Bitcoin or Bitcon? The Potential Influence of a Virtual Currency on the Real Economy

Patty FoxallPSC 502Dr. Lewis

April 24, 2014

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Bitcoin is the virtual world's best known crypto-currency. Its creation and use is leading

to a paradigmatic shift within fiscal and monetary policy today. In order to consider where

Bitcoin may be headed, there are questions about the currency that must be addressed. This paper

will discuss what is needed to define money as a unit of exchange; the potential for Bitcoin to

fulfill the requirements of what money is; the pros and cons of a virtual, non-tangible unit of

exchange; the extent of impact a solely virtual currency may have on specific segments of

population; and the likelihood of Bitcoin surviving as a virtual, unregulated monetary device.

In order for a currency to be considered money it must be able to fulfill three main

functions1. First, the currency - whether coinage or paper - must serve as a medium of exchange

between groups who agree to the currency's value. It must maintain a stable store of value.

Finally, it must be measurable as a unit of account against which an economy's value can be

determined. The US dollar and the Euro, for example, meet the classifications to be considered

currency. As they each have the backing of a government, both the dollar and the Euro are

accepted worldwide as fiat currency.

Fiat currency is currency that a government decrees to be legal tender2. Bitcoin's

defenders, however, would prefer to see currency backed by a tangible commodity (such as gold)

instead of 'only' by government promises. Because of this desire for a different definition of

"currency", these defenders feel the notion of fiat currency itself needs to change or be replaced.

They consider Bitcoin and other virtual currencies as a potential evolutionary step for interacting

within the global economy. In spite of these considerations regarding fiat currency, it is not an

unstable system waiting to be replaced; as long as a government has the ability to back its

1 The Economist "Money From Nothing" Mar. 15, 20142 Hern, Alex. "Bitcoin should not be seen as a currency, warns Ernst & Young" December 11, 2013

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currency, currency will maintain its value. Currency can be described somewhat tongue-in-cheek

as "an asset with an army".3 The value of actual currency in recent history is drawn from the

perception of the stability of the government backing the currency. As an example, during the

early years of the Civil War, the Confederate dollar had a reasonable value; once the

Confederacy lost the war, that money was deemed worthless everywhere.4

Using the above definitions, does Bitcoin meet the criteria to be considered money?

Bitcoin can be used as a medium of exchange for virtual products in some corners of the virtual

world. Aside from its use in the illegal drug trade,5 it is very rare to see Bitcoin transactions for

real world goods.6 One of the eventual aims of Bitcoin is to be considered currency without the

need for a physical representation, using computer files to show value in place of a piece of

currency.7 At this time, Bitcoin cannot be considered a stable store of value. The volatility of the

currency is extremely high. In 2013, the exchange rate for Bitcoin was 142%; during other

volatile periods, such as the Asian financial crisis of 1997-8 and the default in Argentina in 2002,

volatility reached levels topping 50% in Asia and 120% in Argentina. However, unlike Bitcoin,

these volatility levels only lasted a few weeks.8 Bitcoin may become more stable in the future,

due to the maximum limit placed on the currency by the system's creators. The system is set to

reach a total value of 21 million Bitcoins in 2140.9

However, because of the novelty of the online world, there are separate considerations

regarding virtual currencies and how they work. Virtual currency systems have three different

3 Greeley, Brendan. "The Dollar Will Never Fall to Bitcoin" December 24, 20134 Colabella, Patrick and Michael Shoff. "Virtual Currencies: the Challenge to Global Fiat Paradigms" February, 20145 Yermack, David. "Is Bitcoin a Real Currency? An Economic Appraisal" December, 20136 Hern, 27 Verne, Francois R. "Chicago Fed Letter", December, 20138 Conway, Brendan. "Like an Emerging Currency, Bitcoin is 'Vastly Inferior' to Fiat Money" February 11, 20149 The Economist, 2

