What is Bitcoin?

Bitcoin is a new currency that was created in 2009 by an unknown person using the alias Satoshi Nakamoto. Transactions are made with no middle men meaning, no banks! There are no transaction fees and no need to give your real name. More merchants are beginning to accept them: You can buy webhosting services, pizza or even manicures. Why Bitcoins? Bitcoins can be used to buy merchandise anonymously. In addition, international payments are easy and cheap because bitcoins are not tied to any country or subject to regulation. Small businesses may like them because there are no credit card fees. Some people just buy bitcoins as an investment, hoping that theyll go up in value. Acquiring Bitcoins Buy on an Exchange Several marketplaces called bitcoin exchanges allow people to buy or sell bitcoins using different currencies. Mt. Gox is the largest bitcoin exchange.

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Transfers People can send bitcoins to each other using mobile apps or their computers. Its similar to sending cash digitally. Mining People compete to mine bitcoins using computers to solve complex math puzzles. This is how bitcoins are created. Currently, a winner is rewarded with 25 bitcoins roughly every 10 minutes.

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Owning Bitcoins Bitcoins are stored in a digital wallet, which exists either in the cloud or on a users computer. The wallet is a kind of virtual bank account that allows users to send or receive bitcoins, pay for goods or save their money. Unlike bank accounts, bitcoin wallets are not insured by the FDIC. Wallet in cloud: Servers have been hacked. Companies have fled with clients Bitcoins. Wallet on computer: You can accidentally delete them. Viruses could destroy them. Anonymity

Though each bitcoin transaction is recorded in a public log, names of buyers and sellers are never revealed only their wallet IDs. While that keeps bitcoin users transactions private, it also lets them buy or sell anything without easily tracing it back to them. Thats why it has become the currency of choice for people online buying drugs or other illicit activities.

Future in question No one knows what will become of bitcoin. It is mostly unregulated, but that could change. Governments are concerned about taxation and their lack of control over the currency.

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Digital currencies have generated substantial curiosity over the last year, particularly post the favorable hearing that Bitcoin, a prominent digital currency, received at the US Capitol hill in November 2013. There is growing interest in trying to understand what digital currencies really are but they are much confused because of the difficulty in placing them squarely in the current monetary setup of fiat paper currencies. This leads to most dismissing digital currencies as another geeky innovation which will fade post the initial curiosity is over, while some confuse it with an online payment system. This can be quite misleading as digital currencies pose important political economy questions on the control of money supply in a society and are deeply connected to a growing school of right wing economic thought called libertarianism. Given the increasing usage of digital currencies and the ideological support for them in certain section of economic thought, it would be prudent for monetary authorities and regulators to not dismiss such currencies and meaningfully discuss their implication. In this post, we attempt to provide a context for such a discussion by giving a brief overview on the evolution of money and the ideological support for digital currencies. Are digital currencies money as we commonly understand? Are digital currencies even money in the first place? Money is defined as anything that serves as a general medium of exchange. Digital currencies can be used to discharge all the three purpose of money viz., medium of exchange (growing number of establishments accept digital currencies in trade for goods and service), standard of value (the value of other goods and services and can be expressed in digital currencies) and store of value (digital currencies can be stored and used in the future). Digital currencies should not be confused with an online currency which is convertible to a fixed pre-determined value of government legal tender. For instance, the digital currency Bitcoin is not an online architecture for transferring government legal tender from one place to another. Bitcoin is an alternative medium of exchange with its own value which fluctuates with other currencies.

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As can be seen in the graph above, the exchange rate of Bitcoins to USD has gyrated wildly since the digital currency gained prominence. The recent volatility in the value of Bitcoins can be traded to events surrounding the shutting of Mt. Gox, a popular Tokyo based Bitcoin exchange. Thus, even though digital currencies like Bitcoin serve all the three purpose of money, they can emerge as a general medium of exchange only if such currencies gain stability. Evolution of Money Money was invented to counter the limitations of the double co-incidence of wants in a barter economy. Over the years, different commodities have been used as money, such as seashells, tea, fur, cattle and even tobacco. The use of metal coins as money can be traced back to Lydians in 700 BC from where it was passed on to the Western civilization through Greeks and Romans. Coins served several useful purposes like being durable, portable and having an intrinsic metal value. As trading grew, coins became popular throughout Europe during the 18th century. These coins, which contained metals, were examples of commodity money where a commodity which had precious value was used as a medium of exchange. Commodity money had both intrinsic as well as exchange value. The use of paper money can be traced back to the Chinese Tang Dynasty (618907 A.D.). Initially paper money could be exchanged for certain commodities like gold, silver or even tobacco. Such paper money convertible to fixed quantity of certain commodities was termed as representative money. Again, representative

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money had both intrinsic values (as they could be converted to certain commodities) as well as exchange value. The final evolution of money is fiat money. Fiat money is similar to representative money except it cant be redeemed for a commodity. The Reserve Bank of India (RBI) notes we use today are an example of fiat money. Fiat money has only exchange value (which is derived from a government fiat or order) and no intrinsic value.

