What is Bitcoin?
Bitcoin is a digital currency which makes use of peer-to-peer technology to operate without a central authority. It is a technology which enables functions not possible when using other payment systems. The management of transactions and the issue of bitcoins is carried out collectively by the network. Based on both common and new technologies, Bitcoin is an extension to traditional currency and is the fastest growing currency in the world, with the equivalent of over $800million in circulation.
Bitcoin is the first decentralised digital currency in the world, which was launched by a person or persons bearing the pseudonym Satoshi Nakamoto. There is no central monetary authority for Bitcoin, but instead, it is underpinned by a peer-to-peer computer network. The computers in the network mathematically generate bitcoins by carrying out difficult number-crunching task, in a process known as Bitcoin ‘mining’. The total number of Bitcoins which can ever be mined is limited to around 21 million.
How does Bitcoin work?
In order to use Bitcoin, one requires a wallet, which will generate a Bitcoin address. The address can be disclosed to others so that they can pay you, or else you can effect payment to others through their address. Then one would need to acquire bitcoins.
Bitcoins (or fractions of Bitcoins known as satoshis) can be exchanged in return for traditional currency on several exchanges, and can also be directly transferred from one user to another across the internet using the appropriate software. This makes Bitcoin highly suitable for international transactions, avoiding bank charges or exchange rates.
Balances - Blockchain
This is a shared public transaction log which is fundamental for the operation of the entire Bitcoin network as it registers all the confirmed transactions. In this way, it can be verified that all new transactions are making use of bitcoins which are actually owned by the spender. Cryptography is used to enforce the integrity and the chronological order of the blockchain.
Transactions - Private keys
A transaction is a transfer of value between Bitcoin addresses, which is registered in the blockchain. A private key is a secret piece of data which pertains to each Bitcoin address, and which is stored in Bitcoin wallets. Private keys are used as a signature for transactions, providing mathematical proof that the owner of the addresses is the person affecting the transactions and preventing any unauthorized alteration of the transaction once issued.
Processing - Mining
All transactions are broadcast between users and confirmed by the network through a process called mining. Mining is a distributed consensus system through which waiting transactions are confirmed by including them in the blockchain according to very strict cryptographic rules. Mining enforces a chronological order in the blockchain, guarantees the neutrality of the network, and permits different computers to agree on the state of the system. Moreover, mining prevents any individual from controlling what is included in the blockchain, or from replacing parts of the blockchain to reverse their own transactions.
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Benefits of Bitcoin over traditional currencies
Some advantages of using Bitcoins over other currencies are:
- Bitcoin is a transferable and storable currency outside of the banking system - no banks, no central authority and no physical coinage
- Digital - the currency is entirely online.
- Decentralized network – It is not possible for a central bank to issue new Bitcoins and devalue those already in circulation.
- Encrypted transactions.
- Always available 24/7.
- International.
- Faster transfers than banks.
- No chargebacks and immune from friendly fraud – once Bitcoins have been transferred, the transaction cannot be reversed. Only the new owner will have the associated private key, thus only he/she would be able to change the ownership of the coins.
- Transparent.
- Low transaction fees.
Risks
There are a number of disadvantages and risks associated with bitcoins. Amongst the most noteworthy there are:
- No valuation guarantee – given that there is no central authority, no one can guarantee the minimum valuation of Bitcoins. If a large group of merchants leave the system, its valuation will decrease, with immense negative repercussions for other Bitcoin investors.
- Bitcoin valuation fluctuates – There are often large fluctuations in the value of bitcoins according to demand. This not only creates uncertainty but have led to criticism of bitcoin's legitimacy as a currency. Significant variation in value will also create confusion if a refund for a product is required.
- Exchanges are vulnerable to hacking.
- Bitcoin wallets can be lost or stolen – if a hard drive crashes or a virus corrupts data, bitcoins could be lost without any potential form of recovery.
- Bitcoins are not yet widely accepted - since only accepted by a very small group of online merchants, it is unfeasible to rely solely on Bitcoins as a currency.
- No buyer protection – the purchaser who bought goods using bitcoin cannot reverse a transaction if the seller fails to send the promised goods.
- Built-in Deflation – this will inevitably arise since the total number of bitcoins is capped at 21 million. The value of each bitcoin will increase as the total number of bitcoins increases, which could cause spending surges inevitably causing the Bitcoin economy to fluctuate very rapidly, and unpredictable.
