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ABSTRACT

BITCOIN ITS
ECONOMIC
IMPACTS
A term paper by:
Rahul Gaikwad (4022/20)
Amit Pratap Singh (4008/20)
under the guidance of
Prof Parthapratim Pal

The paper talks


about the working of
bitcoin. Compares
its evolution and
working with that of
gold and the
possible scenarios
that bitcoin maybe
used in near future.

What is Bitcoin
Bitcoin is a cryptocurrency. So what exactly is a cryptocurrency! Is it really a currency,
an investment or is it another technological breakthrough. There are different support
groups in favour of all these points. It is simultaneously all of them. Anything that has a
value and can be exchanged for goods or services can be called a currency. It is in this
sense that Bitcoin can be called a currency.
In the beginning people bought bitcoins just because it was something different. Trading
of Bitcoin started after that, some websites started accepting bitcoins and the price stared
to increase. Thus people who invested in it earlier made huge gains. The suite followed
until one of the major trading center Mt. Gox was robbed of its bitcoin inventory losing
the amount in range of 560 Million. The price crashed to half of what it was. Thus bitcoin
can be seen as a highly volatile investment. But one critical thing missing is the liquidity
of bitcoin. People who invested their money in Mt. Gox were not able to get it back till 34 months. This raised the suspicion in the minds of regulators and some warnings were
issued to general public by regulators of many countries including RBI. The warning was
to prevent users from investing in bitcoin since it was very volatile and illiquid. No
government had any jurisdiction or regulation hence all they could do was issue a
warning.
From technological point of view, it can be seen as an invention because it offers features
that traditional banking system cannot offer. It allows you to transfer cash without a hefty
transfer fee, and it is not regulated by any entity so its production cannot be monitored.
The only way to produce more bitcoins is the way gold was produced which is mining. A
peer to peer network monitors the transaction which is encrypted. This network decides
whether the transaction would be authorized or not. To authorize complex mathematical
equations have to be solved and the solver is awarded with more bitcoins to reward for its
computing capability. Thus all these transactions take place without the involvement of
some supervising entity like a traditional bank. This makes bitcoin an innovation which
might endanger the likes of Mastercard or visa who charge upto 3% of the transaction fee.

Who invented it and how does it work?


Bitcoin was invented by a person (or group of persons) known as Satoshi Nakamoto. It
basically works on the premise that a group of people start to accept bitcoin as a currency
to exchange goods and services. They just need the software bitcoin wallet to begin this
system. This wallet generates bitcoin addresses. These addresses are used to transfer
bitcoin from one person to another. The diagram below explains the working of bitcoin
transfer. Moreover the bitcoin protocol is an open source software. This allows people to
see it and understand the working of transfers.
Then what is so different about bitcoin. Isnt bitcoin transfer like wire transfer without
the transaction fee. No there is something more to the equation. Wire transfer represent
transfer of something tangible that is the cash or gold promised for the cash. But a digital
currency is just a series of bits. So cant you use this same series of bits to pay again and
again? This was the exact problem Nakamoto faced. This is called double spending. The
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basic invention of Satoshi Nakamoto was the solution to this problem of double spending
without a central monitoring system. He created a decentralized monitoring system. But
this decentralized monitoring system had its own issues. The monitoring had to be done
by peers now. They can be honest or dishonest about it.

This is one of the famous problem in Communications Network Theory known as the
Byzantine General Problem. So what is this problem exactly? You can imagine the
situation as a group of military generals are waiting outside a city, stationed at some
distance from each other (direct communication is impossible, messengers must
necessarily be used). They have to decide whether to invade the city, or stay put. There
are honest generals as well as traitors in the mix. Decisions and opinions can only be
communicated through messengers. There are enemies lurking in the path used by the
messengers. With all these constraints, how can the group come to a consensus that is
based on the views of all the honest generals?
So how did he manage to crack this challenge? He incentivized the peers (generals) by
giving them more bitcoins for honest verifications and monitoring. So by computing these
transaction you can actually earn bitcoins. But these computations are really complex and
need a computing powerhouse. All these transactions then become the part of an open
ledger known as the block of chain. Here all the previous transactions of a bitcoin would
be added. So there is no use of routing the money and thus double spending can be
prevented. Each new transaction is added to the chain.

