Monday, January 13, 2014

The Skinny on Bitcoin

Precious metals, gold, silver, copper, have been used as payment for goods and services as early as 2500 B.C.  Such money made of precious metals was called commodity currency because it had intrinsic value, the precious metal which could be melted or shorn on the edges to make gold dust.

Currency circulating today, not backed by gold or silver since August 1971, is fiat currency, created and authorized by governments as their official currency. It has value only because the government says it does and there is faith in that particular government that prints the currency.

The Federal Reserve System (a system of privately owned banks) notes today are backed by the full faith and credit of the United States government. The Fed engages in monetary policy to influence aggregate demand by changing interest rates. To increase or lower interest rates, the Fed sells or buys U.S. government securities on the open market.

In the past, American colonists used to cut up coins in order to make change on the spot. “A half coin was considered four bits, and a quarter coin was two bits.” (Kenneth M. Morris and Virginia B. Morris)

A computer programmer, using the pseudonym Satoshi Nakamoto, created in January 2009 a digital currency called Bitcoin.  This currency does not require a third-party middleman such as a bank, Pay Pal, or Visa.

Even though the identities of the buyers and sellers are encrypted, there is a Bitcoin transaction record in a public ledger. The Bitcoin network is “completely decentralized,” the users execute all parts of the deal. Compared to credit card electronic payments or dollar debit and credit, the use of Bitcoin as electronic currency is relatively small.

Users love Bitcoin because it offers privacy from government intrusion, lowers transaction costs, and affords long term protection of loss of purchasing power from inflation. Inflation has been a serious concern lately. Escalating prices, coupled with endless quantitative easings by the Fed are reasons for that apprehension.

The price of Bitcoin as virtual money can be volatile, theft and fraud are serious fears, and a “long term deflationary bias encourages the hoarding of Bitcoins.”

Congress looks at Bitcoin for its potential use in illegal money transfers and laundering (as if that does not occur already with U.S. dollars), protection of consumers and investors (such stated protection did not help GM and Chrysler bond holders even though they held contracts with legal prior claim), and whether the Fed will be able to control “stable prices, maximum employment, and financial stability.” (The Fed does not seem to be doing such a great job, printing in excess of $85 billion a month to buy bonds, the U-6 is in the vicinity of 13 percent even though the official reported unemployment is an impossible 6.7% when 92 million Americans are unemployed).

From the regulatory standpoint, Congress does not know how to grasp and include Bitcoin under federal securities law and under foreign exchange trading. Two Senate hearings were held:

-          November 18, 2013, Senate Committee on Homeland Security and Governmental Affairs, “Beyond Silk Road: Potential Risks, Threats, and Promises”

-          November 19, 2013, Senate Committee on Banking, Housing, and Urban Affairs, “The Current and Future Impact of Virtual Currencies”

The rub is that Bitcoin is not redeemable for another commodity, it is not legal tender like the U.S. dollar, it is not backed by any government (may or may not be a good thing), and supply is not determined by a central bank (may or may not be a good thing).

Because it relies on cryptography, Bitcoin is also called  a crypto currency. To understand how it works, a primer is available, “Bitcoin: a Primer for Policymakers,” Mercatus Center, George Mason University, 2013.

A decentralized public ledger called “blockchain” is visible to all computers on the network but all account holders’ identities are encrypted - “the public ledger verifies that the buyer has the Bitcoin being spent and has transferred that amount to the account of the seller.”

The ledger resolves the issue of the double spending problem, forgery and counterfeiting, and of the need for a bank or a credit card company.

There are three ways to get Bitcoins once you download the free software:

-          Fiat money such as dollars and euros can be exchanged for Bitcoins after an exchange fee is paid based on the size of the transaction (0.5 percent for a small one and 0.2 percent for a larger one). The online exchanges are Mt. Gox, Coinbase, and Kraken. The price of Bitcoin vis-à-vis other currency is based on supply and demand. Prices are quite volatile – November 2013 price was $200, $1,200 in early December, and $800 in mid-December.( The current price of a Bitcoin is found here (

-          Bitcoins can be obtained to pay for the sale of goods and services - a dentist accepting Bitcoin from a patient who buys dentures

-          Mining as in gold mining (using computer power to find new Bitcoins)

According to Craig K. Elwell, there are 12 million Bitcoins in circulation and the total number that can be generated has been randomly capped at 21 million coins by 2140, with maximum amount of spendable units at more than 2,000 trillion. A Bitcoin is divisible to eight decimals. Purchased or mined Bitcoins are stored in a digital wallet on the owner’s computer or in an online wallet service.

To determine the amount of Bitcoin market capitalization, one multiplies the current value of Bitcoin by 12 million – the result is over $20 billion. Bitcoin daily transactions volume in 2013 fluctuated between $20-40 million, about 40,000 daily transactions.

Bitcoin is still low volume when compared with the money supply, credit cards, and foreign exchange markets:

-          Bitcoin $20 billion

-          U.S. money supply in September 2013 $10.8 trillion

-          Visa in June 2013 $6.9 trillion

-          Daily transactions in 2012 on foreign exchange markets $4 trillion (Congressional Research Service, R43339, December 20, 2013, pp. 6-7)

If Bitcoin takes off, its existence might interfere with the Fed’s monetary policy by impacting the quantity of money, velocity of dollar circulation, and potentially interest rates.

Bitcoin use appears attractive and desirable because of lower transaction costs, more privacy, and no loss of purchasing power due to inflation. However, Bitcoin’s purpose as a medium of exchange is questionable due to its price volatility, Bitcoin is no legal tender, and hacking into Bitcoin account holders can be a problem.

Most economists would agree that a market-based economy runs more efficiently if it operates on one monetary unit as opposed to multiple monetary units.

Because Congress was granted the authority “to coin money and regulate the value thereof” in the Article I of the U.S. Constitution, it is exploring how to oversee and control virtual money such as Bitcoin via tax requirements through the IRS, offshoring, and “Homeland Security confronting the rise of virtual currencies.”

The Senate Homeland Security and Governmental Affairs Committee “envisions a government-wide approach to the threats and promises of digital currency.” SEC will definitely be interested in regulating investing in Bitcoins. The Commodities Futures Trading Commission might consider Bitcoin a “commodity“ and regulate it. The Stamp Act of 1862 and the Electronic Fund Transfer Act might be applicable to Bitcoin.







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