IS BITCOIN A CURRENCY OR AN ASSET?

INTRODUCTION:

With the disruptive effect of FinTech and new forms of technology on the capital markets, the ongoing 'war on cash' and the development of new so-called 'asset classes'; this article shall aim to address the reality of the most popular cryptocurrency today- Bitcoin. Below, I provide a brief insight as regards to what Bitcoin actually is especially given that the question as to whether it is a 'currency' or an 'asset' has caused considerable confusion to date.

ORIGINS

Bitcoin is the most popular of what has become known as decentralised digital "cryptocurrencies"[1]. As a cryptocurrency, it uses cryptography to control its creation and management rather than relying on a central authority (e.g. the Bank of England). It differs from other virtual currencies such as those created by Nike, Vodafone, Amazon and those that are often used in the computer gaming industry for so called "in-game purchases" as, unlike Bitcoins, all of these previous virtual currencies have been centrally controlled and managed.

To start from the beginning, the concept behind Bitcoin originated in an online paper published under the pseudonym Satoshi Nakamoto in November 2008 entitled Bitcoin: A Peer-to-Peer Electronic Cash System[2]. The paper proposed a peer-to-peer form of electronic cash which would allow online payments to be sent directly from one party to another without requiring the involvement of a financial institution or third party (e.g. PayPal) (similar, in principle, to the concept of media file-sharing through platforms such as Napster). Instead of placing trust in such third parties and paying the fees associated with their services, Bitcoin requires users to place trust in the protocol that underpins the system which has thus far proved very resilient.

The Bitcoin network came into existence in January 2009 with the release of the first open-source (freely distributable) Bitcoin client software and the issuance of the first ‘bitcoins’[3].

BLOCK CHAIN

Every transaction that occurs in the Bitcoin economy is registered in a public ledger (the "Block Chain") which is distributed among all the users of the Bitcoin system via a peer-to-peer network. This enables Bitcoin to avoid the issue known in computer science as the "double-spending" problem[4] where, without third party intermediaries, electronic money could, in theory, be spent twice, in the absence of ledgers and records to keep track of electronic money transfers.

The Block Chain is maintained by a network of computers that process the payments of bitcoins (a process called "Mining"; the individuals who contribute computer power to this process are called "Miners"). In return for their contribution Miners receive newly created bitcoins. Once all bitcoins have been mined, they will instead be able to charge fees ("Rewards") for these services.

VALUE OF BITCOIN

Transactions on the Bitcoin network are NOT denominated in real world currency units such as Dollars, Euros or Sterling (as they are on PayPal); nor is the value of the currency derived from gold or government fiat. The Bitcoin value is derived from the value that people assign to it only (and its value relative to real currencies as determined on an open market). Regardless of all of the blockchain technology and other technological innovations behind it, Bitcoin has no intrinsic value of its own. Its value derives solely from the confidence in the market. Blockchain technology is ofcourse hugely valuable however it must be separated from Bitcoin as Bitcoin is a ‘product’which simply uses this technology. They are not the same and should not be confused. Despite Bitcoin’s lack of any intrinsic value, its market value bounces around between $15,000 and $20,000 (or some other number depending on when you’re reading this in the world). The difference is pure stock market speculation – one person’s bet that another person will be willing to buy that Bitcoin for more than the first person paid for it.

TRANSACTIONS AND PAYMENT PROCESSING

Transactions are verified through the use of public-key cryptography. Public-key cryptography requires that each user be assigned two "keys", one private key that is kept secret like a password, and one public key that can be shared with the world. The public and private keys are stored in an individual's "Wallet" which can exist in both physical and digital forms.

When an individual ("A") wishes to transfer bitcoins to another individual ("B"), A creates a message (a "Transaction") containing B's public key and signing off with A's private key. The Transaction is then recorded, time stamped and displayed in one "block" of the Block Chain as part of the payment processing carried out by Miners.

Each time a transaction is made it must be verified by a Miner prior to the recipient's funds being cleared. In order to do so, an active computer on the Bitcoin network must assign a "hash key" to the block (a randomly generated value that describes the entire block). This hash key is then transmitted to the rest of the network and is used to confirm that the Transaction in the given block is legitimate and that the funds can be cleared. The process results in a 10-60 minute delay in clearing of funds but it also means there is no need for a central payments processing system.

Therefore, Bitcoins are basically just numbers and the process of mining is the process of generating numbers.

