The rise of the digital currency

July 2013  |  FEATURE  |  BANKING & FINANCE

Financier Worldwide Magazine

July 2013 Issue

July 2013 Issue


Alternative forms of currency are not a new phenomenon. From the WIR Bank in Switzerland and the Ithaca HOURS system in New York to traditional commodities based currencies like the gold standard, alternative currencies are still popular. When faith in local currencies falters, people look to alternative currencies in the hope they will hold their value and protect savings or portfolios. 

Yet, despite the longevity of some of the established alternative currencies, newly formed online currencies are also becoming more popular. Online currencies such as Bitcoin have the potential to help create a disruptive new global monetary system, despite the multitude of regulatory and technical roadblocks which many analysts feel could prevent them from ever entering the mainstream. 

Unlike traditional fiat money, digital currencies operate independently of established banking or money transfer systems. Although some digital currencies such as Liberty Reserve’s LR currency are tied to an existing hard currency, the value of bitcoins fluctuates according to supply and demand. Indeed, because virtual currencies such as Bitcoin aren’t backed by a central bank or controlled by an administrator or government, their values are vulnerable to wild swings. 

Digital currencies offer users convenience and the freedom to carry out the electronic transfer of funds from anywhere in the world using a personal computer or smartphone. This was evident in April when it is believed that a number of large deposit holders in Cypriot banks exchanged their money into bitcoins in order to avoid the ‘haircut’ enforced upon them by the European Union.

Bitcoin, the most popular and visible of the digital currencies, was created in 2009 by an individual (or a collective) operating under the pseudonym Satoshi Nakamoto. Bitcoin is an entirely electronic, open source crypto-currency which is based on a series of complex computer algorithms. Bitcoin operates as a decentralised peer-to-peer cash transfer system that can be traded online or exchanged for goods and services with various smaller vendors. At the time of writing there are over 1000 websites which accept bitcoins as tender, including WordPress and Reddit. Each bitcoin can be subdivided down to eight decimal places, forming 100 million smaller units known as satoshis. 

Bitcoins are created via a ‘mining’ process in which computers solve a series of complex algorithms and are rewarded with a small amount of coins. Alternatively users can acquire bitcoins from currency exchanges such as Mt. Gox, a site which purports to manage over 80 percent of global Bitcoin traffic. 

Ripple is a similar peer-to-peer system which, unlike Bitcoin, is not tied to a single online currency. Ripple allows users to send and receive money in dollars, euros, yen or bitcoins in exchange for the system’s currency XRP, or ‘ripples’. However, Ripple, unlike Bitcoin, does not suffer from exorbitantly long transaction times; dealings within the Ripple community take mere seconds to be completed. 

Corporate finance

Despite the current perception that digital currencies such as Bitcoin and Ripple are niche and specialised, it is not only libertarians and online evangelists who have begun to see their potential. The corporate finance world has begun to look very seriously at digital currencies as viable investments. On 11 April, OpenCoin, the company developing Ripple, announced that it has closed an angel round of funding from Andreessen Horowitz, FF Angel IV, Lightspeed Venture Partners, Vast Ventures, and the Bitcoin Opportunity Fund, an investment vehicle for bitcoins and Bitcoin related companies. In April around $9m was invested in OpenCoin and two other Bitcoin related companies – BitPay and CoinBase. In late May, New York firm Liberty City Ventures announced that it too had set up a $15m fund to back Bitcoin and other digital currency companies. 

It is clear from the investments that have poured into Bitcoin and its fraternity of other digital currencies in recent months that there is genuine interest in the digital currency community. With the backing being afforded to digital currencies it is very likely that we will see a proliferation of Bitcoin related start-ups. 

Although there is still some uncertainty surrounding Bitcoin and its ilk and how widely these new currencies will be adopted, potential applications of the systems are extremely encouraging. Notably, from the perspective of multinational corporations, one of the most intriguing aspects of these new currencies is their ability to carry out cross-border and micro-transactions. Digital currencies are able to carry out cross-border transactions without the expense of having to utilise a standardised, expensive banking system. Like the euro but on a global scale, the cross-border nature of digital currencies will make them increasingly popular to both the man on the street, as well as in the corporate boardroom. Equally, the ease at which digital currencies can be electronically transmitted, coupled with the ubiquity of the technology needed to carry out the transmission, will make digital currencies a unique and powerful tool going forward. 

Challenges

There is obviously a great deal of interest in Bitcoin. Venture capital financing is pouring into start-ups associated with digital currencies, while user numbers, transaction volume and valuation are also increasing across the board. However, despite the positives surrounding the market, there are still many challenges to be faced by the wider digital currency community. 

Although the deal metrics are increasing across the board, the take up of digital currencies is still relatively small. At the time of writing the total market capitalisation of Bitcoin was around $1.36bn, a drop in the ocean compared to other hard currencies and the global monetary system.

