Bitcoin accepted here? Part 1: Issues and challenges

By John Enoch, UK

Part one of a six-part blog series exploring the history, potential and implications of virtual currencies as they become more widely accepted.

A note on the terminology: In the interests of brevity, I will refer to Bitcoin throughout as shorthand for '€˜Bitcoin and other digital currencies'€™, except where it is necessary to differentiate.

My notes inevitably include oversimplification. This is partly because I am not a technical specialist, but mainly because I want to cover major aspects in a way that is comprehensible to non-experts (like me) and do not have the space or the patience to go into great detail.

bitcoin goldThe advantages of Bitcoin and other digital currencies are clear, and listed elsewhere, but there are also enormous challenges. I would list these as follows:

1. Security issues

I will not go into the technical issues, which are beyond my expertise, but my concern is more with the loss of market confidence that increases with each publicised threat or attack, either on a currency as a whole or on a particular player in the virtual currency market.

The best-known example is the collapse of the trading platform Mt. Gox in Japan in February 2014. It was initially reported that $500 million was lost or stolen (nobody is quite clear which), although apparently a significant chunk was later found in an e-wallet that had previously been overlooked. Other examples include the collapse of Bitcoin bank Flexcoin in March 2014, after the theft of $600,000; and of Poloniex, the same month, with $50,000 stolen.

While not strictly relevant, I like to include the example also of poor James Howells, who is said to have thrown away a hard drive containing keys of $4.6m worth of Bitcoin, as one does…

The launch of auroracoin in Iceland earlier this year illustrates a different type of security issue. A substantial percentage of the envisaged total currency supply was given away for free in advance of the official launch. A concerted attack soon after trading started resulted in a split blockchain, a crash in values and a major loss of confidence in the currency, in an environment that would otherwise have been very promising for high adoption.

Stories such as that of Mt. Gox pose a major barrier to mainstream acceptance of Bitcoin. It will not be enough to improve security (which can, of course, never be fool-proof); the public will have to believe that Bitcoin'€™s security is of a standard good enough to ensure that there is no appreciable risk of their losing their holdings. That is a fairly high hurdle.

2. Reputation for criminal use

The name of Silk Road (and its successors) is often the first thing that comes to people'€™s minds when it comes to Bitcoin. This was a virtual black market that allowed for the purchase of illicit goods with Bitcoin. It was shut down by the US Government, which seized 30,000 Bitcoins in the process. Interestingly, these were then auctioned by the Government on 1 July 2014 (they were bought by entrepreneur Tim Draper), demonstrating that it was how the virtual currency was being used that was considered reprehensible '€” the currency itself was untainted.

Using virtual currencies to effect transactions will continue to be attractive to criminals because of the anonymity it offers. Bitcoin is more convenient than cash in many cases, most obviously for online purchases. However, the argument that this somehow makes virtual currencies evil is a very tired old chestnut. Many goods and services '€” from medicines or investments to alcohol or gambling '€” carry risks to individuals or societies if used wrongly, but they are not banned because of that. Illegal drugs and paedophilia '€” apparently the two main areas catered for by Silk Road '€” are evils that need to be tackled, but the role of virtual currencies is marginal.

3. Volatility

The question of volatility would justify a blog on its own. There is a lot of rubbish said about this subject. Below is a graph of the Bitcoin-dollar exchange rate from approximately the last years (data from Coindesk). It shows that its value was minimal until early 2013, when Bitcoin started to gain some publicity and acceptance. In percentage terms, there was a major bubble already then, followed by a large fall, before the explosion of prices in late 2013.

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Bitcoin v US Dollar Exchange Rate (1 August 2010 to 1 July 2014)

I would argue that this behaviour shows a rational market (which isn'€™t to say it is not a problem). This pattern is not unlike many markets in the early stages of their development (look at oil exploration stocks) or those with uncertain supply, such as the rarer commodities. I am based in Bristol in South-West England, and when I talk about Bitcoin to people here, I refer to the housing market in a local area called Clifton, in the 1780s and 1790s. If there had been an index then, it would have shown a similar pattern '€” nobody was interested initially because everyone wanted to live down by the river. Then, overcrowding drove the first few enterprising individuals to buy houses on the hill overlooking the town; all the merchants then wanted one and prices boomed. Unfortunately for trade and for residents, the outbreak of the Napoleonic wars doused demand and prices slumped. My point is simply that this is not unusual.

The late 2014 surge was quite clearly driven by speculation, but also by rational considerations (which also drove the speculators '€” yes, it is circular). In November 2013, news came that BTC China had become the largest Bitcoin trading exchange. The dream of cracking the Chinese market was up and running. Even more significant, on 19 November 2013, a US Senate Committee hearing was told that '€˜virtual currencies provide a legitimate financial service'€™. This what the market had been looking for '€” an acknowledgement that virtual currencies were legitimate. Prices soared.

The bubble was short-lived. On 5 December 2013, the People'€™s Bank of China prohibited Chinese financial institutions from using Bitcoin, and further restrictions were to follow. This was interpreted as a sign of a crackdown by the Chinese authorities, immediately casting a shadow over the potential of Bitcoin in China in particular, and Asia generally. The price dropped again, but, significantly, not to its pre-boom levels. The fact that the Bitcoin price is still, at the time of writing, at $535 demonstrates, in my view, a market acceptance that virtual currencies are going to enter the mainstream.

Next week I'll look at the regulatory issues and what is needed for merchant acceptance