ADVANTAGES:

Lower transaction costs

The removal of third-party intermediaries makes Bitcoin transactions substantially cheaper and quicker than traditional payment networks. This is particularly attractive to small businesses that are seeking to lower transaction costs. For example, although credit cards have made it easier to do business, this is at a considerable cost to merchants. In addition, credit card payments are susceptible to fraudulent charge-backs (or consumer-initiated payment reversals) based on false claims that a product has not been delivered[5]. However, credit cards do afford some protection for users the removal of which may have a detrimental effect on business. From our research, Bitcoin currently does not have such forms of protection; however, businesses could emerge offering such services as the provision of escrow arrangements, amongst others.

Inflation

The lack of control over inflation has been a significant concern for many in relation to the adoption of Bitcoin. Inflation may be influenced by supply of and demand for a currency. However, Inflation can not be affected by the manipulation of the supply of bitcoins as the Bitcoin system was designed to mimic the extraction of gold or other precious metals from the Earth in the sense that only a limited amount can ever be mined. Written into the protocol of Bitcoin is an upper limit of 21 million bitcoins (Note – each bitcoin has 100,000,000 sub-units called "Satoshi"). As the Bitcoin limit is approached, the Rewards for mining bitcoins will reduce in a series of steps occurring approximately every four years to compensate for an increase in total processing power (once the limit is reached transaction fees will be introduced). As such, the rate of expansion of the currency is prescribed and should plateau by around 2030. The de-centralised nature of the currency, the prescribed rate of growth and the upper limit all mean it is impossible for any single person or entity to increase the supply of Bitcoins.

Inflation may occur if demand is significantly reduced. However, as Bitcoin is a distributed system of currency, if demand were to decrease to such an extent as to cause inflation then the system itself would fail in any case[6]. If Bitcoin continues to be adopted and eventually becomes a mainstream unit of ‘currency’ adopted by states then this is unlikely to be of any concern.

Potential to combat poverty and oppression

Access to basic financial services is a significant hindrance to combating poverty. Due to the impediments to developing traditional branch banking in under-developed areas, people in developing countries have turned to mobile banking services for their financial needs. Bitcoin is able to provide people in developing counties with inexpensive access to financial services on a global scale. This is beginning to be seen in countries such as Kenya, Tanzania and Afghanistan, where the closed-system mobile payment service M-Pesa has been particularly successful.

Bitcoin may also be able to provide relief to countries with strict capital controls as there is no central authority that can reverse transactions or prevent the exchange of bitcoins between countries. Bitcoin therefore provides an alternative in countries with devalued currencies or frozen capital markets. Individuals in oppressive or emergency situations might also benefit from the privacy that Bitcoin can provide. 

CHALLENGES

Volatility

The value of bitcoins has fluctuated dramatically in the last few years in what has closely resembled traditional speculative ‘bubbles’. Over-optimistic media coverage of Bitcoin prompts the participation of novice investors which pushes up the value of Bitcoins, until it is over-valued and, as a result, subsequently drops, losing significant amounts of money in the process.[7]

Bitcoin's volatility has divided opinion as to whether the system is a viable alternative to real world currencies. It has been suggested that the speculative bubbles seen to date are simply fluctuations that are stress testing the ‘currency’ and will decrease in frequency.[8] It is also possible that volatility will decrease as users become more familiar with the Bitcoin technology and develop realistic expectations about its future. However, despite the amount of time that has passed, there shows little sign of stability unless Bitcoin is accepted as an everyday monetary medium by states as opposed to an asset reflecting an investment opportunity (we discuss this in more detail below).

Periods of high volatility are not uncommon in current world currencies and asset classes, particularly in commodities and emerging markets. Howecer, Bitcoin’s volatility is extreme, and frequent: the one-day price move has been more than 10 percent on nine days in the past three months and the run-up to the new year of 2018 has shown a massive drop in the value of Bitcoin with it losing over a third of its value in 24 hours[9] and its fluctuation on certain days having gone to as much as 45 per cent less.[10]

Tim Swanson, a bitcoin expert and founder of Post Oak Labs, a technology advisory firm, said he was concerned that if the futures liquidity increases there could be an incentive for someone with a large bet against bitcoin to disrupt or attack the network to make money from the ensuing price fall.[11] Indeed recent weeks suggest that we are already seeing a dip in the ‘value’ of Bitcoin generally!