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classifications: closed, hybrid, and open. The closed systems are limited to virtual communities

where the real-world fiat currency is used to purchase virtual currency for use within the virtual

world. This is seen most often on websites such as World of Warcraft or Second Life, where

people may choose to exchange real money for virtual currency that can be spent on in-game

commodities which will improve their virtual experience. Hybrid systems are found in websites

where users have the ability to purchase virtual money to use within a virtual game or

community, but where tasks can also be completed for points to exchange for goods or services

which have a real world monetary value. Finally, open systems exist where virtual currency can

be used to purchase both real and virtual goods. In these cases, the real world purchase occurs

after the currency has been exchanged from its virtual form into a fiat currency.10 Bitcoin has the

capability to be spent on real goods; however, in most of the exchanges a third party chooses to

accept the Bitcoin currency and then pays the seller in the fiat currency, set at the moment's

exchange rate.11 Because of the volatility, the Bitcoin market behaves as a speculative market.12

There are positive features to the Bitcoin system. While the implications of the system

are just beginning to be considered, one of the most appealing features of the arrangement is that

there is no ownership of the Bitcoin network.13 The network appears to be a loose group of

software engineers and coders who are creating the network to run with Bitcoin protocol. In

order for this to be effective, the software features must adhere to complete consensus with the

users of the network.14 Without complete consensus there is a danger of competing software and,

more importantly, competing data arising that can cause difficulty regarding how the issued

Bitcoins have been spent. For this reason, consensus of all users is a vital requirement for the

10 Colabella, 17411 Yermack, 612 Id., 1013 www.bitcoin.org/about-us14 Id.

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successful use of the Bitcoin platform.15 Because of the decentralized system and the competition

of software used in the management of Bitcoin, there appears to be no need for a central server to

maintain a full record of what is being done, as this record becomes part of all of the blocks

which maintain a cumulative record of all the Bitcoin transactions as they have been

authorized.16

Unlike most currencies where there is a potential of unlimited currency creation within a

system, the founders of Bitcoin have already announced that the creation of Bitcoin currency

(called ‘mining’ by the workers who are in the business of creating the currency)17 will be

capped at 21 million Bitcoins. There is a complex algorithmic function that has been created to

monitor the creation of Bitcoins, which will be used to slow the creation process down based on

firm volume points created in time, with the last Bitcoins expected to be mined in 2140.18 This

may lead to deflationary trouble in the future, since each Bitcoin will become "comparatively

more competitive over time".19

One main feature of Bitcoin is its ability to lower transaction costs associated with

sending money worldwide. While the major banks charge large percentages to transfer money

between one world region and another, Bitcoin has managed to reduce these transaction costs to

a much smaller amount. This makes Bitcoin very appealing for those wishing to send money

overseas.20 It also has appeal to small businesses. Surprisingly, a street in Cleveland is set to

become the first "Bitcoin Boulevard" - eight businesses have agreed to accept the currency

mainly because of the cheaper transaction fees offered by Bitcoin. Bitcoin charges 1% in

15 Id.16 Hobson, Dominic. "What is Bitcoin?" Fall, 201317 Id.18 Id.19 Hern, 220 Rosenblum, Paula. "Bitcoin: The Currency of the Future?" January 27, 2014

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transaction fees over the 2-3% charged by the major credit card companies.21 If this continues,

we could see an impact to the traditional market as major credit card systems may have to

reconsider their higher fees in order to maintain their competitive edge. Bitcoin is also very

popular in countries where the national currency may be unstable or problematic due to political

reasons. Bitcoin has been used by some in Argentina where it is seen as more successful than the

inflation-riddled national currency; it has also been used in Iran to work around internationally-

imposed currency sanctions.22 Anonymity of transactions is one of Bitcoin's most important

features,23 along with the freedom from state power and control that the network enjoys at least

for now.24 The popularity of the black-market Silk Road – one of the first organizations that

accepted only Bitcoins as payment – cemented the assumption of anonymity of the Bitcoin

system.25

Bitcoin works best as a form of payment in industries with a low profit margins as the

low transaction costs make Bitcoin a more attractive option than traditional credit card

companies.26 It presents an intriguing new way to pay for online services27 and offers a veneer of

privacy around what is being purchased and by whom. This privacy is one reason it is currently

considered the “Gold Standard” of crypto-currencies.28 It is also the most widely-circulated

virtual currency.29 However, Bitcoin does have some accepted value beyond its role as a virtual

currency. Some companies have agreed to accept Bitcoin for real (physical) goods that exist

outside of the virtual world. TigerDirect, a low-cost computer peripheral company, began

