Table of Contents
1. Introduction
Right now is the time of excitement as to what will happen with Bitcoin in the next few years, so the topic of this essay will be very important as to the future of Bitcoin; for good or for worse. This excitement can be a lucrative market of financial gain in the future, but in the early stages of Bitcoin, the contributors did not expect that Bitcoin would gain much of a market, or even gain a significant value on its own. In fact, according to the official Bitcoin wiki, one of the contributors spent 10,000 Bitcoin for two pizzas from Papa John’s. Invoice prices in the early days of Bitcoin are a good reminder of the drastic change of value that Bitcoin has gone through. Because transactions with Bitcoin are irreversible, it may lead to a future where an older generation will laugh at the absurdity of how little was paid for something that is worth so much. At the same time, there may be a feeling of regret for those who paid too much for something of too little value, relative to the current state of Bitcoin. These situations are problems still being faced with the young, volatile Bitcoin market, and it is hard to predict what will be done to resolve these problems in the future.
So what is Bitcoin? Bitcoin is a software-based payment system described by Satoshi Nakamoto in 2008, and introduced as open-source software in 2009. Payments are recorded in a public ledger using its own unit of account, which is also called Bitcoin. Payments work peer-to-peer without a central repository or single administrator, which has led the US Treasury to call Bitcoin a decentralized virtual currency. Although its status as a currency is disputed, media reports often refer to Bitcoin as a cryptocurrency or digital currency. Bitcoin is the first fully implemented decentralized cryptocurrency; most other cryptocurrencies are similar and derived from it. It is also the largest of its kind in terms of total market value.
1.1. Definition of Bitcoin
Bitcoin is a digital currency used as a means of exchange over the internet. It is a form of digital money in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. Bitcoin is a type of digital currency that operates only in cyberspace. It can be used to purchase goods and services from anyone willing and is also used to trade on various exchanges. Bitcoin is decentralized, meaning that it is not controlled or owned by any one single entity. It is peer-to-peer and is maintained by a broad network of people connected via the internet. A key feature of bitcoin is that its supply is limited to 21 million. This is in contrast to centralized authority which has the ability to produce currency indefinitely. Step by step, what are bitcoins? Bitcoins is a distributed network, consisting of client software and a public database. The database is called the blockchain and it contains every transaction ever processed, enabling a user’s computer to verify the validity of each transaction. The authenticity of each transaction is protected by digital signatures corresponding to the sending addresses. This ensures all users are aware of each transaction and prevents attempts to double spend coins. Each time a transaction is processed, it is added to the most recent 10 or so blocks on the database. Once a block is full, a small reward is paid to whomever solved the block. Using a block solving is a key component to providing a proof of work, this is critical in sustaining the network. Up until the block reward has reached zero, which is estimated to happen in 2140, proof of work will be used to determine what blocks and what transactions are processed.
1.2. Historical Background
The Cypherpunks mailing list had a very strong influence on the creation of bitcoin. It was formed in the late 90s to early 2000s and had many discussions on philosophy, politics, and cryptographic computer and communication technology. One of the main ideals from the list was the realization that using cryptographic techniques could inhibit a government’s ability to control and monitor the activities of its citizens. By the end of the 1990s, the list had strongly opposed data collection by governments and corporations and had even moved on to ideas of re-establishing privacy rights through activism. This list was the first to provide fertile ground for discussion of how bitcoin could work with Wuala, a secure cloud storage that was using a tentative form of bitcoin and was conceived by a group of cypherpunks.
Since this time, there have been many attempts to detach currency from the control of governments and the central banks. The EU was established in 1995 and set out to create a single currency that is independent of control and debasement by the individual member countries. Then in 1999, David Chaum, an American cryptographer, introduced DigiCash, an encrypted virtual currency which was probably the first attempt we had at safe, private, and non-government controlled currency. Unfortunately, government pressures eventually shut down DigiCash in 1999.
The Bretton Woods Agreement in 1944 established the US dollar as the world’s reserve currency in place of gold. The main representation of money was now based upon the USD instead of physical gold. This agreement also established the International Monetary Fund (IMF) to help rebuild the countries involved in World War 2 and the United Nations (UN) meant to facilitate cooperation in times of international issues or crisis. This decision is largely what has come to form the world that we live in today, with the US right now even being able to fund its continued spending through quantitative easing as the world is still widely using the USD, so it isn’t confronted with the problem that other countries using overinflated currencies face.