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BITCOIN Uses and misuses


Bitcoin is basically a digital currency, virtual currency or a cryptocurrency. One of the
main property of this currency is its anonymity which means transaction carried out by
using bitcoin cannot be linked to any specific user by its name. A different bitcoin address
can be used for each transaction. Bitcoin can be bought and sold in many different
currencies. The currencies which can be converted into bitcoin in an automated way are:

US Dollars

Euros

Japanese Yen

Russian Rubles

Pound Sterling

Pecunix Gold

These bitcoins can be hold or stored in a Digital wallet. Bitcoin are secured with public
key cryptography in which two keys are generated. One is public key and another is
private. Public key is used as account name or number whereas private key is have owner
credentials. This private can only be used to provide the ownership of the Bitcoin and if
user anyhow lost this key then there will be no way to claim ownership. These wallets are
the softwares which holds the digital credentials of bitcoin holdings of the user. These
wallets can be online and offline. Online wallets are the service provided by some websites
where credentials can be stored online and offline wallets are the software application
stored on the users computer.
As of November 2013, more than 35000 online merchant and about 1000 brick and mortar
businesses were willing to accept payment in bitcoins. Some of the mainstream website
that accepts payment in bitcoins are Expedia (US site, for hotel booking only), WordPress,
OKCupid, Atomic Mall, TigerDirect and Overstock.com etc.
Due to its property of anonymity, Bitcoin has been associated with online criminal
activities. In 2012, around 4.5% to 9% of all transactions related to Bitcoin were for the
drug trading on Deep web drug market, Silk Road. Theft cases of bitcoin are also very
difficult to track. Transactions of bitcoins are irreversible and identity of user is also
masked, which makes it almost next to impossible to recover the stolen bitcoins. Theft
issues can be mitigated by generating and storing keys offline or using offline wallets.
Apart from these, there are cases of Malware stealing bitcoins, botnets mining bitcoins.
Conversion of bitcoin with other currencies has also been accompanied with some
chargeback frauds. As in case of payment methods like credit cards and PayPal, the
transaction can be reversed back up to 90 days. Here, in case of Bitcoin, once the
transaction is made it cannot be pulled back. Same may be seen when 2 major exchanges,
Bitcoin market and MtGox, were hit by PayPal scams when a group of individuals
exchange their PayPal currency to Bitcoin from a stolen PayPal account. This led to
freezing of PayPal accounts at MtGox and suspension of new user registration at Bitcoin
Market which caused the temporary liquidity problem.
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Legal Issues
The use of Bitcoin is legal in some countries, Illegal in some, contentious and undecided
in the remaining countries. A map of countries which explains the status is given below.
Let us start by the country where it was invented, Japan. In japan, bitcoin is legal. In fact
in japan the government is supporting the digital currency and launched an bitcoin
industry association which is backed by the government. It is named as Japan Authority
of Digital Asset (JADA).
The aim of JADA is to not to regulate the use of bitcoin. They just want the nascent
currency/technology to evolve its natural course. JADA will be responsible for providing
guidelines and softly monitoring the digital currency.

