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Bitcoin From Three Perspectives


Sean Cremins 15


Final Executive Briefing Paper
UGTTW 2014





























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I. Introduction
Bitcoin is a groundbreaking open-source financial technology created in 2008 by
a person or group of persons known as Satoshi Nakamoto. Bitcoin is a cryptocurrency,
meaning that it is governed by cryptographic algorithms instead of by a central authority
(such as a government). Bitcoins do not exist as a physical currency, but rather as entries
in a digital, public ledger. Every Bitcoin transaction is merely an entry in this ledger,
known as the block chain. The true innovation here is that this allows for peer-to-peer
transactions that are anonymous and digital.
Prior to Bitcoin, third-party payment processors such as PayPal or Mastercard
were needed to maintain financial ledgers to prevent individuals from spending the same
money digitally two or more times (Nakamoto, 2008). Bitcoins block chain, though, is
maintained and secured publicly through the solving of immensely difficult cryptographic
algorithms by computers in a process that is known as mining. Mining can be done by
anybody, and it is in the best interest of the network of Bitcoin users not only because it
keeps the block chain secure and up to date, but also because those that participate in
mining are rewarded with the issuing of new bitcoins.
New bitcoins are issued consistently less often the cryptography problems have
gotten and will continue to get exponentially more difficult with time. In addition, there
will be only a finite number of bitcoins issued by the block chain; no more than
approximately 21 million bitcoins will ever be in circulation, and the Bitcoin network
will reach that volume around the year 2140 (Brito, Castillo 2013). It is clear that Bitcoin
is a fascinating disruptive innovation in the world of finance, but criticism from financial
institutions and regulation from national governments as Bitcoin has emerged have
brought into question exactly how Bitcoin will disrupt global finance.
Bitcoins classification as a cryptocurrency could prove to be a misnomer.
Bitcoin, at its core, is a new financial technology, and Fitch Ratings report on Bitcoin
highlights how Bitcoin both now, and in the future could be viewed from a number of
perspectives. Fitch examines Bitcoin as a payment system, an asset, and a currency. The
report astutely concludes that Bitcoin is currently not numerically significant no matter
how you look at it (it currently has a market cap similar to that of Guatemalas Quetzal)
(See Figure 1) (Grossman, Mitropoulos, Boise 2014), but the reports three-pronged
analysis motivates the question: Just how should Bitcoin be viewed currently, and what is
it likely to become in the future? This paper will similarly analyze Bitcoin from three
perspectives: as a currency, as an asset, and as a financial application environment. Such
an analysis will ultimately lead to the conclusion that though Bitcoin currently exists as a
currency or commodity, its future lies in the financial applications that will be made
based on its core technology.

