million. Updated numbers are reported by https: //coinmarketcap.com/
Bitcoin is built on a transaction log that is distributed across a network of participating computers. It includes mechanisms to reward honest participation, to bootstrap acceptance by early adopters, and to guard against concentrations of power. Its design allows for irreversible transactions, a prescribed procedure to create new money (additional Bitcoins) and a public transaction history, thus providing an incentive to maintain its bookkeeping system, including verifying the validity of transactions.
Bitcoin imposes no obligation for a financial institution, payment processor, or other intermediary to verify a user’s identity or cross-check with watch-lists or embargoed countries. Second, Bitcoin imposes no prohibition on sales of particular items. This is sharp contrast to credit card networks which typically disallow unlawful transactions. Finally, Bitcoin payments are irreversible in that the protocol provides no way for a payer to reverse an accidental or unwanted purchase, whereas other payment platforms, such as credit cards, do include such procedures.
Gold and Bitcoin do share some important characteristics. Their purchasing power fluctuates greatly at very high frequency. They are (or are perceived to be) in relatively fixed supply and the demand for these objects can fluctuate violently. Bitcoin can be used as a medium exchange as gold under the gold standard.
The first notable adopters of Bitcoin were businesses that sought features not easily available through alternatives: greater anonymity and the absence of rules concerning what could be bought or sold. Gambling sites also turned to Bitcoin, both to protect customer privacy and to receive funds from customers unable to use other payment methods.
Bitcoin can also be used to evade international capital controls. In December 2013, the People’s Bank of China, the central bank of China, banned Chinese banks from relationships with Bitcoin exchanges, a decision which the Economist magazine attributed to a desire to prevent yuan from being moved overseas via Bitcoin (D.K. 2013).
Any user holding Bitcoins faces market risk via fluctuation in the exchange rate between Bitcoin and other currencies.
The relatively-low weekly trade volumes means that a person seeking to trade a large amount of Bitcoin typically cannot do so quickly without affecting the market price, thus it can be manipulated for speculative purposes.
The irreversibility of Bitcoin payments creates heightened transaction risk. If Bitcoins are sent due to error or fraud, the Bitcoin system offers no built-in mechanism to undo the error. Transaction risk also arises when receiving payments.
Finally, operational risk encompasses any action that undermines Bitcoin’s technical infrastructure and security assumptions.
As any other asset, changes in its price will affect the composition of the asset portfolio that investors have.
Bitcoin systems face numerous legal and regulatory risks across countries. For example, a law-abiding user could lose funds in an exchange that is frozen or seized due to criminal activity—even if only a portion of the exchange’s customers were in fact engaged in such activity. Furthermore, uncertain tax treatment of Bitcoin gains and losses hinders tax planning.
Professor Pedro Gomis Porqueras has research interests in macroeconomics with special emphasis on monetary economics and search theory.