Mini-Case: Bitcoin�Cryptocurrency or Commodity?

The difference is that established fiat currencies�ones where the bills and coins,
or their digital versions, get their value by dint of regulation or law�are
underwritten by the state which is, in principle at least, answerable to its
citizens. Bitcoin, on the other hand, is a community currency. It requires self-
policing on the part of its users. To some, this is a feature, not a bug. But, in
the grand scheme of things, the necessary open-source engagement remains a niche
pursuit. Most people would rather devolve this sort of responsibility to the
authorities. Until this mindset changes, Bitcoin will be no rival to real-world
dosh.

��Bits and bob,� The Economist, June 13, 2011.

Bitcoin is an open-source, peer-to-peer, digital currency. It is a cryptocurrency,

a digital currency that is created and managed using advanced encryption techniques
known as cryptography. And it may be the world�s first completely decentralized
digital-payments system. The unofficial three letter currency code for Bitcoin is
BTC, and its singular currency symbol is shown above.

But is Bitcoin a true currency? Is it, or can it become, money? In January 2014 a
number of major regulatory bodies across the world�the U.S. Federal Reserve, the
European Central Bank, the People�s Bank of China�were all trying to decide whether
Bitcoin was something to be prohibited, regulated, or simply left alone.
Perspectives on Bitcoin use varied dramatically, and in many cases, unexpectedly
so. But the regulators were only one stakeholder interest; users and producers had
their own perspectives on the potential of Bitcoin.

Producing and Using Bitcoins

Bitcoin was invented in 2009 by a man claiming to be Satoshi Nakamoto. Nakamoto

published, via the Internet, a nine-page paper outlining how the Bitcoin system
would work. He also provided the open-source code needed to both produce the
digital coins (mine in Bitcoin terminology) and trade Bitcoins digitally as money.
(Nakamoto is not thought to be a real person, likely being a nome de plume for some
relatively small working group. Nakamoto disappeared from the Internet in 2012.)

Mining. The actual mining of Bitcoins is a mathematical process. The miner must
find a sequence of data (called a block) that produces a particular pattern when
the Bitcoin hash algorithm is applied to it. When a match is found, the miner
obtains a bounty�an allocation�of Bitcoins. This repetitive guessing, conducted by
increasingly complex computers, is called hashing. The motivation for mining is
clear: to make and earn money.

The Bitcoin software system is designed to release a 25-coin reward to the miner in
the worldwide network (anyone, anywhere, can theoretically be a part of the
network) who succeeds in solving the mathematical problem. Once solved, the
solution is broadcast network-wide, and competition for the next 25-coin reward
begins. The system�s protocol is designed to release a new block of Bitcoins every
10 minutes until all 21 million are released, with the blocks getting smaller as
time goes on. If the miners in the network take more than 10 minutes to find the
correct code, the Bitcoin program adapts to make the mathematics easier. If the
miners solve the problems in less than 10 minutes, the mathematical code becomes
harder.

The difficulty of the search continually increases over time with mining. This
creates an ever-increasing scarcity over time, similar to what many believe about
gold when gold was the basis of currency values. But ultimately the Bitcoin system
is limited in both time (every 10 minutes) and total issuance (21 million).
Theoretically the last of the 21 million Bitcoins would be mined in 2140.

Within a few short years Bitcoin mining has become a big business of its own.
Whereas in the early stages an individual could have theoretically mined Bitcoins
on a laptop, or theoretically without a computer at all, that is no longer the
case. By 2014, Bitcoin mining had become the object of multimillion dollar
investments in computer systems by business startups from Iceland to Austin in what
one journalist described as a �computational arms race.� Eleven million of the
total potential 21 million coins had been mined.

Users. Once mined, Bitcoins are considered a pseudonymous�nearly

anonymous�cryptocurrency.2 Bitcoins are initially issued to the successful miners,
who are then able to buy things with them or sell them to non-miners who wish to
use digital currency for purchases or speculate on its future value. Ownership of
each and every coin is verified and registered through a digital chain timestamp
across the thousands of network nodes. Like cash, this prevents double spending,
since every Bitcoin exchange is authenticated across the decentralized Bitcoin
network (currently estimated at 20,000 nodes). Unlike cash, every transaction that
has ever occurred in the Bitcoin system is recorded in terms of the two public keys
(the transactors, the Bitcoin addresses) in the system. This record, called the
block chain, includes the time, amount, and the two near-anonymous IP addresses
(public keys are not tied to any person�s identity). And unlike credit cards or
PayPal, there is no third-party facilitator. It is true peer-to-peer.

The Bitcoin Foundation, a nonprofit organization, runs the global system. The
current Bitcoin Foundation chief scientist is Gavin Andresen, who is paid a salary.
The Foundation is funded mainly through grants made by for-profit companies (like
the Linux Foundation) who either mine or use the Bitcoin system.

Value Drivers and Concerns

Traditional currencies are issued by governments through central banks. They

regulate the growth of the currency, its supply, and they also implicitly guarantee
its value in some way. Bitcoin has no such guarantor, no insurer, no lenderof-
last-resort. If a Bitcoin user were to lose or erase their records of ownership,
there would be no support or insurer�no one to sue, no institution to apply to for
recourse.3 The value of a Bitcoin is completely dependent on what users and
investors are willing to pay for it at any point in time. This makes it similar in
nature to both a currency and a commodity.

Bitcoin is a rather complex composite of currency systems. A gold standard like

that used in the first part of the twentieth century, is a system based on specie;
it has some fixed link to a scarce metal of some intrinsic value. Bitcoin does have
digital scarcity, and ultimately a fixed limit on its availability. But Bitcoins
have no intrinsic value; they are not composed of a precious metal; they are
nothing more than digital code. Their value reflects the supply and demand by those
in the marketplace who believe in its value�a fiat currency�similar to the world�s
major currencies today. As illustrated in Exhibit A, that value has been very
volatile. After spending several years trading at less than $10 per Bitcoin (using
U.S. dollar values, like an exchange rate), its price skyrocketed to $1238 per coin
in December 2013�and then plummeted.

The reasons behind Bitcoin�s price volatility in 2013 provide some insight into its
potential uses. A bank crisis in November 2013 in Cyprus resulted in many Cypriot
citizens putting their money into Bitcoins (bidding the price up) in an effort to
keep their money out of the hands of government. Similarly, in late 2013 Bitcoins
surged in interest and use in China. Chinese residents, in search of a way to
invest their money outside of China despite Chinese capital controls (restrictions
on taking money out of the country), purchased Bitcoins through a number of
different Bitcoin exchanges in China, using Chinese renminbi, and then used the
Bitcoins to invest abroad. Chinese authorities moved quickly to shut down the
Bitcoin exchanges by prohibiting them from accepting deposits in Chinese renminbi,
the local currency.