Bitcoin: How it works & Why You should/should not choose it.

Bitcoin: How it works & Why You should/should not choose it.

bitcoin

How Bitcoin transactions work?

Bitcoin transaction takes place through a wallet which is simply a mobile app or a computer program that allows the users to maintain as well as send and receive Bitcoins. Once installed, it generates an address for the user.

All the transactions ever carried out using Bitcoins is saved in a backend database ledger called “block chain”. Block chains are replicated graph data structures that store all Bitcoin activity in an encoded form in terms of public keys. Each block consists of a number of transactions. The blocks serve to timestamp the transactions that it contains and guarantee its validity. The block chain is available to all the system users. High end encryption techniques using digital signatures are used to maintain authenticity of transactions. The simplicity in the transaction process makes payments easier to make than debit or credit card purchases without a merchant account. Payments are made from application software by entering the recipient’s address, the payment amount, and pressing send. However, the underlying system is complex. The transactions are broadcasted between the users and confirmed by the bitcoin network in the next ten minutes by an intelligent process of mining. This is the process by which new bitcoins are created.

This system allows users to mine Bitcoins by sharing their processing power, reducing the load on its servers and thus get rewarded with Bitcoins in the proportion of the work done by their systems in creating a block (i.e. performing numerous calculations to solve a mathematical problem). The reward for solving a block is period dependent and is halved every four years. Also, as the number of people involved in generating new coins increases, the difficulty of the mathematical problem also increases.

Advantages of Bitcoin

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Bitcoin offers a higher degree of freedom than that offered by the banking system. Any amount of money can be transferred instantaneously and there are no hassles like bank holidays, cross currency risks etc. The payments are either free or charged very low processing fees and there is also protection of personal information due to its simple payment procedure where personal details are not required to be entered. The use of military grade encryption through it cryptographically secure protocol offers strong protection against identity and monetary theft thus reducing risks for both – buyers and sellers. The transparency of the transactions due to its block-chain structure ensures real-time verifiability and maintains trust amongst its users.

Disadvantages of Bitcoin

The major disadvantage lies in the liquidity risk involved in holding Bitcoins as there is a limited acceptance for Bitcoins, being a virtual and unregulated/illegal currency. Also, as seen over the last year there is a high volatility in value of Bitcoin due to the small market size in terms of coins available for circulation and the actual user base which shies away merchants and users from accepting this currency. Although, this may decrease in the future if the Bitcoin market matures.

Bitcoin software is still in a beta stage and there is stilldevelopment work to be done in terms of features and services in order to improve reliability and acceptability amongst the users.

Anonymous nature of Bitcoin also make it dangerous as there are lots opportunities and incentives for money laundering. There is no third party verification of transactions which reduces the cost of money transfer but also makes it impossible to trace any thefts or wrong doing. An alphanumeric private key is used to secure transactions made by individuals and if this long key is lost or stolen, individuals cannot reclaim the key and their money is lost. There have been many instances of theft of Bitcoins from individuals and exchanges which are impossible to trace and this makes Bitcoin a very perilous investment option. These days’ people are even weary about fiat money like dollar, INR, and are investing in real assets like gold, real estate etc. which makes it harder for Bitcoin to become a widely used currency.

Bitcoins in India

According to SourceForge, since the launch of Bitcoin in the country on November 9, there has been 35,648 downloads. Kolonial, a restaurant in the posh area of Worli, Mumbai has started accepting payment through bitcoins thus becoming the first Indian eatery to accept the currency. The only other business establishment in India which accepts bitcoins is Castle Blue Spa and Saloon in Mumbai. Microsoft Ventures, a Bangalore based technology start-up accelerator has offered to lend its office space for the country’s first Bitcoin meet up in 2014.

In countries like Germany, Canada, Thailand, Bitcoin has got legal status. But RBI is sceptical of using Bitcoin as the digital currency. According to RBI, “it poses significant financial and security risks”. RBI in its circular on December 24th, 2013 cautioned that there is no established framework for recourse to customer problems /disputes / chargeback. It may also lead to money laundering and help the financing of terrorism as there is an absence of information in these peer-to-peer anonymous/pseudonymous systems.