21 Sheeter, Justin. "Cleveland Ohio to Be the Home of the Nation's First 'Bitcoin Boulevard'" April 18, 201422 Colabella, 175-623 Rosenblum, 224 Velde, 225 Yermack, 626 Rosenblum, 327 Cohan, Peter. "Bitcoin or Gold: Which is More Fiat-Proof?" April 11, 201328 Id.29 Colabella, 175

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accepting Bitcoins for payment in January, 2014; Overstock.com, one of the largest online retail

sellers, began to accept Bitcoins for payment in January 2013.30

Lastly, there is money to be made in the creation of the Bitcoin currency. Bitcoins

are “mined” via a complicated system of algorithmic math equations that originally were done by

regular people with regular processing equipment; however, as the value of the currency has

increased, so has the number of people investing in more-powerful equipment to “mine” Bitcoins

more efficiently. Like most gold rushes, the money can be made, but only if one is in a position

both to understand how the system works and to afford the equipment necessary to mine

effectively.31 Like the gold rush of a prior century, those who were able to have the best

equipment and the best information on possible gold veins were much more likely to strike gold

than those who went out into the wilderness armed with only their wits and a dream. The ‘true

believers’ in the system see Bitcoin as a potential savior of economic policy, and believe that one

possible outcome of Bitcoin adoption will include a viable challenge to the fiat paradigms of

today.32

While most of the above positive considerations of Bitcoin make the system sound like

an exciting new platform for the world to adopt, there are many cautions that have to be

considered before jumping completely onto the Bitcoin bandwagon. Foremost at this time is the

concern of Bitcoin’s extreme market volatility. Nearly every article makes strong mention of

volatility as an inherent danger to the system, with fluctuations in value during the four-month

period from January-April 2013 from a low of $20 to a high of over $250.33 While some choose

30 Stock Market Watch. "What Companies Accept Bitcoin?" February 3, 201431 Yermack, 1032 Colabella, 17233 Hobson, 43

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to consider this volatility as an acceptable feature of a new system, others see the volatility as a

sign of the need for regulation.

This lack of regulation is touted by the users of Bitcoin as a design feature; however,

when the lack of tangible value is added to a lack of regulation over the system,34 it becomes

difficult to accept financial transactions that do not have a governing body.35 Because the term

used for creating new Bitcoins is 'mining' there is an illusion of an actual product being brought

into existence. Still, it is nothing more than data on a terminal with nothing to base value on but

an arbitrary value. If one is spending large amounts of money on a potential currency, this lack

of oversight will become more difficult to rationalize.36 Even if someone is interested in using

Bitcoin for transactions, it is a stumbling block when a purchase takes up to an hour for a

transaction to be verified on the network.37

Bitcoin has attempted to work around the need for regulation by placing a firm threshold

on the eventual total value of Bitcoins in the virtual world. The currency will be capped at 21

million units. According to their calculations, this amount will be reached in 2140.38 If Bitcoin

were to become an international currency, "it is hard to imagine a world where the major

currency is based on an extremely complex code understood by only a few and controlled by

even fewer, without accountability, arbitration, or recourse."39 Because of its creation by the

computer elite, the system itself is not a product that is likely to be adopted by the average

person in a developed economy.40 People may choose to work for Bitcoins, but because of the

technological requirements to run software to engage in the 'mining' process, the ability for users

34 Rosenblum, 235 Twomey, Peter. "Halting a Shift in the Paradigm: The Need for Bitcoin Regulation" 201336 Conway, 237 Hern, 238 Cohan, 139 Velde, 340 Hobson, 43

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to make money on Bitcoin will be limited to the understanding of a few technocrats.41 The same

systems that are used to create Bitcoins can also be used against the system via hacking and other

mechanisms designed to manipulate the design protocols. These attacks can only be mounted by

the same high-powered processors used for creating Bitcoins.42 The Bitcoin system is not an

intuitive one. There will be difficulties promoting potential uses of Bitcoin beyond some of the

black market uses (such as the Silk Road) for which Bitcoin has become known. The biggest

meltdown of the Bitcoin system to date is the Mt. Gox bankruptcy. Mt. Gox grew from humble

beginnings as a Magic the Gathering card exchange to become the leader in Bitcoin trading

worldwide before it "imploded in a spectacular bankruptcy. Hundreds of millions of dollars

worth of Bitcoins went missing…."43

Anonymity is a large potential benefit of Bitcoin; however, the system is not able to

ensure total secrecy of its users. This can be seen in the eventual shutdown of the Silk Road

black market online storefront. When a government chooses to do the work, the Bitcoins can be

traced with enough effort. Once enough data was discovered, the government was able to arrest

the main operator of the Silk Road using the NSA's internet data monitoring.44 Bitcoin is volatile

enough to be compared to the risky internet stocks of the 1990s,45 which could explain why the

