Bitcoin: An Experiment in Digital Currency
This is a paper that I wrote for my Writing 340 class at USC in December 2012. Posting here for reflection and to offer insight into why I got into crypto.
In 2008, a report entitled Bitcoin: A Peer-to-Peer Electronic Cash System was published anonymously under the pseudonym Satoshi Nakamato. The paper proposed the development of a digital currency which would “allow online payments to be sent directly from one party to another without going through a financial institution.”1 A detailed description of the technology behind Bitcoin (BTC) is a topic for another paper (the Bitcoin Wiki2 is a great resource for newcomers,) but when trying to wrap your head around the concept of a digital currency, it is useful to keep in mind peer-to-peer or “p2p” music file sharing services such as Napster that gained prominence in the early 2000’s and enabled individuals around the world to share their music libraries resulting in the eventual creation of a free decentralized database of nearly every known song released by a major record label and a number of independent artists. None of the files were actually stored on Napster’s central servers; they simply provided the program that would enable users to share with each other, a fact which made it initially difficult to pursue legal action against Napster and its users.
As the title of Nakamato’s paper suggests, Bitcoin also relies on a peer-to-peer network for operation. After downloading, installing and running the free software you are connected to a network of every other machine that happens to be running the Bitcoin client. The first step towards receiving actual Bitcoins is to create a wallet address, a unique and randomly generated 27-34 digit string of letters and numbers which can be used to receive payments. Wallets are created with the click of a button, you can create as many as you like, and assign labels for each one. Sending transactions is just a matter of knowing the wallet address of the person who you wish to send funds to, pasting it into a box and hitting the send button. The Bitcoin software also acts a ledger, keeping a record of every transaction made over the entire network and verifying each transaction in near real time.
This process of transaction verification across the network requires a lot of computing power resources and would take a lot of time and money if it were performed by a single entity. Fortunately, transaction verification is actually performed by the passive activity of Bitcoin users who choose to perform a process called mining, defined as “ the process of validating transactions by using computing power to find valid blocks (solving complex mathematical problems.)”3 In return for every solved problem the miner is rewarded with 25 new Bitcoins. While the mining process can theoretically be performed by anyone, and getting started is a simple matter of downloading and running a separate mining application, the process is slow and anyone using a standard consumer computer would find little success, considering they are competing directly with individuals who have entire operations dedicated to mining. Efficient mining requires top of the line computer equipment, and most miners build custom computers for the job. A Bitcoin “mining rig” (just a fancy name for a computer optimized for Bitcoin mining, anyone with the knowledge to put together a computer can build one) from Butterfly Labs (a private company with no ties to Bitcoin) can run from $599 to $15,2954. Bitcoin advocates like to emphasize that this decentralized mining process is the only mechanism through which new Bitcoins can be created, which ideally democratizes the process of money creation, taking that power out of the hands of any individual or small groups.
The first Bitcoin client was released in January 2009, and the first real Bitcoins were brought into existence. The project remained obscure for the first two years, receiving little attention, and the price of a single Bitcoin remained consistently under one dollar. Activity was limited to the actions of a small community of individuals; one example of early activity came when a coder bought 10,000 Bitcoins for $50, then setup a website and started giving them away for free as means of promotion. Another early transaction involved a man in Florida paying 10,000 Bitcoins for two Papa John’s pizzas (the Bitcoins were sent to a man in London who then used his credit card to order the pizza for his seller across the pond.) In 2010, the first major Bitcoin website, Mt. Gox (mtgox.com,) was launched, allowing users across the world to exchange their Bitcoins for dollars and other major currencies for a fee.
By April of 2011, Bitcoin had started to receive media coverage and attract more users, and by June the price had jumped up to $33/BTC. This predictably led to an environment of chaos and speculation and the good times ended quickly as the price dropped back down to $17/BTC by the end of the month and under $3/BTC by September. At this point people started to question whether or not this was the end for the Bitcoin experiment considering the extreme instability and volatility demonstrated, not to mention the various security issues raised by a digital currency. In August one Forbes writer wrote, “There’s no logical stopping point to Bitcoin’s price decline…This process has been going on for a couple of months, and now it appears to be accelerating. I suspect it’s terminal.”5His sentiments were echoed by the majority of major news outlets most of which also predicted Bitcoin would never recover.