Figure 1. Bitcoin Legality , source:bitlegal.net

At the same time Football World cup finalist nation Argentina construes bitcoin as
contentious. They have ordered the financial Services firms in the country to report the
activities in the digital currency market in the country. The translation of the resolution
read Virtual currencies are often traded remotely online. The movement of assets, and
that entities from different countries can participate in the same jurisdictions that do not
have controls to prevent money laundering and financing of terrorism, make it difficult
for regulated entities to detect suspicious transactions.
Some other countries which have imposed regulations on bitcoin or are contentious about
the status of bitcoin include Italy, Netherland, India, China, Russia, Thailand, Ecuador
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and other countries. One noticing point about Ecuador is that it has banned bitcoin but
they are planning to start a state run digital currency which would be backed by the assets
of their National Bank.
Similarly the countries which have legally allowed bitcoin are also under pressure to come
up with business regulations, expenditure, transfer and tax regulations. France recently
introduced regulatory guidelines to increase the transparency of the bitcoin market. The
regulation guided the bitcoin distributors to identify the users to limit the anonymity
level. They also imposed capital gain taxes on bitcoin which are subjected to a maximum
limit of 5000 .
One of the major supporter of Bitcoin is USA. Its financial hub New york has recently
launched its legal Framework Bitlicense for bitcoin businesses. The 40 page document
detailing the guidelines can be found here. New York Department of Financial Services
(NYDFS) states in its framework that that bitcoin businesses that receive, transmit,
store or convert virtual currency for customers; buy and sell virtual currency as a
customer business; control, administer or issue a virtual currency; or perform conversions
between bitcoin and fiat or any value exchange will need to be licensed to operate in New
York. The merchants who accept bitcoin are not included under these regulations. Some
other noticeable factors include disclosure of risks to consumers, backup capital
requirements, maintaining customer information, stringent regulations in reporting for
clients outside US, Quarterly and annual reporting, transaction monitoring that requires
disclosure if the amount exceeds 10,000$.

Recent Developments
Forbes has a started a blog about bitcoin to keep track of the latest happenings in the
bitcoin world. Some of the noticeable developments are Canada government passed a
budget with giving provisions to bitcoin. The provisions are regarding anti moneylaundering. Bitgo is a company focused in the security of bitcoin wallets. The company in
its new series of funding raised an amount of 12 Million $. The funding was received from
Radar Partners, Founders Fund, Barry Silberts Bitcoin Opportunity Corp., Liberty City
Ventures, Crypto Currency Partners, Ashton Kutchers A-Grade Investments, and a
number of top Bitcoin industry executives and angel investors.
A new index tracking bitcoin prices is now available on Bloomberg. Its called winkdex. It
is calculated in the basis of top 3 verified bitcoin exchanges in the US. A fund raising
campaign has been stared on kickstarter.com for the documentary Coined: The story of
cryptocurrency. The team making this documentary is based out of Orland. Yahoo
Finance and Google finance have started conversion of bitcoin to various currencies on
their websites. This comes as they have started using Coinbases Application Programing
Interface(API).
E-commerce Giant Amazon has been awarded a new patent on May 6th 2014 which will
be used for allocating financial risk and reward in a multi-tenant environment. The
patent aims to reduce the services cost using digital currency. The top minds of the techworld are taking interest in Bitcoin technologies. Employees from Facebook and Google
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have joined the bitcoin startup Bitgo, which is the first multi signature bitcoin wallet
servicer. In a major development even service firms in the US which are involved the legal
sector are starting to accept bitcoins. McLaughlin & Stern, LLP is law firm situated in
Newyork city. They have started accepting bitcoin payments. This suit was followed after
another law firm F. J. Seibert, LLC has agreed for bitcoin donation for a particular case.
First Live Bitcoin Exchange was opened in Vietnam. Bitcoin ATMs are also in trend and
increasing in numbers. A bitcoin ATM provides you bitcoin for cash without human
intervention. An image showing the bitcoin ATM and its location is given below.

Money
Money is a means by which everybody carry out transaction to own the good or
services in need. It provides a medium through which the person can exchange the
commodity in need with other person. Earlier people use to trade commodities in
exchange of commodities in need. This transaction was known as barter system.
This system has lot of inefficiencies as there are lack of divisibility amongst some
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commodities and people need to find some who has the commodity in need and
who is also willing to exchange the commodity the person currently have.
In view of such inefficiencies, money gave a medium through which we can acquire
the commodity in need by paying the money. The seller can easily accept the
money because it has its own value and through which he can purchase any
commodity required in future.

