CTO Corner: Bitcoin and Other Non-Conventional Financial ... - BITS

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Dec 3, 2013 (3 years and 4 months ago)

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1


C
TO Corner


May
2013


Bitcoin and
O
ther
N
on
-
C
onventional
F
inancial
P
roducts



Dan Schutzer, CTO, BITS


Digital money is a concept that has been
coming

since the dawn of the commercialization of the
Internet in the 90s. Back then we saw a number of start
-
ups such as David Chaum’s Digicash
,
1

Citibank’s Electronic Monetary System (EMS)
,
2

and NatWest’s Mondex
.
3

Others came later, with
names like Millicent,
Peppercoin, Beenz and Flooz.
There were also a

slew of micropayment
schemes
.
4

5

None of them survived
.
6

Recently we have seen
the emergence of new
digital cash
products, such as Bitcoin,

which has captured
the attention and imagination of the
media
,

the
public
,
a
n
d

i
n
vest
o
r
s
.
7

In this article we will discuss
the new crop

of digital money
, using Bitcoin as an
example



and examine
what has changed
to make acceptance of these new payment innovations
more likely this time around, as well as potential barriers

that still exist.
We will also
briefly
discuss
other new innovative financial innovations, such as peer
-
to
-
peer lending,
and
crowd funding
that
appear
s

to be growing in popularity
.


Bitcoin

is a decentralized electronic cash system using peer
-
to
-
peer networking, digital signatures
and cryptographic proof
ing

to enable irreversible payments between parties
.
8

The first Bitcoins were
issued on January 2009, and since then has seen a rapid growth

in media attention
, on
-
line interest

and value
.
9

Its

value has experienced great
volatility, with large swings, ranging from $13 to
$190/BTC
.
10
11
12
13





1

Jeffrey Kutler,

Is It Finally Time to Embrace E
-
Money?,


(
April 05, 2012
,

http://www.institutionalinvestor.com/blogarticle/3007388/Blog/Is
-
It
-
Finally
-
Time
-
to
-
Embrace
-
E
-
Money.html
).
E
-
cash, developed by computer scientist and DigiCash founder David Chaum, emulated physical coins. Represented as bits
on a computer, transferable in
to bank accounts or onto the chips of smart cards, the coins could be exchanged for
goods and services. Chaum insisted that the transactions be as private and anonymous as those done with physical cash
.

2

http://www.businessweek.com/1995/24/b3428001.htm
,
http://www.wired.com/wired/archive/4.10/wriston_pr.html
.


3

Kelley Holland and Amy Cortese
,


THE FUTURE OF MONEY,

E
-
cash

could transform the world

s financial life,


(
Business Week, June 12, 1995,
,

New York, with bureau reports
,

http://www.businessweek.com/1995/24/b3428001.htm
).

4

iPIN, IBM Micropayments, Pep
percoin, Bitpass and others.
http://247wallst.com/2013/02/05/amazon
-
coin
-
launch
-
revisiting
-
micropayments
-
and
-
virtual
-
currency/
.


5

Subscriptions, Appstores and iTunes seems to have superceded the need for micropayments for
n
ow
.

6

The improved economics of credit and debit cards and the market power of the banking industry overwhelmed E
-
cash,
despite Chaum’s efforts to enlist major ba
nks to issue his coins and central banks to oversee and legitimize them. Bitcoin
has E
-
cash
-
like features, but

is open source, decentralized and designed to grow virally. Bitcoin’s proponents are
mistrustful of fiat currency and thus steer clear of officia
l connections like those Chaum sought.
http://www.institutionalinvestor.com/blogarticle/3007388/Blog/Is
-
It
-
Finally
-
Time
-
to
-
Embrace
-
E
-
Mo
ney.html
.

7

Sa
r
a
h
E
.

N
e
e
d
l
e
man

and
S
pen
c
e
r

E
.

An
t
e
,


Bitcoin Startups Begin to Attract Real Cash
,


(
http://online.wsj.com/article/SB10001424127887323687604578469012375269952.html
,
,
Th
e

W
a
ll
S
t
r
e
et

J
o
u
r
n
al
,

u
p
d
ate
d

May 8, 2013
)
.

8

http://en.wikipedia.org/wiki/Bitcoin
,
https://en.bitcoin.it/wiki/FAQ
.