Over one year later, and Bitcoin is once again receiving attention not just from journalists, but also lawmakers and financial regulators as well. The price has been growing at a steady rate since January and currently is sitting at $13/BTC. There are currently around 10.5 million Bitcoins in existence making the total value of the Bitcoin economy easily over $100 million.6 A number of small businesses and websites are starting to explore Bitcoin as a payment option, and the community is showing no signs of giving up. October, 2012 marked a significant milestone in the history of Bitcoin, when the European Central Bank (ECB) published a report on what they refer to as “virtual currency schemes” in which Bitcoin is mentioned 183 times and is featured as a case study. The report highlights concerns that digital currencies like Bitcoin could “have an impact on price stability and monetary policy” and “In an extreme case, could have a substitution effect on central bank money if they become widely accepted.”7So, why is a central bank for the world’s largest economy bothering to investigate a digital currency which just a year ago appeared to be on the brink of collapse?
For central banks, Bitcoin represents a potential future threat to stability and control if (and that is a huge if) it continues to grow at a steady rate and eventually is adopted by a significant number of people. In a response to the ECB’s report, entitled The Gloom of Central Banking, the author summarizes the major reasons why this could be an issue. For one Bitcoin, is a non-fiat currency (fiat currencies have value only because they are issued by a government whom the users trust and are not backed by a commodity.) Clearing is extremely fast and happens over a decentralized p2p network, and as a result Bitcoin can essentially operate independently from the banking system. At the end of the day, a lot of it comes down to the simple fact that there is no central authority that issues Bitcoins. As stated in the ECB report “[Bitcoin supporters] generally see Bitcoin as a good starting place to end the monopoly central banks have on the issuance of money,”8a goal whose merits could be argued indefinitely.
The role of central banks and the use of fiat money has been the subject of debate among economists for decades. The issuance of purely fiat currency by central banks is a relatively new phenomenon; historically all major currencies were backed by something, typically a commodity such as gold or silver. It was not until the 20thcentury that the widespread use of printed fiat money became common. The debate reached a peak in the period leading up to World War 2 and is illustrated by the relationship between two rival economists, John Maynard Keynes (whose works are the foundation for what is now known as Keynesian economics), and Friedrich Hayek, (the most prominent representative of the rival Austrian School of Economics at the time.) Economists who lean towards the Keynesian school of thought generally assert that government spending and the printing of fiat money by central banks are effective tools for fighting economic recession. Those who sympathize with the Austrian school of thought argue that overuse of these policies will result in a misallocation of resources, dangerous levels of inflation and generally tend to question the utility, nature, and intent of modern central banks .
Once the war began there was no choice but to ramp up the printing presses and as we all all know after winning the war, the U.S. enjoyed a long period of economic stability. The ideas of Keynesianism were credited for the economic book, and the ideas of the Austrian school were essentially discarded, that is until recently. Today, largely as a result of opportunities created by the internet, the ideas of the Austrian school are experiencing somewhat of a revival as skepticism of central banking policy grows. And, while the claim of the ECB that Bitcoin has its roots in Austrian Economics may not be entirely accurate (the term is not to be found in Nakamato’s original paper,) proponents of non-fiat currency could not have hoped for a better experiment with which to demonstrate the possibilities opened up by a decentralized privately issued currency.
At the end of the day, speculation about the potential future impact of Bitcoin is useless unless a larger number of people and businesses have good reason to use and adopt Bitcoin. Until then, any notions of the currency affecting change in monetary policy or the world economy are fantasy. That is not to say that there is not a lot of exciting activity happening within the Bitcoin community. A number of users on the web store Etsy have chosen to accept Bitcoin. Localbitcoins.com is a useful website which helps users connect with nearby individuals who are interested in buying or selling Bitcoins, a great resource for those who wish to liquidate their Bitcoins into traditional currency, not to mention allowing for a unique way to convert currency while travelling. Bitpay.com helps businesses to integrate Bitcoin payment systems, and currently has over 1,500 customers in 100 countries. Coinabul.com allows users to purchase precious metals, Bitcoinstore.com has a large selection of electronics laptops, monitors, etc. for sale, and Bitcoinin.com has an impressive collection of books. Mark Warden, a recently re-elected state representative from New Hampshire decided to accept Bitcoin donations during his most recent campaign.9 In August, the Bitcoin Foundation, backed by established entrepreneurs and Bitcoin enthusiasts launched and announced its intention to standardize, promote, and protect the Bitcoin protocol. According to a recent Businessweek article, Iranians, who are currently suffering under heavy economic sanctions and witnessing the rapid devaluation of their currency, are starting to explore Bitcoin and are “resorting to virtual currency to move money into and out of the country in a way that Western authorities find hard to detect.”10Bitcoin has proved useful for Iranians families who are looking to move their money abroad, software developers looking for payment, or simply for those looking for temporary storage for their cash to avoid the effects of inflation.