Characteristics of Money
There are three main characteristics of money as mentioned below
1. Medium of Exchange: Money facilitates the exchange between the buyer
and seller by providing the common means to store and measure the value
of the commodity in exchange. Buyer and seller can mutually value the
commodity in terms of money and carry out the transaction. As a medium
of exchange, money should be portable enough to facilitate the exchange
between two parties. Secondly it should be secured from any
counterfeiting to safeguard the seller from a fake currency from the buyer.
2. Unit of account: Money should be measured easily. It should support
application of basic mathematical functions like addition, subtraction,
multiplication and division. It should be divisible, as if it is divided into four
equal parts then all the four parts should equal value and also this value
should be equal to similar part from any other piece of money.
3. Store of value: Money should able its owner to store the value he obtained
during transaction to a longer period whether in person or with the bank.
It should be stable enough to keep the value of the money intact. It should
be backed by some gold reserves or any government authority to give it the
required credibility.

Performance of Bitcoin on these characteristics


Bitcoin is being used in the transaction by various online portals like Expedia,
Overstock.com etc. It is being used as a replacement of money as it has very low
or no transaction fee and transactions can be made all over the world very easily
as it not associated with any country. Anonymity of the transaction is also one of
the reason of its usage as transaction party may hide their identity from each
other. In view of the same below is the discussion on how bitcoin is performing on
above three main characteristics of the money:

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1. Bitcoin as a medium of exchange: Bitcoin is currently being used as a


medium of exchange in number of transactions from various online portals
and a few brick and mortar shops. The transaction can be made easily and
are relatively cheaper than transaction in various other currencies. Low or
no transaction cost are the main reason of online portals to use it as mode
of transaction in view of their very thin profit margins. As being a
cryptocurrency, it is highly portable and can be easily transferred. It uses
the public key encryption and recorded in a public ledger called block chain.
This block chain follows a chronological order and enforced with
cryptography makes it highly insulated against counterfeiting.
The main problem of Bitcoin being used as a medium of exchange is it is
still not being regulated. While purchasing Bitcoin, it is very difficult to
gauge whether the source selling Bitcoin is credible or not.
2. Bitcoin as a unit of account: It contain almost all the properties of being
unit of account. It is divisible up-to eight places of decimal. It supports all
the mathematical functions mentioned above and can be measured.
The problem associated with Bitcoin under this characteristic is that
Bitcoin is very volatile currency and Seller has to calculate the value of
Bitcoin very frequently in comparison with other currencies which are
relatively very stable than Bitcoin.
3. Bitcoin as a store of value: Bitcoin can be stored in digital wallet and as
per present scenario many people are buying it as for using it as store of
value. But as store of value, Bitcoin has many disadvantages as mentioned
below:
Bitcoin is highly volatile currency and there is high risk associated when
using it as a store of value. During and after the transaction, Bitcoin
doesnt guarantee the value will remains the same over period as in case
of other currencies which are relatively more stable.
This is not backed by any reserve or government authority. So there is a
question of credibility as well.
Bitcoin cannot be stored in Banks. It can only be stored in digital wallets.
Therefore, there are large security concerns. Bitcoin have a risk of theft
and loss which is being overcome by the public after the bankruptcy of
Mt. Gox.

Expert Views on Bitcoins Future


Government Officials and Bureaucrats have a mixed view on bitcoin. The
Chancellor of Exchequer and second lord of Treasury of United Kingdom, George
Osborne recently announced his plans to look into bitcoin regulatory issues and
how it would affect the business. Britain is already a center of global finance.
George wanted to cement this position by leveraging innovations in the Financial
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Technology sector. His statement Its only by harnessing innovations in finance,


