Bitcoin - The Promise and Limits of Private Innovation in Monetary and Payment Systems
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Bitcoin – The Promise and Limits of Private
Innovation in Monetary and Payment Systems
A private initiative that has created a virtual currency and a payment system based on Christian Beer,
cryptography and decentralized management, Bitcoin is considered not only an interesting, Beat Weber1
but also a disruptive technical innovation by many observers. A number of regulatory and
supervisory bodies have issued assessments of the phenomenon, contributing to an emerging
international discussion. Does Bitcoin’s claim to provide useful monetary and payment services
hold up when checked against principles of monetary theory and the economics of payment
systems? We find that while Bitcoin does not rival the established money and payment systems
in their traditional domains, a complementary function is conceivable in niches. Using the
Bitcoin network poses several risks to customers, however. Since this network and financial
services related to bitcoins are not regulated, costumers must take appropriate technical
measures to protect their bitcoin holdings. In case of error and fraud, payments are difficult
to reverse. Furthermore, the significant exchange rate fluctuations could pose a grave risk to
bitcoin owners’ wealth and discourage widespread use for monetary purposes. In a nutshell, at
present, bitcoins can be regarded as speculative assets, and the Bitcoin network might inspire
further innovation in payment systems and other applications.
JEL classification: E42, E52, E58
Keywords: Monetary reform, monetary policy, monetary systems, payment systems, innovation
1
The economic and financial crisis that and section 4 reviews assessments from
had started in 2007 triggered a public authorities. Finally, section 5 concludes.
discussion about the performance of
the financial system. Contributions to 1 Bitcoin – How Does It Work,
this discussion have included innovative and How Does It Perform?
attempts of providing alternative solu- In 2009, a white paper was published
tions for a number of services offered online under the name Satoshi Naka-
by this system (Weber, 2015), with Bit- moto (probably a pseudonym), proposing
coin a prominent example, which has a new solution for something that some
garnered a lot of media attention in the Internet enthusiasts had been looking
last two years. This privately initiated forward to since the beginning of
project, which is based on open partici- the Internet: A form of digital cash
pation, intends to provide a private dig- that functions based on principles dear
ital currency – the bitcoin (BTC)2 – to libertarian strands of the Internet
and a system for transferring payments community – non-state administered,
in this currency. In this article, we decentralized (“peer to peer”) and open
assess the claims of its supporters and source based. In this strand of thought,
the implications of its operation for cryptography and anonymous transac-
central bank goals. tion systems are seen as important
Section 1 describes the way Bitcoin instruments to defend privacy and free-
works and its market development. In dom in the digital age (Hughes, 1993;
section 2 we assess Bitcoin’s claims to Stephenson, 1999). With trust in the
work as a payment system, section 3 monetary and financial system shattered
concentrates on Bitcoin as a currency, by the crisis, Nakamoto’s proposal was
Refereed by:
1
Oesterreichische Nationalbank, Economic Analysis Division, christian.beer@ oenb.at, and European Affairs and Adrian Blundell-Wignall
International Financial Organizations Division, beat.weber@ oenb.at. and Gert Wehinger,
2
“Bitcoin” refers to the system, “bitcoin” and BTC to the unit of account in that system. OECD
MONETARY POLICY & THE ECONOMY Q4/14 53Bitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
taken up in 2009 and implemented by a ing to a specified time path. However,
significant number of supporters. as the reward to miners will be reduced3
Bitcoin offers a purely digital cur- over time, more than 99% of all bit-
rency consisting of strings of numbers. coins will have been mined in about
An open source software provides a 2032. In mid-October 2014, more than
platform where users can produce a 13 million bitcoins were in circulation.