From the above discussion, it is clear that digital currencies are similar to fiat paper money in the sense that they only have exchange value and no intrinsic value. However, the exchange value of digital currencies is completely market determined and is not derived from decree of the government. This is the single most important reason why such currencies are lauded by supporters of the free market, particularly libertarians, who are distrustful of the governments monopoly role in controlling the money supply Exchange Value of Digital Currencies Digital currencies derive their exchange value from several characteristics. Such currencies represent a completely decentralized anonymous peer-to-peer medium of exchange. They bypass any regulatory restrictions for cross border transfers as digital currencies do not depend on conventional payment platforms (like Visa, MasterCard) or clearing houses and are transferred electronically. For instance, Bitcoins are electronically transferred from one e-wallet to another e-wallet hosted on personal computers scattered throughout the world. These features make the architecture of digital currencies the most cost-efficient and anonymous way to transfer money from one place to another. The downside is that this anonymity, regulatory bypass and lack of KYC make them extremely vulnerable to use by antisocial agents. Bitcoins have been used extensively in trading for illegal drugs through an online platform called Silk Road. The anonymous nature of Bitcoins can also lend itself to financing terrorist activities. There have also been concerns on the security architecture of digital currencies with reports of several heists from Bitcoin e-wallets. The fact that digital currencies only have exchange value and no intrinsic value has led many people to say that such currencies represent a bubble, much like the
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tulip mania. This argument however overlooks the fact that by this reasoning, all money are always in a bubble as money (by definition) will always have exchange value over and above its intrinsic value, and in this sense, its value is always inflated compared to its intrinsic value. The caveat here is that while fiat paper currencies are backed by government legal tender laws, there is no corresponding backing for digital currencies from any monetary authority. Ideological support for Digital Currencies Digital currencies have several similarities with the classical gold standard system of 1815-1914 when national currencies were convertible to a fixed quantity of gold. Libertarians consider the classical gold standard as the Golden Age of unadulterated monetary system. Prominent libertarians like US Senator Ron Paul, who leads the Audit the Fed campaign in the US and supports a return to the gold standard, look favorably at digital currencies like Bitcoins because of the similarities. In fact the similarity of the Bitcoin economy to the classical gold standard system has led many libertarians to hail Bitcoin as the free market solution to private currency.. The similarity with gold standard can be clubbed under three broad heads: Market selection of the medium of exchange Sympathizers of the gold standard support digital currencies as they derive their exchange value endogenously without any backing by a government or central bank monetary authority. This is much like the emergence of gold as a medium of exchange in competition to other commodities like tobacco, sugar, cattle, tea, shells among others. Among various alternatives, gold was established as the preferred medium of exchange for its acceptability, durability, portability, homogeneity and scarcity. In April 1933, the US went off the gold standard where US citizens could no longer redeem dollars in gold but the foreign central banks could still convert their dollar holdings to gold at the Federal Reserve. In August 1971, President Nixon took US completely off the gold standard by revoking the foreign convertibility of the dollar to gold. For a supporter of the gold standard, the next best bet would be to support a digital currency which mirrors certain gold standard characteristics.

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Market determined supply The supply of money in a gold standard was market determined. The supply of gold would increase as long as the marginal cost of mining gold is less than the value of goods and services which an incremental unit of gold can buy. Thus, a gold mining company would produce gold till arbitrage opportunities have been exhausted through the forces of perfect competition. The money supply process is similar for digital currencies. For instance, participants in the Bitcoin economy mine the digital currency by solving complex computational algorithms till the time the marginal cost of undertaking this activity exceeds the incremental value of the goods and services which a Bitcoin can buy. The maximum supply of Bitcoin is by design fixed at 21 million coins, which is similar to a gold standard economy where the stock of gold is fixed. It should also be noted that the monetary operation of a Bitcoin economy would be exactly the same as under the gold standard where a fixed stock of the money supply finances growing global exchange through divisibility of the unit of currency. Also, the stock of money supply is immaterial as divisibility ensures adjustment in nominal denominations without changes in real values Competition to Government Legal Tender As an alternative currency without backing of any legal tender laws, digital currencies circulate in competition to fiat currencies as a medium of exchange. This is along the lines of the libertarian demand for open competition in currencies. Regulatory Oversight The regulatory oversight for digital currencies has not fully developed with monetary authorities around the world adopting a strategy of wait-and-watch. The limited regulatory actions that have been promulgated till now has been sporadic and based on two primary concerns financing of anti-social activities and evasion of capital controls. In the case of Bitcoins, given its anonymous character, it has been used extensively in trading for illegal drugs through the online platform Silk Road. In October 2013, the FBI seized 144,000 Bitcoins from Ross Ulbricht, the alleged owner of the online platform. At todays exchange rate, the value of the seized Bitcoins is in excess of USD 70 mn21. By August 2013, the U.S. Department of Homeland Security had seized bank accounts worth USD 5 mn of Mt. Gox as it had failed to register itself as a money transmitting business and was in violation of U.S. anti-money laundering regulations. More recently, Chinas central bank
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prohibited financial institutions from handling Bitcoin transactions on concerns such digital currency pose on bypassing capital controls. This was after China had become the worlds largest trader in Bitcoins. Indias central bank, the Reserve Bank of India (RBI), issued an advisory warning against the risks of dealing in digital currencies like Bitcoins on December 24, 2013. Days later, Enforcement Directorate (ED) officials at Ahmedabad raided two companies engaged in Bitcoin transactions. The concerns highlighted by RBI were susceptibility to hacking, no dispute settlement mechanism as Bitcoins bypass any authorized central agency, speculative value, unknown legal status of Bitcoin exchange platforms, use in illegal/illicit activities, breach of anti-money laundering (AML) and combating the financing of terrorism (CFT) laws. Thus, the regulatory oversight for digital currencies has primarily been inspired by concerns on their end-usage and capital controls. None of the regulatory actions taken so far can be explicitly linked to concerns that digital currencies pose on the control over an economys money supply by a central bank. This can be justified as the volume of digital currencies is small compared to central bank issued money. However, if the usage of digital currencies grows to materially alter the dynamics of money supply in an economy, central banks around the world will have to think hard on the regulatory landscape for such currencies.

