Bitcoins 2013

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File:Bitcoins_logo.png

Bitcoin Logo
Creator Satoshi Nakamoto
Date of Introduction January 3, 2009
Website www.bitcoin.org

Contents

Introduction

After the recent global recession and financial crisis, many have begun to question monetary institutions. Crypto-currencies, which are digital currency based on cryptography, have been introduced (Techopedia, n.d.). Crypto-currencies run on a peer-to-peer network and are decentralized, which means its value is determined by supply and demand and not by a central issuance authority (n.d.). Moreover, crypto-currencies act like gold and other precious metals in the commodity markets (n.d.).

What are Bitcoins?

Introduction on Bitcoins - Source: www.weusecoins.com

This section of the report will explain what are Bitcoins. Specifically, this section will discuss the Bitcoin client, the peer-to-peer network, the Block Chain, generation of new Bitcoins, and the transaction fee associated with Bitcoins.

The Bitcoin Client

Users have a variety of clients to choose from to securely store and use their Bitcoins. However, there was only one original client able to store Bitcoins and it was called Bitcoin-Qt. Bitcoin-Qt was downloaded and installed as software on computers. Since the inception of Bitcoins, many software vendors have come forward with various Bitcoin wallets ranging from software, mobile, and web-based. A few examples are Block Chain, BIPS, Coinbase, Multibit, and Armory (Choose Your Wallet, 2013). These wallets allow you to store and transfer Bitcoins to other wallets (2013). An example of a real Bitcoin wallet can be found in Appendix A. Mobile wallets are becoming increasing popular with quick payment technologies such as QR codes and NFC “tapping” capabilities.

The Peer-to-Peer Network

Bitcoins use peer-to-peer technology to operate and has no central authority (Barber, 2012). The management of transactions and issuing of Bitcoins is carried out collectively by a peer-to-peer network as each transaction block is verified. The Bitcoin network includes a complex set of interactions and checks between existing block chain, newly created blocks, transactions, and the machines that hash algorithms to check and solve the new blocks. Satoshi Nakamoto, the creator of Bitcoins, describes how the peer-to-peer network works (Nakamoto, 2008):

1. New transactions are broadcasted to all nodes 2. Each node collects new transactions into a block 3. Each node works on finding a difficult proof-of-work for its block 4. New transactions are broadcast to all nodes 5. Each node collects new transactions into a block 6. Each node works on finding a difficult proof-of-work for its block

Bitcoins' Block Chain

Blocks are official records of previously executed transactions; moreover, blocks referenced to previous block to create a chain that shows the history of Bitcoin transactions. A block has one coinbase minting transaction, which is how newly created Bitcoins are mined. A block also includes regular spending transactions between accounts, a computational proof of work, and a chronological reference to the prior block. That means the Block Chain bundles a number of transactions and adds a reference to previous block (Vornberger, 2012).

The purposes of creating new blocks is ensuring the timely vetting of new transactions and creating of new Bitcoins (Barbara, 2012). Moreover, when a block is solved, the difficulty increases to solve the algorithim in the next block in the Block Chain (Vornberger, 2012). An real example of a Bitcoin block can be found in Appendix B.

Generating New Bitcoins

Mining Bitcoins - Source: www.bitcoinmining.com

New Bitcoins are introduced and minted through a computational process called Bitcoin mining. Once a block is solved, the miner receives 25 Bitcoins and transaction fees from the solved block (Controlled Supply, 2012). The 25 Bitcoins reward is decreased by 50% every four years, until it reaches zero in 2140 (2012). The money supply of Bitcoins can be found in Figure 1 below:

By 2140, transaction fees paid to miners will be a sufficient incentive to keep miners motivated to solve the blocks (2012). A real example of generating Bitcoins can be found in Appendix C.

As Bitcoin mining matures, miners have changed from homebuilt set-ups to set-ups that are designed solely for the purpose of mining Bitcoins. Mining has gotten very complex that network of miners, called pools, working together and sharing any profits of solved blocks are emerging (Joshua A., Ian C. & Edward W., 2013). Pooling allows miners to utilize more computational power and offset power consumption bills (2013); therefore, allowing for a higher chance of solving a block, which results in more frequent payouts.

Bitcoin's Transaction Fees

The Bitcoin system was designed to allow miners to receive a small fee from each transaction. This is an incentive to miners to continue to solve blocks (Vornberger, 2012). As discussed previously, transactions fees paid to miners will be sufficient when the supply of Bitcoins caps out in 2140. A real example of transaction fees associated with Bitcoins can be found in Appendix D.