RBI fears that Bitcoins can also be used for illicit and illegal activities. For example, Bitcoins were used on Silk Road, an online black market for illegal drugs that was shut down by FBI earlier this year where the agency also seized $28.5 million worth of Bitcoins. Another such website included “Assassination Market”, a crowd-funding service website that lets users contribute Bitcoins anonymously towards a bounty for political assassinations.

This RBI warning caused various domestic exchanges including India’s largest Bitcoin exchange – Buysellbitco.in which even faced police raids to temporarily suspend their operations. However, after Unocoin, an Indian Bitcoin exchange resumed its operations on 8th January 2014, other exchanges are soon expected to follow. Advocates of Bitcoin and related entrepreneurs recently formed “Bitcoins Alliance India” to advocate and lobby on their behalf.

Future of Bitcoin

The conventional currency of the ‘fiat money’ is viable because of the backing of the government and the sense of reliability and stability it offers. There is no way that the government and central banks would allow a rogue currency to flourish. Perhaps a wise guess would be that there will be some regulations on Bitcoin and it may serve as a niche financial product for exchange in OTC markets.

Virtual currencies, in contrast to traditional payment systems, are not regulated; and hence the legal uncertainty around these currencies constitutes a challenge for the government authorities. Bureaucracy is a danger to Bitcoins well seen by the recent suspension of all Bitcoin exchanges by OKPay. A mounting pressure on online money exchanges from US regulators have resulted in smaller Bitcoin organisations finding themselves suddenly unbanked and the banks simply now insist that they do not wish to provide them with accounts any more.

Sudden rise in Bitcoin value has generated high interest among speculators. As a result of frenzy currency speculation, its value against the dollar is highly unpredictable. Traders have turned their attention to it (Bank of America began publishing research on it). This threatens to turn it into a Ponzi scheme – its price fluctuates manically as the slightest hint of action or inaction from regulators, or comment from self-proclaimed experts. This volatility makes it difficult for Bitcoins to gain acceptability as genuine currency, because businesses will be wary of accepting a currency whose value is so unpredictable.

In order to succeed and be popular, it needs to first become a widely used medium of exchange. For that to happen, Bitcoin should be able to be convertible into something else. It could be convertible simply into commodities, but it also needs to be generally and widely accepted for that to happen. Bitcoin must be convertible into fiat currency like pounds, dollars and Euros etc. to suffice for the stores that do not accept Bitcoins. Another problem is there needs to be some entrance for the Bitcoin into the current international financial system.

Many international financial systems have a connection with the US system. And if the US bureaucracy which oversees that US financial system happen to decide that it doesn’t like people dealing with Bitcoin, or if it doesn’t like people who in turn deal with people dealing with Bitcoin, then much is the possibility that Bitcoin won’t have access to the international financial system. It is not a matter of only pure legality. Bitcoin itself certainly isn’t illegal, also paying for something with it isn’t, and subsequently changing $ into $B isn’t and so on. But there are various regulations about who can do what with whom in the financial system that could be of a help for a determined bureaucracy to freeze someone out of it.

What happened with WikiLeaks signifies the above said. It’s not a mere coincidence that the world’s banks gradually stopped to process donations for WikiLeaks. Just the smallest hint that there might be more audits than usual would be just enough to steer a bank away from handling Bitcoin (or say WikiLeaks) transactions. And clearly that’s where the WikiLeaks matter ended up – at one point of time, the only way to donate was through Bitcoin.

It is not known what the US bureaucracy has in store for Bitcoin, but various refusals and withdrawals of banking services has something to do with it. Pressure is rumoured to be put on people not to handle the currency and hence the Bitcoin currency is likely to fail. People’s Bank of China too prohibited financial institutions and payment institutions from dealing in Bitcoins after making it very clear that it doesn’t consider Bitcoin a currency or legal tender, and that it shouldn’t be used to pay for real goods and services.

On the other hand, Bitcoin boosters believe that Bitcoin doesn’t actually need any of the rest of the financial system. They think it is so good that it will be able to replace it. The debate would be best answered in the time to come.

