Bitcoins Decoded

By Victor Chu, Senior Consultant

Bitcoins are an experimental digital “crypto-currency” that enables instant peer-to-peer transactions worldwide. The bitcoin network was introduced to the public in 2009 as open source, meaning that anybody could view the inner workings of the code and contribute changes to it with approval from the user community. The use of bitcoins does not require the presence of issuers and a central authority; rather, its appeal is that it is completely decentralized, anonymous (potentially) and can operate without any intermediaries or third-party intervention.

To ensure that new bitcoins are created, and to spur growth of the bitcoin supply, special servers known as miners – or nodes – authenticate the creation of new bitcoins, and update transaction records to the block chain, or public ledger of transactions. This block chain is then verified by the nodes and stored across the network. Bitcoins can either be transferred via a computer or smartphone without the need of any financial institution.[1]

Payments are made to bitcoin addresses, or public keys, which are digital locations of bitcoin wallets. Links to passwords, or private keys, enable access to these wallets and allow the transmittal of bitcoins.

Bitcoins offer several advantages:

Tax-free. Because the transfer of bitcoins does not require a third party, there is no devised mechanism for taxing bitcoins or even a consideration for taxation. However, taxes can be paid voluntarily if the purchaser decides to do so. This may be subject to change via imposed governmental oversight, guidance or forced rules and regulations.[2]

Difficult to track. It is nearly impossible to track bitcoins unless owners willingly publicize their wallet addresses. However, owners must make a significant effort to keep their digital identities anonymous. In the event that a wallet address is unintentionally publicized, a new wallet address can be generated. However, the continued absence of tracking bitcoins is subject to government approval and can change at any moment.[3]

No transaction costs. When sending or receiving bitcoins, the only requirement is that the sender and receiver stay connected to each other’s node – a bitcoin miner or bitcoin server. Users contribute to the network and share the network bundles of bitcoin transactions, thereby reducing the transaction cost, rendering the cost negligible. This may change as mining bitcoins becomes increasingly computationally and quantifiably expensive through the cost of PC components, utility/electrical bills or other expenses.[4]

Global, unrestricted transportable currency. The digital format of bitcoins circumvents border controls via customs or security checks, whereas a hard currency has limitations on allowable transportable amounts (e.g., amounts greater than USD 10K entering/leaving the country must be declared).

Cannot be seized by a third party (e.g., government). The existence of multiple, redundant block chains (or ledgers) prevent confiscation by a third party. For example, governments cannot freeze an owner’s bitcoins.

Bitcoins also have significant disadvantages:

Not yet widely accepted. Bitcoins are not familiar – nor are they readily accessible – to the general public and, as a result, only a small subset of hobbyists and early-adopting online merchants accept payment in this form. Currently, bitcoins cannot be used to pay for taxes, mortgages, food, cars, gasoline or other commodity items.

No legal tender status in any jurisdiction. Bitcoins are potentially illegal in the United States because the U.S. does not issue bitcoins as part of its Legal Tender Statue. In addition, some governments discourage the use of bitcoins because they cannot be tracked. In 2001, the U.S. convicted a man in federal court for minting his own currency.

Highly volatile. The floating rate of bitcoins has led to large price fluctuations compared to other established currencies. This speculative nature of bitcoins makes it an unsatisfactory form of payment until its floating rate stabilizes.

No recourse for lost or corrupted wallets. If a wallet becomes corrupt due to viruses, malware, hard drive crashes or any other event, the bitcoins in that wallet are potentially lost, unrecoverable and removed permanently from the bitcoin universe.

No buyer protection. The bitcoin world is unregulated and thus absent of consumer protection or insurance. If a purchase is made using bitcoins and the goods are not transferred, the transaction cannot be reversed. Any transfer of bitcoins is permanent without any possibility of restitution to the buyer. An independent third party can act as an intermediary or escrow provider, but that would mimic traditional currency usage and defeat the purpose of decentralization.
No valuation guarantee. No conventional system has been established that guarantees merchants the minimum valuation of bitcoins. If a group of merchants decides to “nullify” their bitcoins, the value of bitcoins will drastically decrease. This implies that bitcoins are a risky business to invest in and many equate it to gambling.[5]  To support that belief, the unit price of bitcoins against the U.S. dollar fell by 61 percent at one point on April 10, 2013. Forbes lists a history of bitcoin crashes.

Potential for government intervention. At some point, governments may impose guidance, rules or regulations to discourage the creation of exchanges or use of bitcoins in general. The Financial Crimes Enforcement Network, a bureau of the U.S. Department of Treasury, released guidance on virtual currencies in March.  As recently as May 14, 2013, “…the Department of Homeland Security shut down Bitcoin trading platform Mt. Gox’s ability to accept or send transfers using Dwolla, a mobile payment service.” Seizure warrant available here.

Susceptible to hacking. Unknown technical flaws exist with bitcoins, along with widely reported theft, manipulation and fraud. According to an April 5, 2013 article in the American Banker, “The biggest six hacking, theft and fraud incidents involving Bitcoin exchanges, wallets, or investment vehicles have resulted in a total 1.2 million coins being stolen. This means that more than 10% of all Bitcoin in circulation has been stolen, and this does not include many smaller thefts and losses from individual wallets.” A number of exchanges have also been hacked and compromised.[6]

Interest in bitcoins has intensified in recent months due to continued financial turmoil and a sense of distrust in the global financial system. Heavy government regulation is causing some people to question traditional forms of wealth storage. The tremendous gains and immediate shifts of wealth in bitcoin online exchanges cannot be ignored and are attracting investors, speculators and the curious, who want to try their hand at striking it big.

Bitcoins have generated differing viewpoints from major global financial institutions. Although the framework is intriguing, the bitcoin universe is still in its infancy, and until major issues such as volatility and security are addressed, bitcoins are unlikely to supplant existing forms of currency and monetary exchanges and become an alternative, competing currency.

What role do you think bitcoins will play in today’s financial markets? Join the discussion.

 Victor Chu is a Senior Consultant in Capco’s Capital Markets practice