private currency and make payments in Once new bitcoin units are in the
this currency without recourse to banks possession of a member (apart from
and central banks, based on encryption mining, bitcoins can be acquired on
technology. This setup is meant to exchanges or by selling goods or ser-
make online payments comparable to vices in exchange for bitcoins), they can
cash payments offline. be kept or spent if other members
The system is run by voluntary sup- accept them as payment in a transaction,
porters that are attracted and governed or exchanged for official currencies. So
by economic incentives provided by the how are bitcoins transferred among
system architecture. With each supporter members? Bitcoins are stored in anony-
contributing computing power, a net- mous addresses in the form of strings
work is formed. Network supporters containing numbers and letters, equipped
are attracted by the prospect of engaging with two complementary keys, one
in competition over receiving newly public and one private. The public key
issued bitcoins. This process is inspired can be compared to the account number
by gold extraction: Like gold, bitcoins of a bank account, and the private key
are “buried” in the system and may be to the PIN to access such account. If A
unearthed and put into circulation by wants to send a payment to B, A needs
“miners.” The mining process is designed B’s public key and encrypts a certain
in the following way: Every ten min- sum of bitcoins with B’s public key and
utes, the system provides a new amount A’s private key, so that only B can
of bitcoin units. In order to obtain decrypt the payment and make use of
them, network supporters, i.e. miners, the sum. To transmit the payment and,
compete to solve mathematical prob- at the same time, to guarantee that A
lems with a random component. These has not spent the same electronic string
problems are hard to solve, but the of numbers on another occasion (double
correctness of the solution is easy to spending), the transaction partners rely
verify. In each of these contests, the on the network. It performs the func-
competitors coming up with the first tions that payment intermediaries
correct solution receive the newly fulfill in conventional payment pro-
issued amount of bitcoin units. They cesses. Every ten minutes new payment
broadcast their solutions to the whole transaction orders are collected by the
network, where they are automatically system and are verified by the system
verified by other members. supporters. To this end, new transac-
The software provides for a fixed tions are recorded in a public ledger
amount of currency units (about BTC called blockchain that comprises all
21 million). A pre-established technical transactions ever operated in the Bit-
rule ensures the issuance of these units coin system. By comparing the new
into circulation up to about 2140 accord- bitcoin payment orders with the history
3
Initially, the reward for solving a block (a record of recent transaction orders) was set to BTC 50. Every 210,000
blocks – i.e. about every four years (given an average rate of six blocks per hour) –, this subsidy is reduced by 50%.
54 OESTERREICHISCHE NATIONALBANKBitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
Chart 1
of all previous orders, the legitimacy
and accuracy of the orders are verified. Market Price
For various technical reasons, a bitcoin USD market price of the bitcoin on the major exchanges
transaction can only be considered 1,400
secure after a number of confirmations 1,200
in the Bitcoin network. The incentive 1,000
for network members to participate in
800
the verification process is the above-
mentioned mining process. The math- 600
ematical problem to be solved to gain 400
newly created bitcoins or transaction 200
fees depends also on information about
0
the previous blockchain and transac- 2011 2012 2013 2014
tion. Mining for bitcoins therefore also Source: http://blockchain.info.
helps check that new transaction orders
are legitimate and adds these new
transactions to the blockchain. 2013 (see chart 1). It then skyrocketed,
Theoretically, the system offers an reaching USD 1,151 in December 2013,
innovative method for solving the prob- which implied a price increase of
lem of producing agreements among 8,388% in 2013. This enormous price
mutually distrustful parties. Technically, hike can be considered both cause and
this process consumes significant effect of growing media attention and
amounts of computing power and elec- further contributed to the popularity of
tricity. Competition among miners Bitcoin (Salmon, 2013). Recently, we
has led to continuous innovation and have observed a general downward
investment in computer processing trend, with BTC 1 worth USD 384.1
power. Consequently, entry barriers on October 22, 2014.
have risen as well, given the cost of In mid-2014, 41 million addresses
computer hardware and energy, which were registered in the system (Ali et al.,
entails the risk of increasing concentra- 2014, p. 4). As users are able, and even
tion in mining (The Economist, 2013). encouraged, to register multiple ad-
Over time, it will be increasingly in- dresses to retain anonymity, the num-
convenient to save the ever growing ber of actual users is likely to be much
blockchain. Fewer supporters might smaller (Sorge and Krohn-Grimberghe,
therefore be willing to support public 2013). Only 1.6 million Bitcoin addresses
record keeping, which would weaken existing in July 2014 accounted for
the network and make it more vulner- holdings of more than BTC 0.001 (Ali
able to attack. Bitcoin mining continu- et al., 2014, p. 4), which can be inter-
ously drives up energy consumption, preted as being indicative of the upper
and given low energy efficiency, energy limit of any estimate of the number of
consumption per transaction is high Bitcoin users. Given the anonymous
(Sorge and Krohn-Grimberghe, 2013). and global nature of the system, no data
The market price of one bitcoin are available on Bitcoin usage in Austria
unit, as derived from quotations on the or other countries. The “Bitcoin Austria”
most frequented private exchanges, was association4 hosts regular meetings for
relatively flat until the beginning of local Bitcoin users.
