Where to Bitcoin?

Author:England, Catherine
  1. Introduction

    "Markets Take Off in Lockstep, Raising Worries of a Reversal," declared a June 7, 2017, Wall Street Journal headline. The article began, "Stocks, bonds, gold and bitcoin--assets that rarely move in unison--have all been surging this spring, confounding investors." How has bitcoin become one of four key assets included in such a review of the markets? From its 2009 introduction as a private money championed by libertarians and cypherpunks to a technology lauded by entrepreneurs and studied by central banks, bitcoin has captured the imagination of many, raised alarm among others, and moved through several regulatory phases in different countries, all in less than a decade. (1)

    In mid-2017, at the time of writing, bitcoins are selling for roughly $2,500 each. Backed by nothing except other people's valuations, plenty of observers see bitcoins as a twenty-first century bubble. But there are other plausible story lines. Bitcoin could overcome its current technological challenges, build on its success, and become "the future of money." Or bitcoin could be the historical antecedent for some future, privately issued electronic currency (or currencies). (2) Finally, interest in privately issued currencies could fade away entirely. While we cannot guess bitcoin's future, we do believe that its brief history offers lessons about the challenges of introducing a new money.

    We begin with an introduction to bitcoin. We then describe its origins, consider its spread among different groups of users, and examine governments' reactions. We conclude with a discussion of future possibilities for bitcoin. Finally, an addendum covers the six months of activity in the bitcoin market that occurred since we originally wrote the paper.

  2. What Is Bitcoin?

    Bitcoins are a privately issued, decentralized, irredeemable asset designed as an electronic, encrypted alternative to government-issued currencies. On July 1, 2017, bitcoins sold for $2,460.20, almost 2.5 times their January 1, 2017, price of $997.69 and more than 3.7 times their July 4, 2016, price of $661.56. (3) The increase in bitcoins' value has been anything but smooth, however. During the first half of 2017, bitcoin prices have been as low as $802.83 (on January 12) and as high as $3,018.54 (on June 11).

    Despite its recent increase in value, bitcoin's share of the cryptocurrency market has fallen dramatically. (4) According to Hileman and Rauchs (2017, p. 18), bitcoins accounted for 86 percent of the cryptocurrency market in March 2015 and 72 percent in April 2017. By July 2017, however, bitcoin's share of the market had fallen to just under 48 percent as interest in and the number of other cryptocurrencies grew. (5) Hileman and Rauchs (2017, p. 27) estimate that there are between 2.9 million and 5.8 million active users of or investors in cryptocurrencies.

    1. But Is Bitcoin Money?

      Bitcoin's creator clearly intended to establish a new type of money. That goal has yet to be fully realized. While bitcoins do have money-like characteristics that other investment vehicles (e.g., stocks, bonds, and real estate) lack, bitcoins currently fail to meet the widely accepted three-part definition applied to a typical "full service" money.

    2. A Medium of Exchange?

      Bitcoins have not become a generally accepted means of payment. An early bitcoin owner bought two Papa John's pizzas for 10,000 bitcoins in May 2010 (Extance 2015, p. 22), but examples of bitcoins being used to purchase goods and services remain scattered--at least in wealthier economies.

      Bitcoins have been used regularly as a medium of exchange where anonymity is important to the buyer and/or seller, raising questions about the legality of these transactions. Bitcoins have also been used in international payments to minimize transaction costs, especially where official exchange rates and government-imposed banking fees dramatically increase the cost of cross-border payments. Some online sellers accept bitcoin payments. In January 2014, Overstock, the first major retailer to accept bitcoins, cited lower transaction costs, fewer chargebacks from customers disputing payments, and less worry about the security of customers' payment information as advantages (Popper 2015, pp. 289-90). In places like Venezuela, where bitcoins are an important resource for purchasing groceries and medicine because of rampant inflation, bitcoin owners must generally use their bitcoins to purchase dollar-denominated gift cards through cryptocurrency-friendly websites and then use the gift cards to purchase needed supplies (Epstein 2016).

      Because these examples remain the exception rather than the rule, we must conclude that bitcoins are not a generally accepted medium of exchange.

