The dramatic rise and fall of Bitcoin in recent times has brought the existence of virtual currencies into the eyes of the wider public. And with this attention has come questions, specifically from regulators, with regards to the functionality of the virtual currency. How does it work? Who backs it? What is its worth based upon? How should it be regulated? What all of these questions come down to in the end is people’s general relationship with money, be it in paper or digital form. It boils down to a question of trust. A more pertinent question perhaps is will people’s trust towards virtual currencies dramatically increase in the future?
Professor Dr. Ron Berndsen, Head of the Oversight Department of De Nederlandsche Bank and Endowed Professor of Financial Infrastructure and Systemic Risk at the University of Tilburg, is in the process of examining the role of virtual currencies in today’s world. In 2011 he created the concept of a Payments Warehouse entitled “What is happening in Scrooge Digiduck’s Warehouse?” to describe the interlocking methods of modern payment systems. He is currently working on where virtual currencies sit in juxtaposition to his Payments Warehouse, a challenge considering how rapidly the landscape of Bitcoin has altered during the first few months of 2014.
In the beginning…
Having launched in 2009, Bitcoin is an experimental, open-sourced, decentralised, digital currency currently made up of processed data blocks to facilitate near instant payments for real-world goods and services. Bitcoin is currently the most popular, but one of many similarly styled crypto-currencies. The elements of Bitcoin that have boosted its popularity are the fact that payments are considered faster and cheaper than traditional methods of payments, and that payments are designed to be anonymous. Existing traditional payment systems created before the development of the Internet, such as credit cards, do not sit well with the real-time payment environment that is required to conduct financial transactions over the World Wide Web. Modern payment systems need to be available 24/7 and on a worldwide basis – Bitcoin answers this need. Bitcoin also removes the pivotal duties of the central bank including the issuance of currency as legal tender, as well as monitoring and backing of payments. Payments via Bitcoin are considered anonymous because they are made through peer-to-peer technology, meaning they are made directly from one private individual’s computer to another with no organisation (such as a bank) residing in the middle of the two parties. Berndsen explained, “There is no official government authority overlooking Bitcoin, therefore there is no central authority responsible for regulation or providing a lender-of-last-resort or liability regime. Bitcoin is essentially governed by CPU units.”
The flip side
In the case of Bitcoin, anonymity has also become a weak point for the currency. From the larger perspective of anti-money laundering there are obvious reasons regulators do not deem peer-to-peer payments (P2P) desirable. The question of anonymity in itself is also not so clear-cut. Berndsen noted that with the right equipment it is possible to detect the identity of a user in most cases. Once the identity of a Bitcoin address is known, authorities can monitor all the other transactions from that address. One could of course create a new Bitcoin address for every single payment in the name of anonymity though this method is considered rather cumbersome.
Outlining some of the other shortcomings surrounding Bitcoin, Berndsen noted that the fledgling currency is not considered very user-friendly, meaning the populous at large would not easily or readily take it up in its current form. Bitcoin is also transitory; Berndsen explained, “There is currently a software problem. There are many people in the process of developing more user-friendly software based around the original “command line” Bitcoin algorithm, however, these will be made available at a cost.”
Furthermore, Berndsen’s research has uncovered the existence of a rather opaque fee structure. Bitcoin transaction fees are not calculated as a percentage of the value of the transaction, but actually by the number of bytes it takes to process the transaction. The calculation of the underlying bytes means that the cost of transaction does not remain at a standard rate.
A matter of trust
Berndsen pointed out that any system of currency is highly dependable on the element of trust. He gave the following description: “If we take one step back from virtual currencies, we had electronic money, where an issuer was still present. If we take one further step back we had the fiat money system, which consists of tokens such as bank notes, and that money becomes dependent on the reputation of the central bank of issue, and people had to trust that that the central bank was running the currency with good monetary policies in order to retain its value.“
“If Bitcoin stabilises there is a possibility that people could feasibly trust the Bitcoin currency more than those of central banks, especially given the fact that trust in the financial sector including central banks has declined over the past 5 years. But Bitcoin will need to have the ability to innovate and they will need to have a stable exchange rate with outside currencies.” In terms of money transacted in the real world, Bitcoin (or other competing digital currencies) will need to achieve an element of ‘trust’ by a large group of people.
A Virtual Euro?
When asked if regulators see virtual currencies as posing a risk to the status quo if and when a larger percentage of people begin to use them, Berndsen pointed out that in the Netherlands, for example, the position has been taken that it is better to educate the public on the risks currently associated with virtual currencies rather than ban them outright, such as has been the case with China and Bitcoin. Furthermore, he explained that European regulators take the view that it is extremely difficult to impose an outright ban on virtual currencies because it would be incredibly difficult to enforce due to the nature of the P2P system. Berndsen clarified the European viewpoint by saying, “With the development of virtual currencies, we have to keep an open mind. We have to be aware that because of this perception of trust by a large group of people, the acceptation of virtual currencies on a widespread level, could perceivably change.”
When asked if a “virtual Euro” could be created in the not-so-far-off future, Berndsen deemed that such an instrument could be on the cards as the ability to transfer Euros over a P2P network “would be a desirable thing”. With the development of mobile contactless payment technology this could indeed become more conceivable. Given the nature of Europe’s financial infrastructure and the dependence of this payment on that financial infrastructure this would not, therefore, be a payment that would be settled immediately such as is the case with Bitcoin. It could, however, have the feeling of an immediate payment as the front-end would show that the funds would be transferred immediately whilst in reality it would take place in a timeframe of more like two hours.
The Ultimate Warehouse
In terms of fitting virtual currencies into Berndsen’s Payments Warehouse, he explained that each virtual currency would get a whole new warehouse respectively since each cryptocurrency is self-denominating. In terms of digital currencies fitting into an “ultimate warehouse” of the future, Berndsen envisaged that perhaps one day there would be a worldwide currency with no governance and with no formal authority or country responsible for managing the currency. If people trust it and wanted to use it, they could do so.
Berndsen concluded, “The future will be interesting – to see how many competitors come along, how different governments choose to accept them or create legislation to bring them more into the fold in order to protect consumers.” But as a rule of thumb in the meantime he recommended that people should not currently trust an open-source software system over a central bank-backed currency.
Professor Dr. Berndsen will be discussing virtual currencies and how they fit in the Payments Warehouse at Sibos University in September 2014 in Boston.