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Bitcoin (Currency)

Bitcoin (currency code: BTC or XBT) is a cryptocurrency where the ‘mining’ and transfer of coins is based on an open-source cryptographic protocol that is independent of any central authority. Bitcoins can be transferred through a computer or smartphone without an intermediate financial institution. The concept was introduced in a 2008 paper by a developer(s) known only as “Satoshi Nakamoto”, widely believed to be a pseudonym, who called it a peer-to-peer electronic cash system.

Purpose

Bitcoin does not have a defined social, poiltical or environmental purpose, although individual users of the currency may use it to further their own personal agendas.

In his paper 1 Nakamoto motivated his conception of Bitcoin by the problem that electronic currencies require a central authority to secure trust (against double spending of a coin) in the currency network, and that the cost of mediation in disputes weighs hard against the possibility to make small casual transactions. Nakamoto writes, “With the possibility of reversal [the payer ‘unspending’ a coin while the payee still thinks he has received the coin], the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need.” In physical currencies the concomitant costs and uncertainties can be avoided, but payments over a communication channel require a trusted party. What Nakamoto pursued was a purely peer-to-peer version of electronic cash that would allow payments to be sent directly from one party to another without going through a financial institution, using a chain of cryptographical signatures. In retrospect therefore, it can been seen that the key achievements of the bitcoin system have been to create a much safer, faster and cheaper payment system that functions both locally and internationally. Also in terms of identity, Bitcoin is pseudo-anonymous, which means that although all transactions are completely transparent in the network it is not provide the personal details fo those involved in the transaction. However, if any of the addresses in a transaction’s past or future can be tied to an actual identity, it might be possible to work from that point and guess who may own all of the other addresses 2.

Community Overview

Bitcoin can be used by anyone with an Internet connection. The media placed particular attention on the association between Bitcoin’s community of users and the, by now closed-down, underground drug exchange ‘The Silk Road’ 3, but as a means of payment it is indiscriminate as to what service or product it is used for. Bitcoins users are widely dispersed throughout the world. Although it is hard to understand the exact number of users ti is widely believed the the majority of users are in the US followed by China and Europe 4. Two groups of stakeholders are important in Bitcoin: miners and exchanges. Miners perform the process of adding transaction records to Bitcoin’s public ledger of past transactions, while exchanges allow Bitcoins to be exchanged from and to legal tender or other cryptocurrencies. Some large exchanges can be be vulnerable to cyberattacks, since forcing them off-line may allow hackers to engage in exchange manipulations 5.

Organisation and History

In January 2009, the Bitcoin network came into existence with the release of the first open source Bitcoin client and the issuance of the first bitcoins, called the ‘genesis block’. The value of the first bitcoin transactions were negotiated by individuals on the bitcointalk forums with one notable transaction involving a 10,000 BTC pizza. In June 2011, Wikileaks, having been frozen out of the traditional payment systems, and other organizations began to accept bitcoins for donations. In February 2013 the Bitcoin-based payment processor Coinbase reported selling $1 million USD worth of Bitcoins in a single month at over $22 per Bitcoin. In October 2013 the FBI seized roughly 26,000 BTC from website Silk Road during the arrest of owner William Ulbricht. Two companies, Robocoin and Bitcoiniacs 6 launched the world’s first Bitcoin ATM on October 29 in Vancouver, BC, Canada, allowing clients to sell or purchase Bitcoin currency at a downtown coffee shop.

For most of first few years, until April 2011, the value of a bitcoin remained well below a dollar and has only been increasing rapidly since January 2013.

In July 2013 the Thai government banned the bitcoin and rendered illegal all activities, including buying and selling Bitcoins, using Bitcoins to buy or sell goods online, and sending or receiving Bitcoins from outside the country. The reason cited was ‘rendered illegal, including buying and selling Bitcoins, using Bitcoins to buy or sell goods online, and sending or receiving Bitcoins from outside the country’ 7.

Impact

Bitcoin has received widespread attention since it took off in 2011. Because of its global application and the rejection of state-issued money by its user base, Bitcoin has caused enthusiasm and concern, entering societal debate in many countries. It has had a limited effect on the promotion of other complementary currencies, however. Siblings of Bitcoin that try to amend its mechanics, such as Freicoin, Litecoin or Feathercoin, have not yet reached critical mass.

In November 2013 the US Senate held 2 hearings, one in the Homeland Security sub-committee and the other at the Banking sub-committee, on what the requirements there were to provide the future regulatory framework. These hearings provoked a large amount of global interest and caused a surge in the value of bitcoin.

Currency Details

Bitcoin in numbers

There are, as of Nov 2013, just over 12,000,000 bitcoins have been mined 8 with a daily number of transations numbering between 60,000 and 90,000 9 and over 1,000,000 bitcoins changing hands daily 10.

Although difficult to calculate exactly it is widely believed that there are over 1,000,000 users in possession of bitcoins 11.