IRS has chosen to tax Bitcoin not as currency, but as an investment.46 This volatility makes it

nearly impossible to hedge risk because there is no correlation either with other conventional

currencies or with gold.47 Because of these risks, it is likely that regulation will be necessary to

protect the users of the system.48 However, due to the nature of the individuals who are looking 41 Bradbury, 242 Id.43 Yermack, 2-644 Id., 845 Id., 246 Wood, Robert W. "IRS Says Bitcoin Is Property, Not Currency, And Forms 1099 Are Required" March 25, 201447 Yermack, 348 Velde, 3

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for a non-government currency, the early adopters may not stay with a system that is eventually

regulated. This catch-22 is one of Bitcoin's largest issues with a possible transition to a

commonly accepted currency.49 Even as Bitcoins are accepted more places, most Bitcoins are

still being exchanged between investors - 80% of activity on the leading digital wallet service

was related to speculation.50

There are two types of users who are embracing the Bitcoin system. The first type are the

technocrats who are more comfortable within a virtual world. These are also the individuals most

likely to understand the 'mining' system and how money can be made within the Bitcoin

universe. This is analogous to the other financial technocrats who were created CDOs and other

money-making vehicles. Other early adopters have been the 'pseudo-libertarians' who are

concerned about the influence of an overarching State on every aspect of society.51 However, the

first time a enough value is lost to impact the real economy, there will be a demand for

regulation if not by the people who have lost money then by the states who may be impacted by

another financial crisis. Once regulations start to become an aspect of the Bitcoin currency, it

will begin to lose appeal.

Bitcoin could also become a victim of its own success. If the Bitcoin platform is shown to

be as successful and as safe as traditional currencies, there is a potential for the various

governments around the world to move into the creation and tracking of their own virtual

currency. The difference would be that this currency would be backed by the strength of a

government, becoming a fiat virtual currency.52 Once there are alternative currencies backed by a

49 Yermack, 1050 Id, 751 Id., 852 Colabella, 176

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stable government, the likelihood of Bitcoin maintaining dominance in the virtual world without

either regulatory controls or government backing is unlikely.

As long as Bitcoin is both anonymous and unregulated , it will attract people interested in

spending their money on illegal activities. When this combines, it is not surprising that the black

market finds a home selling real goods for virtual money. Middlemen facilitate most transactions

by agreeing to purchase Bitcoins from a client, then purchasing the requested real good on behalf

of the client with his own fiat currency. The middleman has the expectation that by facilitating

the transaction and in essence purchasing the Bitcoin being used, Bitcoin will increase

dramatically in value and he will be able to make money off of the investment.53

One aspect of Bitcoin's creation is the consideration of an entirely new way of

considering who gets to create a society's money. A debate is ongoing as to whether money

should be a state monopoly, or if it should be another commodity controlled by the private

sector.54 People who are afraid of government regulation in general would rather see private

industry control every aspect of a society. However, experiences from the early years of the

Industrial age are replete with stories of disadvantaged workers who lived in homes owned by

their employer, shopped in 'company stores', and earned wages in company chits that could not

be spent outside of their employer's domain. When nobody else is willing to accept a currency,

declaring a currency's value is suspect. Because of the inherent dangers of abuse of a private

financial system, governments must maintain the creation of money. Otherwise an unfavorable

playing field will tilt permanently to the advantage of those who create the money and

everything purchased with it.

