Abstract

Bitcoin is an open-source, peer-to-peer decentralized digital currency. Recently, bitcoin has received great attention. Both big and small businesses are trying to integrate the bitcoin system into their operations. Moreover, venture capitalists are considering investing in this growing industry. Also, regulators are working on the issue of bitcoin. This report is going to explain the nature and working mechanism of the bitcoin system. The issue of whether bitcoin could replace traditional currency would be discussed as well.

Introduction

With the development of various information technologies, digital currency becomes more prevalent in the contemporary business world. Bitcoin – a peer-to-peer electronic cash system was introduced in 2008 and has attracted great attention among regulators, policymakers, the black market, and conventional investors. There are both advocators and opponents of such digital currency.

This report is going to focus on the topic of bitcoin. Firstly, the definition and basic information about bitcoin would be introduced. Secondly, this report is going to explain how bitcoin works. Next, this report will discuss whether bitcoin could replace the traditional currency by comparing the similarities and differences between those two kinds of currencies. To finish off, a stance of bitcoin cannot replace traditional currency would be demonstrated for several reasons.

Background Information of Bitcoin

Bitcoin is introduced by one or several unknown programmers under the name of Satoshi Nakamoto in 2008. Bitcoin is made by computers’ processing power and is a form of digital currency. Bitcoin has several features. Firstly, instead of the trust-based model used in traditional currency or digital signature, Bitcoin is based on cryptographic proof. It allows direct transactions between any two entities without involving a trusted third party such as PayPal and MasterCard, which is required in the traditional transaction systems to avoid the problem of double-spending (Nakamoto, 2008).

Secondly, under the bitcoin system, it is impossible to reverse transactions. It could avoid fraud in online payments (ibid). Thirdly, bitcoin is the world’s first decentralized virtual currency. According to Sagona-Stophel (2013) and Calvery (2013), the Bitcoin network has no central hub and does not use U.S dollars or Euros but bitcoins. Brito & Castillo (2013) state that the value of bitcoin is not determined or influenced by gold or government fiat but the value people put on it in an open market, which is similar to the exchange rates between foreign currencies.

How Does Bitcoin Work?

After knowing the basic information and feature of bitcoins, this report is going to explain how bitcoin works. The key of the bitcoin network is its blockchain. In order to avoid the problem of double-spending without relying on a trusted third party, all transactions are recorded in the blockchain under the bitcoin network.

Under such operation, each user has two keys: a private key and a public key respectively. The private key is like a personal password and the public key could be shared with the public. For example, if A transfers bitcoins to B, A would create a message containing B’s public keys and verified by A’s private key.

Everyone could see this transaction and the transfer of bitcoins’ ownership (Brito & Castillo, 2013). This is the way that the transactions are recorded in the blockchain using public-key cryptography technology.  Public-key cryptography ensures all computers within the bitcoin network verify and update transactions constantly.

The above paragraph explains bitcoin’s basic working mechanism – blockchain, this part is going to demonstrate how bitcoins are created and how to get bitcoins. As stated before,  bitcoin is not issued by any institutions but created by computer powers. According to Sagona-Stophel (2013), everyone could create bitcoins by themselves. The creating behavior is called mining and the creators are called miners.

Miners’ computer processing power is utilized to maintain the infrastructure and support the bitcoin network. Miners would receive bitcoins according to the contribution they made in terms of processing power (Brito & Castillo, 2013). Miners often from mining pools and collaborate with each other since mining requires great computing power.

Moreover, some entrepreneurs create unique hardware aiming to mine bitcoins efficiently (Sagona-Stophel, 2013). However, the mining process will not last forever. Only 21 million bitcoins are designed to be circulated in the network. When all the bitcoins are mined, rewards for miners would take the form of transaction fees, which still provide incentives for miners to provide processing power for the network (Brito & Castillo, 2013).

Another way to get bitcoins is to purchase. For example, MtGox.com, the most prevalent and largest bitcoin exchange center, lists sellers’ and buyers’ prices in USD and then match them for further transactions. Additionally, gift cards could be used to exchange for bitcoins. Moreover, users could also contact miners for exchange directly (Sagona-Stophel, 2013).

Whether Bitcoin Could Replace Traditional Currency?

Bitcoin becomes much more prevalent nowadays. According to Cuthbertson (2015), there are more than 100,000 retailers accepting bitcoins and there is a 57% increase in bitcoin trading volume in 2014. The topic of whether bitcoin could replace traditional currency has received great public attention. This report is going to discuss this issue.

4.1 Benefits of Using Bitcoin

Acknowledging the advantages of bitcoin is helpful when analyzing whether bitcoin could replace traditional currency. Firstly, using bitcoin could reduce transaction costs. Since no third party is required in the bitcoin system, transactions are conducted cheaper and quicker. For price-sensitive users such as small businesses, the cheaper bitcoin system may be a great alternative for the credit card which requires considerable costs to retailers (Brito & Castillo, 2013). Secondly, bitcoin is an international currency.