One of the most significant adoptions of Bitcoin by a legitimate business came in early November 2012 when Wordpress announced that they would be accepting payments in Bitcoin. Wordpress is a popular website and blogging platform used by over 57.8 million websites and Wordpress.com is the 22ndmost visited website in the world. It is the platform used by The New York Times, CNN, Reuters, Ted Talks, the NFL, UPS, and several other well-known organizations, not to mention being one of the top choices for bloggers across the world. They provided a powerful endorsement for the currency and its community in their press release: “With Bitcoin we join a new digital economy that doesn’t leave anyone behind, essentially making financial transactions open source — something WordPress.com is behind 100%. We’re proud to support bloggers from all over the world by providing a Bitcoin option.”11
So, why should you use Bitcoin? If you are not intrigued by the concept, there is honestly probably no reason to. Bitcoin is far from perfectly secure and coins can be definitely be stolen through hacking. It is still not very user friendly, and at the end of the day there’s absolutely nothing to guarantee value won’t plummet, not to mention the very limited marketplace of available goods and services. However, just because it is not yet worth adopting, does not mean it is not worth watching. Gavin Andresen, co-founder of the Bitcoin Foundation put it nicely: “Bitcoin is an experiment. Treat it like you would treat a promising internet start-up company: maybe it will change the world, but realize that investing your money or time in new ideas is always risky.”12Bitcoin certainly has helped to foster productive discussion regarding the role of central banks, the nature of monetary policy, and whether or not there is better way for society to approach money. The fact that policy makers at central banks, (who in many ways wield just as much power as political leaders) are taking it seriously, is proof of the real future potential for technology to change the way we think about money just as it has transformed communications, the entertainment industry, and so many other aspects of modern day life.
1 Bitcoin: A Peer-to-Peer Electronic Cash System p.1
2 https://en.bitcoin.it/wiki/Main_Page
3 Virtual Currency Schemes P. 34
4 http://www.butterflylabs.com/products/
5 http://www.forbes.com/sites/timothylee/2011/08/07/the-bitcoin-crash/
6 http://www.theverge.com/2012/11/28/3701434/total-number-of-bitcoins-hits-10-5-million-production-halves-to-stop
7 Virtual Currency Schemes P. 33
8 Virtual Currency Schemes p.22
9 http://www.markwarden.com/page/bitcoin-donation
10 http://www.businessweek.com/articles/2012-11-29/dollar-less-iranians-discover-virtual-currency
11 http://en.support.wordpress.com/bitcoin/
Works Cited
European Union. European Central Bank. Virtual Currency Schemes P.27. European Central Bank: , 2012. Print. <http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf>.
Jeffries, Adrianne. "Total number of Bitcoins hits 10.5 million, production halves to stop inflation." Verge. 28 2012: n. page. Web. 9 Dec. 2012. <http://www.theverge.com/2012/11/28/3701434/total-number-of-bitcoins-hits-10-5-million-production-halves-to-stop>.
Lee, Timothy. "The Bitcoin Crash." Forbes. 27 2011: n. page. Web. 9 Dec. 2012. <http://www.forbes.com/sites/timothylee/2011/08/07/the-bitcoin-crash/>.
Nakamato, Satoshi. "Bitcoin: A Peer-Peer Electronic Cash System." Bitcoin- P2P Digital Currency. Bitcoin.org, n.d. Web. 9 Dec 2012. <http://bitcoin.org/bitcoin.pdf>.
Raskin, Max. " Dollaer-Less Iranians Discover Virtual Currency." Businessweek. 29 2012: n. page. Web. 9 Dec. 2012. <www.businessweek.com/articles/2012-11-29/dollar-less-iranians-discover-virtual-currency>.
Warden, Mark. "Donate Bitcoins to the Campaign." Re-elect Mark Warden State Rep. N.p., 09 2012. Web. 9 Dec 2012. <http://www.markwarden.com/page/bitcoin-donation>.
Wordpress, . "Pay Another Way: Bitcoin." Wordpress.com. Wordpress, 15 2012. Web. 9 Dec 2012. <http://en.blog.wordpress.com/2012/11/15/pay-another-way-bitcoin/>.