4
See http://bitcoin-austria.at.
MONETARY POLICY & THE ECONOMY Q4/14 55Bitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
So far, user traffic has been signifi- ments may involve (substantial) costs.
cant, but still modest when compared However, the advent of globalization
with established payment systems. and digitalization has led to an increase
According to the Bitcoin information of commercial innovation in the retail
site blockchain.info,5 the system had payment market, expanding on the
administered about 50 million bitcoin initial innovation of the credit card
transactions by October 2014. In 2013, (Maurer, 2011; Salmon, 2013). As a
the daily average came to about 60,000 consequence, competition among pay-
transactions (representing a total daily ment service providers has been on the
value of USD 237 million based on the increase over the past few decades. The
bitcoin’s peak valuation in December established business model of inter-
2013). By contrast, the biggest credit mediating electronic payments can be
card provider, Visa, registered 212 mil- characterized as a two-sided market,
lion transactions per day (representing where a payment service provider links
a value of USD 16 billion).6 Given the payer and payee. In facilitating and
anonymous nature of bitcoin transac- recording transactions, the payment
tions, there is no reliable information service provider is faced with a choice
on what they are used for. concerning the allocation of the burden
of fees among payer and payee. In most
2 Bitcoin as a Payment System card payment systems, merchants bear
Bitcoin claims to operate a retail pay- most of the cost charged by the payment
ment system with no need for trusted service provider. Consumers may like-
intermediaries. The latter are perceived wise face significant costs, especially in
to charge excessive fees for payment cross-border consumer-to-consumer
transmission7, to lack adequate protec- payment services (Bolt, 2013). In this
tion of personal financial data (e.g. with context, Bitcoin has positioned itself
regard to credit card fraud or disclosure as a low-cost alternative (Pflaum and
to public authorities) and to expose Hateley, 2014).
customers to financial risk by being With respect to cost, bitcoin pay-
prone to financial crises (Nakamoto ments can currently be made at mini-
cited in p2p foundation, n.d.). In this mal or no financial cost to the two
section, we discuss whether Bitcoin can parties engaged in a payment transfer.
legitimately claim to provide improve- This is possible because the mining
ments on these charges. process described above is devised to
Whereas users have over decades substitute for the role of banks and
become accustomed to paying with other established payment operators
cash at zero financial transaction costs in the Bitcoin system. Instead of a
within national economies thanks to centralized intermediary, the payment
public support for the underlying infra- transfer is operated by miners following
structure, other forms of retail pay- the procedures of the Bitcoin protocol
5
See http://blockchain.info.
6
See http://www.btcfeed.net/infographics/bitcoin-vs-other-payment-systems-daily-transaction-volume (retrieved
on October 28, 2014).
7
According to a survey by the European Commission published in 2012, the European payment card industry
provides the means for consumer payments with an overall value of EUR 1,350 billion per year. Such payments
generate an estimated EUR 25 billion in annual fees (European Competition Network, 2012, p. 17), which
corresponds to an average fee of 1.9%. On the basis of this study, the European Commission started to launch
proposals to regulate the market for card, Internet and mobile payments.