II. Bitcoin as a Currency
Satoshi Nakamoto defined Bitcoin as A purely peer-to-peer version of electronic
cash in the original Bitcoin manifesto, implying the original intent of the technology was
for it to serve as a currency. Bitcoin has functioned as a currency since its inception,
gradually being accepted by more merchants in recent years, including Overstock.com
and Gyft. Already discussed was Bitcoins main advantage as a currency, anonymous
digital payments without the need for a third party. Bitcoins other feature that cannot be
construed as anything but a competitive advantage is the lack of fees associated with its
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use when compared to paying with other currencies digitally. MasterCard, as an example,
has an interchange fee for merchants that currently hovers around 2% (Region
Interchange Rates, 2013), depending on what type of merchant one is classified as.
Similarly, PayPal charges 2.9% +$.30 per transaction for sellers (PayPal Fees, 2014).
The majority of Bitcoin fees, however, can be made without any sort of
transaction fee. Transaction fees are applied if the data size of the transaction is high
(meaning a high-price transaction or a high volume of smaller transactions). Even these
already low transaction fees, though, are soon to be reduced tenfold, according to
Bitcoins core developers (Bradbury, 2014). No other currency can claim such low digital
payment fees.
Two other features of Bitcoin as a currency could be viewed as advantages or
disadvantages, those being that Bitcoin is both decentralized and deflationary. Bitcoin on
its own is not recognized or regulated by any central authority as other currencies are.
This is possibly advantageous since this means Bitcoin users can bypass the fees and wait
time associated with banks. In some countries, this could even mean avoiding taxes to an
extent, although many countries, including the United States, have begun taxing Bitcoin.
In addition, Bitcoin not being associated with any individual country means users are
likely to avoid problematic exchange rates and fees as more merchants in more countries
begin to accept bitcoins.
However, decentralization has risky negative aspects. Whereas funds in the
United States are insured by the FDIC, there exists no such insurance for Bitcoin. This is
problematic in light of Bitcoins price volatility and its recent security concerns (both
detailed below). These risks could lead to a slower pace of adoption of Bitcoin. National
governments are beginning to regulate Bitcoin anyway, so whether decentralization is an
advantage or a disadvantage could become a moot point as Bitcoin becomes more
regulated.
More amounts of other currencies can be issued indefinitely, meaning they are
inflationary currencies that decrease in value as more money is printed. Bitcoin, though,
is deflationary since there will be only a finite amount of bitcoins ever mined. Bitcoins
value will theoretically increase against other currencies over time in light of this. This
can be beneficial to Bitcoin users as the relative price (in bitcoins) of goods and services
fall and bitcoins become worth more when converted to other currencies. However, the
Economist notes that deflation could cause a rise in unemployment since wages
generally dont adjust downward with prices (R.A., 2014).
Turning to distinct disadvantages for Bitcoin as a currency, the collapse of Mt.
Gox is instructive. Ryan Selkis revealed in February 2014 that Mt. Gox, a Japan-based
Bitcoin exchange, had lost 750,000 bitcoins. A number of the bitcoins were lost due to a
feature of Bitcoin known as transaction malleability an intentionally programmed
feature that can help facilitate high-volume operations such as crowdfunding (Morris,
2014). However, transaction malleability under the wrong circumstances allows for the
double-payment problem Bitcoin sought to solve. Basic accounting of bitcoin
transactions (which Mt. Gox supposedly did very little of) can prevent this issue but
this is not the only major security breach Bitcoin has faced. The Canada-based Bitcoin
bank Flexcoin closed its doors in March after $600,000 worth of bitcoins was lost to a
hacker attack (Chakrabarty, 2014). While Bitcoin has had few security breaches due to
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the sophistication of its code and the sheer difficulty of the cryptographic algorithms it is
based upon, the hiccups that have occurred have been immense.
Finally, the volatility of Bitcoins price is of note. Just months prior to the Mt.
Gox collapse, Bitcoins price had skyrocketed over the previous few months to above
$1,000. Following Mt. Gox, the price collapsed to just over $500, and it has only
fluctuated since then (See Figure 2). Bitcoins price can change substantially even within
a ten minute period, which is significant since Bitcoin transactions currently take ten
minutes to be completed in full. While some early adopters have benefitted from the
skyrocketing price, many that have used Bitcoin since have been hurt by this volatility.

