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Bitcoin: The definitive guide

Bitcoin has been the subject of almost no serious analysis despite its popularity in recent years. This guide aims to explore various issues raised by virtual currency schemes including the creation of monetary value, lack of legal basis and oversight and volatility of virtual currencies.

Issues

Creation of Monetary Value

Monetary value is based on trust – if people trust something is valuable then it will have value. People’s trust is linked to how credible it is that a currency is valuable and accepted as a medium of exchange.

Enduring and stable traditional currencies are credible because they are linked to things that people trust and value – Commodity money is considered intrinsically valuable, commodity-backed money is redeemable for bullion, fiat money is tied to the credibility of the central authority, and law guarantees that electronic funds are redeemable for central bank currency.

Virtual currencies are less credible. None of the preceding mechanisms exists to induce people to trust their value. The value of a virtual currency is based only on the trust gained by the virtual currency issuer.

Lack of Proper Legal Basis and Oversight

Virtual currency schemes have no framework legislation and the rights and obligations of different parties are not clear. They are not subject to regulation, oversight or supervision by central authorities. This is clearly unacceptable and creates significant risks to users as well as opportunities for criminals and money launderers.

It will be difficult for central authorities to ban or effectively regulate virtual currencies. States have uncertain jurisdiction over global virtual communities and authorities encounter difficulties even identifying the location of the owners, creators and users of these schemes. It is difficult to target crime and money laundering because online transactions are anonymous and very difficult to trace.

Volatility

 Virtual currencies tend to be volatile and prone to collapse because:

  • Real currencies are affected by the performance of the real economy to which they are linked. This moderates fluctuations in their exchange rates. In contrast, the price of virtual currencies is determined solely by demand and supply in exchange markets and is more likely to fluctuate.
  • Virtual currency schemes are not particularly credible. As argued above, trust in them is not supported by connection to institutions that people trust.
  • They lack legal certainty and users’ rights are unclear.
  • They are prone to security breaches.
  • They are immature.
  • Low volumes of virtual currency are traded. Fluctuation can occur based on purchase or sale by only a few users.
  • Some virtual currency schemes, most notably Bitcoin, are particularly volatile especially insofar as they are a vehicle for speculation.

Monetary policy in the virtual economy can be used to moderate or control the volatility of these currencies. By manipulating the supply of Linden Dollars in the market, Linden Lab manages to maintain the stability of Linden Dollars. Without such interventions, significant volatility of virtual currency seems unavoidable.

Risks Associated with Virtual Currencies

Risks for Users

 Virtual currencies have characteristics of traditional money – they act as a medium of exchange and unit of account in a virtual community. However virtual currencies are not a safe store of value and entail significant risks to users because:

  • They tend to be volatile and susceptible to collapse.
  • Issuers of virtual currency rely only on their own creditworthiness and are not privy to the last-resort loans of central banks.
  • There is no guarantee that users can convert virtual funds to real currency. Virtual currencies have no intrinsic value – if they cannot be converted to real currency they are worthless.
  • Virtual currency schemes and their creators are not subject to proper oversight and prudential requirements
  • There is no proper legal basis for virtual currency schemes and accordingly, users bear all the risks of holding virtual currencies.

Potential Implications for the Real Economy

At present, virtual currencies do not impact the real economy because they are traded in limited volumes and users are spread around the world. However, these schemes are expected to continue to grow due to increasing use of the internet, virtual communities and electronic commerce. If virtual currencies were sufficiently grown to challenge traditional currencies as a medium of exchange, they could substantially impact the real economy in the following ways:

Fluctuations in virtual currencies could be transmitted via the exchange markets into the real economy. This could be a source of potential financial instability if virtual currencies were traded in substantial volumes.

If a virtual currency became widely used as a medium of exchange, they could affect central banks’ ability to implement monetary policy and maintain price stability. Widespread use of virtual currency could cause the following consequences:

  • The amount of central bank money required for transactions would be significantly reduced. Therefore central banks’ ability to influence short-term interest rates would be diminished.
  • It would be difficult for central banks to accurately measure money aggregates and the money supply and effectively target inflation.
  • Transmission of central bank interest rate decisions through the economy could change which could reduce central banks’ control of money and credit development.

Competition to the Central Bank Monopoly on Money Issuance

Dangers

If a virtual currency such as Bitcoin was to operate alongside national currencies in significant volumes, it could undermine the benefits of having a “single unit of account as a common financial denominator for the whole economy” Multiple units of account send multiple, possibly conflicting price signals and complicate transaction for economic decision makers. This effect is worsened insofar as exchange rates for virtual currencies are volatile.

  Theoretical Justifications

Bitcoin is designed as a challenge to central bank monopoly on money issuance. As such, Bitcoin highlights a wider theoretical debate about the nature of the monetary system. Bitcoin has theoretical foundations in two arguments of the Austrian School of Economics:

(1) The supply of Bitcoins does not depend on the monetary policy of a central bank. New Bitcoins are created through “mining” (a technical process of validating transactions by solving complex algorithms that rewards “miners” with new Bitcoins when they solve an algorithm). They are created at a predictable, decelerating pace and the supply of Bitcoins is ultimately limited to 21 million.

Austrian Economists and Bitcoin supporters argue that business cycles arise from monetary interventions of central banks. These interventions lead to an excessive increase in the money supply through the fractional reserve banking money creation process. The excessive money supply pulls down interest rates causing overinvestment and widespread imbalances in the economy. Eventually, the economy enters into recession as firms liquidate investments and change their production to match consumer preferences. The Australia School advocates a return to the gold standard arguing that the limited supply of gold would curb monetary interventions and excessive money creation. Bitcoin’s limited supply is theoretically justified by analogy to the gold standard. Of course, the fixed supply of Bitcoins could also be designed to drive up its price allowing its creators, who presumably hold Bitcoins, to make super profits.

(2) Bitcoin is a starting point to undermine the central bank monopoly on money issuance. According to the economist Hayek, there should be no such monopoly and private banks should be able to issue currency. Competitive forces would eliminate unstable currencies and “a highly efficient monetary system would emerge where only stable currencies would coexist”.

Despite the arguments of Bitcoin’s supporters, various Austria School Economists have criticised Bitcoin’s validity in the Austrian schema. They argue that Bitcoin, unlike gold, has no intrinsic value and does not have roots in a commodity expressing purchasing power. Therefore, Bitcoin does not provide the stable foundation for the monetary system that the gold standard does.

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