By Nidhi Mardi

Edited by Namitha, Associate editor, The Indian economist

There has been a tremendous hue and cry in the bitcoin market after the RBI governor Raghuram  Rajan’s warnings regarding the danger of using virtual currencies due to potential money laundering and cyber security risks. The bitcoin market has found a home in Indian financial markets in the recent past making it an ideal avenue for modern tech-savvy Indian speculators and investors. However how many of us actually know about how this system works? Do deflationary currencies like bitcoins have deeper economic repercussions in the long run? Does it have the power to meddle with the Indian financial market? The answer to these questions lies in understanding how this system works. Introduced in 2009 by pseudonymous developer Satoshi Nakamoto, bitcoin is defined as a peer-
to-peer payment network using digital currency. This ‘cryptocurrency’ can be conveniently used for electronic purchases and transfers and makes use of a public transaction log for the purpose. This transaction log tracks every single transaction using bitcoins and works like an ‘audit trail’. This digital transaction log is referred to as a ‘blockchain’ which records the past and present ownership of every single bitcoin in the market. An important aspect that must be understood here is that the Bitcoin is designed to be a finite economic resource. It was initially programmed to self-generate new units if currency at a gradually decreasing pace with the passage of time such that once 21 million bitcoins have been virtually minted, no more can be created. There are people who constantly verify the blockchain, in order to ensure that all the information is correct and the log is updated regularly. Called ‘miners’, they ensure the safety of transactions and are paid by merchants and vendors for their services.

With increasing popularity, however, the primary demand for bitcoins is by speculators who are concerned with making profits by buying bitcoins at lower prices and selling them at higher prices when the market is favorable. Recently, the bitcoin has also become an accepted payment system as it is more convenient than cash payment and has lower transaction fees unlike credit card payment. With more than $1.5 billion worth circulation in the world market, many big companies like WordPress, Overstock.com and Reddit as well as a number of bricks and mortar companies accept bitcoins as a payment method today. Bitcoins are like any other currency; the value of a bitcoin against the dollar is constantly changing according to the market demand and supply for the same. However the primary difference between a bitcoin and any standard currency is that there is no centralized bank that prints the currency or sets its relative values. Now if one wants to get started with transactions using bitcoins, all one needs is a bitcoin wallet and someone willing to exchange bitcoins for goods, services or traditional currencies of other countries.

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Figure 1: The covers a few months of bitcoin value fluctuations against their relative dollar value. It can be noted that fluctuations are wilder in the past few months.

Now if one looks at the economic repercussions of bitcoins one can conveniently call it a deflationary currency, unlike rupees and dollars which are inflationary in nature. This is because bitcoins do not get replaced and added overtime, hence it is analogous to a commodity like gold which has a finite and absolute amount. Many economists believe that deflationary currencies are not healthy as they have the tendency to be stockpiled and have an increased propensity of being hoarded. Having assumed that the bitcoin will be viewed as a valued commodity, its value will continue to go up, as long as the investors hold onto it. In less than a year the value of bitcoin has gone up from $10 to $1000. As per reports by researchers at Palo Alto Research Center at the University of California, Berkley the disappearance of bitcoins is due to both stockpiling as well as outright loss decreases liquidity. This is definitely bad for the bitcoin economy as a whole, as it will make it difficult to make bitcoin transactions active and streamlined for efficiency in online transactions. Many speculators and investors just stock their bitcoin holdings, treating it like some sort of investment in currency, making such bitcoins dormant.

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A recent story that shocked the bitcoin market was that of James Howell, who is believed to having inadvertently thrown away $7.5 million worth of bitcoin when he tossed out an old hard drive containing 7500 units of bit coins. This Welshman’s agonizing story began when he purchased these bit coins in early 2009 when they were initially introduced for less than $6. Because bit coin is a finite economic resource, these lost 7500 bit coins cannot be replaced. This incident highlights one of the primary problems with bit coins is that it’s a vulnerable currency, as one that relies on safety and proper functioning of the hard drives, servers and other storage devices on which bitcoin wallets are kept. Hence handling electronic money is always considered a dicey affair. Having established its nature, it is worth mentioning that the bitcoin market has its own long history of controversies and being associated with illicit activities. The Washington Post recently labeled it “the currency of choice for seedy online activities”. History takes us to late 2012 when FBI reported that “bitcoins will likely continue to attract cyber criminals who view it as a means to move or steal funds”. On one hand in March 2013 the US Financial Crimes Enforcement Network (FinCEN) enforced legal obligations to constrain the “miners” of “decentralized virtual currencies”, and on the other hand in late August 2013, the German Finance Ministry announced Bitcoins as a medium of exchange subject to capital gains tax. The European Banking Authority similarly gave a nuanced approval to bitcoin usage with notices of warnings about the potent dangers of using cryptocurrency. The reason for this cold attitude towards the usage of cryptocurrency by financial regulators is the constant surge of illegal activities and cyber crimes associated with it, especially the case of the Silk Road. The ‘Silk Road’ is an online black market which allowed users to browse the e-market anonymously and securely without potential traffic monitoring. On 2nd was shut down by FBI on charges of alleged murder for hire, narcotics trafficking violation and other illegal activities. It was then noticed that the transactions of the organization were carried out using bitcoins due to the “anonymity of cryptocurrency” and the FBI seized over 26,000 BTC from the accounts on Silk Road, which were worth $3.6 million at the time which is being held to be liquidated only after the legal process is over. Apart from this scam, the past years have seen myriad such incidents of use of bitcoins for online gambling, drug sale and online October 2013, the site guns and arms dealing. As recently pointed out by the European Banking Authority, Bitcoin also is a potential medium for money laundering. The issue was taken up even by the RBI when on December, 2013 they issued an advisory to the Indian public to not indulge in the buying 24th selling of bitcoins. Raids were conducted by the Enforcement Directorate on online platforms for virtual currency transactions like buysellbit.co.in, an Indian online entity assisting in bitcoin transactions, based in Ahmedabad.

It is true that bitcoin circulation encourages illicit activities, but at the same time its virtues cannot be denied. Though economists feel that bitcoins have tendencies towards deflation, defenders have pointed out that bitcoins are designed to be divided to the 8th smaller chunks can be meaded out into the economy. Such defenders go a step ahead and justify bitcoins by stating that a certain degree of deflation is healthy for the economy. They invoke the Friedman Rule which calls on financial regulators to enact interest rates that prevent inflation from decreasing the value of money that is not spent. All said and done, it can be reasonably concluded that it is too early to talk about the deflationary problems. It is believed that the bitcoin market is and will be suitably regulated due to its rapid price fluctuations and government regulation.

Love it or hate it, the bitcoin entity can definitely not be ignored as has been seen with the cold attitude of Central Banks towards it. Virtual payment systems like bitcoins are definitely the future of efficient payment systems for a tech-savvy and gizmo obsessed world. Making bitcoin a ‘forbidden fruit’ has definitely increased its popularity, which we can only expect to increase in the times to come.

Nidhi is currently pursuing Economics in Lady Shri Ram College, Delhi University. She has a keen interest in global economic affairs. An avid reader, she loves writing on various topical issues in economics, politics and international affairs. She loves travelling and considers herself much of a movie buff.

Posted by The Indian Economist | For the Curious Mind