Security

The Bitcoin protocol has thus far proved to be impervious to hacking; the majority of challenges instead concern Wallet services and bitcoin exchanges[12]. However, if users are not careful they can inadvertently delete or misplace bitcoins and, as with cash, once lost it cannot be recovered. Further, if users do not protect their private addresses then they leave themselves open to theft. Bitcoin Wallets can now be secured by means of encryption; however, users must choose to activate the encryption. Failure to do so could result in bitcoins being stolen through malware. The media has also reported on several attacks on Bitcoin exchanges which have resulted in thefts or downtime of services as a result of distributed denial-of-service ("DDoS") attacks. Many of the security risks facing Bitcoin are similar to those facing real world currencies; bank notes can be destroyed or lost and banks can be robbed or targeted by DDoS attacks.

Criminal use

A significant concern in relation to Bitcoin has been the anonymity of the system. In the absence of third-parties, Transactions take place only between two individuals and, as is the case when paying for items and services in cash; no record is explicitly made of the individuals involved. The public keys used in transactions are recorded but these are not currently tied to anyone's identity. However, in the sense that all transactions to and from a particular Bitcoin address can be traced, it is more accurate to describe Bitcoin as pseudonymous rather that anonymous.

A concern that results from this lack of a tie between virtual and real-world identities is that Bitcoin may be used for the purposes of money laundering, financing terrorism and trafficking of illegal goods. However, the public record of all Bitcoin transactions contained in the public ledger allows for the ongoing tracing of funds through transactions and so until such time as a public key is matched with a real world identity, any misused funds can be traced and followed.

Some exchanges have already taken steps to comply with anti-money laundering, record-keeping and reporting requirements[13]. This, combined with the public ledger will go some way towards reducing the risk that bitcoins will be used for such purposes. It is also important to note that many of the potential downsides associated with the potential criminal use of bitcoins are similar to those facing traditional cash.

Nonetheless, there still exists structural designs within Bitcoin’s framework that allow the mixing of ‘clean’ and ‘dirty’ money. There exists the use of so-called "tumblers" to mix illegally obtained funds with "clean" funds, the intention being to confuse the trail back to the fund's original source. These services are available on the internet, with one provider having the audacity to call its website "bitlaunder.com".

Importantly, the pseudonymous nature of Bitcoin means those who own the largest amounts of Bitcoin (termed as “Whales”) cannot be identified and that those who mine it also benefit from the same. This is extremely dangerous given the affect that they can cause to the ‘value’ should they decide to act ns any particular direction with respect to their holdings.

Scalability and splinters in Bitcoin versions

The security of Bitcoin is generally accepted. However, it comes at the cost of a ‘daily transaction limit’ to Bitcoin payments. In the original Bitcoin design, each component (“block”) in the Blockchain is used to store transactions made by the users as well as the other sensitive information. So a block can store multiple transactions but this must be within the specified size limit of 1MB. Whenever a block is completed, it is added to the Blockchain as a permanent record. As a matter of fact, this 1MB block size limit was imposed to prevent the Blockchain from the potential DDoS attacks by the hackers who might try to freeze the network by creating blocks of uneven or massive size. But as long as the size limit is as low as 1MB, all the blocks exceeding this size will be automatically rejected by the network and they will not be added to the Blockchain.[14] This limit is a design element of Bitcoin alone, as opposed to the underlying Blockchain technology, and its implementation is a crucial security measure that comprises part of the state of the Bitcoin network. As such, it suggests that the original Bitcoin protocol itself did not contemplate accommodating a massive user base in the same way currencies do. A surge in bitcoin trades in recent weeks has also left the blockchain network that the cryptocurrency relies on to process and verify transactions struggling to keep up. As of Wednesday 13 December 2017, at 14.45 GMT, more than 125,000 bitcoin transactions remained unconfirmed.

In order to solve the issue of the transaction limit (which caused a raging debate between ‘Bitcoin Believers’) Bitcoin actually splintered into two versions of the currency in August 2017 (known as the “hard fork”). The original product is now known as ‘legacy Bitcoin’ and the new version is known as ‘Bitcoin Cash’.[15] Legacy Bitcoin's blocks are capped at 1MB, and Bitcoin Cash can support up to 8MB (with current blocks having 2MB). Bigger block sizes is the major difference between the two and the impetus for the split. However, it has been noted that Bitcoin is looking increasingly likely to splinter off again, creating a third version known as ‘SegWit’ as miners and developers pursue separate visions to scale its rapidly growing marketplace. There exists an ongoing debate between ‘Bitcoin Believers’ as regards to conception of the Bitcoin system – which was designed around scarcity and whose traditionalists insist on keeping the block size small in order to maintain security etc. It is clear that it was never actually designed to be a particularly convenient means of payment for the masses to go an buy their groceries.[16]

SO IS IT A CURRENCY OR AN ASSET?

