The amount of ink being spilt over the bursting of the speculative Bitcoin bubble should not be allowed to darken the contours of a healthy debate over the technical, but no less considerable, implications of the emergence of a new virtual currency. The technology represents a major qualitative leap forward in online payment solutions and facilitates the exchange of small sums while reducing transactions costs.
As a reminder, the brief history of Bitcoin (for a more detailed analysis readers are invited to refer to an earlier article) began in 2008 with the Internet publication of a protocol to create a decentralized monetary system independent of banks. Peer-to-peer technology created the framework and access to the network was made possible by downloading an application or registering with a web portal. The result is an ecosystem under which individuals become their own bankers and transactions flow freely between peers.
Networks were given a currency to call their own and online exchanges emerged to allow conversion between Bitcoins and more traditional denominations. Whereas the generation of dollars or euros depends on credit, a fixed number of Bitcoins are created ex nihilo through a special transaction emitted every ten minutes to the profit of whichever participant solves a hash-based cryptographic puzzle.
Underpinned by a complex system of digital signatures and asymmetric cryptography (my 2012 publication Bitcoin, monnaie libre provides a thorough explanation) the supply of Bitcoins is created automatically by the network and will never surpass the asymptotic limit of 21 million.
In fact, since the demise of the gold standard in the 1970s, ex nihilo creation has been the rule rather than exception for central bankers making it difficult to distinguish whether the term “virtual currency” denotes state-backed denominations or new types of money for which the regulatory framework remains poorly sketched.
The value of a Bitcoin is protected by mathematically enforced scarcity and represents a radical departure from the trend toward exponential increases in levels of national currencies circulating through the economy. Shadowy discussions in the corridors of central banks count for rather less when monetary policy is based on freely available algorithms.
Similar tentatives by Internet giants Amazon or Facebook have so far been limited by an unwillingness to separate the platform from the virtual currency that circulates across it.
Since 2009 the Bitcoin network has risen to become the most powerful distributed computing system on the Internet and has achieved performance of 1000 petaFLOPS (one hash function represents around 13 kFLOPS) surpassing the combined power of the top 500 super-computers on the planet.
The security of the system is assured through the phenomenal computational power required to validate transaction blocks.
Near instantaneous electronic transactions between Bitcoin users worldwide have been made a reality and have raised eyebrows at more traditional financial institutions because of the threat they could pose to these intermediaries’ comfortable margins.
Transactions, like the protocol, are completely transparent and are broadcast over the Internet. Data is sufficiently diverse to ensure anonymity if users prefer to create a boundary between their identity and their transactions. The unique characteristics of Bitcoin, and the vitality of its network, have not escaped the notice of investors and speculators. Indeed, it is the latter who are largely responsible for the extreme volatility observed in the flexible exchange rate since 2011. The phenomenon, typical of the growing pains associated with any radical idea, should not distract from the potential of Bitcoin to reshape the landscape of payments on-line.
Released under the terms of the open-source MIT license, the protocol creates a de facto global standard for interoperability between payment solutions and avoids some of the pitfalls associated with recent bank or telecoms offerings such as Popmoney, Pingit, and Buyster (a mobile payments solution created by French mobile carriers). Walled off from the potential for network effects due to the difficulty of a user from one service paying the user of another, these and other technologies have failed to become the natural choice for online merchants in the way Paypal has. Unable to match Paypal’s rate of market penetration, competitors are almost certainly doomed unless they rapidly come to an agreement over a shared standard.
It is against this backdrop that Bitcoin takes on its allure for consumers who, for the first time, are no longer constrained by the use of closed networks for transactions (Visa/Mastercard,Western Union, etc.). The virtual currency has the potential to become a vital ingredient in the creation of more healthy competition between payment methods. For online retailers this could significantly reduce fees — a 3% commission in the case of Paypal — that can typically eat away more than a third of already narrow profit margins.
The free software foundations of Bitcoin ensure the integrity of its users. Transparency eliminates any temptation to gouge consumers with excessive fees as any business foolish enough to do so will find itself quickly overtaken by competitors. The stakes are considerable as the market for online payments has yet to mature to a point where the rules of healthy competition can be taken for granted.