Advantages of Bitcoins

This section of the report will go over the advantages of Bitcoins. Specifically, it will talk about decentralization, inflation control, anonymity of Bitcoins, divisibility of Bitcoins, and the low transaction fees associated with Bitcoins.

Decentralized - No Issuance Authority

There is no central government agency or any other type of governing body to regulate the flow of Bitcoins; therefore, Bitcoins rely solely on the peer-to-peer network and design of the crypto-currency itself (Barber, 2012). Bitcoins are controlled by a finite supply, complex algorithms, and built in check-and-balance systems (Nakamoto, 2008). The result is what should be a stable currency, which combats inflation.

Controls for Inflation

The generation of Bitcoins is designed so that only a controlled amount is released after each successful algorithm is solved. This means that prices of goods under Bitcoins won't generally inflate due to a sudden increase in money supply. Moreover, centralized currencies have faced increase in general prices when there is a short supply of cash. It would be impossible for more Bitcoins to be generated than designed, so the result is a currency with a very low risk of hyperinflation. Furthermore, due to the finite supply of Bitcoins, a single Bitcoin will be able to purchase more goods or services, which results in deflation.

Anonymity

When Bitcoin users fulfill a transaction, the record of transaction cannot be traced back to any particular person. When a client has any activities associated with their Bitcoin wallet, there is no identifying information for authorities to track or trace transactions (Danielle , 2012). This feature is excellent for Bitcoins users but troublesome for government agencies. The reason is that transfers can't be audited or checked for criminal activities (2012).

Divisibility of Bitcoins

Bitcoins are divisible to eight decimal places, yielding approximately 21×1014 currency units (About Bitcoin, 2013). This is one of the leading benefits of Bitcoins relative to other crypto-currencies. The ability to break down Bitcoins allows for users to utilize the currency for small day-to-day payments in smaller than full Bitcoin denominations (2013).

Low Transaction Fees

Transaction fees are purposely designed to stay at a low to entice users to pay for purchases with Bitcoins. The built-in transaction fees are minimal and usually stay below a penny, which can be seen in Appendix D. Bitcoins also appeal to users of international money transfers because of the simplicity of transactions, no international fees, and low transaction rates even for large sums of Bitcoins (Barber, 2012).

Disadvantages of Bitcoins

This section of the report will explain the disadvantages of Bitcoins. Specifically, it will talk about the volatility of Bitcoins, Bitcoin mining costs, criminal activity associated with Bitcoins, other crypto-currencies, network attacks, and unrecoverable wallets.

Volatility of Bitcoins

A major disadvantage of Bitcoins is that its price keeps fluctuating, which creates volatility. According to BlockChain.info, a website that records various statistics about Bitcoins, reported a 60% decrease in Bitcoins market price from April - July 2013 (BlockChain.info, 2013). This decrease in market price is show in Figure 2 below:

Figure 2: Bitcoins' Market Price Fluctuation from April - July 2013


Source: Bitcoin Charts. (n.d.). BlockChain.info. Retrieved July 27, 2013, from https://blockchain.info/charts

According to PCWorld, the main reason for the volatility of Bitcoins is that it is not backed by anything (PCWorld, 2013). Bitcoins has no central backing and the value lies only in someone's willingness to pay for a single Bitcoin, thus the price of Bitcoins tends to change quickly (2013). Also, the volatility in Bitcoins' price represents the characteristics of an economic bubble, according to Professor Magnus Thor, an Assistant Professor of Business Administration at Harvard Business School (2013). This volatility in Bitcoins' price should be taken into consideration when choosing to invest in the crypto-currency.

Mining Electricity Consumption

The cost of mining Bitcoins has risen exponentially that it is not feasible for new miners to start mining Bitcoins. According to TechCrunch, a leading technology news website, people are driven to mine Bitcoins due to the sharp increases in price (TechCrunch, 2013). Figure 3 from BitChain.info, reveals eletricity consumption costs when mining Bitcoins:

Figure 3: Daily Bitcoin Mining Revenue and Electricity Consumption Costs


Source: Currency Stats. (n.d.). BlockChain.info. Retrieved July 15, 2013, from https://blockchain.info/stats

Figure 3 reveals that it takes 4,144.9 megawatt hours per day to mine Bitcoins and in monetary terms, this amounts to $621,734.31 (BlockChain.info, 2013). This large expense leads to an operating profit of -$214,918.67 (2013). These high consumption costs are attributed to the specialized hardware required to mine Bitcoins (TechCrunch, 2013); furthermore, for regular users, the energy cost and depreciation of the computers outweighs the revenue gained from mining (2013). Mining Bitcoins is not profitable but miners are hoping to leverage the highly fluctuating Bitcoin price to cover their costs. As the price fluctuates frequently, leveraging to cover cost based on Bitcoins' market price is very risky.

