BITCOIN A COMPARATIVE ANALYSIS BETWEEN CONVENTIONAL AND CRYPTOCURRENCY

FROM THE ARCHIVES:
BITCOIN A COMPARATIVE ANALYSIS BETWEEN CONVENTIONAL AND CRYPTOCURRENCY

Presented at Pepperdine Graziadio Business School (Malibu, CA)
December 16, 2016
Professor Jasso
National Economic Markets

This paper will define and describe what cryptocurrency and Bitcoin is by providing a structural analysis of the platform.  The positive and negative economic characteristics it intrinsically has, and the problem it solves. A brief historical analysis of currency will be given to lay down the foundation of how societies formed an understanding of conventional money, and a comparative analysis between government backed currencies and Bitcoin, will showcase intrinsically has, and the problem it solves. A brief historical analysis of currency will be given to lay down the foundation of how societies formed an understanding of conventional money, and a comparative analysis between government backed currencies and Bitcoin, will showcase economic strengths, weaknesses, opportunities, and threats the establishment of Bitcoin has generated.

If you don’t change you die. The need for innovation is inherently rooted in the human psyche, and drives the need for adaption, as a tool for survival. Innovative thinking as a means to progress society and civic life explains the evolution of individuals, organizations, societies, and systems. In the realm of technology and currency, the 21st century actualized the first two forms of creative disruption in our understanding of conventional currency, mobile payments, and virtual currency. Mobile payment platforms are the outcome of advances in software and encryption, which in turn facilitate the transfer of money to friends and family, or payments for a product or service through a portable electronic device such as a cellphone, or PDA. Increasingly, we see services like Apply Pay and Samsung Pay fighting for marketshare and recognition from retailers to accept their point-of-sale restitution platforms. Although digital currencies like Microsoft points, Facebook credits, and supplementary platform systems like Paypal, Visa, MasterCard have been around for decades, Bitcoin introduced a new model challenging the need for financial institutions to facilitate monetary transactions, and exploited the weaknesses plaguing digital payment systems,. Bitcoin is gaining traction in revolutionizing what society views conventional currency as, and modifying the framework society views money in. This paper will define and describe what cryptocurrency and Bitcoin is by providing a structural analysis of the platform.  The positive and negative economic characteristics it intrinsically has, and the problem it solves. A brief historical analysis of currency will be given to lay down the foundation of how societies formed an understanding of conventional money, and a comparative analysis between government backed currencies and Bitcoin, will showcase economic strengths, weaknesses, opportunities, and threats the establishment of Bitcoin has generated.

Money, is one of the most  necessary implements of modern civilized life. The cliched phrase, “money makes the world go round,” is cliched and passively accepted for good reasons. Aristotle expressed the fundamental reasons for the use of money as “a necessity for an article of merchandise to be desired by all men because it was capable of being exchanged against all other things.” (Brinton, 1934, p.308 ) Prior to money, bartering was a method for exchange. Bartering is rooted from the primitive survival instinct of mankind. A person’s first mission is to survive, and in order to do so he or she must kill his own animal food, gather his or her own vegetables for sustenance, make his own clothing for warmth out of whatever he or she may find, and build his/her own shelter for protection against natures brutal elements. Exchange comes into fruition when civilization and in thus, economies advanced to facilitate easier societal practices for surviving. 

Bartering can be defined as the exchanging of one commodity for another, a solid practice in theory, however flawed in its own right because of its heavy reliance on a coincidence of wants. The daily challenge of finding a seller who has the good or service you want, and also desires the good or service you are willing to provide is both an inefficient use of time and a pitfall to the core competency economic exchange is designed to provide.  From barter arose the use of money, for the capital means of importing what was wanted and  needed, or for exporting a surplus. (Conant, 1849, p. 326) The first known recordings of money begins with the Anatolian Kingdom of Lydia, now Turkey, over 3000 years ago. The Anatolian Kingdom mass-produced coins composed of a naturally occurring alloy of silver and gold. Standardized coinage expands on the platform of commodity money as an effective mechanism to transfer and hold value.  In 1000BC money was used during the Zhou dynasty in China as a method of exchange, storage of value, and a unit measurement in the shape of small knives made of bronze. Silver coinage developed in the Athenian Empire and facilitated their dominance of the region. Throughout history, gold and silver have been the most common form of money due to their strategic advantage of holding and carrying their weight in value. A fundamental shift from this model occurred when coins evolved from being a unit of weight, to being a unit of value. 

