Re-thinking What We Think We Know About Bitcoin (Part I)

by LeClairRyan
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It’s no surprise that, as the way we exchange information continues to evolve at an ever-increasing pace, the way we exchange value is rapidly evolving too.  This two-part series explores the Bitcoin evolution occurring in the world of electronic payments.

In today’s business environment, we already mostly exchange value digitally—with payment cards or mobile apps linked to our bank accounts.  Most of the world’s wealth is accounted for by 1s and 0s in computer files, not coins and bills.  As the Internet and mobile converge, paying with physical currency and checks with perforated edges is less and less common.

Many still wonder whether alternative digital currency—that is, currency not issued or backed by any government, but available to anyone and regulated by everyone, and capable of nearly instant global transfers—will ever become widespread.  Perhaps there is reason for doubt.  But who would have thought in 1995 that, in just 20 years, more correspondence would be written in e-mails than in all of the letters written in history beforehand?

Of course, much has been written already about Bitcoin.  From the Winklevoss twins, who are staunch supporters, to Mt. Gox, the world’s largest bitcoin exchange from which nearly half a billion dollars (in corresponding Bitcoin value) disappeared, to Silk Road, the underground marketplace where criminals used Bitcoin to finance their enterprises, the general public has formed some common assumptions.  Most popular are that Bitcoin is a highly speculative, volatile, untraceable, Internet currency used only by criminals on the Dark Web.  But perhaps some of these perceptions discount the real potential of alternative digital currency over the next 20 years.

Let’s back up a moment for a short Bitcoin primer.  The Financial Action Task Force (FATF) is a self-described “independent inter-governmental body that develops and promotes policies to protect the global financial system against money laundering, terrorist financing and the financing of proliferation of weapons of mass destruction.”  According to FATF, digital currency “can mean a digital representation of either virtual currency (non-fiat) or e-money (fiat) and thus is often used interchangeably with the term ‘virtual currency.’”  FinCEN, the U.S. agency under the Treasury Department whose “mission is to safeguard the financial system from illicit use and combat money laundering and promote national security,” define[s] currency (also referred to as ‘real’ [or fiat] currency) as:

‘the coin and paper money of the United States or of any other country that [i] is designated as legal tender and that [ii] circulates and [iii] is customarily used and accepted as a medium of exchange in the country of issuance.’  In contrast to real currency, ‘virtual’ currency is a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency.  In particular, virtual currency does not have legal tender status in any jurisdiction.”

In short, all virtual currencies are digital currencies, but the converse isn’t always true.  When we use PayPal, Square, or Venmo, we’re using digital currency (a.k.a. e-money)—not actual coins or bills.  But that digital currency is backed by real currency—or fiat currency.  Therein lies the difference with virtual currency, which is backed by no real currency, and hence by no government.

But virtual currency can be convertible to fiat currency.  Bitcoin, for instance, is a type of convertible virtual currency, meaning “it has an equivalent value in real currency and can be exchanged back-and-forth for real currency.”  But Bitcoin is decentralized, meaning no central bank oversees its exchange or regulates it.  As such, Bitcoin relies on cryptography (i.e., using encryption and decryption techniques) for integrity and security.  Bitcoin is the world’s first cryptocurrency, in addition to being the world’s first decentralized convertible virtual currency, having first been developed in 2009.

Essentially, as explained by the FATF:

“Bitcoins are units of account composed of unique strings of numbers and letters that constitute units of the currency and have value only because individual users are willing to pay for them.  Bitcoins are digitally traded between users with a high degree of anonymity and can be exchanged (purchased or cashed out) into US dollars, Euros, or other fiat currencies, or other virtual currencies.  Anyone can download the free, open-source Bitcoin software from a website to send, receive, and store bitcoins and monitor Bitcoin transactions.  Users can also obtain Bitcoin addresses, which function like accounts, at a Bitcoin exchanger or online wallet service. Transactions (fund flows) are publicly available in a shared transaction register and identified by the Bitcoin address, a string of letters and numbers that is not systematically linked to an individual.  Therefore, Bitcoin is said to be ‘pseudoanonymous.’”