9

The USD value of a bitcoin

increased ten
-
fold in early 2013 from $13/BTC on 1 January to $190/BTC on 9 April,
three months later,
http://en.wikipedia.org/wiki/Bitcoin
; also
http://www.economist.com/blogs/graphicdetail/2013/03/daily
-
chart
-
12
.

10

BTC is the commonly used shorthand for the Bitcoin currency
.

11

Also, different exchanges quote different prices, implying the market is not yet efficient
.

2



In a traditional economy, a central authority issues currency.
Unlike conventional fiat currency
,
14

Bitcoin

has no centralized issuing authority.
Bitcoins can be created by anyone by

mining
” for it
.
It

s a bit like digging for gold. Bitcoins are small blocks of data hidden in a huge amount of
irrelevant data. To get Bitcoins, one has to take the entire chunk o
f data, rearrange it, and process it
through a set of algorithmic functions until the desired result is found.

Freely available open source

software does everything automatically

but

you need powerful hardware

as m
ining takes time and
energy in terms of
processing power. As mining activity increases, and as more coins are discovered,
the difficulty level of mining rises.

The network is programmed to grow the money supply as a
geometric series until the total number of
B
itcoins reaches 21 million BTC
.
15



Y
ou can buy Bitcoins from Bitcoin Exchanges
.

Bitcoins can be broken into small units of up to
eight decimal points,
they can be

transferred
and exchanged with other people, and you can sell
them for
real
dollars and other currencies.
Bitcoins
can
also
be us
ed
as payment for goods or
services where

ever

accepted
;

there are over 2,000 merchants now accepting Bitcoins
.

Bitcoin works
everywhere except North Korea
.
16

Wikileaks, Freenet
, Singularity Institute, Internet Archive, Free
Software Foundation and others accept donations in Bitcoin.
A frequent problem faced by retailers
willing to accept Bitcoin is the high volatility of its exchange rate
relative
to the U
.
S
.

dollar, as well as
the absence of futures to hedge this volatility (although option contracts are available).


To use Bitcoin, you download a

free open source

wallet, or client software, onto your computer or
smartphone. The client generates a Bitcoin

address which is a unique series of characters and
numbers.
Buyers and sellers remain anonymous, as the identification numbers include no personal
details.
You can get as many numbers as you want for additional anonymity. You give the address to
anyone wh
o wants to send you a payment.
Owners transfer Bitcoins by sending them to another
Bitcoin address using a website or program designed for this purpose
.
17

Every time Bitcoins change
hands, they are stamped with

the transaction details and the identification

key of the new owner. All
transactions are communicated to the public network and indexed for future verification.
Bitcoin
nodes record all data necessary to make any valid transaction in a publicly distributed database called
the block chain. Nodes build

the block chain using a proof
-
of
-
work system that prevents double
-
spending and
c
onfirms transactions

(Some transactions might require a transaction fee for them to
get confirmed in a timely manner
.
18
)

It also allows analysis of the typical behavior of acco
unt holders

(how they behave, acquire and spend Bitcoins)
,

while preserving anonymity
.
19



If a Bitcoin user loses his
/her

wallet, his
/her

money is gone forever, unless
found
again. And it

s
gone completely out of circulation, rendered utterly inaccessible to anyone. As people will lose their





12

D.J. Murphy, Editor
-
in
-
Chief
,


Bitcoin: Speculative Investing Fad or Real E
-
Commerce Value?
,”
(
http://www.cardnotpresent.com/articles/displaylogin.aspx?id=1404
).
y
.

13

Using a
Bitcoin processing service can smooth out the volatility for merchants. For example, a processor such as
BitPay lets a merchant accept Bitcoin and have a Bitcoin immediately converte
tr
d into U.S. dollars and deposited in their
bank account, protecting merc
hants from volatility. The fee for BitPay is .99 percent per transaction and its costs 1
percent to buy Bitcoins. So a total of 2 percent is quite a bit less than PayPal or payment cards.

14

Fiat money is money that derives its value from government regulat
ion or law. The term fiat currency is used when the
fiat money is used as the main currency of the country.
http://en.wikipedia.org/wiki/Fiat_money
.

15

As of 2012, over 8 million of the total 21 milli
on BTC have been mined. By 2013 half of the total supply will be
generated, and by 2017, 3/4 will be generated
.

16

http://www.cardnotpresent.com/articles/displaylogin.aspx?id=1404
.

