COMPASS MAGAZINE #11
COMPASS MAGAZINE #11

VIRTUAL CURRENCIES’ ROUGH ROAD Despite scandals, government-free currencies are gaining fans

Many people have difficulty believing that a currency created by a computer geek can have real value, but 75 “crypto-currencies” are available today and they’re being exchanged for actual goods and services – including some that are illegal. Compass looks at the attractions and drawbacks of virtual currencies and their evolution to date.

The concept of virtual currency – money created on a computer rather than produced in a government mint – is, at first glance, promising. Such “crypto-currencies” can be moved around the world at virtually no cost, while traditional money-transfer services charge hefty fees. More importantly, because virtual currencies are not controlled by governments, they are not subject to exchange controls and should be immune from hyperinflation or sudden depreciation.
But the reality of such currencies is proving less utopian, with scandals ranging from drug trading to trader bankruptcies threatening the concept’s long-term viability.

More than 75 e-currencies are being traded worldwide, with an estimated market value of US$11 billion. The largest, with about US$10 billion value, or almost 90% of the market, has gained fame as “bitcoin”; competitors have names that include litecoin, dogecoin and XRP.

Virtual currencies get their value from people’s willingness to exchange goods, services and traditional, government-issued currencies for them. This same “willingness to believe” has given government-issued currencies their value since 1971 when the USA, followed by the rest of the world, canceled their promises to exchange coins and notes for government-held gold reserves. Once the exchange to gold ended, as economist Milton Friedman observed, “the pieces of green paper have value only because everybody thinks they have value.”

The public’s trust in virtual currencies is not nearly as widespread or strong as public confidence in government-issued currencies, credit cards and electronic bank transactions (in fact, money that exists only on a computer and gets passed from bank to bank now accounts for 92% of the world’s supply).

But enough people have confidence in virtual currencies’ stability and exchangeability that they are gaining wider acceptance.

US$460 million

Japan’s MtGox, the world’s largest bitcoin exchange, filed for bankruptcy after admitting that bitcoins worth US$460 million had been stolen by hackers.

A BRIEF HISTORY

Virtual currencies have been around for at least 18 years, when something called e-gold was first unveiled. Bitcoin was created by a programmer with the pseudonym Satoshi Nakamoto in 2008, and each coin was initially worth about 25 cents US. (The person or organization behind the currency has, so far, kept its identity secret.)

The value of a single bitcoin soared as high as US$1,176 before crashing back to US$625 in early 2014. Many analysts now believe bitcoin’s success or failure in winning acceptance as an alternative currency may have long-lasting implications for the use of all virtual currencies.

Steven Englander, global head of G10 foreign currency strategy at Citibank, notes that bitcoin emerged at the height of the 2008 financial crisis, when the value of traditional currencies was stumbling. “It may not be perfect, but in a country with hyperinflation like Argentina or Venezuela, where households have lost confidence in the government’s ability to offer a stable store of value, bitcoin is the best thing ever, but that is unusual,” Englander said.

FEE-FREE TRANSACTIONS

For businesses, virtual currencies’ ability to be transferred electronically at little or no cost may hold the most attraction. Virtual currencies don’t carry the 3%-5% fee charged by MasterCard or VISA for processing credit card transactions, which could benefit retailers. Such currencies also carry virtually no charges to compensate for fraudulent usage.

Javier Marti, who runs a bitcoin investment consultancy in London, says such transfer arrangements will benefit business-to-business users as well. One of Marti’s customers recently moved US$1 million from the UK to South Africa for the equivalent of 25 cents US, rather than the US$200 fee typically charged by his bank.

 “WE BELIEVE BITCOIN CAN BECOME A MAJOR MEANS OF PAYMENT FOR E-COMMERCE.”

DAVID WOO HEAD OF GLOBAL RATES AND CURRENCIES RESEARCH, BANK OF AMERICA MERRILL LYNCH

“We believe bitcoin can become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money transfer providers,” David Woo, head of Global Rates and Currencies Research at Bank of America Merrill Lynch, wrote in a recent analysis.

But Mark Williams, who teaches finance at Boston University, counters that virtual currency “was dreamed up in a virtual world; the market is testing that experiment, and it’s failing in lots of different ways.”

HACKERS AND SMUGGLERS

Bitcoin has gained the most following, in part because it is supported by the most elegant software infrastructure and was designed to avoid the need for a central clearinghouse to supervise transactions. Instead, an electronic public ledger records every transaction since the first day of issue. When new transactions are verified and updated by computer experts known as “miners,” new bitcoins are created to reward the miners for their efforts in keeping the currency’s value transparent.

For the average customer who lacks the computer skills to be a miner, bitcoins can be purchased at online exchanges, available from China and Japan to Slovenia. Automated bank machines that issue bitcoins also are beginning to crop up. Bitcoin credits are transferred into a virtual “wallet” that can be downloaded for later use.

One of the controversies surrounding bitcoins is that the virtual currency is concentrated in relatively few hands. Williams estimates that just 47 people, principally the first “miners,” own 29% of the bitcoins in existence, and 800 people own a whopping 50%. This creates the risk of hoarding to keep the supply small and prices high, affecting the currency’s value.

Several solutions to the value question have emerged. Bitpay, for example, converts a transaction into US dollars or other traditional currencies at a guaranteed rate as soon as a bitcoin transaction is complete, insulating retailers from currency risk. The Ripple transfer network offers a similar service for its own, rival e-currency, XRP.

Hackers are another challenge. While bitcoins themselves are virtually impregnable thanks to the public ledger, several online bitcoin exchanges set up to facilitate the transfer of established government currencies into bitcoins have been infiltrated by hackers. In February 2014, the largest bitcoin exchange, Japan’s MtGox, filed for bankruptcy after admitting that bitcoins worth US$460 million had been stolen by hackers. The resulting blow to confidence sent bitcoins’ value skidding.

THE CRIMINAL ELEMENT

Because bitcoins can be traded and sold without revealing your name, they also have become attractive to criminals.

Two recent high-profile arrests have underscored bitcoin’s darker side. Charles Shrem, a 24-year-old enterpreneur on the board of the nonprofit educational group Bitcoin Foundation, was charged with money laundering by US authorities in January 2014. In October 2013, 29-year-old American Ross Ulbricht was arrested on narcotics and money- laundering charges, accused of being the mastermind behind Silk Road, an online bazaar for drugs that only accepts bitcoin payments.

China subsequently announced a crackdown on bitcoin transactions, which sent the price plummeting. A number of other governments, including Russia and Vietnam, made bitcoin transactions illegal.

THE FUTURE OF CRYPTO-CURRENCY

Marti notes that fluctuations of new currencies are typical as markets seek to determine their true value. Despite bitcoin’s recent difficuties, Marti said his business, which sells real estate and high-priced art for bitcoins, is “expanding very aggressively.” The number of online retailers accepting bitcoins also is growing, and the University of Cumbria in northwest England accepts bitcoins as tuition payments.

The US government has not taken a position on virtual currencies. In fact, the new US Federal Reserve chairman, Janet Yellen, told the US Congress that cyber-currencies are completely outside her purview. If other government regulators follow suit, it may be too early to count the crypto-currencies out. ◆

by Charles Wallace Back to top
by Charles Wallace