Criminal Activity

Hackers are able to infiltrate Bitcoin exchange websites and acquire the crypto-currency. According to The Verge, a technology news reporter, hackers were able to gain access to Bitinstant's employee emails (The Verge, 2013). Bitinstant is a Bitcoin transaction website, and through the employee emails, the hackers stole $12,000 worth of Bitcoins (2013). This lowers the credibility to Bitcoins and lowers adoption rates among the general population.

Also, there are online market places where you are able to purchase illicit drugs with Bitcoins. Forbes reports that Silk Road first appeared in 2011 and in 2012, its revenues from illicit drugs were estimated to be $22 million (Forbes, 2013). Forbes also states that the currency accepted on the Silk Road is Bitcoins. The reason for this is that government agencies and banks won't be able to trace a transaction to a person, due to the anonymity provided by Bitcoins (2013). The ability not to be traced by using Bitcoins has been exploited by organized crime groups; therefore, reducing the credibility of Bitcoins and crypto-currency in general.

Furthermore, Bitcoins are being utilized to carry out white-collared crimes. The Guardian, a British newspaper, reported that a man has been arrested for creating a multimillion-dollar Bitcoin Ponzi scheme (The Guardian, 2013). The man accumulated 700,000 Bitcoins from 2011-2012 and used new investors' money to pay off interest due to old investors (2013). The value of the Bitcoin scheme, based on today's market price, is approximately $66 million (2013). These white-collared crimes reduce the public's faith in Bitcoins; therefore, leading to lower adoption rates among the general population.

Other Crypto & Digital Currencies

According to http://coinmarketcap.com/, there currently at least 47 different cryptocurrencies as of July 30. For example, the second largest cryptocurrency is Litecoin with a market cap of $58.6 million USD and one of the smaller currencies is GoldCoin with a market cap of $36,000 USD. Many of these currencies are based off of Bitcoin’s source code and modified slightly, such as shortening the block time or changing the hashing method required to mine (Archer, 2013).

Figure 4 below shows the market capitalization of various crypto-currencies. Figure 4 also shows the Bitcoins' competition and where they stand relative to Bitcoins.

Figure 4: Market Capitalization of Crypto-Currencies

Source: Crypto-Currency Market Capitalizations | Bitcoin Litecoin Namecoin PPCoin Novacoin Feathercoin Primecoin Terracoin Devcoin Freicoin and more.... (n.d.). Crypto-Currency Market Capitalizations | Bitcoin Litecoin Namecoin PPCoin Novacoin Feathercoin Primecoin Terracoin Devcoin Freicoin and more.... Retrieved July 30, 2013, from http://coinmarketcap.com/

Network Attack & Double Spending

As described in previous sections, the Bitcoin network is composed of all the individual nodes. If a hacker or group of hackers are able to have more 50% of the network's mining power, they will be able to conduct double spending (The Genesis Block, 2013). Double spending is when a transaction is accepted in one Block Chain and the hacker creates an alternate Block Chain in order to maintain control of the Bitcoins (2013); therefore, allowing the hacker to double their Bitcoin holdings. The probability of this attack is relatively low because of the high energy consumption costs associated with mining.

Reception of Bitcoins

In the Law of Diffusion of Innovations, Bitcoins have entered the Early Adopter Stage. This stage is shown in Figure 5 below:

Figure 5: Bitcoins' Law of Diffusion of Innovations

Source: Flanagan, K. (n.d.). Content Marketing isn't Your Silver Bullet. SEO Services, Link Building Services Ireland — :: Searchbrat.com. Retrieved July 30, 2013, from http://www.searchbrat.com/content-marketing-isnt-your-silver-bullet/

Bitcoins are in the Early Adopter stage because people are starting to slowly become aware and accept Bitcoins. This is reflected in the sharp price fluctuations described in the previous section. Reuters, a reputable news agency, reported that employees of Morgan Stanley and Goldman Sachs have been visiting Bitcoin exchange websites as often as 30 times a day (Reuters, 2013). Moreover, employees at almost all major international banks and investment firms have been showing interest in Bitcoins' exchange websites (2013). As explained in the next section, a lot of affluent venture capitalists are funding new Bitcoin businesses. All of these factors contribute to Bitcoins being in the Early Adopter stage in the Law of Diffusion of Innovations.