Proponents of Bitcoin think it’s the wave of the future for how we transfer value, while others are more interested in the technology that makes Bitcoin work—called the blockchain.  Arvind Krishna, Senior VP of IBM Research, recently wrote in Forbes,

“[T]he basic mechanics of how people and organizations forge agreements with one another and execute them have not been updated for the 21st century.  In fact, with each passing generation we’ve added more middlemen, more processes, more bureaucratic checks and balances, and more layers of complexity to our formal interactions — especially financial transactions.  We’re pushing old procedures through new pipes. . . . [Blockchain is] a completely novel architecture for business —a foundation for building a new generation of transactional applications that establish trust and transparency while streamlining business processes.  It has the potential to vastly reduce the cost and complexity of getting things done.  Essentially, it could help bring to business processes the openness and hyper efficiency we have come to expect in the Internet Era.”

The transparent trustless payment system that is Bitcoin is unlike our current electronic payment system.  As we have reduced our reliance on tangible currency (coins and bills) to pay for goods and services and increased our use of the digital representation of money (1s and 0s in a computer file), we have developed techniques to verify—or trust—that the digital money exchange is legitimate (not fraudulent) and occurs only once per transaction.  In a typical consumer transaction using digital currency, the transaction occurs seemingly in an instant—from the consumer’s perspective, just as quickly as using cash.  But what the consumer doesn’t see is the back room work done to verify the transaction, which typically involves 6 or 7 levels of authorization among 4 or 5 different parties (merchant, processor, brand, issuing bank, etc.).  And the payment cycle doesn’t end with authorization.  After the transaction, settlement occurs, again involving multiple exchanges of information among multiple parties in the payment processing chain.  Each participant in the chain takes a fee off of the total amount of the transaction, and the merchant receives the remainder.  So, a single digital currency transaction involves many steps and many participants to verify the legitimacy of the transaction, and this occurs in a closed environment, meaning not open for all to see.

In contrast, every transaction that occurs on the Bitcoin network is recorded on the blockchain, which is  a public, distributed ledger.  New transactions are checked against the blockchain to confirm that the same bitcoins haven’t been previously spent.  Whereas fiat-based digital payments depend on multi-party intermediaries communicating in a closed environment, Bitcoin relies on a global peer-to-peer network, composed of thousands of users, to verify the legitimacy of each transaction through the use of public key cryptography.  In short, Bitcoin transactions are verified by solving mathematical problems.  In return for a small fee—usually a fraction of a bitcoin—anyone with the requisite computing power to solve these problems (referred to as “miners”) work together to verify then log each Bitcoin transaction on the blockchain.  Once recorded—in other words, once that block is “placed”—new blocks are recorded, or stacked on top of it, and the blockchain keeps building onto itself.  The presumption is that it’s impossible to tamper with or manipulate a record of the Bitcoin transaction once it’s been recorded on the blockchain, making each transaction irreversible and permanent.  In that regard, Bitcoin is no different than cash.  If I pay for something with dollars, that exchange is irreversible and permanent.  I can’t get that cash back without the party to whom I gave it returning it to me.

Bitcoin is certainly not without its critics, who say there is no need for it.  In other words, it doesn’t solve a problem.  The average person gains no advantage by using Bitcoin (or any other virtual currency) over fiat-based digital currency, according to these critics.  Moreover, they point out that Bitcoin is highly volatile (though its value swings have calmed somewhat, holding between $200-300 all year).  And many think Bitcoin is susceptible to cybercrime (though the instances of hackers stealing Bitcoin are the result of security breaches on the wallet providers and exchanges holding Bitcoins, not the blockchain that facilitates the exchange of Bitcoin).

Right now, some of the criticism may be valid.  Unless you need to instantly send $1 million to someone in China, or you live in a country with an unstable central bank, you’re probably not going to setup a Bitcoin wallet and start using Bitcoins tomorrow.  Most significantly, very few merchants accept Bitcoins (though that list is growing with the likes of Amazon, Overstock.com, Target, Victoria’s Secret, Subway, and CVS).

Still, some think the technology that makes Bitcoin work is the real game-changer, with potential to completely overhaul how we conduct business in an online and mobile society.  In Part II of this article, we’ll take a further look at why the technology is so important, and why it could radically change the future of global payments.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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