There are thousands of (predominatley online) shops and services, located all over the world, that accept bitcoin with a variety of websites helping users locate places to spend their bitcoins such as –  https://www.spendBitcoins.com/places/

Function and Unit of Account

Bitcoin is in practice used as a medium of exchange. Users pay close attention to exchange rates to fiat currencies when setting or negotiating a price. Most shop owners who accept payments in Bitcoin actually charge prices in Euros (converting fixed Euro prices at current rates to Bitcoin). As such, it has not yet reached the status of a unit of account. Bitcoin serves for many as a speculative means of saving, based on the believe that its overall trend is to gain value while fiat currencies are largely stagnant. This presents large risks since the price of Bitcoin has so far fluctuated largely. Some commentators have characterised bitcoin more as a commodity or secutiry since its value fluctuates so wildly and does not trend with other currencies 12.

Issuance – Backing

New bitcoins are generated by the network through the process of “mining”. In a process that is similar to a continuous raffle draw, mining nodes on the network are awarded bitcoins each time they find the solution to a certain mathematical problem (and thereby create a new block 13). The difficulty of this opreation varies automatically with the overall strength of the network 14. Every four years the amount of newly created units halves until reaching the hard coded amount of 21 million Bitcoins.

A bitcoin is therefore defined “as a chain of digital signatures. Each owner transfers the coin to the next by digitally signing a hash [cryptographic derivation of a chunk of data] of the previous transaction and the public key of the next owner and adding these to the end of the coin.” 15

As for the verification of non-reversal, i.e. a received coin is not being double-spent by the previous owner, the common solution would be to introduce a trusted central authority, or mint, to which the coin must be returned after each transaction, upon which it issues a new coin to the new owner. Only newly issued coins are to be trusted. In Bitcoin, no central authority is in control and master of all transactions, but the whole P2P network follows the transaction history. Bitcoin describes a protocol to publicly announce each and every transaction and for all nodes (computing individuals in the system) to agree on the ‘block chain’, a single history of the order in which the transactions were received.

It has been contended that bitcoins are baked by the processing power needed for the mining process, which confuses the meaning of the term backing. In fact bitcoin is more akin to a fiat currency in that it is not pegged to something (either commodity or currency) for which a bitcoin could be redeemed at all times.

Taxation and Compliance

The Cryptocurrency Legal Advocacy Group (CLAG) stressed the importance for taxpayers to determine whether taxes are due on a Bitcoin-related transaction based on whether one has experienced a “realization event”, generally seen to mean ‘undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion’ 16. When a taxpayer has provided a service in exchange for Bitcoins, a realization event has probably occurred and any gain or loss would likely be calculated using fair market values for the service provided 17.

In August 2013 the German Finance Ministry characterized Bitcoin as a unit of account, usable in multilateral clearing circles and subject to capital gains tax if held less than one year 18.

However the largest concern expressed by regulators around the world is that bitcoin and other cyrtocurrencies could become the medium of exchange of choice for criminals and money launderers. It is therefore vital the all businesses operating as exchanges should make sure that they comply with ‘Know your customer’ and ‘Anti-money lending’ requirements imposed on all payment services. This was the major subject of debate in the 2 senate hearings held in Nov 2013 19.

How it works?

Once a Bitcoin wallet is installed on a computer or mobile phone, it will generate a unique Bitcoin address. This address can be disclosed to others so that they can pay you or vice versa. In fact, this is pretty similar to how email works, except that Bitcoin addresses should only be used once.

Balances are kept up to date through the use of the block chain, which is a shared public ledger on which the entire bitcoin network relies. All confirmed transactions are included in the block chain. This way, Bitcoin wallets can calculate their spendable balance and new transactions can be verified to be spending bitcoins that are actually owned by the spender. The integrity and the chronological order of the block chain are enforced with cryptography 20

A transaction is a transfer of value between Bitcoin wallets that gets included in the block chain. Bitcoin wallets keep a secret piece of data called a private key or seed, which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet. The signature also prevents the transaction from being altered by anybody once it has been issued. All transactions are broadcast between users and usually begin to be confirmed by the network in the following 10 minutes.

References

  1. http://bitcoin.org/bitcoin.pdf
  2. https://en.bitcoin.it/wiki/Anonymity
  3. http://mashable.com/2013/10/02/silk-road-seized
  4. http://www.zerohedge.com/news/2013-05-27/mapping-bitcoins-global-adoption%5d
  5. http://www.wired.co.uk/news/archive/2013-04/26/large-Bitcoin-exchanges-attacks
  6. http://en.wikipedia.org/wiki/Bitcoiniacs
  7. http://www.huffingtonpost.com/2013/07/31/thailand-bans-bitcoins_n_3682553.html
  8. http://blockchain.info/charts/total-bitcoins
  9. http://blockchain.info/charts/n-transactions
  10. http://bitcoinwatch.com/
  11. http://www.taxanalysts.com/www/features.nsf/Articles/C1A7ED502DD2B84685257AAF0056A2A2
  12. http://www.coindesk.com/bitcoin-regulated-commodity-banking-hearing-advised/
  13. https://en.bitcoin.it/wiki/Block
  14. https://en.bitcoin.it/wiki/FAQ#How_are_new_bitcoins_created.3F
  15. http://bitcoin.org/bitcoin.pdf
  16. http://en.wikipedia.org/wiki/Realization_%28tax%29
  17. http://en.wikipedia.org/wiki/Bitcoin
  18. http://en.wikipedia.org/wiki/Bitcoin
  19. http://swampland.time.com/2013/11/18/bitcoin-price-soars-as-the-senate-mulls-regulating-the-cryptocurrency/
  20. http://bitcoin.org/en/how-it-works
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