Bitcoin and the payments revolution

by Joe Curtis| 16 January 2014

Cryptocurrencies could change the nature of transactions forever.

LATE LAST YEAR a man walked into a San Francisco library, headed to the science fiction section and quietly turned on his laptop, one of many people using the internet available there that day.

However, unlike the others, he then was rugby tackled by half a dozen FBI agents.

The man was Ross William Ulbricht. It is alleged that Ulbricht is also Dread Pirate Roberts, the figure behind Silk Road, an online drug marketplace where people can use the near-anonymous Bitcoin to enable people to buy and sell illegal substances.

Ulbricht’s arrest triggered a 20% drop in Bitcoin’s value, just one of the stark fluctuations experienced by the digital currency in 2013. Since then its value climbed and fell on the back of every new headline written about it.

Its value peaked at $1,250 in November not long after a US Senate hearing in which virtual currencies were described as a “legitimate financial service”, before plummeting to around $421 after China restricted trade in the digital cash in December.

Today a single bitcoin stands at $832, after bullish endorsements from Wall Street analysts and gaming companies like Zynga, which have started accepting it as a form of payment.

While aficionados believe it could even hit $10,000 in 2014, Bitcoin is the frontrunner of a pack of cryptocurrencies collectively referred to as altcoins - alternatives to fiat-based mediums of exchange.

How does Bitcoin work?

Bitcoin was created in 2009 by a developer working under the pseudonym Satoshi Nakamoto, and its units are best thought of as virtual tokens rather than physical coins.

As with sterling, the dollar or the yen, Bitcoin’s value is determined by what people are willing to exchange it for, but unlike such fiat currencies, it is not controlled by a single entity such as a central bank, whose responsibilities include controlling supply by doing things like printing more cash.

Instead bitcoins are produced by a method known as ‘mining’ or ‘hashing’, in which computers use processing power to solve difficult equations. Whoever solves the problem has successfully ‘mined’ a new block of bitcoins.

To compensate for users who acquire more processing power in an attempt to solve these problems faster, and thus mine bitcoins more quickly, the difficulty of the equations is adjusted to ensure that a steady stream of 3,600 new bitcoins are produced each day.

That means no sudden influx (the equivalent of a bank printing lots of money) can devalue the currency.

That number is halved every four years, and once Satoshi’s limit of 21 million bitcoins is reached, no more will be produced - but that won’t be for another 143 years.

The bitcoins can then be sent to and received in electronic bitcoin wallets, which basically store strings of letters and digits, which are your own personal key to your bitcoins.

Just as if you lose your real wallet you lose the cash it contained, if you misplace your virtual wallet you lose the keys to your bitcoins, too.

While Bitcoin’s value fluctuated wildly last year, Jonathan Turrall, CTO of MetaLair, a startup developing currency exchange software, believes it is ultimately more reliable than fiat currencies.

“When I found out about Bitcoin I took all my ISA, personal savings, everything, and moved it straight into that,” he says. “Everyone thought that I was nuts. [But] it’s a finite resource, something which time has shown, like with gold or silver, causes a greater level of stability.

“Since we went fiat in the last 30 years, it’s just gone insane in its valuation and the level of inflation that’s happened since the dollar was divorced from the silver value.”

Turrall is as optimistic about Bitcoin as he is pessimistic about fiat, believing that we will see the digital currency reach far higher heights than $10,000 by the end of 2014.

“There’s a figure that one company put out that if Bitcoin hits 5% of the gold market you’re looking at $25,000 per bitcoin. The gold market in my mind is quite small so I think that’s easily achievable.”

The rivals

The total number of bitcoins is currently valued at $12bn, a prohibitive cost to those hoping to buy into it, leading some to consider other up and coming altcoins.

But Turrall warns speculators to avoid so-called copycat currencies that have simply ripped off Bitcoin’s open source code.

CoinyeCoin is one such currency, which initially used the image of hip hop star Kanye West to ride to fame on the internet before legal action from the musician forced the developers to change tack.

Before Kanye’s lawyers got in touch…

Coinye West

After Kanye’s lawyers got in touch…

Coinye

The changes weren’t enough, however, with a lawsuit killing off CoinyeCoin earlier this week.

But Turrall says similar such altcoins have ridden a wave of initial popularity that fuels their value, at which point developers cash in, before demand drops away and the coins become worth little.

“I know of people who pump and dump new coins as they come in and nine times out of 10 you make a profit on it,” Turrall says. “The Kanye West coin itself brings no new technology.”

Instead, Turrall says the altcoins worth investing in are the ones that do offer new innovations.

Two of the biggest are Peercoin and Litecoin. Unlike Bitcoin, Peercoin has no upper limit on the number that can be produced, but is designed so that its annual inflation rate is capped at 1%.

This provides longer term scalability, while its proof-of-stake system, where someone who holds 1% of the currency can mine 1% of the coins available that day, is designed to prevent those with more hardware mining more of the coins.

However, it’s Litecoin that has Turrall’s backing to eventually become the dominant cryptocurrency.

While similar to Bitcoin, Litecoin offers several distinct differences that has seen it tipped as Bitcoin’s successor, the key factor being the ease with which people can mine Litecoins.

“There’s no special hardware required, whereas with Bitcoin people are making the microchips to increase their mining capabilities,” explains Turrall. “With Litecoin, you’re going to see everyone from kids in their bedrooms to banks and large organisations mining it. The distribution of hashing power is fairer.”