2. Advantages of Bitcoin
The second reason is that Bitcoin is cryptographically secure, meaning that it is near impossible to counterfeit or double-spend. The process of mining is essentially the backbone of the Bitcoin network. Miners provide security and confirm Bitcoin transactions. This is done by solving mathematical problems called blocks. When the block is solved, the transactions are verified and combined into the block. A block is given a hash or a set of letters and numbers. This means that once the block has been added to the blockchain, it is set in stone and near impossible to change a transaction from that point on. This is a further reason why it is a secure currency for transactions.
In comparison to fiat currency, Bitcoin is far more secure due to several reasons. Firstly, when a consumer pays a merchant in a transaction using Bitcoin, there is no information given that can be used to steal the payment. Bitcoin is a push type of payment. This means that the transaction can be made without needing any sort of details linked to the consumer. Since there is no personal information required for a Bitcoin transaction, there is no identity theft involved with payments. This makes for a far more secure transaction, and thus the consumer will feel that their data is safe when purchasing goods through Bitcoin.
Decentralization refers to the process of redistributing or dispersing functions, powers, people, or things away from a central location or authority. Bitcoin trading is allowed to be fully decentralized, meaning that the network is distributed and does not have a central point of control. This is a large cause of the continued support of Bitcoin as it gives the currency its security and fault tolerance.
2.1. Decentralization and Security
One of the main draws of Bitcoin is that it is completely decentralized. There is no specific server, company, or middleman to be hacked or shut down, and 51% of the network must still be in consensus (which would require a great amount of collusion) to affect any major changes. While individual Bitcoins are vulnerable to theft (like cash), the transaction network is incredibly secure. Bitcoin is a protocol of information that is passed through the various Bitcoin networks; computers that run Bitcoin software have it as a reference to the protocol that must be in agreement to consider Bitcoin transactions valid. This ensures that the protocol cannot be effectively modified, and that double spending of Bitcoins cannot occur. High levels of encryption ensure that the network is safe from the efforts of ‘crackers’ or individuals who seek to attempt to change the protocol in efforts to steal other people’s Bitcoins. In all, the system is difficult to hack, and when compared to the cost of security for other forms of transaction (usually involving an even higher chance of theft with insurance, legal fees, and various hidden costs), the nature of Bitcoin is much cheaper. The only real threats to Bitcoin as of present are theoretical, future advancements to what is known as a ‘quantum computer’ that could effectively crack the current level of encryption on the network.
2.2. Fast and Low-Cost Transactions
Due to high inflation rates in some countries, people may not have access to a bank account and therefore not have access to digital payment systems. Bitcoin was created to enable a process of mining and earning bitcoin, although there have been questions as to the value and effect the cost of electricity may have on the number of bitcoins earned. It is often more accessible to those who may not have a sufficient bank account and can sign up to various websites for schemes offering bitcoin in return for work done. This can be great for third world or developing countries in order to incorporate themselves within a global economic system. Bitcoin is portable, inexpensive to transact, and can be stored securely, enabling easy access to those in undesirable economic situations. Remittance is a huge market for Bitcoin transactions. Companies such as Western Union or MoneyGram act as a go-between for someone to send money from one place to another. It can be an expensive and timely process, with the cost for a single transaction costing on average 10% of the value sent. This is due to service charges, currency conversion charges, and in some cases, the less favorable rates of exchange. High value needs to be placed on the secure transfer of the funds. With Bitcoin, the actual moving of the money can take place in a matter of hours at a very low cost, making it an attractive prospect for many who need to send money overseas. Bitcoin stored in a wallet can be sent to another person’s wallet in any country with internet access or converted into local currency, enabling significant savings.
2.3. Financial Inclusion and Accessibility
The difficulty linked with access to basic and conventional banking services in many developing countries is well documented. The percentage of people unbanked (those having no access to traditional banking facilities) or underbanked (those having limited access to banking facilities) remains high globally, particularly in some parts of Africa as well as Asia. Reasons for the low penetration of financial services include lack of proper identification, unstable address, and bad credit history. High account maintenance fees acting as a deterrent, unavailability of banking institutions, and in some cases mistrust in the banking system; in countries with high inflation rates people’s trust in banks storing value within their accounts has been eroded due to instances of account holders losing a large portion of their savings. In such countries, to where the majority of international aid is funneled, the primary form of finance comes in the shape of physical money sent via remittance. This method is both costly and riskier for the sender. Bitcoin is borderless and hence presented as an attractive prospect for offering banking services to those who are denied access at present. With the use of a phone or computer, individuals can store and transmit BTC using software as a form of secondary income. Identification requirements are minimal, given that it is possible to operate a software client and receive Bitcoin addresses without accessing the network. Transaction fees can be very small or in some cases free (using certain web wallets) making remittance using Bitcoin a more attractive proposition than current methods, given the risky nature of carrying cash and the high cost of sending money via Western Union. An example of positive action in this area would be the charity Bitgive who operate in various countries worldwide with the aim of improving public health. They will be able to take advantage of Bitcoin’s micro payment capability to complete donation projects that would otherwise be uneconomic.