- No Physical Form – bitcoins need to be converted into other currencies to be used in physical stores, unless a universal system of Bitcoin cards is proposed and implemented.
- No Tracking – transactions are not traceable, unless users publicise their wallet address.
Security measures in place
To combat against such risks, there are various security measures in place, for instance, the private key is encrypted, data is stored in a TrueCrypt container on three separate flash drives, and the container password is then split into three parts making use of a 2-of-3 secret sharing model. Electronic security is combined with physical security, ensuring that each flash drive is duplicated several times and vaulted in a bank safety deposit box in three different geographical locations. Furthermore, only part of the key is stored in a particular bank, to ensure that if a single deposit box is compromised, the safety of the funds would prevail.
Does Bitcoin possess all the characteristics to be considered money?
There are nine characteristics for a medium to be considered money, and it would seem that Bitcoin has significant advantages in this regard over gold and fiat money, that is, the money officially used by a country.
- Scarce – Bitcoin supply is tightly controlled, and highly predictable
- Durable - Bitcoin digital, so it does not degrade with use, and bitcoin wallets can be duplicated to prevent file corruption
- Portable – Large amounts of Bitcoin can easily fit on a flash drive, and transferred to a recipient located anywhere in the world.
- Divisible – At present Bitcoin is divisible up to 8 decimal places
- Authentic Verification – It is not possible to visually identify Bitcoin since it does not exist in physical space, however, with advanced software one can identify Bitcoin in the blockchain.
- Storage – Bitcoin can be easily stored, and backup methods such as cloud storage could be used to reduce risk of loss.
- Fungible – At present, all bitcoin are considered equal.
- Difficult to counterfeit – It is widely considered to be almost cryptographically impossible to counterfeit a bitcoin
- Widespread Use – this is the most problematic characteristic since bitcoin is only accepted by a relatively small number of websites and traders.
Regulatory Perspectives
The treatment of bitcoins in different countries varies from money to an asset class, a highly secure P2P global information exchange, as a technology platform and even as if it were a startup entity in its own right. Some analysts have opined that the US may have made a strategic mistake in classifying Bitcoin as if it were money so early on in its development.
European Central Bank report on Virtual Currency Schemes
The European Central Bank (ECB) has recently issued a report on digital currencies, holding that these currencies pose risks that potentially require future regulation. An increase in the use of virtual money could potentially lead to a decrease in the use of ‘real’ money, in turn substantially reducing the size of central banks’ balance sheets and their ability to influence the short-term interest rates – they would not be able to impose minimum reserve requirements on virtual currency schemes. The central banks’ ability to monitor price stability and ensure control over credit developments would become less effective.
Amongst the other difficulties associated with virtual currencies highlighted by the ECB is that Central Banks would no longer be able to act as lender of last resort in order to prevent any possible chain reaction resulting from payment incidents or unforeseeable liquidity shortages. The level of safety of Bitcoin is below that of commercial bank money, given that the latter is subject to prudential requirements and ongoing supervision to reduce the likelihood of default. Moreover, there is no such thing as an investor/depositor protection scheme in relation to Bitcoin.
The ECB acknowledges that the use of virtual currencies such as Bitcoin has increased significantly in a relatively short period of time, and opines that regulation is necessary in order to minimize the risks associated with potential mishaps in the system, which could tarnish the reputation of the banking system as a whole. The ECB opines that Bitcoin cannot fall under the Electronic Money Directive (2009/110/EC) because it does not fulfil all the criteria outlined in the Directive. Bitcoin would also fall outside the scope of the Payment Services Directive (2007/64/EC), since this directive does not regulate the issuance of electronic money. One potential way forward identified by the ECB is that virtual currency scheme owners undergo a similar trajectory to the one taken by PayPal, where they seek authorization as financial institutions. This would prevent these schemes from being used by criminals, fraudsters and money launderers for illicit purposes.
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Bitcoin in Malta: What is the Regulatory Status of Malta Bitcoin Companies?
Chetcuti Cauchi Advocates has recently assisted clients with the obtainment of important clarifications from the regulatory authorities confirming the unregulated nature of the bitcoin business at present. Given that Bitcoin is not deemed to be a regulated instrument under MiFID, companies dealing in Bitcoin are not at present required to undertake a licensing process with the Malta Financial Services Authority (MFSA). However, the rapid growth of the industry is likely to necessitate greater regulatory oversight in the mid to near term. With this in mind, it will be important for bitcoin operators to maintain a close watch over regulatory developments and to operate their businesses in line with best practices established in other regulated industries.