17

Under the hood, the software transfers the coins by generating a digital signature to link the prior transaction with the
public key of the next owner.

18

https://en.bitcoin.it/wiki/FAQ
.


19

Dorit Ron and Adi Shamir,

Quantitative Analysis of the Full Bitcoin Transaction Graph,


(
Department of Computer
Science and Applied Mathematics, The Weizmann Institute of Science, Israel, {
dorit.ron,adi.shamir}@weizmann.ac.il
,
http://eprint.iacr.org/2012/584.pdf
).

3


wallets, the total number of Bitcoins will slowly decrease. An already small number will be
permanently whittled down further and further. And as there

become fewer and fewer Bitcoins, the
laws of supply and demand suggest that their value will probably continually rise.


Transactions are irreversible by design, and fast (
funds
received are available for spending within
minutes). Since Bitcoin

transactions are irreversible, scammers and fraudsters find them useful
-

people can collect payments and not deliver. There have been incidents of theft of bitcoin
balances
,
20

technical failures and denial of service attacks,
21

and just plain overloads tha
t have
impacted operations and value dramatically
.
22


The anonymity of Bitcoin payments has led to their use for illegal activity. Money
-
laundering is a
threat, as is illegal trade. Silk Road, an online trading website for illegal drugs, uses Bitcoins.
The
Bitcoin economy is currently a traders


paradise in India

and many other countries where

the coins
do not attract VAT (value

added tax) or service tax
.


Regulators have been looking at digital money for quite some time

(as far back as 1996)
.
23

R
ecently,
i
n
March

2013
, the U
.
S
.

Financial Crimes Enforcement Network
(FinCEN)
said a money
transmitter

s licen
s
e would be required to sell or exchange Bitcoins, although they can still be freely



20

On 19 June 2011, a security breach of the Mt.Gox bitcoin exchange caused the nominal price of a bitcoin

to
fraudulently drop to one cent on the Mt.Gox exchange, after a hacker allegedly used credentials from a Mt.Gox auditor

s
compromised computer illegally to transfer a large number of bitcoins to himself. He used the exchange

s software to
sell them all n
ominally, creating a massive

ask


order at any price. Within minutes the price corrected to its correct user
-
traded value. Accounts with the equivalent of more than USD
$
8,750,000 were affected;
i
n July 2011, the operator of
Bitomat, the third largest bit
coin exchange, announced that he lost access to his wallet.dat file with about 17,000 bitcoins
(roughly equivalent to
$
220,000 USD at that time). He announced that he would sell the service for the missing amount,
aiming to use funds from the sale to refun
d his customers; In August 2011, MyBitcoin, a now defunct bitcoin
transaction processor, declared that it was hacked, which resulted in it being shut down, with paying 49% on customer
deposits, leaving more than 78,000 bitcoins (roughly equivalent to
$
800,
000 USD at that time) unaccounted for;
i
n early
August 2012, a lawsuit was filed in San Francisco court against Bitcoinica


a bitcoin trading venue


claiming about
$
460,000 USD from the company. Bitcoinica was hacked twice in 2012, which led to allegatio
ns of neglecting the safety
of customers


money and cheating them out of withdrawal requests;
i
n late August 2012, an operation titled Bitcoin
Savings and Trust was shut down by the owner, allegedly leaving around $5.6 million in bitcoin
-
based debts; this
led to
allegations of the operation being a Ponzi scheme;
i
n September 2012, it was reported that U.S. Securities and Exchange
Commission has started an investigation on the case;
i
n September 2012, Bitfloor, a bitcoin exchange, also reported
being hacked,

with 24,000 bitcoins (roughly equivalent to 250,000 USD) stolen. As a result, Bitfloor suspended
operations;
t
he same month, Bitfloor resumed operations, with its founder saying that he reported the theft to FBI, and
that he is planning to repay the victi
ms, though the time frame for such repayment is unclear;
o
n 3 April 2013,
Instawallet, a web
-
based wallet provider, was hacked resulting in the theft of over 35,000 bitcoins

($129.90 at the time of
trade, or nearly $4.6 million USD)
;

Instawallet suspended
operations
,

http://en.wikipedia.org/wiki/Bitcoin
.


