Bitcoin is a virtual currency scheme, managed in a private and decentralized manner, created by Satoshi Nakamoto (probably a fake identity) in 2009. Bitcoins are awarded to those ‘miners’ who, by using CPU power and electricity, solve complex mathematical algorithms precisely linked to the validation of the authenticity of transactions carried out with Bitcoins. Each miner originally received 50 Bitcoins for each algorithm solved, although this reward is halved every four years (currently, it is 25 Bitcoins).
This bizarre method of creation has two objectives. On the one hand, it makes the monetary supply growth predictable: algorithms become more and more difficult each time but if they were not solved, they would be eased so that new Bitcoins would be created every 10 minutes. On the other hand, it introduces a deflationary bias by limiting the amount of Bitcoins to 21 million (there are currently 12 million circulating, according to Yermack, 2013), a cap that will be reached not far from 2033. From then on, Bitcoin miners will have to fund their validation activity through transaction fees, which are nowadays feasible but negligible.
Bitcoin’s owners possess two keys linked by an algorithm: one is made public and acts like a bank account and the other one is private and sent to the payee (who sells a good or service or another currency) so that he/she can access the payer’s Bitcoins associated with the public key. When the transaction is validated through the resolution of the algorithm which links the private and the public key, the transaction is made public (although the parties involved are kept anonymous) and it is incorporated to each Bitcoin’s chain of transactions. Fraud becomes more and more difficult, as the fraudster would have to accumulate more CPU power that all the honest participants (in order to rewrite the history of previous transactions). Furthermore, according to Nakamoto (2009), fraudsters have incentives to play by the rules: instead of using their CPU power to steal or double-spend Bitcoins (provoking an abrupt reduction of its value), they would better use their mining capacity to earn Bitcoins by validating transactions.
Bitcoin has gained appeal in recent months. With an initial value of 0.05$/Bitcoin in 2010, it peaked at more than 1,200$ in November 2013. This is an outstanding appreciation, since its value was around 100$ in August and 10$ in January 2013. On January 11th 2014 it was quoted at 957$, after the mid-December trough of 500$ (a sign of its remarkable volatility).
Bitcoin is becoming growingly accepted in online transactions, but the recent appreciation is due to speculation rather than to the transaction motive for demanding money. Its base of users is still very limited (estimated at around 10,000 users in 2012, according to the ECB, and some of them involved in illicit activities), far from the critical mass that would be needed to generate a positive network externality.
Its creators aimed at creating a popular alternative to fiat money, actually comparing the Bitcoin earners with gold miners, seeking the blessing of Hayekians and Libertarians. Whether accidentally or not, Bitcoin was created after the aggressive expansionary monetary policies outset by major Central Banks.
However, Bitcoin is certainly not ‘commodity money’, as it does not have an intrinsic value. Owing to its enormous volatility (Yermack, 2013), Bitcoin performs poorly the ‘store of value’ and the ‘unit of account’ functions of money, merely serving the purpose of a ‘medium of exchange’. The fact that the supply of Bitcoins is capped exerts a deflationary bias, although this could be an advantage for its ‘store of value’ role and boost speculators’ appetite.
Bitcoin may be a positive innovation for the system of payments, reducing transaction costs and financial intermediation. Nonetheless, some of its characteristics hinder its development in a global economy marked by financial integration. Bitcoins are absent from the financial system: there are no banking operations nor derivatives denominated in Bitcoins, they lack the access to deposit guarantee schemes, there are no central clearing houses to address operational risk and there is no financial regulation nor oversight, implying higher uncertainty and risks of fraud. As a consequence, the market of Bitcoins is still small, illiquid and immature; these factors lying behind its enormous volatility.
To conclude, bearing in mind that money is a social convention, a private virtual currency scheme may be a logical step forward in the world of information technology. This evolution must be closely monitored in order to assess its eventual real and financial effects. A regulatory response might be justified in the case of severe disruptions in the system of payments or in the case of connections with illicit activities and money laundering. The potential to affect monetary aggregates and the financial system remains limited hitherto.
European Central Bank (2012), Virtual Currency Schemes.
Nakamoto, S. (2009), Bitcoin: A Peer-to-Peer Electronic Cash System.
Plassaras, N. (2014), Regulating Digital Currencies: Bringing Bitcoin within the Reach of the IMF, Chicago Journal of International Law, forthcoming.
Yermack, D. (2013), Is Bitcoin a Real Currency?, NBER Working Paper 17947.