If Bitcoin’s many advantages are to countervail the causes of its currently dubious “trustworthiness”, a regulatory framework is needed.
“The root problem with conventional currencies is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.“
On October 13th 2008 these words along with the rest of the fabled “white pages” essay were posted to a cryptography mailing list under the name Satoshi Nakamoto. The paper not only detailed the mechanisms of a revolutionary new system of electronic transactions called Bitcoin but also articulated a radical new philosophy of currency independence. In fact, before Bitcoin lit Wall Street ablaze as a get rich quick commercial venture, it was conceived as a way to wrest control of the money supply away from “untrustworthy” central banks. These days, when asked what the future of banking will look like, many financial luminaries, according to a Business Insider study, point to Bitcoin style blockchains. The question arises, however, of whether Bitcoin is indeed “trustworthy”? Yes, it circumvents the need to trust a central bank in order to anchor inflation expectations, but could Bitcoin be untrustworthy in other ways? Let’s have a look at Bitcoin’s shadowy entrails and understand how this trailblazing fintech works.
So, what even is it? Well, Bitcoin is a peer to peer system of electronic payments. In other words, it is a system where two individuals in the real world can transfer money to one another over the internet. Bitcoin transactions are entries in a global ledger called a block chain that specify the sum being transferred in addition to the value of the transaction fee. Once the transaction takes place the payer will use a secret piece of data called a private key to sign the transaction. This signature includes a mathematical proof that verifies the digital identity of the payer and prevents the transaction from being altered.
However, the process does not end there. How can we be sure that the payer is not double spending, merely copying and pasting the details of a previously completed transaction to feign payment? Well, the transaction between the payer and the payee must be confirmed by nodes in the Bitcoin network called miners. Miners receive the details of many pending contemporary transactions and compile them in “blocks,” which include an encoding of preceding blocks. This process of creating a chronological chain of blocks generates a mathematical problem or “challenge string” that the miner must solve by finding the corresponding “proof of work.” In order to find the “proof of work,” miners will use their computer to try billions of calculations per second. As a reward for securitizing the transaction in this way, miners receive the payer’s transaction fee and new bitcoins that are generated specifically for them.
Pitfalls and Perils
So, if the Bitcoin universe is just a virtual Kumbaya jam session, what’s the problem? Actually, many of Bitcoin’s unique properties are also at the heart of its problems and, therefore, contribute to its possible “untrustworthiness.”
For starters, an advantage of using Bitcoin rather than a credit card, for example, is that all Bitcoin transactions are anonymous. “Bitcoin wallets” are not tied to a payer’s real-world name but to a numerical alias called a Bitcoin address that should be used only once. This added privacy, however, has made Bitcoin a popular medium for the purchase of illicit goods like drugs and weapons. Indeed, in a 2018 study, Australian researchers concluded that about 44% of all bitcoin transactions were associated with illegal activity as of April 2017.
Another special characteristic of the Bitcoin network is that its operations are decentralized; there are no intermediaries like banks that verify and organize monetary transactions. As a result, there is no bank to see a user’s assets or reverse previous transactions. However, the absence of supervision by a strong central body or established intermediaries has contributed to the emergence of cyber gangs called mining pools. These mining pools can use their computational power to thwart the verification of certain transactions and preclude other miners from generating income. This issue became especially pertinent when in 2014 a mining pool called Ghash.io obtained 51% hashing power.
The decentralized nature of the Bitcoin network is related to another one of its distinctive characteristics: its openness. Anyone with a computer and an internet connection could potentially conduct a monetary transaction or become a miner. This feature enables people who do not have access to a credit card or bank account to make purchases online. However, the fact that virtually anyone can join the Bitcoin ecosystem makes the network more accessible to preying hackers and cyber thieves. Since December 2017, around 980,000 Bitcoins were stolen from cryptocurrency exchanges like Coincheck and Coinrail.
Now that we better understand how Bitcoin works as well as some of the issues surrounding it, what can we say about the future of this cryptocurrency?
Certainly, instituting government regulation and surveillance of the Bitcoin ecosystem could diminish problems like theft and double spending; however, these measures could also simultaneously diminish Bitcoin’s popularity. This point of view is espoused by Nobel Prize winning economist Joseph Stiglitz: he says,” [if] you regulate it so you couldn’t engage in money laundering and all these other [crimes], there will be no demand for Bitcoin. By regulating the abuses, you are going to regulate it out of existence. It exists because of the abuses.”
Others, however, are more optimistic about possible government regulation and point to Japan as heralding a more favorable future for Bitcoin. In 2017, Japan became the first country to completely regulate Bitcoin like any other financial institution. Since then, Japan has had the highest Bitcoin trading volume in the world. Indeed, regulation can bring bitcoin exchange firms under a stringent legal system able to ensure accountability for hacking and illegal transactions. In turn, this regulatory framework will bring legitimacy to this new digital financial market, making it more attractive for new businesses, established banks, and investors worldwide. Therefore, if Bitcoin’s many advantages are to countervail the causes of its currently dubious “trustworthiness”, a regulatory framework is needed.