Moreover, digital currencies and their online exchanges remain extremely vulnerable to security breaches and distributed denial of service (DDOS) attacks. Due to the anonymous nature of bitcoin transactions, the security of the system is reliant on the honesty and integrity of its users. Following the first real boom in bitcoin value in 2011, Mt. Gox suffer an enormous security breach in June of that year. Usernames, email addresses and encoded passwords were all leaked, and fraudulent trading temporarily drove the value of a bitcoin down to just one cent. Also in 2011, a Polish bitcoin exchange lost access to its own bitcoin account, making all its funds inaccessible.  

In April 2013, Mt. Gox was the victim of an enormous DDOS attack that caused the site and trading engine to be unavailable for approximately four hours. The attack saw the value of bitcoins fall by 60 percent in a day, dropping from a high of $265 to around $150. “Attackers try to exploit any system where they think they can profit and get away with it, whether that is robbing banks, stealing online banking credentials, or attacking a bitcoin exchange,” said Gavin Andresen, chief scientist at the Bitcoin Foundation. Mt. Gox, in a statement, noted that the attack may have been motivated by hackers trying to prompt panic selling among bitcoin users. 

While these security breaches were all related to third parties, rather than Bitcoin itself, it is clear that there are still enormous security issues which need to be addressed by the digital currency community. Susceptibility to attacks from criminal organisations and hackers will leave many investors questioning the wisdom of fully embracing digital currencies. Accordingly, one of the most attractive tenets of the Bitcoin system – its lack of regulation – is, conversely, one of its biggest pitfalls. When users or exchanges are attacked, there is no legal recourse. Lost bitcoins are exactly that, lost. 

Furthermore, the utilisation of bitcoins by black market sites such as ‘Silk Road’ is another concern which could hinder the development of the currency as a mainstream venture. Visitors to the Silk Road site can use bitcoins to buy practically any illegal substance imaginable.

For many of the above reasons, analysts and critics are quick to disparage digital currencies. Digital currencies, particularly Bitcoin, are often described as Ponzi schemes or are deemed to be the latest overinflated bubble poised to crash at any time. Wild fluctuations in the value of bitcoins do lend credence to these arguments. At the time of writing, Mt. Gox’s statistics show that one bitcoin is worth $114. On 10 April the currency experienced particularly violent swings in valuation, with the bitcoin exchange rate dropping from $266 to $70 before recovering to $160 six hours later. 

Regulation

Despite remaining decentralised and unregulated since the emergence of Bitcoin, things have recently begun to change. In March 2013 the US Treasury Department’s anti-money laundering (AML) unit, the Financial Crimes and Enforcement Network (FinCEN), stated that digital currency firms must comply with the same AML regulations as other financial institutions, including monitoring customers and reporting suspicious activity. 

The arrest of five people at digital currency firm Liberty Reserve in June was also a reminder to Bitcoin and others in the digital currency market that they must comply with AML regulations or risk a crackdown. Liberty was closed after enabling criminal gangs to launder over $6bn, according to US prosecutors. While there are fundamental differences between Bitcoin and Liberty, the message is clear: in order for Bitcoin to continue to operate, it must satisfy government regulators by emulating the very banking systems it attempts to circumvent. 

The future

Despite the multitude of problems and issue surrounding digital currencies, it is difficult to see past their proliferation in the coming years. While Bitcoin and its contemporaries were not within the first wave of alternative currencies, they have made the greatest impact so far. Bitcoin itself is currently the world’s most popular secondary currency. 

Although some analysts and economists are wary of new, alternative currencies, they have clearly struck a chord with Wall Street. The level of investment that has been supplied to peer-to-peer organisations demonstrates an interest from investors to help develop what could be the next step in the evolution of financial systems. 

In order to protect the future propagation of digital currencies, it is crucial that the multitude of VC backed start-ups utilise their funding to develop rigorous and effective security measures. If digital currencies are to survive, prosper and continue to attract investment from Wall Street, more must be done to protect those investments. 

Regulation will undoubtedly have a significant impact on Bitcoin and its rivals, in some ways eroding the very principles which have made digital currencies popular in the first place. Yet, ultimately competition may have a greater impact on the future of the market. Thus far, Bitcoin has set the agenda for digital currencies, however the history of digital ventures is littered with trailblazing companies that experienced a meteoric rise and subsequently a debilitating fall. We need only look to once popular and now virtually defunct sites such as Napster or MySpace – companies which set the precedent for the other more successful companies that followed. 

While the debate around Bitcoin and its legitimacy as a currency will continue to rage long after it has ceased to exist, it would appear that digital currencies, in their various forms, are here to stay. 

© Financier Worldwide


BY

Richard Summerfield


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