21

Morgen Peck
,


Biggest Bitcoin Exchange Halts Trading After Price Plummets,


(
Thu, April 11, 2013,
http://spectrum.ieee.org/tech
-
talk/computing/networks/biggest
-
bitc
oin
-
exchange
-
halts
-
trading
-
after
-
price
-
plummets/?utm_source=computerwise&utm_medium=email&utm_campaign=041713
)
; The timing of the sell
-
off
coincides with a spate of technical failures over at Mt. Gox. Mt. Gox claims that it has been signing up 20 000 new
a
ccounts every day and had seen the number of trades triple in the 24 hours prior to suspending trading. It said it was
this sudden increase in the trade volume that froze the trade engine; Mt. Gox had a similar problem last week. After
customers complained

about not having access to their accounts, the company revealed that it had been the target of
denial of service attacks.

22

Bailey Reutzel
, “
BITCOIN EXCHANGE HALTS, CITING RISK, AS BANK CLOSES ITS ACCOUNT,


(
April
19, 2013, Payments Source,
http://www.banktech.com/payments
-
cards/the
-
bitcoin
-
bubble
-
explained
-
colbert
-
sty/240153323?cid=nl_bnk_daily&elq
=37996364f82041b6a57da296ce65be02
);

Possibly viewing Bitfloor, a popular
Bitcoin exchange, as a risky money transmitting business, Capital One Financial Corp. has closed the exchange

s bank
account, prompting Bitfloor to halt operations. The incident may p
ortend a growing wariness of businesses that handle
virtual currencies.

23


An Introduction to Electronic Money Issues
,”

(
http://www.occ.gov/topics/bank
-
opera
tions/bit/intro
-
to
-
electronic
-
money
-
issues.pdf
, prepared for the United States Department of the Treasury Conference: Toward Electronic
Money and Banking:

The Role of Government, September 19
-
20, 1996, Washington
,

D
.
C
.).

4


used to pay for goods and services
.
24
T
his month, the Commodities Futures T
rading Commission
announced it is considering whether Bitcoin should be subject to its rules in order to provide
consumers more protection from any mishaps.
25

Regulatory oversight could make Bitcoin

a more
stable and secure currency, but it also could make it less attractive to illegal activity. Some of the
benefits o
f

regulation can also be achieved through partnerships
,
such as Bitcoin Central and its
parent company Paymium and Aqoba, which is a re
gistered PSP

(Payment Service Provider)
.
26


There were several m
otivation
s for introducing
digital cash and related payment innovations in the
past.
They
are still valid and
include:



A
bility to perform a
nonymous transactions

to satisfy
privacy

and other concerns
;



Speed
and finality of transaction
;



L
ow transaction costs
;

this is especially relevant to low value transactions, such as
micropayments
(payments under a few dollars)
, which are more transaction fee sensitive



where the transaction fee
could equal or exceed the amount paid
;




Ability to serve
the
u
nbanked

(no need for a bank or credit card account)
;



P
roviding a sati
s
factory substitute for cash

(both in
-
person and remote use)
; and



Ease of use and implementation
.


Some
features that should
be considered for design in any digital money system or payment
innovation include
:



Ability
to
detect double spending
;



Can’t be counterfeit or copied and used
;



Can be easily verified by receiving party that digital cash is authentic
;



Confidence in the
value and stability
; for pay
e
r and payee
;



Support for dispute resolution


ability to verify payment was made
;

and



Holding back transfer of digital or physical goods and payment until both are verified as
received and good
.


Bitcoin satisfies m
ost

of these motivations and
contains m
any

of the desired design features
.


There are a number of changes that make t
oday’s

environment more favorable to digital cash

than in
the past
. The
Move to Mobile

and the
Cloud
,

and the increased
availab
ility of

processing power makes
secure digital cash solutions more affordable and easier to use.
S
ecurity concerns have increased as
the cyber
-
criminal ha
s

grown in sophistication and effectiveness
, making digital cash schemes that
appear secure and private more a
ttractive
.
W
e are now in the era of Digital
N
atives, people born
into the Internet, Mobile, and smartphones. They prefer to transact over
digital

media for all their
needs and they want more individual control
. This desire and the growing use of
social net
works and
games drive the
demand

for digital cash.
Therefore,

overall the environment is much more favorable
for a successful take
-
up of Bitcoin or some other digital cash alternative.


A real threat to Bitcoin use
could be
the development of other, superior virtual currencies, which
could supplant Bitcoin and render it obsolete and valueless.
Certainly contenders are emerging.
Two



24

http://www.fincen.gov/statutes_regs/guidance/html/FIN
-
2013
-
G001.html
.