53 Yermack, 654 Velde, 2-3

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Bitcoin has definite potential to remain a niche currency in the facilitation of online

exchanges. Within the last week a Texas gubernatorial candidate announced his willingness to

accept Bitcoins as campaign donations.55 It would be interesting to follow his campaign if only to

see how many donations come to his campaign in that format, as well as to determine how many

individuals chose to donate with Bitcoins. It also opens a new concern in the murky area of

campaign finance; while the caps to how many individuals a donor may give to have eroded, the

amount allowed to be given to any one candidate are still in place. This could be yet another

attempt at a run-around of the maximum donations allowed to individual candidates by those

who can afford to do so. However, Bitcoin must become less volatile before it can reliably serve

as a unit of value for commercial markets. As long as it is only available as a virtual commodity,

with no easy avenue of confirmation or proof of ownership, it will always be in danger of having

a system failure destroy large chunks of data. Because there is no central storage facility, if

anything were to happen to one major area, data would inevitably be destroyed. Since currently

there are also issues with being able to double-spend the same value if the network is

compromised, and because those who know how to hack the system can do so with ease, there is

as of yet no way to maintain the system's integrity.

Fiat currency is the measure of the strength and stability of an issuing institution,

typically a government. Regulations give the value stability because there is recourse if

something happens to the currency while it is in storage, held by banks. Bitcoins will never be

stable because the system lacks regulation. The only strength behind Bitcoin comes from faith in

the Bitcoin system, and faith in the internet itself. Unfortunately, the Bitcoin network has already

shown itself to be vulnerable to both cyber attack and software malfunction. At best, Bitcoin will

55 Starr, Hugh. "Texas Attorney General Greg Abbott to Accept Bitcoin in His Run For Governor" April 17, 2014

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become a tool of the technocrats, those who can understand and manipulate the market to make

money off of those who choose to use the system for political ideology's sake. At worst, it could

become politically disruptive, with its anonymity and grey legal definition enabling corruption of

the campaign donor system. Allowing Bitcoins to be used in campaign donations - with its

international access and the effort needed to trace the currency trail - has the potential to open

our democratic process up to foreign investment. However, this is a new step in financial

evolution and while it may not have a future as a fiat currency, it may end up as the next Wall

Street CDO/CDS system, where the few who are able to understand the mechanism that drives

the system forward will be able to extract real world value from the people who may choose to

opt into Bitcoins for the illusion of privacy offered by the network. Overall, Bitcoin is likely to

be another exploitative tool that will take money from those who would choose to risk a

deregulated financial market in order to avoid the evils of 'guvvermint'.

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Works Cited

______. https://Bitcoin.org/en/about-us (general information about Bitcoin structure)

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Cohan, Peter. "Bitcoin or Gold: Which is More Fiat-Proof?" The Guardian April 11, 2013. Retrieved from http://www.forbes.com/sites/petercohan/2013/04/11/bitcoin-or-gold-which-is-more-fiat-proof/

Colabella, Patrick and Michael Schoff. "Virtual Currencies: The Challenge to Global Fiat Paradigms". ASBBS Annual Conference: Las Vegas. February 2014, Vol. 21, No. 1. Pp 171-186.

Conway, Brendan. "Like an Emerging Currency, Bitcoin is 'Vastly Inferior' to Fiat Money" Barron's February 11, 2014. Retrieved from http://blogs.barrons.com/focusonfunds/2014/02/11/like-an-emerging-currency-bitcoin-is-vastly-inferior-to-fiat-money/

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Hobson, Dominic. "What is Bitcoin?" XRDS: Crossroads, The ACM Magazine for Students - The Complexities of Privacy and Anonymity archive Volume 20 Issue 1, Fall 2013 Pages 40-44

Jacobs, Edwin. "Bitcoin: A Bit Too Far?" Journal of Internet Banking and Commerce, August 2011, vol. 16, no. 2. Pp 1-4.

_____. "Money From Nothing" The Economist March 15, 2014. Retrieved from http://www.economist.com/news/finance-and-economics/21599053-chronic-deflation-may-keep-bitcoin-displacing-its-fiat-rivals-money

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Sheeter, Justin. "Cleveland Ohio To Be the Home of the Nation's First 'Bitcoin Boulevard'". Crypto Crimson April 18, 2014. Retrieved from http://cryptocrimson.com/2014/04/cleveland-ohio-home-nations-first-bitcoin-boulevard/

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Yermack, David. "Is Bitcoin a Real Currency? An Economic Appraisal". National Bureau of Economic Research, (working paper 19747) December 2013, rev. April 2014, Pp1-22.