For the region it covers, the European Commission has estimated the annual total of payments made by cards at €1.35 trillion (almost $1.8 trillion). Interchange fees account for an estimated €25 billion ($33 billion) in annual transaction costs that fall largely on the shoulders of the EU’s business community. As a result of increasing pressure from a diverse range of national bodies the commission has launched numerous missives at the arbitrary, anti-competitive, and disproportionate nature of fees. Coming in for especially vehement criticism is the way in which they drive up the cost of accepting cards for small retailers while providing questionable gains in efficiency. Moreover, consumers are often hit twice (first in annual charges from issuing banks and second in rising prices as merchants factor in the cost of accepting cards).
The growth in credit card fraud threatens the health of online commerce and demands a response that focuses on the legal and regulatory framework but also moves beyond them toward a more technological approach.
A February 2012 study detailed the full magnitude of the problem by revealing that the likelihood of fraud in online transactions was 113 times higher than face-to-face payments. In a study released at the end of 2012 by the Bank of France’s dedicated body on the subject (the Observatory for Payment Card Security), the trend was confirmed: fraud rose by 12% between 2010 and 2011 despite a progression of only 7% in card-based transactions. E-commerce accounted for 61% of total fraud while representing only 8.4% of volume. It should be noted that in fully 70% of cases it was the consumers and not their banks who detected the anomalies—the latter responsible in only 22% of cases.
Bitcoin is one of a number of technological solutions being proposed to defuse concerns and restore the somewhat bruised confidence of the public. The anonymous nature of transactions ensures bank details are kept private and prevents unauthorized access to accounts. Traditional payment methods such as credit cards disclose sensitive information such as card numbers to “pull” funds from an account whereas Bitcoin takes the opposite approach using an online protocol to “push” money. Between adding a product to their shopping cart and checking out of an online marketplace one-third of users abandon their transaction when it comes to the cumbersome process of keying in a 16-digit number (in those cases where no possibility exists to save the information). Moreover, in the moments between a purchasing decision and the actual payment fears of fraud have a way of intruding to cast doubt over the entire operation.
Bitcoin creates an efficient solution to the problem of online fraud through the simple fact that it is much easier to identify trustworthy businesses than to comb through the buying habits of millions of users. As recent revelations of the largest cybercrime in US history make clear, the storage of credit card numbers by a growing number of online merchants and digital wallet services is both costly and inefficient. Costly because of the security infrastructure required to guard against attacks. Inefficient because according to the principle of the weakest link, the exploitation of vulnerability in a single operator completely negates the measures taken by others.
Concerns over some of the more innovative aspects of the Bitcoin protocol have placed some question marks over the otherwise undeniable advantages the technology possesses in its ability to provide payment solutions both today and in the future.
First off, it should be noted that powerful banking lobbies have been only too happy to stoke fears and caricature the risks associated with Bitcoin which may explain how two representatives of the Bitcoin Foundation found themselves incongruously summoned to Washington in mid-June for a conference on combating child pornography. It would be no great stretch to imagine why private banks might have an interest in creating an atmosphere of suspicion around the emergence of a truly disruptive innovation and its threat to the cozy rents they have enjoyed for decades. Similar tactics were deployed in the early days of the web when the new technology was smeared by associations with terrorism and pornography.
Moving to the heart of the debate leads to lingering suspicions over anonymous transactions of the sort that might present opportunities to money launderers. The recurring criticism rests on shaky foundations not least because it ignores a number of conditions under which anonymity is in fact desirable as a safeguard of individual freedoms. If public or private institutions are given too much control over the data produced through online transactions their monopoly could be used to undermine the ability of the public to report abusive or dangerous practices. Moreover, citizens of a number of countries might hesitate to use credit cards to support opposition parties if they risk coming under increased scrutiny because of collusion between banks and sitting governments. In an era where the authority over so many daily activities is being ceded by states to international corporations the need for a more nuanced view of digital identities would seem more necessary than ever.