The shift from a unit of weight to a unit of value is perhaps the most important pivot the evolution of money has made. Once money no longer had to carry its value in physical weight, bank notes and a trust based government backed currency could come into realization.

Imagining a world without money is a challenging, if not impossible mental workshop because of how deeply money has influenced the way societies live, think, and function. Money has created a unified world economy in the sense that each currency, despite its name, is able to facilitate trade. Bartering is relatively obsolete from a macroeconomic perspective, and people are now, contrary to some streams of logic are able to walk into virtually any store holding nothing but a piece of linen enriched papyrus and walk out with a valuable good. 

The functions of money are to represent a unit of account, common measure/metric of value, function as an medium of exchange, means of payment, and a store of value. For the sake of this analysis, the three functions of money that will be analyzed, are Bitcoin’s functionality in respect to storing value, medium of exchange, and a unit of measure. (Davies & Julian Hodge Bank, 2002, p. 28)  From bartering to cryptocurency, money has naturally evolved to fit societies needs the most effective way possible. The latest evolution of money has been the introduction of cryptocurrency, namely Bitcoin.

Crypto-currency is a new experimental type of currency with high-tech monetary distinctions that made it different from any other economic model of currency. Crypto-currency is not a commodity money, nor is it a fiat money. Most modern paper currencies are fiat currencies, including the US dollar, and the Euro. Meaning, if people loose faith in the respective nations currency, it is not protected by any valuable physical reserves, and risks becoming worthless. Crypto-currency defines the system that uses cryptography, an computer-centric high speed intersection of mathematics, electrical engineering, and computational science to scramble and decipher text through algorithms and mathematical proofs to ensure encryption. “ It allows the secure transfer and exchange of digital tokens in a distributed and decentralized manner.” (Nakomoto, S. 2008) 

Digital currency merges the traditional functional features of cash and the convenience and growing demand of electronic transactions. Bank issued credit and debit cards are a primarily example of digital currency facilitating the growth and ease of an organized consumer society. Bitcoin is arguably the gold standard, or leading example of crypto-currency, representing about 93% marketshare of at the total crypto currency market  (10 Billion). (Shandrow, 2014) 

“Bitcoin uses peer-to-peer technology to operate with no central authority of banks; managing transactions and the issuing of bit coins is carried out collectively by the network.” (Bitcoin – Open source P2P money, 2016) Its creator remains an elusive unidentified programmer, or  perhaps group of programming specialists, going by the name of Satoshi Nakamoto, who released the open source software in 2008, and facilitated the start of public trading in 2009. The structural arrangements of Bitcoin consist of vastly distributed network nodes who verify transactions, a publicly distributed ledger known as ‘the block chain’, and supplementary software aligning with the model for practical use. Virtual wallets, Bitcoin mining, and exchanges like Mt. Gox, BitStamp facilitate the use, creation, and distribution of these digital currency files. (Bitcoin – Open source P2P money, 2016) 

The block chain is a shared public ledger, this is the most crucial component on which the entire Bitcoin network gains credibility from. All confirmed transactions are included in the block chain, the purpose is the calculate spendable balance and so that transactions can be authenticated. A new bitcoin user will need to download the Bitcoin wallet in order to make transactions, which is essentially a digital representation of a physical wallet carrying cash. The transactions are authenticated against duplications and fraud by storing a private key, “ a secret piece of data that proves your right to spend bitcoins from a specific wallet through a cryptographic signature.” (Bitcoin – Open source P2P money, 2016) The user must never reveal his or her private key, as this is the primary tool allowing bitcoins to be spent out of the owners respective wallets. A second safety guard in place is a cryptographic signature. The formal website providing content on bitcoin, bitcoin.org defines a cryptographic signature as, “ a mathematical mechanism that allows someone to prove ownership. When your Bitcoin software signs a transaction with the appropriate private key, the whole network can se that the signature matches the bit coins being spend.” The creator, Satoshi Nakomoto created these two safeguards to ensure that double spending and theft does not occur, “if a malicious user tries to spend their bit coins to two different recipients at the same time, this is double spending. Bitcoin mining and blockchain are there to create a consensus on the network about which of the two transactions will confirm and be considered valid.” (Bitcoin – Open source P2P money, 2016) Very complex mathematical algorithms are in place to authenticate and allow for a decentralized peer to peer interaction.