Since the value of bitcoin fluctuates with the value of various currencies, bitcoins could be utilized worldwide. Thirdly, the bitcoin system is beneficial for improving poor people’s life quality. According to Ardic, Heimann & Mylenko (2011), 64% of residences in developing countries are unable to access financial services due to the high costs for traditional financial institutions to open branches in poor areas. Bitcoin could help those poor people to receive the same financial services as others do.

4.2 Challenges Bitcoin Faces in Replacing Traditional Currency

In the short term, it is impossible for bitcoins to replace traditional currency. Firstly, the value of bitcoin is unstable, which makes it difficult to achieve the valuing and exchanging function of traditional currency. The value of bitcoin is determined by supply and demand.

The demand for bitcoin varies over time. However, the supply of bitcoin is relatively inelastic. As mentioned above, the number of bitcoins is limited with a maximum of 21 million, which means that an increase in demand will not lead to additional supply but only a surge in the dollar value of bitcoins. Similarly, a decrease in demand will not result in fewer bitcoin supply but a huge fall in the dollar value (Luther & White, n.d.).

The inelastic supply and volatile demand of bitcoin result in an unstable value. Such value fluctuations make it difficult for retailers to use bitcoins to price products, which means that bitcoin lacks the ability to measure the value of other things. Therefore, it cannot replace traditional currency in short term. Moreover, bitcoins’ value fluctuations provide an opportunity for speculators.

As a result, bitcoin’s function of serving as the medium for exchange declines. Doguet (2013) states that one of the objectives of currency is to facilitate transactions, but not purely for investment i.e. increasing users’ wealth. Therefore, bitcoin cannot replace traditional currency.

Secondly, the bitcoin network is anonymous which makes it a good platform for some illegal activities.  According to Sagona-Stophel (2013), a user of bitcoin could utilize multiple addresses. Moreover, due to crypto technology, it is impossible to decipher individuals from the transaction history.

Additionally, the bitcoin system does not tie to any identifiable information. Therefore, transactions could take place between entities without any identifiable knowledge of each other. Doguet (2013) demonstrates that money laundering, tax evasion, online gambling, illegal drug selling, etc. would be facilitated under the bitcoin system because of its anonymity. Therefore, it is impossible for bitcoin to replace traditional currency in short term.

Thirdly, bitcoin has security problems. There are several incidents of bitcoin theft, for instance, MyBitcoin.com has been hacked and an enormous amount of bitcoins were stolen in 2011 (Jeffries, 2011). It reduces the public’s confidence in the currency (Doguet, 2013). Therefore, bitcoin cannot replace traditional currency unless it could solve the security problem thoroughly and build a reliable image in users’ minds.

Conclusion

To conclude, this report has introduced what bitcoin is and how bitcoin works. The invention of bitcoin is revolutionary since it is the first time that the problem of double-spending is solved without employing a third party. The issue of whether bitcoins could replace traditional currency is discussed as well. Using bitcoins could help to reduce transaction costs, accepting by retailers from all countries, improving life quality for poor people. However, considering the fluctuated value, anonymity feature, and security problem of bitcoins, it is impossible for bitcoins to take the place of traditional currency in the short run.

References

Ardic, O.P., Heimann, M. & Mylenko, N. (2011). Access to Financial Services and the Financial Inclusion Agenda around the World. Policy Research Working Paper, World Bank Financial, and Private Sector Development Consultative Group to Assist the Poor. Retrieved from: https://openknowledge.worldbank.org/bitstream/handle/10986/3310/WPS5537.pdf.

Brito, J. & Castillo A. (2013). Bitcoin A Primer for Policymakers.  Arlington: Mercatus Center.

Calvery, J. S. (2013). Statement of Jennifer Shasky Calvery, Director Financial Crimes Enforcement Network United States Department of the Treasury. Retrieved from: https://www.fincen.gov/sites/default/files/2016-08/20131118.pdf

Cuthbertson, A. (2015). Bitcoin Now Accepted by 100,000 Merchants Wordwide. Retrieved from: http://www.ibtimes.co.uk/bitcoin-now-accepted-by-100000-merchants-worldwide-1486613

Doguet, J. J. (2013). The Nature of the Form: Legal and Regulation Issues Surrounding the Bitcoin Digital Currency System. Louisiana Law Review, 73 (4), 1118-1153.

Jeffries, A. (2011). MyBitcoin.com Is Back: A Week After Vanishing With at Least $250 K. Worth of BTC, Site Claims It Was Hacked. Retrieved from: http://observer.com/2011/08/mybitcoin-disappeared-with-bitcoins/

Luther, W. J. & White, L. H. (n.d.). Can Bitcoin Become a Major Currency? Working Paper. Retrieved from: https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2446604

Nakamoto, S. (2008). Bitcoin: A Peer-to-Peer Electronic Cash System. Retrieved from: https://bitcoin.org/bitcoin.pdf

Sagona-Stophel, K. (2013).  Bitcoin 101 How to Get Started With the New Trend in Virtual Currency. Retrieved from: http://www.trssllc.com/wp-content/uploads/2013/05/White_Paper_Bitcoin_101.pdf