It is clear that Bitcoin (whichever version you are referring to) has carved out a disruptive place in the capital markets. The reality of the product is causing debate in all spheres of academia and industry. NYU Professor Aswath Damodoran, has staked his claim that Bitcoin is officially a “currency” not an “asset” as so many others claim. He defines assets as something that generates cash now or is expected to generate cash in the future. Currently the only way to generate cash from Bitcoin is by selling some that you already own. In contrast, Initial Coin Offerings (ICOs) or equity offerings of startups priced in cryptocurrencies, would be construed as an asset because the coin-holder theoretically has a claim on the future cash flows of the business (but these are not being considered in this paper).

However, Damodaran fails to effectively define what a currency is beyond a ‘medium of exchange’. Those who term Bitcoin as falling into the relams of an ‘asset’ do so on the basis of two key observations: 1) its value being unstable and 2) its transaction processing is too slow.

We have addressed the issue of the transaction limit above (see section: Scalability and splinters in Bitcoin versions) aswell as addressing the idea of how the value of Bitcoin is determined (see section: Value of Bitcoins) and how it is extremely volatile (see section: Volatility).

Stability and Liquidity as conditions for currencies

A key feature of a currency is that it be a stable store of value.[17] Too high a level of instability in currency values mean that people cannot trade or finance their economic activity and investors cannot accurately predict the value of future earnings. Currently, it is clear that currencies are not expected to function so as to be capable of losing half their value in a few months (such as Bitcoin recently did). Bitcoin is considered a highly volatile currency and it must be made clear that as much as it can go up in price, Bitcoin also has the potential to lose significant value, fast.[18] Such volatility is characteristic of ‘assets’ such as publically listed shares on stock exchanges and other financial instruments. The 2017 current record-breaking rise in Bitcoin’s ‘value’ on the markets has only furthered fears of an impending crash or at the very least a correction with the drop in price in December 2017 has increasing and indicating these concerns further. Indeed the hundred-fold increase in its price has strengthened arguments of those who argue it should be understood as an asset.

A further role of currencies is that they facilitate transactions. As mentioned in the section relating to the issues of Bitcoin’s scalability, the framework of Bitcoin itself is not designed to actually function as an alternative currency for the masses. The very nature and security of Bitcoin means that it suffers from the same problems the normal Barter system does, whereby it is hard to make changes and you must find two people who want to exchange goods (three or four way trades get complicated). Whilst this is fine to do in the case of large scale corporate and capital markets transactions (for example, PwC Hong Kong has recently in 2017 accepted Bitcoin as payment of a real estate related transaction), to protect the security of the Blockchain that makes cryptocurrencies like Bitcoin so secure, processing of Bitcoin transactions is very slow. We argue that to change these rules will compromise the current security of the system and therefore it is tenuous to argue that Bitcoin can become a widely-used currency. Its very security negates its value in everyday use as its decentralised nature means that it cannot provide the stability needed to facilitate transactions widely (atleast not at the time of writing).

In terms of its treatment generally, compared with fiat currency, Bitcoin is being treated more akin to a financial instrument. The Norwegian government has subjected it to capital gains tax.[19] The U.S. Securities Exchange Commision has recently laid out guidelines with respect to its treatment as a financial instrument consitituting a ‘security’ for the purposes of being a regulated product. The Internal Revenue Service has also ruled that Bitcoin and other "convertible virtual currencies" are "treated as property" and not treated as currency.[20]

A further point to consider is that of Regulation. Bitcoin’s decentralised nature means that it does not fall under the jurisdiction or responsibility of any one state. There is no formal regulatory body. This makes it hard to address Bitcoin-related fraud cases. This is not the case with traditional currencies. Law looks at both substance and form. The regulatory approach varies across jurisdictions with many not regulating crytpocurrencies per se, as these are not considered as ‘securities’ or ‘legal tender’, but rather regulating the exchange process as a money service business. The U.S. regulates exchanges and administrators as subject to the Bank Secrecy Act, whilst users are covered by tax legislation as virtual currencies are generally treated as property with gains or losses calculated. The Hong Kong Monetary Authority does not regulate it and the Monetary Authority of Singapore is undergoing a consultation process as a precursor for introducing regulation. Whilst, there are jurisdictions which do not yet classify Bitcoin as a security and therefore regulate it in this way, the U.S. Financial Crimes Enforcement Network defines such currencies as “A medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency.” From our research, Bitcoin does not have ‘legal tender’ status in any jurisdiction. 