alongside our existing world class knowledge and skills in financial services, that
well ensure Britains financial sector continues to meet the diverse needs of
businesses and consumers, here and around the globe, and create the jobs and
growth we all want to see in the future. made UKs stance on bitcoin pretty clear
that they are willing to support it and are clearly looking into bitcoin innovations
that might drive the finance sector in the future.
On the other hand academicians seem to be skeptical about bitcoin. Mostly
because of the volatility issues. Mark Kamstra, a finance professor at York
University's Schulich School of Business, says that bitcoin has "fatal flaws" such
as fixed supply that limits its growth. Even then he agrees that the underlying
technology has a potential to change the traditional payment system. Also JeanPaul Lam, a professor at the University of Waterloo and a former assistant chief
economist at the Bank of Canada says that price fluctuation is another important
issue. With a traditional currency, price spikes are managed by Central banks by
printing more money. Jean-Philippe Vergne, an economics professor at Western
University's Ivey Business School says that the underlying architecture of
decentralized banking has many more uses. The invention of similar 275 digital is
a testament to the success of the architecture. Kenneth Rogoff, Professor of
Economics at Harvard University when asked about his view of bitcoin indicated
that bitcoin cannot be and will not be a currency. Another Economics prof at
Harvard, Larry Summers holds an opposite view saying I think bitcoin has the
potential to be a very, very important development. Paul Krugman, Nobel prize
winning economist wrote an article titled Bitcoin is Evil. In this article he
compares bitcoin with gold and explains why bitcoin economics would not work.
Investors see potential in Bitcoins. A total of 240 Million $ have already been
invested in crypto currency startups up to date. Barry Silbert, from SecondMarket,
a bitcoin investment trust says Just like the Internet disrupted the publishing
industry, were going to see bitcoin micropayments creating some very interesting
opportunities for pay-as-you-go, pay-based-on-time online businesses, and,
frankly, some risks as well to the traditional business model as to how things get
sold online. Another PE Investor from Pantera Capital Management, Dan
Morehead says On the question of whether bitcoin will replace money, a good
analogy is the postal service and email. Email didnt replace traditional mail, and
we still send the same amount of mail today as we did before. But today we have
totally new ways of communicating chat, text, Facebook things we didnt
imagine when the Internet first arrived. Greg Brockman, CTO of emerging bitcoin
firm, Stripe says that Unless we solve decentralized reputation, the bitcoin
ecosystem will see the emergence of a few centralized consumer trust providers.
Were still in the very early days, but we can already start to see the shape of the
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potential impact of Bitcoin and other cryptocurrencies. If we get things right, life
is going to be much better for billions of people. Stripe a payment processor
company is looking into bitcoin and has raised over 120 M $ from from venture
capital firms such as Andreessen Horowitz, Khosla Ventures and Sequoia Capital.
John Donahoe, Ebay sees bitcoin and other cryptocurrencies playing an important
role in pay pal. He himself owns some bitcoins just to understand the mechanism
and is planning to integrate the bitcoin architecture with paypal.
Let us also take a look at what the bankers have to say about bitcoin. Two
Goldman Sachs economists, Dominic Wilson and Jos Ursua, agreed to the belief
supporting bitcoin. Giving their view they said We would argue that Bitcoin and
other digital currencies lie somewhere on the boundary between currency,
commodity and financial asset. Our best definition would be that it is currently a
speculative financial asset that can be used as a medium of exchange. But they
also made a very important point about the P2P technology could be used for
moving money without third-party verifiers like banks. Another banker from Wall
Street Gil Luria of Wedbush Securities called bitcoin volatility an extended price
discovery. This implied that no one knew what the exact price of bitcoin is since
there is no commodity backing or the exact uses of bitcoin are still unwinding.

Conclusion
We feel that bitcoin has a future. A rationale behind this thinking is there is a
group of supporters for bitcoin. They are willing to accept bitcoin in lieu of their
services or products. This group may be small now but it is increasing day by day.
The currency maybe be a volatile one right now but as time passes and the
regulatory limits of bitcoin get clearer, we can come up with valuation models for
bitcoin too. Liquidity of bitcoin is also increasing day by day. The bankruptcy of
Mt. Gox was a hindrance to this but plane crashes never meant that people will
stop flying, it was just an indicator that the current flying technology has some
flaws and they need to be corrected. Even some governments have started to take
bitcoin seriously and if at some point of time they introduce backing it then it will
be nothing less than a digital revolution.
Moreover at some point even if things go sour for bitcoin because of some legal
restrictions across the globe, the underlying technology that is being developed for
it might be put to better use. The decentralization can be a solution to the Internet
of Things which experts believe will be the future of networks and connections in
the near future. The scope is unlimited for this technology. We can see the number
of bitcoin technology companies growing day by day, all we need is another Google
or Facebook for bitcoin.

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