56 OESTERREICHISCHE NATIONALBANKBitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
(engaging in competition to solve prob- transaction fees are of minor impor-
lems, with the byproduct being the tance. Calculations with data from
confirmation and recording of the pay- blockchain.info show that less than 1%
ment transfer). As mentioned before, of miners’ revenues are from transac-
Bitcoin miners incur substantial costs tion fees. However, while successful
for hardware and electricity. Stiffer miners are currently rewarded with 25
competition and greater complexity of newly issued bitcoins, this amount will
the problem to be solved8 imply a decrease to about 0.78 bitcoins in 2032
continuous upgrade of computing power (when about 90% of all bitcoins will
and increased electricity use. Miners have been mined). Whether miners
incur that cost without charging sub- will be able to recover their costs with
stantial fees to customers because such a reward, will depend on the
successful miners are rewarded with bitcoin’s market value and the produc-
new units of the remaining bitcoin tion costs. The reward will eventually
stock. So, the cost advantage for drop to zero in 2140 when the whole
customers is based on systematic cross- bitcoin stock will have been put into
subsidization of the payment system by circulation. Hence, eventually miners
the currency creation process. This will have to fully recover their costs
advantage is dependent on collective from customer fees. To give some
value attributions to Bitcoin being estimates of transaction costs, calcula-
sufficiently high in order for miners tions with the above-mentioned data
to cover their costs (which are due in reveal that, in 2014, miners’ average
official currency). Cross-subsidization revenue (new bitcoins plus fees) per
may also be evident in traditional pay- transaction amounted to USD 37.05
ment systems: Many banks, for instance, (2013: USD 14.59), which is equivalent
allow customers to make payments free to 4.40% (2013: 2.42%) of the transac-
of charge, recovering costs through tion volume. Based on an educated
profits in other areas. Most credit card guess of capital and operating expendi-
operators charge merchants per-payment ture for competitive bitcoin mining,
fees, while customers – apart from a McCook (2014) calculated that, in
lump-sum annual charge – do not pay mid-2014, the costs (capital expendi-
extra for individual payments. In cash tures and electricity, excluding labor
payments, important logistical costs costs) for bitcoin mining amounted to
are borne by central banks and by ATM about USD 600 per bitcoin, which
operators (Schmiedel et al., 2012). basically equaled the market price at
How sustainable is the cost recovery the time.
process in the Bitcoin system? While Because all payment transfers are
there is no fixed charge for bitcoin preceded by a race, where many com-
payments, users can and do offer small petitors attempt to solve the same task,
fees to miners. Because there is no the marginal costs in the Bitcoin system
obligation for miners to include all for verifying transactions is higher
payments in their calculation, more than in centralized payment systems
resourceful miners can be incentivized (Ali et al., 2014, p. 6).
to include a payment when a fee is All this implies that the price
offered, thereby increasing the speed of advantage of bitcoin payments is not
transaction for customers. Currently, based on a cost advantage and is a
8
The difficulty is adjusted in order to keep the average number of blocks solved at six per hour.
MONETARY POLICY & THE ECONOMY Q4/14 57Bitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
transitory phenomenon only.9 More- must either be purchased from third-
over, if Bitcoin is merely used as a pay- party providers or be provided by users
ment vehicle, the costs of exchanging themselves.
legal tender currency for bitcoins and In light of the anonymous and
back must be added.10 decentralized nature of payment trans-
Another important question is fers in Bitcoin, there is no intermediary
whether users of Bitcoin are exposed to to reverse payments that were made
risks. Bitcoin, which does not eliminate erroneously or where counterparties
financial and operational risks to cus- did not fulfill their obligations in
tomers, rather implies a transfer of return. Consumers who want their
risks to the individual. The Bitcoin money back have to pay for third-party
system’s efforts to ensure the integrity escrow services or go to court in the
of the payment system concentrate on case of complaints, provided anonymity
counterfeit control and securing ano- does not prevent such measures.
nymity. Bitcoin attempts to digitally Merchants, on the other hand, might be
mimic cash in terms of anonymity, inclined to perceive the lack of charge-
payment finality, transaction costs and back risks as an advantage. They may
decentralized operation of transfers. To also benefit from the lower Bitcoin fees
prevent double spending, a public compared with card payment services,
record of all transactions is kept against where they usually bear the brunt of
which every new transaction is checked. fees. Also, accepting bitcoins might
As long as users manage to prevent serve as a marketing move to attract
detection of address ownership by out- additional customers and profit from
side observers, transactions can remain the public attention the project receives
anonymous. Anonymity in transactions (Fuchs, 2014; Wingfield, 2013). The “no
could make the system suitable for chargeback” feature of Bitcoin and the
money laundering, tax evasion and the elimination of merchant fees involved in
purchase of illicit goods and services. credit card payments favor merchants.