3. Challenges and Concerns
Despite being a robust and disruptive technology, Bitcoin is not exempt from issues. Its three main problems are volatility, regulatory issues, and environmental damage. Volatility refers to the price fluctuations of a commodity over a certain period of time. Although all currencies experience volatility, Bitcoin is especially erratic – it often increases or decreases in value by 5-10% in a single day. While this is a positive thing for speculative investors and day-traders, it is not conducive for a currency. A lack of price stability discourages using bitcoins as a unit of account for debts and credits and a store of value: for instance, if a transaction is undertaken when 1 BTC = $10 and the same amount is owed at a later date, but 1 BTC = $5, then the debt has essentially doubled. The creditor would also be less than pleased if he found out that the value of the bitcoins owed to him had halved the next day. This is in fact what happened to the first real-world bitcoin transaction for a pizza: back in 2010 when the value of a bitcoin was a fraction of a cent, someone bought a pizza for 10,000 BTC. These bitcoins would now be worth millions, and the pizza guy is probably kicking himself. Price fluctuations of the pizza-loving scale. A less volatile Bitcoin would be a more useful Bitcoin.
3.1. Volatility and Speculation
Finally, a study by Tetsuya Saito and Mehmet Dinc of Keio University on Bitcoin price determination [3] found that price of Bitcoin relative to other currencies is determined more by speculative motives rather than use as a method of making cheap and efficient financial transfers. This implies that if speculative demand were to decrease, it is unlikely that there would be corresponding increase in speculative supply and thus the price would not be stable.
Imagine a scenario where a Bitcoin user made a purchase in January for $1000 worth of goods. If the price of Bitcoin doubles the following month then that user essentially spent $2000. But if the price of Bitcoin were to halve in the subsequent month in expectation of future price decreases then the seller incurred an opportunity cost of $1000 in Bitcoins. This volatility in relation to other currencies may deter businesses from dealing in Bitcoin. In the longer term, price volatility has generally been damaging for Bitcoin. Though it has experienced annual deflation in the price of 25% relative to the US dollar, there have been many speculative bubbles where the price may increase by 200-50,000% over short periods. This means that an entity wishing to hold Bitcoin reserves may have been better off holding USD and simply buying Bitcoins when they were to make a purchase. With higher expected future prices of Bitcoin there is also increased incentive to hoard the currency rather than spend it. This is a rational response and has been cited by Krugman as a problem that a deflationary currency will increase liquidity preference and decrease spending in the short term [2]. The speculative bubbles are the perfect demonstration of Gresham’s law which states bad (inflationary) money drives out good (deflationary) money. Bitcoin essentially behaves as a commodity investment vehicle rather than as a functional currency.
One of the largest challenges facing Bitcoin comes from speculators who greatly increase price volatility. This can, in turn, create feedback loops. For example, higher Bitcoin prices can lead to increased expectations of future price increases. If “suppose that more people buy bitcoins because they expect the price to rise in the future. But the only reason the price is rising is because these people are buying bitcoins” [1] then the price of Bitcoin will inevitably fall when those who expect the price to drop start to sell, creating a speculative bubble. This is a fundamental problem for a currency which by design should be deflationary.
3.2. Regulatory and Legal Issues
Meanwhile, legal issues are further widespread at the private level. For cryptocurrency users, seizure of assets and inconsistent tax enforcement has been prevalent. This contrasts to the US state of Arizona which in May 2018 passed a bill to allow state residents to pay tax by cryptocurrencies; a measure which provides clear legal status and essentially represents legitimization, though may not be applicable in many regions of the world. At the corporate level, lack of regulatory framework and legal uncertainty has deterred potential blockchain adoptions from major companies. A recent report has shown heavily increased preference for private ledger solutions, this has been a safe bet to avoid associating with cryptocurrency. In the summer of 2018, Google moved to reverse its ban on cryptocurrency ads, but would only allow ads to be run by regulated entities in the US and Japan, and for ads to be targeted solely at those specific countries. This reflects an attempt to avoid possible legal issues that advertising non-regulated financial products. In a major tech industry, legal resolution will be necessary for blockchain to progress towards its potential.
