Coin of the Digital Realm: Bitcoin and the Future of Virtual Currency

May 22, 2013

Photo: Tomohiro Ohsumi/Bloomberg

The digital currency Bitcoin has become a focal point as business leaders, investors, regulators, and law enforcement seek to understand how the emerging world of virtual currency may change how we think about money, payments and finance.

While government officials scramble to craft rules—or crack down—on the new currency, online merchants and financiers hope to determine what role digital currency may play in the larger financial and trade systems.

Nicholas Colas, chief market strategist at Convergex, suggests that while digital currency experiments like Bitcoin may be relatively small in scale today, they have broader implications for the future.

“Bitcoin is gold for nerds, if you will,” Colas explains in an April interview with Bloomberg TV. “It is something that a whole new generation of people believe in – the online nature of their lives, their economy – and so Bitcoin resonates with them.”

How Virtual Currency Works

Bitcoin, though not the only virtual currency, is the most well-known example of this growing trend. The decentralized digital currency launched in 2009 following the global financial crisis, just as confidence in existing currencies was at a low ebb.

Unlike physical dollars, which can be printed at will by a central bank (thus deflating the value), Bitcoins are designed as a decentralized, limited money supply. The currency’s developers created only about 21 million Bitcoins, which users must “mine” by solving progressively more challenging math problems. Bitcoin miners, often working together in pools, solve increasingly complex math problems to release new Bitcoins into the supply. Bitcoin mining is a highly competitive process that requires substantial computing power, so most Bitcoin users don’t mine, leaving that aspect to the more advanced users.

It’s the decentralized nature of the currency, Colas says, that attracts many users who may distrust the political and banking maneuvers that govern real-world currencies.

“What I think is most ironic and interesting about Bitcoin is that real people put real money into this system, having the same faith in it that they do in a sovereign government,” Colas says in the Bloomberg TV interview. “Would you rather trust an unelected federal official or a decentralized computer system?”

Adding to the Bitcoin mystique is the fact that creator’s identity remains unclear. The currency’s invention is attributed to Satoshi Nakamoto, though it’s uncertain if the name refers to an individual or a team of hackers. (Bitcoins can be broken up to facilitate fractional trading. In honor of the currency’s mysterious origin, these pieces are called “satoshis.”)

Bitcoins are traded through online exchanges, the largest being Tokyo-based Mt. Gox, and users maintain their Bitcoin deposits in a digital wallet (though some tinkerers have actually minted physical Bitcoins, as well). Many online enterprises, and even a few brick-and-mortar businesses, have bravely entered the virtual currency world and are accepting Bitcoins as payment.

In mid-May, Bitcoins were trading around $118, according to Mt. Gox, though the currency is volatile and steep swings are common. 

The Virtual Currency Debate

As with any innovation, digital currency boasts supporters and detractors. Critics argue that virtual currency is high risk, since it’s unregulated and deposits are uninsured. It’s also vulnerable to manipulation and theft by clever hackers, they warn.

Perhaps more ominously, the anonymity and presumed untraceability of Bitcoins could make the currency attractive to those seeking to operate outside the law—think trade in illegal drugs, child pornography, or illicit gambling.

In 2011, Democratic Sen. Chuck Schumer of New York declared Bitcoin transactions “an online form of money laundering,” an early indication that the official response to virtual currency may be something less than subtle. 

Regulators are moving into this digital frontier world. In March, the U.S. Treasury Department proposed new rules to govern digital currencies. And on May 14, officials at the U.S. Department of Homeland Security seized an account tied to the Mt. Gox exchange, arguing that the company must register as a money transfer business.

Bitcoin supporters, however, point to the currency’s promise as a near-frictionless unit of exchange. Many believe a global digital currency will make e-commerce smoother and simpler, opening up new opportunities for legal selling and exchange. And digital natives, young consumers who have grown up in a world of debit cards and electronic banking, are likely to be more comfortable with the concept of a currency that you never see or touch.

There’s also a case to be made for a form of currency that affords a measure of privacy in financial transactions, argues Jerry Brito, a research fellow at the Mercatus Center at George Mason University. Brito notes that in this respect, Bitcoin operates much like traditional cash.

“Cash is also difficult to control: a $100 bill never gets ‘declined,’” Brito writes in a recent Reason Magazine article in defense of virtual currency. “As we move to an all-digital world, we should ensure that we retain some type of digital cash that is not tied to a financial intermediary that can spy on or control transactions—even if, just like physical cash, it is put to nefarious uses.”

A Lasting Impression

Bitcoin and other virtually currencies have rapidly matured into something more than an experiment for crypto-anarchist hackers and libertarian dreamers.

Many of the big players at the intersection of technology and consumerism are watching the experiment closely, and in some cases developing their own currencies. Facebook introduced “Facebook Credits” to facilitate purchases of games and apps through its social network, and in May, Amazon.com launched “Amazon Coins” for use in its online ecosystem. While these proprietary currencies are the polar opposite of Bitcoin’s decentralized philosophy, they suggest the concept of virtual currency is entering the mainstream, and quickly. 

An April 2013 Economist article suggests that Bitcoin may be to digital currency what Napster was to digital music. The MP3 sharing service revolutionized how we consume music, but was waylaid by legal challenges. And just as iTunes and other services institutionalized online music consumption, other digital currencies are likely to follow even if Bitcoin falls.

“Napster and other file-sharing services have forced the music industry to embrace online services such as iTunes or Spotify,” the Economist notes. “Bitcoin’s price may collapse; its users may suddenly switch to another currency. But the chances are that some form of digital money will make a lasting impression on the financial landscape.”

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