Bitcoin At Crossroad

Bitcoins, the peer-to-peer currency with no central bank, based on digital tokens with no intrinsic value, appears to be headed where no other virtual currencies has gone to date. Its lack of centralization mirror that which has defined the internet to date but also represent new challenges for regulators.

First mentioned in a research paper written under a pseudonym 5 years ago Bitcoin has, in the last year, moved from the domain of crypto-geeks to a more mainstream type of adoption. Today, companies are offering specialized computers and chips to “mine” bitcoins, and many middlemen have emerged to help turn it from an interesting math problem into a useful currency that can be used to purchase items or make donations. A new ecosystem has arisen around the currency with both good and bad actors.

This has forced governments and regulators to scramble and define how the new currency fit into the global regulatory framework. In March, the Treasury’s Financial Crimes Enforcement Network (FinCEN) issued regulations that would require people mining bitcoins for financial gains to register with the government. A couple of month later, the Kenyan government gave its approval to a project linking bitcoin to M-PESA, a popular mobile currency in that country. By August, the German government had essentially recognized bitcoin as a real currency sitting alongside the euro and the dollar.

And by late November, the US Senate was holding hearings on the currency that were described as a “lovefest” and US federal reserve chairman Ben Bernanke gave the currency some extra legitimacy by mentioning its potential as an alternative currency. A recent note by the Chicago Federal Reserve concluded that Bitcoin “represents a remarkable conceptual and technical achievement, which may well be used by existing financial institutions (which could issue their own bitcoins) or even by governments themselves,” a rallying cry to all central bankers that the currency could be a very strong emerging standard that needs to be regulated.

All this has added up to Bitcoin becoming a new hope in the long road to creating a virtual currency. That road is littered with the corpses of many previous efforts, dating back to the early days of the commercial internet: Digicash, Ecash, Beenz, Flooz, Linden Dollars, and Qcoins were all heralded once as the new currency to be born out of the internet and unattached to any governments. Digicash ended up being acquired by Ecash, which itself was acquired after the dotcom crash; Flooz collapsed after the FBI found it was used as a tool for credit card fraud; Beenz turned itself into a reward scheme; the Linden dollar met with the same kind of enthusiasm as bitcoin did but didn’t get widespread acceptance beyond its initial base of Second Life; and the Qcoins set China on fire, even leading the Chinese central authorities to complain about its impact on the Yuan.

Each of these case is instructive about the roadmap for bitcoin.

Regulatory Issues

Over the next few months, expect a lot more legal activity around bitcoins. The currency has already received some negative press due to criminal activities being performed with it (in truth, all successful technologies have good and bad uses so one may consider this as another validation point): In 2011, security firm Symantec noted that criminals were using computer trojans to create botnets that could use a victim’s computer to mine bitcoins; Earlier this year, US authorities seized assets from Mt. Gox, the leading bitcoin exchange, arguing it was being used for money laundering; In October, Silkroad, a sort of ebay for drugs and other illegal goods was shut down, throwing a pal on Bitcoin as it was the currency of choice for the marketplace. These have led prominent politicians like New York state senator Chuck Schumer to look at bitcoin as a money laundering tools while some senatorial candidates now take bitcoin donations.

So the future of bitcoin may be defined by how well the regulatory frameworks adopt it. With legitimate uses behind it, there is room for the currency to succeed but remember that legitimate uses existed behind every other previous efforts. To meet a better fate than previous cryptocurrencies, the bitcoin communities may have to make certain concession around tracking or identifying bitcoin activity, loosening some of the anonymity that has been a defining element of the currency and potentially making it more like a credit card or paypal type of transaction.

Today, a large part of the financial system is based on understanding and reporting how money flows, with different types of reporting and identification requirements based on the size of transactions.For example, US financial institutions are required to file a Currency Transaction Report (CTR) for every transaction of over $10,000 (at today’s bitcoin rate, it would mean somewhere around 10 bitcoins); donations to politicians or non-profit organizations need to be accounted for for tax purpose so every individual or organizations willing to accept bitcoins as donations must have a way to track the source and size of a transaction; companies that set themselves up as exchanges for bitcoins are treated as money transmitters (or money transfer operators) and fall under other sets of regulations. In order for bitcoin to survive, each element in the distribution chain will have to agree to moving closer to the regulatory framework.

Then, there is the question of threat: when the Qcoin started gaining traction as a mean of transaction, the chinese government started applying pressure on Tencent, the company behind the Qcoin. But as bitcoin is decentralized and does not have an individual corporate owner, expect a fair amount of hang wringing from regulators who generally see threat in the things they cannot control.

Technical challenges

The technology that has made bitcoin successful to date may also represent issues down the road. At the current time, over half of all the bitcoins that could ever be in circulation have been mined, due to a hard limit set into the mathematical algorithm controlling its distribution and limiting the total number of bitcoins to 21 million coins in circulation. That feature has lead to an inflationary bubble in bitcoin to dollar trading, with prices fluctuating largely from one day to the next. As fewer and fewer bitcoins become available through mining, new entrants in the market may be limited, making it more difficult for the currency to increase its overall float.

Today, bitcoin chains keep track of all financial activity in a block. As the currency changes hands, that register gets longer and longer and will require some changes to the protocol in order to go beyond a certain point. And more problems exist from the fact that no compensation exists for people who relay transactions, an important part of what makes the network successful. The increasing cost of relaying such transaction may end up making the currency to expensive to manage outside of a small core group of users. To date, the protocol has been edited several times, with agreement from most members of the community but as the currency grows larger, getting to agreements on changes may take substantially longer.

As the currency is gaining interest, it is already getting more attractive to criminals, who will look for ways to exploit security flaws in order to steal bitcoins. While the algorithm has not been cracked yet, expect increased attempts to find ways to steal or counterfeit bitcoins to emerge over the next few months.

Societal Acceptance

And beyond the technical and regulatory issues is the societal challenge of getting acceptance from the general population. On that end, there is hope as many recent changes have made such currencies more acceptable. The success of the Qcoin in China has led to increased acceptance of bitcoin. In Europe, the generational move to the Euro a decade has gotten individuals to become more attuned to the idea of using a different currency and some seeing the new currency as a great alternative the Euro.

For bitcoin to gain more widespread acceptance, advocates will have to make the case that it is as safe to use as any other form of payment, bringing a message to the masses that this is a legitimate and valid currency that can be used in the same fashion as dollars, euros, or yuans.

To date, the growth of bitcoin has been extremely impressive but the currency now sits at a difficult crossroad: on one side, its backers may have to make concessions to established governments and financial operators, abandoning some of the core features that have made it successful to date (anonymity, artificial limits, etc…); on the other, the community may decide that it will not compromise the core philosophy of the currency, setting itself up for an uphill fight against established actors. As a result, the next 12 months will be ones of transition for the cryptocurrency, defining whether it will be sitting alongside debit or credit as a valid form of payment next holiday season or whether it will be seen as another historical footnote in digital currency history.

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