Furthermore, to cement Bitcoins in the Early Adopter stage, the USA government has started looking into regulating Bitcoins. Mashable reports that US Treasury Department enacted new rules where businesses will be required to keep more detailed records of transactions surrounding Bitcoins (Mashable, 2013); furthermore, businesses will need to report transactions that are over $10,000 (2013). Mashable also reported that the US Treasury Department is also looking into regulating the Bitcoin trading market. The reasoning behind it is that Bitcoins, though a crypto-currency, have real risks when people trade them due to the volatility in price (2013). The interest from government agencies further cements that Bitcoins have reached the Early Adopter stage in the Law of Diffusion of Innovations.

Adoption of Bitcoins

Bitcoins businesses are being started throughout the USA and affluent investors are backing them. Figure 6 below shows Bitcoin ventures and investors who have helped fund those start-ups:

Figure 6: Bitcoin Businesses & Affluent Bitcoin Venture Capitalist in the USA

Source: Genesis Block. (2013, May 19). Mapping Bitcoin Adoption: A Global Perspective In 11 Graphs - The Genesis Block. Home Page - The Genesis Block. Retrieved July 17, 2013, from http://thegenesisblock.com/mapping-bitcoin-adoption-a-global-perspective/

Figure 6 reveals that Bitcoin related businesses are sprouting in tech-centric cities like San Francisco. Also, these companies are being backed by affluent venture capitalists like Tim Draper and Barry Silbert. The backing of Bitcoin businesses will help aid in the adoption of Bitcoins by the public.

Also, local businesses are incorporating Bitcoins into their operations in order to attract more customers. According to The Bitcoin Co-op, a lobbyist organization to promote Bitcoins in Canada, there are 15 Vancouver businesses that accept Bitcoins as a form of payment (The Bitcoin Co-op, 2013). The following list below are businesses that accept Bitcoins in Vancouver, British Columbia (2013):

1. Pacific Bliss Massage - specializes in Swedish relaxation massages and Hot & Cold Stone Therapy 2. Sweet Tooth Café - a local café shop 3. No Limit Landscaping - formed in January 2013, which provides full landscaping 4. Your Local Movers - provides services ranging from moving to junk removal 5. Art of Muse - provides music lessons for youths and adults 6. Lulie Lens - a high end freelance retoucher for beauty and fashion images 7. Rocketcases - provide cases for smartphones 8. Cabin 12 Restaurant - American cuisine 9. Free Geek Vancouver - a non-profit organization 10. India Gate Restaurant & Bar - Indian cuisine 11. Krystal Fit Studio - personal training studio 12. Central Bistro - American cuisine 13. Bestie - sausage and beer parlour 14. Popsike Records - online record store 15. Key3D - 3D printing services

Moreover, organized crime has also adopted Bitcoins in their illicit operations. Mashable, a leading source for technology related news, reported that a $6 billion money-laundering scheme included Bitcoins (Mashable, 2013). Liberty Reserve, a Costa Rica based online currency exchange, facilitated credit card fraud, identity theft, investment fraud, and computer hacking was shut down by federal agencies in the US (2013). Liberty Reserve was the platform used to facilitate the money-laundering scheme, which included the utilization of Bitcoins (2013). Bitcoins involvement in this scheme has led to government agencies to consider looking at regulating Bitcoins, as mentioned in the previous section.

Business Applications of Bitcoins

Bitcoin Businesses are already being acquired, which adds to the legitimacy of Bitcoins. Coin Desk, a news outlet on crypto-currencies, reported that a Bitcoin business was purchased (Coin Desk, 2013). Coin Desk states that SatoshiDice, an online Bitcoin casino, was sold for 126,315 Bitcoins, which was approximately $11.47 million during the time of sale. Furthermore, it has not been disclose who has purchased SatoshiDice for $11.47 million (2013). When businesses are being purchased by Bitcoins, it helps add to its legitimacy.