References

 

Bitcoin: Currency of the future?

Bitcoin: Currency of the future?


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Bitcoin

Have you heard of a currency that has gone up 200,000% within a year? There is but only one currency – Bitcoin (abbreviated as BTC). The Bitcoin concept has become so popular that its features and future are even discussed at investment conferences. This has attracted many well-known investors including the Winklevoss twins of Facebook fame who believe its value can easily touch USD 40,000 from the present roughly USD 900.

Bitcoin is a digital currency and the first crypto-currency (a concept first described by Wei Dai) which is claimed to have been developed by an unknown person or group known as Satoshi Nakamoto in 2009. The market size is estimated to be USD 4 billion with around 12 billion bitcoins in circulation.

Mt.Gox USDbtc all time arith (1)

Fig: Value trend of Bitcoin on Mt. Gox (in USD)

 

The cryptographic protocol and software used in Bitcoin are open source. Bitcoins are snippets of code that use encryption to prevent counterfeiting and double-spending. It is pseudo-anonymous in the sense that its ownership is anonymous but the transactions are transparent. Complex algorithms control the supply of Bitcoins which can be generated or “mined” by running a program on a powerful computer. Bitcoins grow at a rate known to all parties in advance (it grew at a rate of 25 coins per 8 minutes on 11th April 2011). The total number of Bitcoins can’t exceed 21 million (which will be reached in around the year 2140) but their value depends purely on market forces. It is a purely virtual currency which is not backed by any security or government obligation. Its value is determined by the demand and supply forces, is traded Bitcoin exchanges like BTC China, Bitcoin 24 and Mt. Gox.

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Fig: Life of a Bubble (Expected Life of Bitcoin)

Nowadays, Bitcoin is increasingly being accepted as a mode of payment for products and services by vendors that accept Bitcoin payment such as WordPress, Reddit, OkCupid. There are even mobile apps that allow Bitcoin payment and spot trading facility. Surprisingly, many start-ups have been listed on the Global Bitcoin Stock Exchange where bonds and stocks can be traded. The ‘cryptocurrency’ wave has hit the world of financial markets and there have been a lot of speculations as to what the future unfolds. Understandably, there has been apprehension of wide spread money laundering and criminal fraud due to complete anonymity of Bitcoin transactions. Also, Bitcoins at present is highly volatile and the graph below shows the fluctuation in its value over the past two years.

Alternatives to Bitcoins

Bitcoin is one of the many virtual currencies which presently exist. Some of the other popular virtual currencies include:

  • Litecoin: It is a peer-to-peer currency enabling instant payments also based on the bitcoin protocol and its network is scheduled to produce about 84 million currency units.
  • Peercoin: It is the first cryptocurrency whose creation was inspired by bitcoin and is based upon a proof-of-work system.
  • NovaCoin
  • NameCoin
  • Protoshares
  • AnonCoin
  • MegaCoin

Though being different from Bitcoins, the following virtual currencies were popular in the past:

  • WebMoney: It is a virtual payment system which aids internet users for conducting real time transactions using WebMoney unit
  • Pecunix: It is a digital currency backed by gold
  • World of Warcraft Gold: Designed by Blizzard Entertainment, it is a virtual currency that is used by a popular online role-playing game
  • Nintendo Points: It is a virtual currency which has been established by Nintendo and it can be redeemed at Nintendo’s games/shops
  • Linden Dollars (L$): It is a virtual currency wherein digital characters can be customised
  • There have been instances where some virtual currencies have ceased to operate like:
  • Facebook Credits: It was a virtual currency that was introduced by Facebook in 2009 and ceased its operation in 2012. It allowed users to buy virtual goods in the form of applications on the Facebook platform
  • Liberty Reserve: It was a centralized currency based on Costa Rica which promoted itself as the oldest, safest and most popular payment processor. It was shut down by none other than the U.S. government due to accusations of money laundering

 

What is the future of Bitcoins, What is its status of Bitcoins in India? Please read on to Bitcoin: How it works & Why You should/should not choose it.

 

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