III. Bitcoin as an Asset
In addition to the Fitch report, Goldman Sachs examined Bitcoin from both a
currency and a commodity standpoint. In the report, Dominic Wilson and Jose Ursua
denounced its viability as a currency in the report, arguing that what matters is not the
comparison with other currencies, but a comparison with the volatility of the currency
that they hold (dollars in the US for instance) in terms of the things that they need to buy
(6). This serves to say that Bitcoins volatility compared to other currencies (see Figure
3) could cause confusion as to what can and cannot be afforded when a purchase needs to
be made. In light of this, Goldman proceeds to examine Bitcoin as a commodity,
specifically by comparing it to investing in gold. The key to golds success is the
stability and predictability of its demand. On net, we find that bitcoin is easier to store
and transport and is potentially more difficult to counterfeit, but it is not nearly as stable
as gold and competitors still pose a greater risk, Jeff Currie points out in the report (7).
While Goldmans view on Bitcoin as a commodity is negative, the Fitch report
points out its volatility actually likens it more to an asset than a currency. Sahil
Deshpande of Bain Venture Capital makes a similar point in greater detail, asserting that
the diversification value of gold is the value addressable by Bitcoin over the long term.
There will be many ways to play this, including wallets, remittances and payments,
exchanges, and mining, but one simple way to play, which everyone can participate in, is
to accumulate Bitcoin, Deshpande said.
Recent trends in government regulation support Bitcoin as a commodity as well.
Bitcoin was classified by the Finland central bank as a commodity in January after it
failed to meet Finlands definition of a currency. Finland followed the lead of Norway,
whom also found it not to be a currency (Pohjanpalo, 2014). In the wake of the Mt. Gox
incident, Japans Financial Services Agency decided they as well did not consider Bitcoin
a currency (Mochizuki, Obe, 2014). One Japanese government official said the statement
doesnt mean it will automatically be categorized as a commodity, making it unclear
exactly how Japan views Bitcoin. The statement also outlined plans for Japans
government to tax bitcoin transactions, though, making Japan among the first countries to
regulate Bitcoin.
The IRS took it a step further later that month, declaring they would treat Bitcoin
as property for tax purposes (IRS, 2014). As a result, IRS rules used to govern stocks and
barter transactions were applied to Bitcoin, along with income tax liability. Any capital
gains or losses made based on Bitcoins volatile price had to be reported for taxation
under this ruling, which makes bitcoins more like stocks or bonds now in the US rather
than units of currency. However, the regulation in the US defeats the purpose of Bitcoins
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decentralized and anonymous nature in a sense, since one has to self-report their Bitcoin
transactions to a central government under these regulations.
The majority of national governments still have not made a decision regarding
Bitcoin regulation, but the IRSs decision may set a precedent, especially since other
nations have declared Bitcoin not to be a currency. The Goldman Sachs report does raise
valid concerns that Bitcoin may not have any legitimate use as a commodity or asset, but
it would appear for the moment that Bitcoin will be legally treated and regulated by the
US and possibly other governments as an asset or commodity.
IV. Bitcoin as a Financial Application Environment
Goldman Sachs is optimistic about Bitcoins underlying ledger-based technology,
as opposed to Bitcoin as a currency or commodity. Software developers have created a
number of apps taking advantage of Bitcoins technology, ranging from wallet apps for
exchanges like Coinbase to financial applications that could completely disrupt finance.
Bitcoin is completely open source, meaning anyone that wants to can use the code behind
its technology.
One of the most prevalent uses of Bitcoins technology besides Bitcoin itself is
the Altcoin concept that is, other cryptocurrencies completely independent of Bitcoin.
Hundreds of alternate cryptocurrencies have been developed and circulated some
differing from Bitcoin only in name and branding, others having significant additional
innovations. Examples of these Altcoins are incredibly numerous. One prominent
example is Litecoin, a cryptocurrency designed to make it not profitable to upgrade
mining equipment. This allows smaller Bitcoin miners to still be able to compete.
Dogecoin, an Altcoin whose name is based on an Internet meme, only differs from
Bitcoin in the sense that there are so many more dogecoins in circulation than there are
bitcoins. This decreases the value of Dogecoin, which could be a good thing, simply
because its a lot easier to think about 100 dogecoins than it is to think about 0.1
bitcoin, writes Morgan Peck of Scientific American.
Perhaps the most promising applications of Altcoins are those specific to a region
or industry. While a currency called Sexcoin may sound crude, it is a legitimate Altcoin
targeting the adult entertainment industry (Shandrow, 2014). The anonymity of a