 Bitcoin mining is “the process of making computer hardware do mathematical calculations for the Bitcoin network to confirm transactions and increase security.” (Bitcoin,org) If a user wishes to participate in this, sophisticated computer processing power is needed, accompanied by time and effort, it is not an easy way to make money, and requires vast knowledge as well as computational power. “ As a reward for their services, Bitcoin miners can collect transaction fees for the transactions they confirm, along with newly created bitcoins.” (Bitcoin – Open source P2P money, 2016) Bitcoin mining is how new coins are introduced into the market, approximately 3,600 new Bitcoins are mined each day, and it takes roughly 10 minutes to confirm transactions by the network of authenticating nodes. There are over 20,000+ computers working on mining new Bitcoins and the number is expected to increase. There is a maximum amount of Bitcoins allowed to ever exist, Bitcoins will continue to be mined until the maximum amount of 21 million is created, and it is expected to be reached by 2040. (Shandrow, 2014)

Bitcoin’s strengths and weakness’, opportunities and threats can be interchanged depending on the perspective one takes. However, the Bitcoin market has disrupted the conventional depiction of currency with a mammoth rise in 2013. It’s price per coin, essentially an encrypted digital file, peaked at $266, its all time high peaked at $1242 in Q4 of 2013 before it settled back down to its current $400 range. Relatively speaking, the price has stabilized and is expected to continue its stability as depicted by the Bitcoin Volatility Index. (Btcvol.info)  Volatility can be a double edged sword, risk is high, reward is high. If a user views Bitcoin from the perspective of an asset, it is very risky to hold. One week a bitcoin’s value may go up or down massive margins. As the volatility of an asset increases, the more people strategize to limit their ties to it, by either holding or hedging it. ( (1.42%) The Bitcoin Volatility Index,” 2014) 

Volatility can be measured differently, currently the standard deviation of daily returns preceding 30 and 60 day windows is used by bitcoin’s volatility index, meaning its computation is purely based on the historical pricing.(1.42%) The Bitcoin Volatility Index,” 2014 ) Everything is relative, Bitcoin, relative to other world currencies and gold, ranks as a riskier investment, with is latest 30 day estimate at 1.42% volatility, and 1.85% in the latest 60 day estimate. The volatility of gold averages around 1.2%, while other major currencies average between 0.5% and 1.0%. ((1.42%) The Bitcoin Volatility Index,” 2014) 

A major benefit of government backed currencies is that the bank note is backed by the full faith and credit of the US government, similarly bitcoin is based on faith, because the users expect that the bit coin will retain a relatively acceptable price fluctuation from the time they acquire it to the time they sell it for a good. In the case of the US dollar, its no surprise value relative to other currencies will fluctuate over time. Similarly, its purchasing power in the market fluctuates over time. However, it is expected that if person A sells a item of value for an economic price dictated by the market, the sheet of paper(s) he or she receives, will maintain its purchasing power within a week, month, or year. The expectation is that he or she will be able to purchase a different good or service of value from person C in the near future. Government currencies have advantages that private currencies do not. The market share of a dollar for example, is protected by the protectionist method that the government will only accept dollars, so in order for that same seller or buyer to pay taxes, he or she will need to acquire a dollar(s). Within the framework of the justice system, contracts are enforced in government backed currencies, meaning if that seller or buyer is sued, he or she can settle the lawsuit and as dictated by the contract, and a government backed currency will need to be paid. The reason the US dollar is a good storer of value, and a good unit of account is the fact that it does fluctuate astronomically in value against other currencies or its own purchasing power. 

