Bitcoin as Digital Currency— The Road Ahead

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bitcoinsIn the times of economic volatility and in stiff crisis, here comes what is named “Bitcoin”. A mysterious new technology emerges, seemingly out of nowhere, but actually the result of two decades of intense research and development by nearly anonymous researchers.

Political idealists project visions of liberation and revolution onto it; establishment elites heap contempt and scorn on it.

Now on other note, technologists – nerds – are transfixed by it. They see within it enormous potential and spend their nights and weekends tinkering with it. (ANDREESSEN, 2014)

As Bitcoin becomes ever more popular in the public eye we’re seeing two different things going on. One is the way that the regulatory regime is considering it and this ranges from outright bans in Thailand, through no bank should touch it in China, to India’s rather messy warning that it might breach money laundering regulations to the US view that it’s just fine but must obey all the other regulations about money transmission and so on. It’s a difficult terrain to navigate. (MARC, 2014)

The second is that we’re getting economists weighing in on something that they’ve not really fully considered before.

The fact is that Bitcoin is by design a deflationary currency (assuming that it does at some point pass all of the tests needed to be a currency). And that’s just not something we want to have as part of a currency. This is of course normative economics, not positive, but deflation is something to be feared much more than inflation. For deflation depresses economic activity: that is, everyone gets poorer. For in a deflationary environment no one will do anything today for tomorrow their money will be, as a result of that deflation, worth more. Thus investment and innovation suffer the economic equivalent of constipation. (KRUGMAN)

To give an extreme example, just to illustrate the point. Say that Bitcoin prices were rising 10% a day. They’ve been doing this for some time and are expected to continue to do so. Imagine that all 21 million that will ever be mined have been and the global economy is still growing requiring more money to grease the wheels of commerce. MV = PQ of course, the quantity of money times the velocity of its circulation equals prices times quantity demanded of goods. M is now set in stone, Q is increasing so either P or V must change. But we’ve already said that given a fixed M that we expect the value of Bitcoin to keep on rising: therefore P must fall. We’ve got deflation. And of course in a deflationary environment why would people increase the rapidity with which they spend or invest money? For with deflation it’s going to be worth more tomorrow than it is today without our actually doing anything. V will in fact fall: meaning that with a fixed M then either P or Q must fall more rapidly increasing the deflationary effect.

Eventually mainstream products, companies and industries emerge to commercialize it; its effects become profound; Bitcoinand later, many people wonder why its powerful promise wasn’t more obvious from the start.

What technology am I talking about? Personal computers in 1975, the Internet in 1993, and – I believe – Bitcoin in 2014. Well, the list doesn’t just seem to be endless at all.

It is imperative that one can hardly accuse Bitcoin of being an uncovered topic, yet the gulf between what the press and many regular people believe Bitcoin is, and what a growing critical mass of technologists believes Bitcoin is, remains enormous. In this post, I will explain why Bitcoin has so many Silicon Valley programmers and entrepreneurs all lathered up, and what I think Bitcoin’s future potential is.

Bitcoin is a digital bearer instrument. It is a way to exchange money or assets between parties with no pre-existing trust: A string of numbers is sent over email or text message in the simplest case. The sender doesn’t need to know or trust the receiver or vice versa. Related, there are no chargebacks – this is the part that is literally like cash – if you have the money or the asset, you can pay with it; if you don’t, you can’t. This is brand new. This has never existed in digital form before. (WAGNER, 2014)

Bitcoin is a digital currency, whose value is based directly on two things: use of the payment system today – volume and velocity of payments running through the ledger – and speculation on future use of the payment system. This is one part that is confusing people. It’s not as much that the Bitcoin currency has some arbitrary value and then people are trading with it; it’s more that people can trade with Bitcoin (anywhere, everywhere, with no fraud and no or very low fees) and as a result it has value.

It is perhaps true right at this moment that the value of Bitcoin currency is based more on speculation than actual payment volume, but it is equally true that that speculation is establishing a sufficiently high price for the currency that payments have become practically possible. The Bitcoin currency had to be worth something before it could bear any amount of real-world payment volume. This is the classic “chicken and egg” problem with new technology: new technology is not worth much until it’s worth a lot. And so the fact that Bitcoin has risen in value in part because of speculation is making the reality of its usefulness arrive much faster than it would have otherwise.

Other huge benefit of Bitcoin micropayments is to fight spam. Future email systems and social networks could refuse to accept incoming messages unless they were accompanied with tiny amounts of Bitcoin – tiny enough to not matter to the sender, but large enough to deter spammers, who today can send uncounted billions of spam messages for free with impunity. (PICKENS)

bitcoin-robberIn 2013, Bitcoin’s valuation didn’t just skyrocket, but its infrastructure, services, and adoption exploded as well, culminating in recent announcements that major online retailer Overstock.com and NBA team the Sacramento Kings would accept the digital currency as payment. (MORRIS, 2014)

I am sure some still doubt Bitcoin’s usefulness and durability, but 2014 may leave skeptics even further behind — developers and entrepreneurs are already hard at work building features on top of the Bitcoin protocol that will allow for the decentralized execution of financial services, from currency hedging to loans to stock issuance to rental and purchase contracts. These new services rely on the same innovative proof-of-work model of distributed security and record-keeping that has kept the bitcoin currency secure as its value ballooned well past $10 billion. In the long term, peer-to-peer finance threatens to weaken banks and other financial agents just as peer-to-peer file sharing did the music industry — and some of the architects of this financial Napster seem gleeful about the possibility. (ERRANT, 2014)

“In the next year, Bitcoin will start its transformation from a mere currency into an entire open-source, decentralized exchange for everything from futures contracts to car rentals.”

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Neha Gosain

The author is pursuing MBA in Finance and International Business at Amity Business School, Noida.

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