cryptocurrency has the potential to greatly benefit the struggling industry. Industries
taking advantage of Altcoins provokes thoughts such as credit card companies using an
Altcoin or some other form of ledger technology to disrupt the industry. Any industry
that could benefit from ledger technology or anonymous payments has the potential to
benefit from an application of Bitcoins technology.
Iceland may very well have set a precedent by releasing Auroracoin in recent
weeks, the first country-specific cryptocurrency (Mack, 2014). While country-specific
Altcoins may not be decentralized like Bitcoin, the possibility of a government using the
ledger technology to improve economic infrastructure is a promising prospect. Digital
payments could become government centralized, raising the possibility of much simpler
taxation processes, to name a potential benefit.
Applications of Bitcoins ledger technology that address more than payments
have appeared in recent months, demonstrating the versatility of the block chain.
OneName uses Bitcoins anonymity and decentralized nature as the basis for a
decentralized identity that is, instead of having ones identity managed by a central
authority, such as how the US government issues and manages official identities to its
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citizens in the form of Social Security numbers. OneName allows for individuals to
choose a unique username to associate with their private key in the block chain (Midha,
Shea, Ali, 2014). With such a union, all the information needed for a bitcoin transaction
is the username, and the individuals private key is still protected. No credit card number,
billing address, or other personal information is theoretically needed to make a payment.
Direct deposit processes for employers could be simplified from needing a voided check
and sensitive personal information that could be used for ill purposes to simply needing a
OneName username, for instance.
While current applications for Bitcoins technology are groundbreaking as it is,
future possibilites boggle the mind. A Turing-complete programming language and
environment known as Ethereum has come to the forefront of the industry (Sams, 2014).
Just as the knowledge of a computer programming language like Python or C gives a
developer boundless opportunity to create software applications limited only by
computing power and imagination, knowledge of Ethereum will allow developers to
create ledger-based finance applications that will be unlike anything that currently exists.
Programs written in Ethereum are known as contracts. These contracts are
programmed such that input transactions from any number of parties associated with the
contract cause the Ethereum code to be executed, making payments of some kind occur
through the ledger. Examples of this are numerous, but one outlined by Bitcoin magazine
is as follows: A CFD might have Alice put in $1000, Bob put in $1000, and then after
30 days the blockchain would automatically return to Alice $1000 plus $100 for every
dollar that the LTC/USD price went up during that time period and send Bob the rest
(Buterin, 2014). Such a process may involve multiple cumbersome third parties
otherwise. Savings accounts and peer to peer gambling are examples of highly useful
contracts that Ethereum could facilitate.
Ultimately, between Altcoins, innovations like OneName, and a complete
programming language in Ethereum, financial innovation using Bitcoins block chain
technology will see a rapid increase in the coming months and years. The benefits of this
truly disruptive innovation are evident already, and while it is nearly impossible to
predict the ways in which entrepreneurs will use this technology moving forward, it is
clear that the technology behind Bitcoin will change the world of finance dramatically.

V. Conclusion
Bitcoin is a nascent technology, and it is tough to define its purpose today. Some
use it as currency, despite the volatility that sees the value of Bitcoin change significantly
even in the brief ten-minute timeframe in which transactions are approved. Others have
used it as an asset investment, having seen significant gains if they were early adopters of
Bitcoin. Trends among national governments certainly point toward Bitcoin being a
commodity. Yet does it have a use as a commodity when compared to, say, gold? It
certainly fails to maintain a consistent value like gold does. Innovation using Bitcoins
underlying technology, though, appears to be where the real promise lies. Beyond all the
Altcoins that keep being made, though, most of these innovators like OneName and
Ethereum are in their infancies. Bitcoin as a financial application environment is a glance
into the future, currently. In the present, Bitcoin straddles the line between a currency and
an asset, and is hardly significant in either sense. The future is where Bitcoin will be truly
disruptive through the many applications of its ledger technology that will emerge.
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VI. Appendix

Figure 1 Image via Grossman, Atanasios, Boise - Fitch Ratings


Figure 2 Image via Coinbase











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Figure 3 Image via Wilson, Ursua - Goldman Sachs




























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