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Bitcoin market cap rose from $55 million on the rst of January 2013 to $143 million by the rst of February 2013. By March the market cap surpassed $403 million and by mid-March bitcoins surpassed $500 million. A few days later Laiki Bank announced it would freeze the deposits of all account holders in Cyprus as a way to secure assets to maintain liquidity for the bank. Within hours every Parliament and Congress of every major economic power in the world said that nothing stood in the way of other banks doing this throughout the world, though most reassured their people this would not be needed for them. Banks followed suit saying they were not like Cyprus yet reiterated that they did have the right to seize deposits under certain circumstances. No legal consultation was made of the worlds legal establishment throughout all this. JP Morgan had a glitch that day as well zeroing out the balances of all its depositors. The glitch was xed by midafternoon and that became the focus of most news reports in New York and Washington. By the 20th of March the market cap for bitcoin surpassed $1 billion. During the rst week of April 2013 New Yorks Federal District Court ruled that banks could not be prosecuted under relevant laws for LIBOR rate rigging and other wrong-doing. Top cop, Attorney General Eric Holder re-iterated that due to the systemically important nature of modern banks it is impossible to prosecute them for signicant breaches of the law, including bid rigging, money laundering or outright theft, since doing so would have severe societal costs. On April 10, 2013 the value of all bitcoins surpasses $2.8 billion. As the rule of law crumbles, many people are seeking ways to preserve their property by removing it from the care of trusted third parties. Modern electronic commerce relies upon trusted third parties to take place. Thus a need exists for a transaction system that operates independently of trusted third parties. The bitcoin system of exchange relies on cryptology to remove the need for trusted third parties to conduct business electronically. Thus, bitcoin is an ideal alternative to traditional legacy systems of nance, despite the difculties faced in making bitcoin easy to use and adapting its unique features to meet the needs of the electronic marketplace.

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Bitcoin values are growing rapidly and that growth is accelerating. It is important to realize that despite this rapid and accelerating growth, most people (around 72%) are buying bitcoins to store value, not realize trading prots. This value is likely to rise since the number of bitcoins is limited whilst the number of dollars in circulation is constantly increasing. Bitcoin numbers are limited today to 11.08 million and are limited for all time to less than 21.00 million not by convention, but by the nature of numbers themselves. Bitcoins are freely traded on a 87 exchanges at present which determines their value day to day minute by minute. Bitcoins offer secure, reliable, fast and private transfer of value between parties using a peer to peer communication of encrypted digital money. They offer intrinsic digital value. How can digital bitcoins have intrinsic value? Just as precious metals give coins an intrinsic value so too do precious numbers give bitcoins intrinsic value. Just as precious metals are mined from a sea of rock and dirt, so too are precious numbers mined from a sea of lesser numbers. Using double SHA 256 encryption we know that there are 2.1 quadrillion numbers that are possible to use as the base of a block chain that is used to build an innite series of transaction sequences. Today through the effort of hundreds of thousands of miners, we know 1.1 quadrillion of these numbers. Over time we will know 2.1 quadrillion of these numbers. The numbers possessing a unit of value called the Satoshi is the smallest unit of a bitcoin. It takes 100 million Satoshis to make a group that forms a bitcoin. This allows nearly innite divisibility. These numbers are traded among users securely without any possibility of counterfeit. With these numbers we create transactions that share all the features we associate with gold and silver in the real world. We have in essence the digital equivalent of gold. We have precious numbers.

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