The reality of Bitcoin is that you can create the populace is capable of creating its own currency. Government treasuries are usually responsible for the creation of currency but with Bitcoin you can actually create currency yourself if you have enough computing power.

Based on my research to date and the discussions I have had with those far more knowledgeable than mysef, I can only conclude that Bitcoin is to be considered an asset and not a currency. In this regard, I go further to say that it can only be considered a ‘virtual asset’ and not a ‘real asset’ as a result of the lack of an inherent intrinsic value to it. There is little evidence to suggest that buyers are using bitcoin as a means of exchange and payment. On the whole, they buy the cryptocurrency as a speculative investment, attracted by massive price gains.[21]

So in conclusion, despite claims to be a ‘virtual currency’, Bitcoin is simply a ‘virtual asset’ for the simple reason that:

“If it looks like a duck and sounds like a duck, it usually is.”[22]

By Aysh Ahmed Chaudhry

References:

[1]    Bitcoin A Primer for Policymakers, 2013, Jerry Brito and Andrea Castillo, George Mason University, https://mercatus.org/sites/default/files/Brito_BitcoinPrimer.pdf

[2]    Bitcoin: A Peer-to-Peer Electronic Cash System, Satoshi Nakamoto, www.bitcoin.org/bitcoin.pdf

[3]    The Rise and Fall of Bitcoin, 2011, Benjamin Wallace, Wired Magazine,     https://www.wired.com/magazine/2011/11/mf_bitcoin/

[4]    Achieving Electronic Privacy, 1992, David Chaum,            https://www.chaum.com/articles/Achieving_Electronic_Privacy.htm

[5]    Emily Maltby, “Chargebacks Create Business Headaches,” Wall Street Journal, February 10, 2011, https://online.wsj.com/article/SB10001424052748704698004576104554234202010.html

[6]    Bitcoin wiki: Myths, 29 December 2013,               https://en.bitcoin.it/wiki/Myths#Bitcoin_can.27t_work_because_there_is_no_way_to_control_inflation

[7]    Felix Salmon, “The Bitcoin Bubble and the Future of Currency,” Medium, April 3, 2013, https://medium.com/money-banking/2b5ef79482cb

[8]    Adam Gurri, “Bitcoins, Free Banking, and the Optional Clause,” ümlaut, May 6, 2013, https://theumlaut.com/2013/05/06/bitcoins-free-banking-and-the-optional-clause/

[9]    https://money.cnn.com/2017/12/22/investing/bitcoin-plunges-below-14k/index.html

[10]   https://uk.businessinsider.com/bitcoin-price-drops-plunges-friday-december-22-2017-12?r=US&IR=T

[11] https://uk.reuters.com/article/uk-markets-bitcoin-risks-insight/bitcoin-fever-exposes-crypto-market-frailties-idUKKBN1E724X

[12]   Dan Kaminsky, “I Tried Hacking Bitcoin and I Failed,” Business Insider, April 12, 2013, https://www.businessinsider.com/dan-kaminsky-highlights-flaws-bitcoin-2013-4

[13]   Jeffrey Sparshott, “Bitcoin Exchange Makes Apparent Move to Play by U.S. Money-Laundering Rules,” Wall Street Journal, June 28, 2013,             https://online.wsj.com/article/SB10001424127887323873904578574000957464468.html

[14]   https://www.quora.com/What-is-block-size-limit-with-regard-to-bitcoin-and-blockchain

[15]   https://www.gambling911.com/businessfinancial/coingeek-interviews-bitcoin-evangelist-roger-ver-.html

[16]   https://www.bloomberg.com/view/articles/2017-11-14/bitcoin-s-high-transaction-fees-show-its-limits

[17] https://www.forbes.com/sites/jeffreydorfman/2017/05/17/bitcoin-is-an-asset-not-a-currency/#3afa02e62e5b

[18] https://www.luno.com/blog/en/post/bitcoin-and-islam

[19]https://coinalert.eu/2015013940-Breaking+News-+Norway+Doesn-t+Consider+Bitcoin+a+Legitimate+Currency.html

[20] https://www.thebalance.com/how-bitcoins-are-taxed-3192871

[21] Garrick Hileman, a research fellow at the University of Cambridge’s Judge Business School.

[22] https://www.gtreview.com/news/fintech/icos-the-next-goldmine-for-trade-finance-lenders/?utm_medium=email&utm_campaign=GTR%20eNews&utm_content=GTR%20eNews+CID_b7c69a50e13f74a02d91c586d70c2d74&utm_source=Email%20marketing%20software

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