Bitcoin represents change, how much better is it?

By Russ Wiles The Republic | azcentral.com Sat Feb 15, 2014 6:52 PM

Imagine that moment, maybe 3,000 years ago, when an artisan in the Middle East one day got paid not in grain but in shiny silver coins. Or that time in Colonial America when a weaver or blacksmith received wages not as coins but in freshly printed paper currency.

Both events, or something like them, marked major milestones in the evolution of money, and they had profound impacts for society and economic development.

Many people think society is now on a similar cusp with digital currencies.

The fact that bitcoins, the most prominent form, marked their fifth birthday this year strongly suggests that digital money is here to stay. Bitcoins still are not widely embraced by the public. They’re also somewhat cumbersome to use, confusing to non-tech geeks and subject to wide price swings. Yet they continue to gain acceptance. Overstock.com recently declared that it would take bitcoins in payment. The Sacramento Kings basketball team is planning to accept them for tickets. Virgin Galactic is taking them for future space flights.

Ajay Vinze, an associate dean and professor of information systems at Arizona State University’s W.P. Carey School of Business, believes digital currencies right now are about where the Internet was in 1993, shortly before it went mainstream and altered human business and communication forever.

“It’s at the early stages of being practical, when everyone’s testing it,” he said. “But once you see 100 million people using it, you’ll take a look, too.”

We’re not there yet. A December primer by the Federal Reserve Bank of Chicago estimated 30 bitcoin transactions happen every minute. That’s well below the 200,000 transactions per minute on the Visa credit- and debit-card network, but bitcoin transactions tend to be bigger in value, and commerce is growing fast.

Many media reports have been skeptical, warning that bitcoin could be a fad, if not a bubble, and pointing to recent wide price fluctuations and security stumbles. BitStamp, a Slovenia-based website that allows users to swap bitcoins for dollars and other currencies, last week fell victim to a cyberattack that forced it to halt withdrawals. Mt.Gox, another large exchange in Tokyo, cited a software snafu of its own that halted withdrawals. The two mishaps prompted one blogger to wonder whether the bitcoin world is ready for prime time.

In a January survey of 1,000 people by TheStreet.com, 76 percent of respondents said they’re not familiar with bitcoin and 79 percent vowed to never use digital currency.

Because of the anonymous nature of transactions, bitcoins also have been implicated in money laundering and other illicit commerce, with federal prosecutors last month filing charges against two individuals for allegedly using the coins to buy drugs.

Yet dollars also are used for illegal activity. And despite these and other setbacks, bitcoin is still around and growing.

It’s already an acceptable means of payment. Could it emerge as a full-fledged currency, perhaps even a dominant one?

Peter Steinmetz, a Valley medical researcher, got intrigued about bitcoins through his interest in computing. Now he uses them to buy gift cards, sold by various online firms, that can be redeemed for groceries and other products at Target and other retailers. Steinmetz has been tracking bitcoins for the past four years and predicts they eventually could supplant dollars, euros, yen and other global currencies. “The long-term prospects are extremely good,” he said.

More businesses are accepting them. The Rose Law Group in Scottsdale last summer announced it would take bitcoins as payment for legal services, apparently becoming the first law firm in the nation to do so. Partner Ryan Hurley said the company has attracted three clients who paid this way.

“It’s a very minor part of our business but an increasingly important one,” said Hurley, who has started to develop an expertise in bitcoin-related law. “Once you go down the rabbit hole, there’s a lot to look at.”

New way of thinking

Ah, the rabbit hole. It’s common to hear bitcoin enthusiasts make a reference to the term from “Alice in Wonderland” because it does require a new way of thinking about money. For thousands of years, humans required something tangible, primarily metal coins or more recently paper notes or plastic cards, as evidence that these monetary objects have value. Confidence has been affirmed by the issuance and regulation of money by governments.

Digital currencies represent a radical break from all that. They provide a way to conduct business through the Internet, person to person, without any involvement by a financial intermediary or government entity. The original paper that conceptualized bitcoins envisioned “a purely peer-to-peer version of electronic cash” that could be sent “without going through a financial institution.”

Transactions can be transmitted across national borders on a nearly cost-free basis. They’re quick, taking 10-30 minutes or so for the community of online users or “miners” to confirm each bitcoin transaction and thus validate that a coin hasn’t been spent previously.

“Bitcoin allow you to send any amount to any person anywhere in the world,” said Steinmetz.

Because bitcoin transactions are direct, with no involvement from the financial system or governments, it raises questions about the role of central banks and other entities. If bitcoin usage catches on in a much bigger way and government influence wanes, that could be good or bad for economic regulation and development, depending on your viewpoint.

If bitcoin develops into a major currency, supporters predict it would be less vulnerable to inflationary pressures, because the supply of coins is designed to increase at a slowing pace and eventually become fixed at around 21 million units.

Governments have been watching from the sidelines so far, although New York’s Department of Financial Services is working on regulations that might cover capital requirements, permissible investments and consumer disclosures. Among the warnings to consumers: Once you make a bitcoin transaction, it can’t be canceled or reversed.

Role of governments

Greater government regulation is a possibility. It’s conceivable that one or more nations might prohibit their residents from using or holding bitcoins.

On the other hand, official government sanctioning of bitcoins or other digital currencies could spur rapid acceptance. Steinmetz thinks this initially might happen in a relatively poor nation that doesn’t want to shoulder the cost of maintaining its own currency. Ecuador abandoned its national currency in favor of the dollar more than a decade ago, and U.S. currency is the de facto standard in Panama and Costa Rica.

The involvement of governments as the bitcoin network matures will be a key development to watch.