It will also currently cost you $24 per Litecoin, considerably cheaper than Bitcoin, which also suffers the disadvantage that many of the coins have already been mined, and so there are far less available now - Satoshi himself is believed to have two million coins set aside for himself, accounting for nearly 10% of all Bitcoins that will ever be available.

Litecoin

Litecoin2

Stronger united, weaker divided?

But with 70 altcoins listed on coinmarketcap.com, a site monitoring their value and total supply, what does the proliferation of digital currencies mean for frontrunners’ potential to become ubiquitous?

After all, if a medium of exchange’s value is determined by how widely it is used, then surely it is better for digital currencies if people are not all using different altcoins?

Turrall thinks it is healthy to have options, but IDC research director James Wester believes users will adopt just one or two of the digital currencies.

“People will use one or a very limited number of digital currencies,” he claims. “But we’re not far enough along in the development of them to know if there’s anything that could limit their progression.”

His colleague, Alex Kwiatkowski, head of IDC Financial Insights’ European arm, believes the options could become even more fragmented, however, resulting in ‘micro-currencies’ offered by brands with large and loyal customer bases.

“If you have a large captive audience then you could do that,” he posits. “Why wouldn’t Disney do this? Instead of people paying in dollars, which means it has to handle a large volume of cash, the company could reduce its costs massively [by creating its own currency].

“It’s a safe bet that firms like Apple and Disney are paying attention to virtual currencies.”

Ubiquity

But to achieve ubiquity, it is places like Apple, Disney and Amazon that need to start accepting cryptocurrencies as payment, argues Turrall.

That, he claims, should lead to people treating Bitcoin as something to trade for goods, rather than as a store of value.

“As Bitcoin is used more and more as a currency, it will stabilise because it will be fixed as a relative asset priced by ‘one Bitcoin buys this’,” he says.

The currency is already growing far faster than he had predicted: in May he found 190 businesses listed on coinmap.org, which logs companies accepting Bitcoin. Now there are 2,550.

His sentiments are echoed by the founder of startup Mysendoff.com, Colin Firth.

He has invited Bitcoin investments into his Canadian firm as he hopes to finance its growth into a popular resource for funeral life celebrations.

Firth says: “Bitcoin could fundamentally change the nature of transactions. If we see the iTunes store and eBay or PayPal accepting it, then the sky’s the limit.

“If someone in South Africa doesn’t have a bank account, but has a Bitcoin account on their mobile phone, it opens up new customer bases.”

But for IDC’s Kwiatkowski, the problem is that there is “no sheriff in town”.

“Right now it’s the case that if you do use it, you’re going it alone, without the safety net of a guarantee scheme underneath it. So if you lose your money, hard luck,” he says.

“If virtual currencies want to be taken seriously then they have to recognise they must fall under regulatory supervision.”

But while cryptocurrencies’ cash-like nature does make tracking transactions hard, the closure of Silk Road has demonstrated governments’ commitment to crack down on illegal activities taking advantage of that anonymity, while last week marked the opening of London’s first Bitcoin storage service.

Elliptic Vault provides cold storage for bitcoins in offline servers and, backed by Lloyds of London, underwrites their value for a fee of around 2% per year.

It is an early sign that people are prepared to trust the volatile currency, and potentially a step towards regulation - Elliptic claims it is talking with the British government about a regulatory framework.

However, Gartner research VP Christophe Uzureau questions the benefit of underwriting altcoins until they are in widespread use.

“If you don’t create that stability for people to use their bitcoins, it’s not trusted as a medium of exchange,” he states.

If Bitcoin, Litecoin, or another cryptocurrency is to achieve ubiquity, then perhaps revolutionising the way payments work is its opportunity.

Mysendoff.com founder Firth tells CBR he would be happy to accept Bitcoin payments, and there’s little question that it would be much cheaper than banks’ steep charges on international transfers.

MetaLair’s Turrall says: “The problem with banks is they have been making money so long there’s no incentive to innovate.”

In comparison, the nature of Bitcoin transactions means they are fast and cheap, with people rarely paying any fees on smaller transactions.

Bitcoin transfers are sent from one electronic wallet to another, and are tagged with digital signatures for security.

Wallet

Everyone on the network can see any transaction, and its history can be traced back to the point at which the bitcoins were actually produced.

When transfers are logged on the network, miners then confirm transactions, usually taking a mix of large and small ones, and larger transfers are usually confirmed within ten minutes.

It is not only much faster than banks, but much cheaper too, because miners are not paid from Bitcoin users’ own pockets.

Instead they receive 25 bitcoins for every block of transactions they put through, which comes from the total allocation of bitcoins, plus any fees users decide to pay to express their transfers.

IDC’s Wester believes banks could learn a lot from how Bitcoin changes payments technology.

“The idea of having a ledger that is open and public and tracks transactions is worth paying attention to,” he says. “It shows us these big changes that need to be made have been solved.”

Where will digital currencies end up?

Wester says America has recognised Bitcoin’s potential, and so is taking a ‘hands off’ approach.

“That might not be the way it’s treated in China and India, which I find interesting because one wonders if they may not be in need of a Bitcoin,” he adds, saying those countries’ citizens could make use of cheap international transfers.

But Uzureau does not see China’s rejection of Bitcoin as a barrier to its widespread acceptance.

He says: “Even in the worst case where some of the big countries block Bitcoin, you still have some countries that are likely to experiment with Bitcoin and keep it alive.

“Real experiment in some markets could see it used as a complementary currency and that is very positive for Bitcoin.

“We will see a new type of commerce. It’s never about one type of currency or payments solution; it’s all about what kind of flexibility you provide to the customer or merchant.”