25

Douwe Miedema
, “
U.S. regulator mulls setting rules for digital currency Bitcoin,


(
May 6, 2013,
http://www.reuters.com/article/2013/05/06/bitcoin
-
regulation
-
idUSL2N0DN1WW20130506
).

26


Bitcoin
-
Central backtracks on PSP claims,


(
07 December 2012,
http://www.finextra.com/News/FullStory.aspx?newsitemid=24361
, Bitcoin
-
Central has now backtracked on its original
claims, revealing that it has not become a registered PSP but will offer th
e new services thanks to a partnership between
its parent company Paymium and Aqoba, which is a registered PSP
).

5


recent examples are Kurrenci and Amazon Coins.
Kurrenci
27

is a virtual currency for use online t
hat,
unlike Bitcoin, is working within the established financial system.
Kurrenci is registered with the
federal government as a money services business and registered in 48 states as a licensed money
transmitter. It has fully fleshed out AML and KYC polic
ies.
Amazon has announced Amazon
Coins
,
28

a
new virtual currency and an easy way for Kindle Fire customers to spend money in the
Amazon Appstore
.

Apple has filed patents in this area, so we might see some digital cash
-
like
offering coming out from Apple in
the near future.
Digital cash implementations could be tied to a
currency (e.g. U
.
S
.

d
ollar) rather than float in value relative to national currencies as Bitcoin does.
Indeed
,

some bank or government originated version of digital cash could appear

as disc
ussed in a
recent Cnet article
.
29

Will Bitcoin or some successor succeed this time around and will it have a
significant impact on the status quo? Quite likely,

but
w
e tend to overestimate the timescales for
adoption
and

underestimate the long
-
term impact.


There are other
payments related
innovations on the horizon worth watching as well
, such as
Crowdfunding
.
Crowdfunding
30

websites helped companies and individuals worldwide raise $2.7
billion from members of the public in 2012
. This represents

an 81 percen
t increase
from

the
previous year
.
31

As banks rein in lending due to tougher capital rules and greater regulatory scrutiny,
crowdfunding, which originated in the United States as a way to raise money for creative projects,
has expanded rapidly as an
alternative source of finance.

Many websites now offer small investors
the opportunity to earn interest from lending money either to individuals or small business
. O
thers
allow people to invest as little as $15 in companies in return for an equity stake. W
hile the size of the
market still pales in comparison to bank lending to small
-
and
-
medium
-
sized firms it is growing.

I
nnovations such as digital cash and crowdfunding can create synergies that can drive up the
demand for each other

as they grow in use
.
So,

with the likely future advent of electronic cash,
crowdfunding and other such innovations, i
s today’s mono banking culture on the way out?


Some say yes, only time will tell.




27

https://kurrenci.com/visitorpage.aspx?ReturnUrl=%2f
;
http://abclocal.go.com/wpvi/story?section=news/consumer/save_with_6abc&id=8974018
.

28


Amazon Coin Launch: Revisiting Micropayments and Virtual Currency,


http://247wallst.com/2013/02/05/amazon
-
coin
-
launch
-
revisiting
-
micropayments
-
and
-
virtual
-
currency/#ixzz2RDTXDonk
.

29

Molly Wood
,


Here

s why Bitcoin is the future of money, commentary Bitcoin may not last, but crypto
-
currency is
here to stay


it

s only a matter of time before a government replaces paper with more traceable, secure digital money.
But is that a good thing?,


(
April 2
9, 2013 1:01 PM PDT,
http://news.cnet.com/8301
-
31322_3
-
57581952
-
256/heres
-
why
-
bitcoin
-
is
-
the
-
future
-
of
-
money/
).

30

Crowd funding (alternately crowd financing, equity crowdfunding, or hyper funding) describes the collective effort of
individuals who network and pool their money, usually via the Internet, to support efforts initiated by other people or
organizations. Cr
owdfunding is used in support of a wide variety of activities, including disaster relief, citizen journalism,
support of artists by fans, political campaigns, startup company funding,

motion picture promotion, free software
development, inventions developm
ent, scientific research, and civic projects,
http://en.wikipedia.org/wiki/Crowd_funding
.

31


Global crowdfunding volumes rise 81 percent in 2012,


http://www.cnbc.com/id/100623238
.