“Although some of the enthusiasm for bitcoin is driven by a distrust of state-issued currency, it is hard to imagine a world where the main currency is based on an extremely complex code understood by only a few and controlled by even fewer, without accountability, arbitration or recourse,” wrote Francois Velde, a senior economist who wrote the Chicago Fed primer.

What happens if the Bitcoin network comes under harrassment or attack, especially as the value of the coins increases from current levels worth around $1 billion? “Bitcoin is free of the power of the state, but it is also outside the protection of the state,” Velde wrote.

For bitcoin to gain traction, it will need broader public trust and familiarity. That could be a challenge. Everyone knows that a dollar bill can be accepted and readily used for payment elsewhere. So too for foreign currencies, gold and so on. But what about a monetary unit that’s stored on an encrypted computer file?

Novices also will need to learn how to conduct transactions and protect themselves. You start the process by creating a virtual “wallet” protected by cryptography. You use secret codes or “keys” imbedded on your computer to unlock your wallet so you can spend bitcoins. It sounds weird and rabbit-hole-esque. On the other hand, said Vinze, young adults who are comfortable with the digital world and change in general are among the strongest proponents of bitcoin use.

Internet similarities

The bitcoin system is transparent and jointly controlled by users, much like the Internet. But the mathematical underpinnings, which dictate how coins are created and safeguards put in place, are beyond the understanding of the general public.

“At first it was basically a puzzle contest for cryptographic hobbyists, with a prize for solving an endless battery of puzzles,” wrote Nicholas Colas, chief market strategist at ConvergEx Group, a securities brokerage in New York. “Then, in 2011, bitcoin began to find an actual following.”

Perhaps the comprehension part won’t matter much, assuming bitcoin continues to operate as intended. Most people don’t understand the technical underpinnings of other financial innovations. Hardly anyone thinks twice about buying stuff over the Internet using credit and debit cards that also make use of cryptographic safeguards. The inner workings of the Internet itself are beyond the mental grasp of most mortals.

“Most people don’t want to know how electricity works, either,” Vinze said. “You just want to flip the switch and know that the lights will come on.”

Methods of payment that would have sounded absurd generations ago have become mainstream. The transition from barter to coins was the giant leap, and that was followed in later centuries by a monumental shift to paper currency. Recent decades have seen the rise (and, in some cases, fall) of checkwriting, ATMs, credit cards, debit cards, gift cards, prepaid cards, automatic bill payments, rewards points, point-of-sale swiping, banking on cellphones and more.

People adapt, and they might just be ready for bitcoin.

Bitcoin basics

Here are answers to typical questions about bitcoins.

What are digital currencies? Any currency is a means of exchange, a store of value and a unit of accounting or pricing. But unlike dollar bills, metal coins or silver bars, digital currencies aren’t tangible, with transactions conducted over the Internet. Mainstream currencies are issued and regulated by governments and are recognized as a legal way to pay debts. Bitcoin, the most prominent form of digital currency, doesn’t share these traits.

How long have bitcoins been around? Five years. They were conceptualized in an academic paper written under the apparent pseudonym of Satoshi Nakamoto.

Who owns or controls the Bitcoin network? Nobody owns it while all users control it. Think of it in the same way as the Internet, which is controlled by users following a basic set of rules.

What are bitcoins worth? More than $600 each at present, down from a peak above $1,000 but well above initial prices well below $1. Bitcoin prices fluctuate considerably, but supporters expect they will stabilize. When stability comes, that should support routine commerce rather than speculation. Then bitcoins could become more like dollars, euros, Japanese yen or other mainstream currencies that trade regularly against one another and are primarily used for commerce yet retain a speculative element.

Can I buy things with bitcoins? Yes. The list is relatively small but growing and ranges from merchandise at Overstock.com to tickets for Sacramento Kings basketball games. Smaller, routine transactions aren’t really practical because it takes several minutes for transactions to be authenticated. Customers buying a small item like a cup of coffee aren’t willing to wait that long, explained Ajay Vinze, a professor at Arizona State University. But the day is probably coming when smaller purchases can be made with bitcoins. Also, you can swap bitcoins for mainstream gift cards sold by various online firms or convert them into dollars.

How do I get started? You set up an account by installing a bitcoin “wallet” on your computer or mobile phone. One way to do so is by downloading software from bitcoin.org.

There are mathematical underpinnings to bitcoins. Do I need to understand them? You don’t need to understand them and probably won’t anyway. But one thing to note is that the supply of coins is regulated by individual and collective contributions made to the bitcoin network, through monitoring of transactions and more, said Vinze. Initially, bitcoins were awarded to sophisticated individuals with the ability and computing power to solve complex math equations. Now they’re allocated to or “mined” by parties that perform services for the network.

What are obstacles to greater bitcoin acceptance? There are many. Maybe the biggest is the time it takes for more people to understand how the process works, overcome their fears and start using the coins. As another risk, governments could suppress the market through increased regulation, possibly making transactions illegal. Taxation, assuming it’s even feasible with digital currencies, also represents an unknown.

Are bitcoins safe? That’s a multifacted question that defies a simple answer. On one level, there’s always a danger that the system could be corrupted and bitcoins stolen or counterfeited, though those also are risks for other currencies and methods of payment. On a personal level, users must be able to safeguard their own passwords and computers to minimize the dangers that coins could be taken from them. From a markets perspective, bitcoin values fluctuate against the dollar and other currencies, so there’s a risk prices could fall while you hold them.

One more thing to note: Bitcoin transactions are anonymous and there’s little recourse if you’re not satisfied with a purchase.

Reach the reporter at russ.wiles@arizonarepublic.com or 602-444-8616.