There is nothing within the structure of bitcoin that inherently makes it a volatile  or unstable currency, the volatility can be attributed to a number of facts. The market cap of bit coin is about 10 Billion dollars, relative to other currencies, it is small. With that in mind, any one large trade can send the bitcoin price up or down much more drastically than a more developed  actively engaged currency. The bitcoin market is also very illiquid, it is estimated that 64% of the Bitcoins that have been mined are sitting in accounts untouched since the the currency began publicly trading in 2009. Illiquid markets, in the case of bitcoin, which only has 36% of users engaging as active users, characterizes the infantile state Bitcoin is in. A lack of active users is symptomatic of people’s lack of understanding in the decentralized system, the fact that it is still in its developmental stages of growth, and the faith that the currency will accumulate value over time. (Bitcoin Differences,” 2015, p. 31) People do not want to tether themselves to risky transactions, only to look back and see they used a bit coin to buy a pizza one week, and the following week they could have purchased the a good upwards of 20-40X the value of a pizza.

As more individuals, businesses, merchants, developers, and institutions enter the bitcoin market the price will stabilize and become a better storer of wealth and unit of account. However currently, being a storer of wealth, and a unit of measure is not where the genius of Bitcoin lies.

The economic strengths of bitcoin in present day market conditions is the excellent use it has to be a medium of exchange. The peer-to-peer exchange of decentralized digital coins allow for a number of benefits when compared other payment platforms. Peer to peer transactions are fast, bitcoin.org argues that sending a bitcoin to someone is as easy as sending money across the street. No tedious 1-2 day bank holds, there are no substantial processing fees for the service of a transaction going through third party financial institution or clearing house are charged to users, and no spending limits are in place. There are no prerequisites for joining the bitcoin open source software, a users account can not be frozen, and worldwide payments are simplified. Sending bitcoins is as simple as sending an email, a great incentive to join in an increasingly fast paced, mobile world. Bitcoin opens up a new platform for innovation, as stated by the bitcoin.org website, “Bitcoin is changing finance, how the internet changed publishing. When everyone has access to a global market, great ideas flourish.” (“Bitcoin- Open source P2P money, 2016) 

One of the biggest incentives of bit coin is the lower processing fees. Small business owners are often negatively impacted by processing fees in place by other payment processing firms. A small business owner running a laundry mat, family owned restaurant, or nail salon may find bitcoin to be a solution in decreasing the cost of doing business. Often, we see small businesses with signs on the wall stating ‘cash only’, or, a minimum amount needed to swipe a credit card, because they simply can not afford to do business, provide their service at the economic value the market dictates —due to the processing fee taken by a Visa or Mastercard of example. 

A merchant who wants to accept electronic payments needs to spend money by applying to a credit card company, if they are approved they then are able to run electronic payments by swiping customers credit cards for about 25 cents a swipe, and an additional 3-5% is payed to the firm of the total bill being charged. 

Bitcoin removes the barriers to entry by not charging any application fees, a merchant can simply join the open source software. Processing fees are are about 1% or less, and there is no cost per swipe. Effectively, you can send 1 bit coin or 1,000,000 bitcoins for the same small processing fee.

Although traditional payment systems operate at such a market capacity that other new, smaller payment platforms are unable to compete, they do provide a number of benefits to the user. Bitcoin should be conceptualized as cash, where a person either has it, or does not. In contrast, credit card companies are operating within entirely different business models, (granted they are in the business of lending money, and making money). 

The high processing fees crippling small business owners in different degrees do provide benefits that Bitcoin does not. Insurance, fraud, and identity theft are some of the securities a merchant or customer benefits from. For example, if a consumer orders a good from Amazon or Ebay that never arrives, or is defected, he or she can call Paypal to reverse the charge. Similarly, if someone steals your wallet and goes on a shopping spree, the respective firms operating your cards will eat the incurred illegitimate spending. Processing fees are not just donations to financial institutions, they do provide benefits, however it is important to look at Bitcoin from the perspective of simply another option.

