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The Bones of Bitcoin

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April 12, 2014

By Ted Howard

The innards that make digital currencies possible hold promise for companies looking for safe, quick ways to move cash globally. 

It takes guts to buy and hold Bitcoin, and it will likely take the guts of the infamous digital dough and other so-called cryptocurrencies to stay alive. That is, the platforms and peer-to-peer technology by which the currencies are exchanged could be the future of global payments.

With all the drama surrounding Bitcoin lately, most people know it more for drama than for an actual financial instrument: Mt. Gox, the fantasy-trading-card hub-turned-Bitcoin-exchange went belly up in February, after losing upwards of 850,000 of the coins. There was also the shutdown of Silk Road, which US authorities thought was just an anonymous way for criminals to do drug deals. Then there are the hacks and thievery at other exchanges. Any one of these could have a negative effect on Bitcoin. In total they’ve helped cut the value in half, making the whole concept less than viable.

But Bitcoin and the concept of cryptocurrencies marches on, driven by factors such as wild swings in fiat currencies, countries with staggering inflation or restrictive capital controls or just people wanting to buy stuff anonymously. Bitcoin, “is the easiest way for people in countries where they can’t trust their currency or their banks to protect the fruits of their labor,” said Wences Casares, founder of Xapo, an offline bitcoin storage firm, in an interview with the Wall Street Journal recently.

This could mean more uptake from corporates as demand grows. Julie Conroy, research director at consultancy Aite and author of a recent report on Bitcoin called “Bitcoin, the Good, the Bad and the Ugly,” says that Bitcoin and other cryptocurrencies aren’t “ready for primetime” yet as there are just too many uncertainties. “But I do think the core concept as a platform is one that addresses a number of pain points,” Ms. Conroy says. These include the costs of, say, cross-border remittances or those associated with digital commerce.
 The Bones of Bitcoin 

Bitcoin: uncertainties and headwinds

Despite the uncertainties, Bitcoin does have lots of merits. It’s a completely decentralized currency, which means it has no issuing entity and therefore no single point of failure or a central bank. It’s a safe currency, built on cryptographic features and offers financial privacy or as much anonymity as a user wants.

But these are also some of the issues that might make for unacceptable levels of risk for businesses. No issuing entity or central bank also means no central authority to mediate disputes. Decentralization, which in this case means the network is powered by millions of computers around the world, could make global payments easier, but the millions of computers could make boards nervous as a risk issue (the promises of encrypted safety notwithstanding). The computers could also crash.

Bitcoin’s and other cryptocurrencies’ “crypto-ness” could hamper its development and regulators are already concerned about their use. Silk Road was just one instance of the criminal possibilities of the currencies, but there are also other concerns, including the potential for facilitating money laundering, tax avoidance and other inappropriate activities. Multinational corporations are already fighting off charges of tax avoidance; they may not be eager to get involved in a system that heightens that risk.

Another knock for cryptocurrencies’ use in the corporate sphere is the limited quantities and the fact that, as per a recent IRS ruling, it’s not really a currency. The IRS considers it property, which makes it more like gold-like. This means that while one can buy things with it, it’s more like a stock that people are hoping will continue to gain in value. The gold comparison comes from the fact that, like gold, there is a limited supply. According to Bitcoin news site CoinDesk, there are about 12.5 million Bitcoins in circulation as of the end of March; there will be 21,000,000 by the time it reaches its self-imposed limit by 2040.

One treasurer keeping an eye on it doesn’t see his company using it any time soon. “I have not and do not consider it a viable alternative from a treasury perspective,” the treasurer says. “There are just too many uncertainties for a staid public company unless and until there is a significant consumer demand for its use. It’s a long ways from PayPal to Bitcoin.”

Demand growing but still small

Demand is growing but, at the moment, it still pales in comparison to other payment forms. Currently, despite its ubiquity in the news and the fact that it has seen a significant increase in use in the past year, cryptocurrencies are seeing very limited use as a payment system. Among notable companies accepting Bitcoin are Overstock, Wordpress and computer equipment store TigerDirect.com. And just recently, after trying out a new paywall system, the Chicago Sun-Times, the ninth-largest newspaper in the US, has become the first major US newspaper to give readers access in exchange for bitcoin.

But again, it’s still niche. According to Blockchain.info, a digital currency wallet and transaction tracker, there are about 60,000 transactions a day using Bitcoin, averaging about $68mn in transaction volume per day. According to Fitch Ratings, this pales in comparison to Western Union and PayPal, which averaged $225mn and $492mn in transaction volume per day respectively at the end of 2013.

The IRS guidance will also be problematic for casual users of the currency, as “a payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property,” the IRS announced. “The effect of calling it property,” says William Cavanagh, a corporate tax attorney at Chadbourne & Parke, “is that when someone uses it to buy something, they have taxable gain or loss on the digital property equal to the difference between their tax basis in the digital property and the fair market value of the digital property at the time.”

A Better Platform

This means that the future is in the platform, says Aite’s Ms. Conroy. She says there are many parties involved in cryptocurrencies that are trying to create a viable, stable, and trustworthy platform. These companies are looking to improve on the Bitcoin model “and they’re not necessarily hitching their wagon to becoming this ubiquitous currency that will displace credit cards,” she says. “They’re looking at more of the internal use case that would be very attractive to corporates.”

One platform Aite mentions that’s looking to gain traction is Ripple. The company, whose currency is called Ripple or XRP, touts a platform it says can do transactions with attributes that any corporate treasurer would love: no counterparty risk and no fees. It’s also decentralized, but the companies has contained the risk in that only computers that us its Ripple transaction protocol can participate.

There are also other cryptocurrencies, including Auroracoin (an Icelandic iteration), Scotcoin (the Scottish version), Dogecoin (“such profit, so crypto, wow”), as well as Litecoin, Quark and Webmoney. The more entrants into the market, the more evolution as the newcomers learn from the mistakes of earlier entrants. This will be further enhanced by advances in technology that will support better encryption and speed at which people can “mine” for coins (see callout).

Computing Muscle Required

“As the growing pains of Bitcoin 1.0 shake out I do think we will see the platform embraced for a number of use-cases over time,” Aite’s Conroy says. “And by platform, it’s not necessarily a platform called Bitcoin, but it’s the same concept of an open source protocol that runs on the rails of the internet.”
 Bitcoin's Transaction Volumes Remain Relatively Low 


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