    3. A Unit of Account?

      Do we record transactions and write contracts in bitcoins? Is it a unit of account? White (2015, p. 399) notes that because bitcoins have the "thickest" market, they are frequently used to buy and sell other altcoins and cryptocurrencies, making bitcoins the unit of account in this market. This lonely example highlights the limited use of bitcoins as a unit of account, however. Few prices are quoted or contracts are written in bitcoins today.

    4. A Store of Value?

      Bitcoin most clearly meets the store of value test. Even in the more developed economies of the United States, Europe, and Japan, proponents view bitcoins as a hedge against possible future inflation or political instability. This is even more true in countries where monetary systems are less stable, political systems more restrictive, and property rights less secure. Bitcoins exist on a decentralized distributed ledger, or blockchain, maintained by computers around the world. Wherever a bitcoin owner has internet access, he or she can access bitcoins. Accounts cannot be "frozen" or "held hostage" by individual governments. As recently as November 2016, Chinese investors were purchasing bitcoins to protect against a falling yuan, despite the government's efforts to limit purchases (Vaishampayan, Hunter, and Deng 2016). (6)

      In summary, bitcoin fulfills just one component of the three-part standard definition of a full-service money. So why study bitcoin? First, by exploring bitcoin's history, we hope to better understand why it has failed thus far to become a more widely accepted medium of exchange. Second, as a store of value, bitcoin's role most closely resembles that of gold. Considering the parallels between bitcoins and gold may provide clues to bitcoin's possible future.

  3. The Origins of Bitcoin

    "What we really want is fully anonymous, ultralow transaction cost, transferable units of exchange. "

    --Adam Back (creator of Hashcash) quoted by Popper (2015, p. 19)

    In October 2008, Satoshi Nakamoto shared with a cryptography-focused mailing list a working paper titled "Bitcoin: A Peer-to-Peer Electronic Cash System." Nakamoto's stated goal was to eliminate the need to trust third-party financial institutions to hold deposits or process payments. (7) In Nakamoto's model, every existing bitcoin is owned by a public address, and each address has an associated private key. Anyone with the appropriate private key could instruct the bitcoin community to transfer bitcoins from one address to another.

    Bitcoin's important technological innovation was the introduction of the blockchain, and Nakamoto's original system is still used today. Every bitcoin transaction is recorded by all the computers on the network using a distributed (decentralized) ledger, or blockchain technology. The resulting public record tracks how many bitcoins are owned by each address (Popper 2015, p. 20). The system is maintained by "miners," or servers that devote computing power to keeping records in return for the prospect of receiving newly issued bitcoins (Popper 2015, p. 22). A majority of the programs running the code and communicating over the internet must agree to any change in the transaction record so that bitcoins are controlled by a consensus of those using them rather than by any central authority.

    Nakamoto provided the code for bitcoin in January 2009 and explained his vision in a February 2009 post on the P2P Foundation website: "The root problem with conventional currency is all the trust that's required to make it work.... The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust." (8) To establish trust in the ultimate value of bitcoins, Nakamoto set an upper limit of 21 million bitcoins. Computers participating in the network earn new bitcoins randomly. It is designed so that, on average, every 10 minutes a computer gains the new bitcoins and records some pending transactions, thereby receiving the associated transaction fees. The amount of new bitcoins rewarded halves every 4 years, so that while 16 million bitcoins had been created in July 2017, the total of 21 million will be reached over 120 years later in 2140.

    1. Why Bitcoin? Why Now?

    The motivation for the issuer or developer of a new money is clear. As with any new product or service, if users attach more value to the money than its cost of production, the issuer or developer will earn a profit. But why would users adopt a new type of money? Historically, new monies generally appeared when a medium of exchange was needed to support trade, (9) distant traders needed a more widely accepted form of money, the existing money failed to hold its value, or governments found it useful to issue new monies as a means of generating seigniorage. (10)

    None of these conditions seemed to exist in 2008 and 2009 when Nakamoto launched bitcoin. Widespread inflation in the 1970s and 1980s had generated interest in alternatives to government-issued fiat currencies. Bordo (1981), Hall (1982), and Goodfriend (1988), among many others, explored the possibilities for a modern gold standard. Vaubel (1986), Yeager (1983), and Taub (1985), to name just three authors, described...

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