While other payment systems (apart In contrast, consumers face a compara-
from cash) do not support such ano- bly higher risk of nondelivery, and may
nymity, they typically offer payment or may not be offered discounts by
services as part of a bundle of services. merchants to share in their fee advan-
For example, banks offer deposit taking, tage (Fleishman, 2014; Wingfield,
account keeping, proof of payment 2013). In any case, these considerations
services and chargeback facilities apply mainly to online businesses. In
together with payment services. In the offline retail commerce, undue waiting
Bitcoin system, these services are times result from the fact that a bitcoin
unbundled. The core infrastructure only transaction can only be considered
offers one-way payment transfers and secure after six confirmations in the
counterfeit checks. Related services Bitcoin network. This can be expected
9
The cost disadvantage vis-à-vis centralized systems can induce concentration pressure in the market of bitcoin
miners in order to achieve economies of scale. Such an outcome would defeat the original intention of decentralization
and increase fraud risks (Ali et al., 2014, p. 6).
10
Within the scope of this article we cannot analyze whether there are circumstances where – despite these features
– use of Bitcoin could promote financial inclusion either because of lack or excessive cost of alternatives, e.g.
payments to and within underbanked areas (see Pflaum and Hateley, 2014, for a discussion of the legal
dimension). Of course, Bitcoin is only one of many possible solutions in this regard, as indicated by the success of
money transfers via mobile phones in some regions.
58 OESTERREICHISCHE NATIONALBANKBitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
to take up to one hour, which may in area denominated in the same unit
many cases be longer than customers makes them comparable and enables
are prepared to wait for payment to be the operation of markets. Usually, means
completed (Velde, 2013). of payment are issued as official cur-
In Bitcoin, users must store their rency by a central bank that is in charge
holdings either on their own computer of ensuring the quality and quantity
or in wallets provided by third-party of that money according to a public
service providers. Currently, the latter mandate. In most countries, such a
are private startups not (yet) subject to mandate entails ensuring the functioning
bank-like regulation and the associated of these means of payment as stable and
safety nets. Bitcoin users are therefore most liquid store of value over the short
subject to risks from loss, theft and to medium term. The acceptance of
fraud of their holdings to a greater official currency among the public is
degree than with established service supported by the currency’s exclusive
providers. In February 2014, Mt.Gox, acceptance by the state for the discharge
the biggest Bitcoin trading platform at of tax liabilities and its use by the state
that time, had to close after significant as (one of) the biggest single transaction
amounts of user holdings had been parties in the economy. Apart from the
reported to be lost or stolen (McMillan, central bank, private issuers can also
2014). offer means of payment as long as they
Furthermore, there are significant are accepted by the public. Such private
risks and costs involved in exchanging means of payment, denominated in the
bitcoins for official currency. As there official unit of account, represent a
is no market maker, being able to buy claim on the issuer for official currency.
and sell bitcoins depends on finding a Banks are the biggest providers of
transaction partner on one of the private means of payment, as the bulk
private exchange platforms online. The of daily transactions among economic
exchange rate is very volatile, and the subjects is conducted by transferring
market is rather illiquid. Exchange bank deposits (which represent a claim
charges can be in the order of a few per- on official currency). In their role as
cent (Fleishman, 2014). Many exchanges the biggest providers of private means
closed after a few months, with at least of payment, banks are subject to
one involving severe losses for users regulation, supervision and monetary
(Moore and Christin, 2013). Although policy. The resulting monetary system
various exchanges coexist, there are is a hierarchical construction, where
rarely any arbitrage opportunities, as the state-provided unit of account and
these are outweighed by the cost of means of payment issued in that unit
moving funds between exchanges form the apex of the system, and private
(Gandal and Halburda, 2014, p. 3). means of payment represent claims on
the official means of payment denomi-
3 Bitcoin as a Monetary System nated in the official unit of account.
In economic theory, money is defined The need to maintain the ability to
by three functions: unit of account, keep the promise underlying these
means of payment and store of value. claims serves as a major disciplining
In modern economies, there is a device for the issuers.
single unit of account in every currency While Bitcoin represents one of
area. This is considered to be an efficient many private means of payment, it
solution: Having all prices in a currency entails three peculiarities: It introduces
MONETARY POLICY & THE ECONOMY Q4/14 59Bitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
a separate unit of account, it has no the Bitcoin system, but does not repre-
single and identified issuer and its quan- sent the issuer of the currency.11 The
tity is ultimately fixed once and for all. latter is replaced by a decentralized
Built around the model of gold, the process of mining as described above.