With the introduction of a new currency, threats come into play. The IRS is responsible for ensuring tax payer compliance. In the arena of cryptocurrency, no guidance was in place prior to 2014. In march of 2014, the Internal Revenue Service issued guidance on the standard taxation of virtual currency. Notice 2014-21 stated virtual currency should be treated as property, not currency. It did not delineate potential ramifications on gains and losses in transactions for merchants or sole proprietors. From a global perspective, there is no worldwide guidance dictating a unified policy for the treatment of virtual currency. The question in part still remains, depending on what part of the globe you are standing on. Is bit coin a currency, or an asset? A 2013 US Federal Court Case ruled Bitcoin as a currency which raised questions regarding retroactive tax filings. The new parameters set specified no foreign currency gains or losses to be recognized, all transactions subject to capital gains taxation, and ultimately placed substantial administrative burdens, confusion, on businesses and individuals. The current IRS Guidance has evolved further to clarify income in the form of bitcoin is taxable and classified as a ‘barter’, – the receiving of goods or services for specified economic values in exchange for property. Income in the form of bitcoins is taxed at ‘fair market value on the date of reciept’ (IRS Virtual Currency Guidance : Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply,” n.d) 

For independent users, if more than $600 dollars was acquired, a 1099 is issued identifying the recipient as an independent contractor. If a user is a participant in Bitcoin mining, he or she is classified as self employed and subject to FMV taxable income. Taxation on Bitcoin mining is a threat to the future of bitcoin, granted that the IRS maintains its stands on the taxable basis of fair market value on the date the bitcoin, not taking price fluctuations and market volatility into account. is This could cause Bitcoin mining to become very costly to mine, and add to the cost of being a user in the platform.  

When a bit coin is bought and sold, the recipient of the coin must formally recognize the gain or loss, bitcoin taxation in respect to capital gains or losses, are somewhat similar to how stocks and bonds are held. If a bitcoin is bought and sold within one year of its purchase, it is subject to taxation as ordinary income. If, the bitcoin is held in excess of a year, a longer term holding, it is taxed at lower investment rates. (Ungerman, 2014)

In summation, cryptocurrency is a landmark in the evolution of money. Bitcoin is an impressive technical achievement, but at this stage remains a monetary experiment. Despite its newness, people should care about the possibilities crypto currencies offer, regardless of whether or not Bitcoin or future competitors displace fiat currencies. Currency governance remains a weakness with bitcoin due to the lack of understanding people have of it. However, the characteristics of money, the political economy of third party clearing houses and financial institutions, and the nature of innovative currency competition are all topics that influence the lives of billions of people everyday. 

Reference:

(1.42%) The Bitcoin Volatility Index. (2014). Retrieved from http://Btcvol.info

Bitcoin – Open source P2P money. (2016). Retrieved from https://bitcoin.org/en/

Bitcoin Differences. (2015). The Digital Currency Challenge. doi:10.1057/9781137382559.0017

Black, F. 1970. Banking and interest rates in a world without money: the effects of uncontrolled banking. Journal of Bank Research, 1 (Autumn): 9–20.

Brinton, C. (1934). The History of Paper Money to the War. The Journal of Modern History, 6(3), 308-318. doi:10.1086/236150

Charles C. (1849). The Bankers Magazine. Scientific American, 4(41), 326-327. doi:10.1038/scientificamerican06301849-326f

Davies, G., & Julian Hodge Bank. (2002). A history of money: From ancient times to the present day. Cardiff, CA: University of Wales Press.

IRS Virtual Currency Guidance : Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply. (n.d.). Retrieved from https://www.irs.gov/uac/newsroom/irs-virtual-currency-guidance

Nakamoto, S. 2008. Bitcoin: A Peer-to-Peer Electronic Cash System. bitcoin.org. https://bitcoin.org/bitcoin.pdf.

Shandrow. (2014, March 1). 50 Facts About Bitcoin (Infographic). Retrieved from https://www.entrepreneur.com/article/231973

Ungerman, J. (2014, December 4). Forbes Welcome. Retrieved from http://www.forbes.com/sites/irswatch/2014/12/04/irs-approach-to-taxation-of-bitcoin/#30152ca0198c