Bitcoins and the Future of Money

Kyle Lindquist

Prof: Antonio Bojanic

Econ 435: Money and Banking

10/24/12

Bitcoins and the Future of Money

Traditionally, there are two types of money; commodity money and fiat money. Commodity

money is backed by a real asset, while fiat money has no intrinsic value but is backed by faith in the

currency and limiting its supply. Fiat money by definition is also state-issued money, and declared by a

government to be legal tender. In contrast, Bitcoins have no centralized issuing authority. Instead, the

peer- to-peer network regulates Bitcoins balances, transactions, and issuance according to network

software. Some have called Bitcoin a precursor to the future of money.

What is a Bitcoin?

A Bitcoin is a peer-to-peer digital currency existing since January 3, 2009. Peer-to-peer means

each computer in the network can act as a client or server for other computers in the network, allowing

access to files (in this case money) without the need of a centralized server. Bitcoins are essentially

"mined" in batches of 50 for "confirming a block" as a result of intensive calculations carried out on

computers around the world. Anyone who wants to mine the coins can download the software, but as

time goes on, the time and computation effort to mine the coins greatly increases. An average personal

computer would currently take around 2 years to confirm a block. The supply of Bitcoins is finite, with

about 10 million in circulation now. The Bitcoin supply is setup to cap at 21 million Bitcoins which are

estimated to be mined by year 2140 (assuming they last that long). Currently it is about 1 million times

more work to confirm a block now than when Bitcoins were first created. The network adjusts the

difficulty every 2016 blocks based on the time taken to find the previous 2016 blocks so that one block is

created roughly every 10 minutes.

Bitcoins are currently the world's most widely used alternative currency, with a market cap

exceeding 110 million US dollars. They can exchanged either directly from person to person, or through

an exchange such as Bitpay, which offers more security against fraud for a transaction cost. With the

service Bitinstant, you can exchange Bitcoins for traditional currencies and vice versa. Currently, one

Bitcoin exchanges for approximately $10.00 USD.

Benefits vs. Drawbacks

There are several appealing aspects of Bitcoins. It is a great alternative to traditional money

transfers when exchanging money internationally. Moving money from country to country by an

international money transfer not only exposes parties to risk as exchange rates fluctuate but can take up

to 10 days to get from point A to B. The transfer of Bitcoins is virtually instant and eliminates transaction

cost. Perhaps the biggest draw to Bitcoins is there anonymity. They are not tied to a bank account,

difficult to trace, and can be stored inside the memory of your home computer. This has led Bitcoins to

be a widely used currency for trading illegal goods. Weapons and drugs among other things are easily

purchased online with Bitcoins.

While Bitcoins are a novel idea, they have some glaring drawbacks. The first is exchange rate

volatility. In 2011, Bitcoins reached as high as $30 USD and crashed to as low as $2 USD. There is a huge

amount of uncertainty regarding fluctuations in exchange rates. Another issue is hackers. In June 2011, a

hacker stole around $500,000 USD worth of Bitcoins. Also, because of the anonymity Bitcoins provide,

moral hazard is extremely high. It is difficult to recoup money if for instance you ship an item but the

buyer fails to transfer coins. Asymmetric information needs to be reduced if Bitcoins are to be more

widely adopted. Last, because Bitcoins have no central bank, several of the functions of the central bank

are not covered. Who clears payments with Bitcoins? Also, the central bank is a guiding force for

monetary policy and financial regulation. Bitcoins are far from regulated.

The Future of Bitcoins

I believe that Bitcoins have a strong future. They are not even four years old, yet have an

economy of $110 million USD with around 14 million