bitcoin is a pure asset not related to The Foundation is based on voluntary
credit creation processes. It has no membership, whose voting and other
central issuer and does not represent rights depend on the size of the fee
anybody’s liability. This implies that its (based on four membership classes with
quantity cannot be adjusted to varia- different rights). Whereas central banks’
tions in demand, and it does not come role in the monetary and payment
with anybody’s promise to convert it system is based on a legal mandate of
into official currency at a certain rate. the polity of the currency area and its
Given its operation based on crypto- ability to issue currency, the Bitcoin
graphic mechanisms described above, Foundation lacks such ingredients
the term “cryptocurrency” has been and therefore cannot fulfill the role of
introduced to characterize Bitcoin-type a central bank. Indeed, deliberately
systems. Bitcoin governance is not designing a system without a central
completely decentralized: There is the bank is one of the cornerstones of the
Bitcoin Foundation, which describes its Bitcoin concept.
tasks as standardization (e.g. funding Being nobody’s liability is a feature
the Bitcoin infrastructure, including a the bitcoin shares with gold. But in
core development team), protection contrast to gold, which is customarily
(e.g. maintenance, improvement and used for various products (e.g. elec-
legal protection of the integrity of tronics, industry, dental fillings or
the technical protocol underlying the jewelry) and has a commodity value,
operation of Bitcoin) and promotion of the bitcoin has no use value other than
Chart 2
Volatility
Annualized standard deviation of daily logarithmic changes
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
2011 2012 2013 20141
EUR/BTC EUR/CHF EUR/USD ATX DJ EURO STOXX DJ Industrial
Source: OeNB, http://blockchain.info, authors’ calculations.
1
January 1 to October 20.
11
See https://bitcoinfoundation.org for more details.
60 OESTERREICHISCHE NATIONALBANKBitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
serving its role in the Bitcoin system. the bitcoin’s fluctuating exchange rate,
Therefore its value is determined only possibly including additional costs for
by the subjective valuation of users, the conversion spread.
exhibiting substantial volatility in terms While several (mainly online) mer-
of official currency (see chart 2). The chants accept payment in bitcoin13 and
fixed increase, up to a predefined final the Bitcoin network has attracted a
level, of supply makes demand effects significant number of payment transac-
dominant. This has led some observers tions, there are strong reasons to sus-
to invoke the “greater fool theory” as pect that bitcoins are not widely used
basis for the bitcoin’s valuation (Blundell- as a means of payment. Due to the
Wignall, 2014, p. 9). Can the bitcoin anonymity of transactions, no direct
nevertheless serve monetary purposes? observation on the motives underlying
Economists in the tradition of bitcoin payments is possible. But the
Friedrich A. Hayek have called for the fixed supply of bitcoins is designed to
abolition of the prevailing monetary attract users with the promise of value
system in favor of competing private appreciation in the face of growing
units of account (see Weber, 2013, for a demand. Whereas official currency is
detailed account).12 Such a conception managed with a view to serving as a
entails a number of problems, however. stable store of value over the short and
A newly introduced rival private unit of medium term, Bitcoin builds on the
account is at a huge disadvantage against promise of long-term value apprecia-
an established unit, all the more if it has tion, not stability. In the short term, it
an unstable exchange rate against the even exhibits extraordinary volatility in
official unit of account. A unit of comparison with most other financial
account is subject to significant net- assets (Yermack, 2013; see chart 2).14
work effects, which entails switching There is no market maker willing or
costs for users (Dowd and Greenaway, able to ensure the stability usually
1993). If a merchant were to start to expected from a currency by users.
price goods and services in bitcoin, she Rather than a store of value, the bitcoin
would incur substantial exchange rate can be better characterized as a specu-
and conversion risks. With inputs and lative asset. In light of this, economic
taxes being priced in official currency, incentives for hoarding are far greater
bitcoin income from sales would have than incentives for spending bitcoins.
to be at least partially converted into Exceptions are transactions where using
official currency. But their value would official currency is not applicable or
fluctuate in terms of the official cur- disadvantageous (e.g. illicit transactions
rency according to the daily exchange and small-denomination online pay-
rate, and conversion costs would accrue. ments). According to Segendorf (2014,
As a result, while there are a number of p. 79), trade appears to be subdued as a
online merchants accepting bitcoins in mere 4% of all bitcoin holdings are
payment, none of them is known to use traded within one week and 24%
the bitcoin as a unit of account. Instead, within three months. It takes six months
prices are fixed in official currency and for some 50% to be traded, and about
bitcoin prices are adjusted according to 38% are held for more than one year.