The rise of Bitcoin and other cryptocurrencies has been met with both increased regulation and enhanced efforts at legitimizing the technology. Though for now, there still remains no indicator of full acceptance or refusal, the Menell source suggests that “Due to the regulatory ambiguity surrounding digital currency, sufficient time has yet to pass to determine their status and success.” While ambiguity in its status seems to inhibit early financial investment from traditional financial institutions, it is the general consensus that specific regulatory guidelines will advance the process of institutional investment. Progress on this front has not been ideal for cryptocurrency interests. A February 2018 report issued by the European Central Bank provides an impressive in-depth analysis of current EU regulation, it ends up sending mixed signals. While stressing AML compliance, it largely defers regulatory provision to member states, many of which hold starkly differing attitudes to cryptocurrency. This contrasts from the ROC’s recommendation (conveyed through Menell) that more specific regulation should be developed to reduce legal uncertainty and improve enforceability. The aforementioned China mining crackdown and actions of other national governments serve as further testament to Bitcoin’s uncertainty in legal status. While not necessarily a negative, the upcoming year may well be more definitive of Bitcoin’s place in law, an upcoming G20 conference in Buenos Aires Nov 30th-Dec 1st of 2018 is slated to have cryptocurrency on the agenda. France and Germany have issued a joint letter requesting that discussion at the conference be used to create a specific, unified framework for regulating Bitcoin. Canada, a blockchain leader, has made recent statements that they intend to regulate ICOs and cryptocurrency in alignment with AML and terrorist financing protocol. The aforementioned EU report concedes that due to rapidly changing technology, any specific legislation will take time to draft and may well require modification once cryptocurrencies present further clarity on their functionality. This collective effort at global regulation contrasted with past inefficient individually national legislation may well alleviate Bitcoin’s current legal anxiety. Menell argues that this would help to equalize currency status and remove competitive disadvantages enforced through disparate national regulation.
3.3. Environmental Impact
Over the past few years, awareness of the environmental impact of Bitcoin mining has increased. At this point, the impact is so widely recognized that the prospect of Bitcoin moving to PoS to limit its energy use has a noticeable impact on market prices. Researcher Hass McCook recently published an in-depth analysis on the energy usage of the Bitcoin network using data from Suan Mwangagthai, an economics professor that evaluates Bitcoin’s energy usage. The report concludes that Bitcoin consumes at least 40 TWh of electricity per year and possibly more than 80 TWh. The upper bound is comparable to the yearly energy usage of countries like Sri Lanka, Jordan, and the Slovak Republic. The lower bound is comparable to the yearly energy usage of countries like Peru, Hong Kong, or Israel. The report estimates that Bitcoin will use around 0.5% of the world’s electricity by late 2018. This energy usage is comprised of two components. The first and most energy-intensive is the mining network, it consumes ~10x more energy in terms of computations to collect market data because an open market for hashpower implies miners will mine using hardware that is relatively inefficient at the current network difficulty level. This will change as efficiency-seeking competition among miners raises the equilibrium. The second component is the energy usage of the mining hardware. McCook’s study finds the energy usage of mining hardware by determining its lower bound through efficiency ratings and its upper bound through profitability analysis using energy costs. At the current rate, hardware energy usage is proportional to total daily mining revenue, so the cost of one unit of electricity is “1”, and we’ll set the derivatives to revenue equal to zero. The LHS is the rate of change of energy usage w.r.t. change in hardware, and the RHS is the rate of change of revenue w.r.t. change in hardware. Divide both sides by the rate of change of hardware, rearrange, and we have a formula to determine energy use. This analysis produces an upper bound of ~71 TWh and a lower bound of ~30 TWh. In terms of greenhouse gases (GHG), a study by a researcher at the French CNRS estimates emissions at 20 megatons (Mt) per year. This is similar to the GHG emission rate of countries like Jordan and Sri Lanka. It can be expected that GHG emissions are correlated with energy usage, as one would assume miners are using a similar mix of energy from one year to the next. Assuming that Bitcoin continues to use similar energy quantities over the next few years and there are no significant technological advancements in terms of energy efficiency, GHG emissions can be estimated through simple equivalence between energy usage and GHG emissions or through more complex life cycle analysis emissions studies of specific types of energy. At this point, energy usage is excessive. A network with a higher hashrate does not make Bitcoin more secure, only the block subsidy and transaction fees matter. As the block subsidy approaches zero and assuming rational miners, it is a competitive race for fees to out-bid one another. To circumvent a tragedy of the fees with massive price increase and little change in transactions, fees will need to replace the security budget. But if the value of transactions needing security is small, fees are economically inefficient to secure a large amount of value, as evidenced by the low fees in USD during periods of high Bitcoin valuation. Step-wise changes to the Bitcoin PoS are a possible way to mitigate energy usage but obviously the effects of such changes are no longer simulated.