Furthermore, there are online Bitcoin catalogues that sell items ranging from everyday goods to luxury items. Figure 7 and 8 below shows examples of these online Bitcoin catalogues:

Figure 7: BitPremier - The Bitcoin Luxury Marketplace

Source: BitPremier. (n.d.). BitPremier. Retrieved July 19, 2013, from http://www.bitpremier.com/

Figure 8: Bitmit - A Bitcoin Marketplace

Source: Bitmit. (n.d.). Bitmit. Retrieved July 17, 2013, from https://www.bitmit.net/en/item/ 18891-monster-energy-drink-lo-carb-flavor

Figure 7 and 8 reveal businesses are being created where people are able to buy and or sell goods through Bitcoins. On BitPremier, you are able to purchase or sell luxury goods such as villas, luxury cars, yachts, and art. Furthermore, on Bitmit you are able to purchase or sell food, beverages, animals, books, and computers. These online market places for goods will be critical in terms of increasing the adoption of Bitcoins.

Another application of Bitcoins in businesses is using the PayPal model to pay for online purchases. BIPS is an enterprise solution that allows other business to start accepting Bitcoins for their goods or services (BIPS, 2013). BIPS also offer Bitcoin shopping cart plug-ins to mobile checkout solutions (2013). BIPS ability to provide a form on infrastructure for businesses to utilize Bitcoins will help in Bitcoin adoption rates by consumers.

Some investors are choosing to include Bitcoins as a part of their investment portfolio. Two of the most prolific investors are Tyler and Cameron Winklevoss, best known as the twins who claim to be the concept creators of Facebook. Reports claim that the Winklevoss’ own a total of 1% of all the Bitcoins in current circulation, worth about $10 million USD, and are currently in the process of creating an ETF for investors to trade and purchase (Soltas, 2013). This means that instead of purchasing Bitcoins directly, investors can buy shares of a portfolio consisting of Bitcoins.

The examples listed above of Bitcoin business applications is just a minor list. This list will continue to grow with innovative new ideas to utilize Bitcoins in new business ventures.

The Future of Bitcoins

Bitcoins are similar to gold in the fact that there is a scarce and limited supply (Liu, 2013). In this sense, Bitcoins are currently being used as currency to trade for goods and services. However, in the future, Bitcoins use may trend further and further into being used as a store for wealth (2013). The limited supply of 21 million Bitcoins is the greatest appeal, since this ensures that there will not be a future dilution of the currency. However, just like gold, Bitcoins need supporters to continue holding and seeing the value in Bitcoins (2013).

Many investors purchased Bitcoins early on in their inception and are now realizing the rewards of getting in early. There are cases of investors purchasing hundreds or thousands of Bitcoins when they were priced between $0.20 and $5 (Raskin, 2013). Raskin states that some investors include Bitcoins as part of their investment portfolio; furthermore, others have even gone so far as to convert half of their assets into Bitcoins, and some have even fully converted all of their assets into Bitcoins (Raskin, 2013). This investment activity shows that there is much interest in investing in Bitcoins and this investment should continue as long as investors see value holding this virtual crypto-currency.

Conclusions

Although Bitcoins are an intriguing and innovative concept, there are some concerns over the true credibility and value in the long-run. Recent investor activity and spikes in value has resulted in increased interest in the crypto-currency and businesses are now setting merchant stores to enable users to spend their newly created wealth. However, the reality is that there is no real reason for the high price of Bitcoins, except for someone’s willingness to pay for it. There are also flaws in the security of the Bitcoin accounts and hacking is a very real threat to be concerned of with crypto currencies. Given that Bitcoin accounts are untraceable, it would be nearly impossible to track Bitcoin thefts if and when they occur. Therefore, the concept of Bitcoins is still new and only the future will reveal the fate of the crypto-currency.

Recommendations

The following recommendations are based on the analysis and conclusions of this report. The recommendations are segregated between consumers and businesses.

Consumer Side

Consumers should hold back on investing into Bitcoins for a few reasons. First, the value of Bitcoins is very volatile as the price has fluctuated between 25 USD per Bitcoin, to 237 USD, and back down to 94 USD in a mere 6 months. There is no real upward trend or reason behind the large swings in prices so it would be very risky to invest heavily in this current situation.

Another reason to avoid using Bitcoins is other competing crypto-currencies that could one day overtake Bitcoins in terms of market cap and public acceptance. In other words, if the online community decides one day that another crypto-currency is better than Bitcoins, there is a possibility that people would stop using Bitcoins in favour of the new currency.

Business Side

Businesses should also avoid accepting Bitcoins until the prices stabilize to a manageable level. It is already difficult enough to manage a business and to factor in the changes in currency values could mean a risk that would potentially bankrupt a successful business. For instance, if the value of Bitcoins drops suddenly, it may be impossible to pay other vendors for the expenses incurred while carry out business.

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