As with decentralization or security, anonymity should not be reduced to the value of a Boolean variable where only true and false apply. In fact, every Bitcoin transaction is logged on a public ledger and can be traced to the address of a specific sender (with the exception of the fixed number of Bitcoins generated ex nihilo upon completion of a block) and recipient. Reviewing transaction histories should be enough to reveal the identities of users or, at the very least, identify any deliberate attempts at dissimulation. In particular, the use of the encrypted Tor network or third-party “exchangers” should act as instant red flag for an intent to cloak activities.
In many ways the discussion is merely academic as the vast majority of fiscal evasion is based on the ability of multinationals to exploit favorable taxation regimes. Bitcoin is a far riskier proposition than cash when it comes to eluding the attention of inspectors as each transaction leaves an indelible mark on the Internet. Tracing a transaction to its source, while cumbersome, is by all means possible. To say the emergence of Bitcoin encourages dishonest behavior is thus an exaggeration.
Finally, the standard practice of payment validation by means of a systematic verification of data linked to a name increases the risk of identity theft: our digital age demands we rethink outdated forms of security and, in an era of multiple identities, the name of a user should be viewed as just one parameter among many. To take an example, the verification of age required by some sites need not necessarily force users to disclose any name other than a virtual one. Bitcoin operates according to the same logic and it is entirely possible to imagine a system in which payment could be validated as being transmitted by a user of the requisite age without demanding the disclosure of an actual name (it would suffice to store a record of age verification along with the private key of a given user).
In the United States public policy is evolving and, with new Director Jennifer Shasky Calvery firmly in place, the Financial Crimes Enforcement Network (FinCEN) has certainly taken notice. As head of the agency responsible for enforcing laws against money laundering she issued a statement on 13 June 2013 to reassure operators of Bitcoin exchanges they would be left in peace as long as they were willing to conform to the same regulations as other financial institutions.
What this means in practice is that exchanges fall under the category of “money transmitters” and must therefore register as “Money Service Businesses” (MSBs) for each state in which they operate. The expense of navigating this process could serve to exclude all but those businesses backed by venture capital or business angels.
In Europe, exchanges must be backed by a payment institution (a legal entity created to facilitate the SEPA agreement on a common European payments framework) in order to receive deposits and verify their origin. Upon clearing this hurdle business can be conducted legally across the euro zone which stands in contrast to the US requirement for registration with individual states. In a move that may illuminate the path ahead for European exchanges, Bitcoin-Central inked a deal with Aqoba (a payment services provider) that will allow it to operate more or less like a bank.
Even without payment institution status, obtaining a license to exchange currency online would allow entities to sell Bitcoins directly at prices reflective of movements in the market. This has been the example of Coinbase in the United States and Israeli start-up Bits of Gold. In both cases, the business model is based on commissions charged for the exchange of Bitcoin into traditional currencies. One would hope that the commissions charged for the exchange of virtual currencies would be taxed at the same rate applied to traditional currency exchanges and not, as some have suggested, at the rate used for commodities. To clarify matters, guidance issued by FinCEN in March 2013 (FIN-2013-G001) and the ECB in October 2012 (“Virtual Currency Schemes”), confirms Bitcoin’s status as a legitimate virtual currency.
For a native system of payments to evolve over the Internet it will be necessary to provide businesses with a means to bypass legacy banking networks. The web created the conditions for the rise of on-line banking as an alternative to “brick and mortar” branches without sacrificing speed and efficiency. Could not the Bitcoin network possess the same potential to increase options and encourage the growth of a whole new range of options for making payments?
A monopoly cannot be understood outside the context of free competition in much the same way as efficiency must be considered in relation to resilience. A series of repeated shocks has rendered the economy less resilient and the only groups arguing that a monopolistic financial sector is more efficient are the bankers who benefit from maintaining the status quo.
In the same way that changing regulations led to the emergence of alternatives to legacy telecoms operators—inspiring successive waves of innovation and performance improvements—Bitcoin would benefit from an even playing field on which it could compete with more traditional payment systems.
Bitcoin has established itself as a credible and open technology with the potential to improve banking practices through its injection of some much needed competition to the market for payment services. Are the regulators listening?