12
According to a Bitcoin Foundation executive, “Choice in currency is the free speech of commerce.” (Matonis, 2013).
13
According to http://coinmap.org about 50 Austrian companies accept payment in bitcoin.
14
Although the implications of this attribute for portfolio choice are subject to debate, see Briere et al. (2013).
MONETARY POLICY & THE ECONOMY Q4/14 61Bitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
Gandal and Halburda’s (2014) ob- alia because of their relatively low
servations on market developments in volume and their limited interrelation
competing cryptocurrencies confirm with the real economy. However, this
this assessment. A number of crypto- could change if virtual currency schemes
currencies have emerged in the wake of became quantitatively more important
Bitcoin, most of them modeled after and their use more widespread. The
the latter with small variations in ECB further notes that, as payment
design. If there were an emerging mar- systems, virtual currency schemes fall
ket for cryptocurrency as a substitute into the responsibility of central banks.
for money, network effects would Central banks therefore also need to
entail a winner-takes-it-all dynamic. take into account potential reputational
But although Bitcoin was the first and is risks as central banks may be held
by far the largest network in terms of responsible by the public for incidents
market capitalization, several hundred involving bitcoins. In any case, the
competitors have since then been estab- development of virtual currency schemes
lished by various entities and some have and their interaction with the real
succeeded in gathering some support. economy should be closely monitored.
This could be considered evidence that After the EBA had issued a warning
the financial asset function is a more to make consumers aware of risks that
prominent motive than currency adop- arise from the fact that virtual curren-
tion among users. cies are not regulated (EBA, 2013), the
regulatory agency published an opinion
4 The Opinion of Governments on virtual currencies in July 2014
and Regulators (EBA, 2014). It comprises a discussion
Following the bitcoin’s price hikes and of potential benefits and risks of virtual
increasing coverage by the media, gov- currency schemes as well as the EBA’s
ernments, central banks and regulators opinion on their regulation. Even
have started to publish opinions on though the EBA (2014) concedes that
Bitcoin. These publications discuss the there are potential benefits (e.g. lower
risks of Bitcoin (e.g. to costumers or transaction costs, increased financial
financial stability), potential regulatory inclusion), it considers these benefits
responses or the legal and fiscal classi- less relevant in the EU. Some of the
fication of Bitcoin. In this section, we potential advantages may only exist
review some of these assessments, because of the lack of regulation.
focusing on Austrian and European Furthermore, it is not guaranteed that
contributions. these advantages will still apply in the
The risks of Bitcoin and potential future. On the other hand, the EBA
regulatory reactions are for example identifies about 70 risks and categorizes
discussed by the European Central them (see figure 1 in EBA, 2014,
Bank (ECB, 2012) and the European p. 22), for instance, into risks to users
Banking Authority (EBA, 2014). The (e.g. losses through hacking), risks to
ECB focuses on those aspects that are non-user market participants (e.g. mer-
relevant for central banks, i.e. risk to chants are eventually not reimbursed),
price stability, financial stability, the risks to financial integrity (e.g. money
payment system, and reputational risks laundering, other financial crime),
for central banks. Overall, the ECB risks to existing payment systems (e.g.
concludes that virtual currency schemes conventional payment services compro-
do not pose considerable risks, inter mised from virtual currency operations
62 OESTERREICHISCHE NATIONALBANKBitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
of the payment system provider), and the fact that virtual currencies are not
risks to regulatory authorities (e.g. legal tender and that there is no author-
reputational risks when chosen regula- ity that provides exchange rate stability
tory approach fails). Not all of these remain deliberately unaddressed.
risks are specific to virtual currencies; Another strand of official responses
some are also present in conventional deals with the legal classification of
payment services or financial products. both Bitcoin and economic activity
As to regulation, the EBA (2014) related to bitcoins as well as tax-related
differentiates between an immediate issues. In this regard, the Austrian
response and a comprehensive response Ministry of Finance (BMF, 2014) argues
that can most likely only be imple- that the bitcoin does not constitute a
mented in the long term. The immedi- financial instrument. The Ministry of
ate regulatory response that the EBA Finance basically shares the opinion of
advocates should mitigate risks that the Austrian Financial Market Author-
arise from the interaction of virtual ity (FMA, 2014), which states that
currency schemes and the regulated – while Bitcoin is in principle neither
financial sector. This should essentially regulated nor supervised by the FMA
be achieved by separating regulated – certain business models involving Bit-
financial services from virtual currency coin may require compulsory licensing.
schemes as regulators should discour- Certain activities involving bitcoin
age regulated financial intermediaries transactions can be taxable, e.g. VAT
from buying, holding or selling virtual for the exchange of bitcoins and income
currency schemes. Furthermore, the tax on income from mining and capital
EBA recommends for “market partici- gains. The view of the Ministry of
pants at the direct interface between Finance that the bitcoin is not a financial
conventional and virtual currencies instrument departs from the opinion of
such as virtual currency exchanges, to the Austrian Ministry of Economics
become ‘obliged entities’ under the EU (BMFWF, 2014). In the same vein,
Anti Money Laundering Directive and Germany’s Federal Financial Super-
thus subject to its anti-money launder- visory Authority (BaFin, 2014) regards
ing and counter terrorist financing the bitcoin as a financial instrument,
requirements” (EBA, 2014, p. 6). The but not as e-money. Trading of bitcoins
comprehensive long-term regime in- may require authorization.
cludes, among other elements, the Several institutions also warned
creation of a governance authority for consumers against using or investing in
each virtual currency scheme that is bitcoins, stressing the risks involved.
accountable to the regulator, the col- The above-mentioned warning by the
lection of basic identity information EBA (2013), for instance, stresses the
when someone buys virtual currencies, fact that users of Bitcoin are not
standards for individuals performing protected by regulation (e.g. in case
certain functions with respect to a “platforms that exchange or hold virtual
virtual currency scheme, mandatory currencies fail or go out of business”)
incorporation as a legal person in an EU and that the value of bitcoins may not
Member State, capital requirements for remain stable. The EBA (2013) dis-
those market participants that hold cusses potential losses due to fraud (e.g.
virtual currency on behalf of others as when digital wallets are hacked) and
well as measures that ensure the security advises consumers to take care of
of IT systems. Risks stemming from potential tax liabilities resulting from
MONETARY POLICY & THE ECONOMY Q4/14 63Bitcoin – The Promise and Limits of Private Innovation
in Monetary and Payment Systems
the use of virtual currencies. In Austria, The price hikes of bitcoins suggest
the warnings of the EBA were reiterated that this virtual object is largely regarded
by the FMA (2014). Similar warnings as a speculative asset rather than as a cur-
were issued, inter alia, by the Banca rency. The high volatility of the exchange
d’Italia (2014) and the Banque de rate against official currencies makes
France (2013). the use of bitcoins in a world in which
most payments eventually have to be
5 Summary and Conclusions made in official currencies quite risky.
From a technical point of view, Bitcoin While exposing the lack of compe-
offers an interesting proposal for a tition in certain payment markets and
decentralized payment system. But potentially contributing to competition-
doing away with regulated intermedi- inducing innovation in payment sys-
aries in payment systems exposes users tems, the bitcoin in its present form
to a number of new risks and costs, cannot therefore be expected to offer
which will make its use only attractive noteworthy competition for official
for purposes which are underserved by currencies in their established domain.
existing payment systems, such as illicit Its design points to instability over time,
transactions due to its anonymity disfavoring adoption as a unit of account,
features as well as small-denomination means of payment and store of value.
online payments due to transitory low Nevertheless, technological innova-
user costs. The risks involved have been tions that are associated with bitcoins
the subject of a number of opinions and other cryptocurrencies may inspire
recently issued by authorities world- innovation in payment systems and
wide. other applications.
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