(Theoretical and practical analysis of virtual currencies in case of Bitcoin) 

What is Bitcoin?

•Bitcoin is software-based online payment system described by Satoshi Nakamoto in 2008. and introduced as open-source software in 2009.

•Payments are recorded in a public ledger using its own unit of account (Bitcoin).

•It is a form of digital currency (physical form is absent), created and held electronically. It can be used to buy things electronically and in that sense it is no different than conventional dollars.

•Bitcoin is commonly referred to as cryptocurrency and it can be divided into smaller unit called Satoshi (one hundred milionth of a BTC).

What is it based on? 

•System is runned by The Bitcoin protocol

•It is based on mathematics unlike conventional currencies that had been based on fixed quantity of metal (gold, silver…) or fiat currencies. 

•Bitcoin has several features that set it apart from fiat currencies:

1.It is decentralized

2.It is easy to set up and it is fast

3.It is anonymous

1.  It’s decentralized 

•Base for the Bitcoin protocol is a peer-to-peer  system which means that there is no need for  a third party. 

•Therefore, in theory, bitcoin network is not controled by central authority (fully decentralized monetary system).

•Bitcoins are being created by a community of people that anyone can join. 

•In theory, there is no authority (financial institution) which can tinker with monetary policy and in that sense devalue or revalue Bitcoin currency. 

2. It’s anonymus and transparent

•Bitcoins are stored in wallet with digital credentials for your bitcoin holdings and allows you to access them. 

•Wallet uses public-key cryptography, in which two keys, one public and one private are generated. Public key can be thought of as an account number or name and the private key, ownership credentials. 

•Bitcoin is transferred to the next owner when the next owner gives a public key and previous owner uses his private key to publish a record into system announcing that the ownership has changed to the new public key.

•Bitcoin protocol stores details of every single transaction that occurred in the network in huge version of general ledger (Block chain).

3. Negligible fees and irreversible process

•Bitcoin doesn’t charge fees for either national or international transfers.

•Bitcoin is not the first private money, not the first digital currency, and not first currency based on cryptography, but it has been the first to rely on peer to peer network decentralization to avoid double spending.

•Bitcoin protects against double spending by verifying each transaction added to the block chain to ensure that the inputs for the transaction had not previously already been spent. 

How are Bitcoins created - Mining process 

•Miners use special software to solve math problems (Bitcoin algorithm), and upon completing the task they receive certain amount of coins.

•They are created each time a user discovers new block (finds hash value).

•Software is creating new units until it reaches amount of 21  million unites (currency with Finite Supply).

•The rate of block creation is approximately consistant  over time (6 per hour) with 50 % reduction every four years.

•Halving (in theory) continues until 2110-2140 when  21 million BTC have been issued.

How can one obtain Bitcoins? 

1.Earn Bitcoins from mining

2.Earn Bitcoins by accepting them as a means of payment 

3.Earn Bitcoins trough trading

4.Earn Bitcoins as a regular income 

5.Earn Bitcoin from interest payments

6.Various ways (donations, gambling, getting tipped, completing tasks on websites...)

Why price of bitcoins soared and why it  became the world pionner in virtual currency field? 

•Financial crisis that caused meltdown of the economy started 2008-2009.

•It caused a transfer of assets form real-estate and financial sphere to investment into commodities that are traditionally considered as a stable store of values. 

•Historically, Gold is best known commodity of that type because quantity of this metal is limited and, therefore, it is great way how to hedge your portfolio in times when usage of expansive monetary policy is highly likely.

•In this sense, bitcoin is similar to gold (except there is no intrinsic value) and when the value of gold started to decrease due to the price roof that it had reached and partial recovery of financial market, value of bitcoin soared because it was cleverly designed financial product with finite quantity.

Theoretical and technical problems which goes against favor of bitcoin usage: 

1.Illegal activities, speculations and nature of this currency,

2.Theoretical base for digital currency usage,

3.Regulation and taxation issue,

4.Disputable status of independent and  decentralized currency,

5.Mining problems,

6.Skepticism towards implementation  of new, unregulated, theologies in  finance sphere.

Illegal activities, speculations and nature of bitcoin currency

•Can currency be anonymous and transparent at the same time? (Slide 5)

•Why would somebody give you approximately 27,000 $ for solving impractical mathematical equations?

•According to Forbes (2014.), currently, more than 90 percent of bitcoin accounts are in a buy-and-hold mode!

„At some point in the growth of a boom all aspects of property ownership  become irrelevant except the prospect for an early rise in price. Income  from the property, or enjoyment of its use, or even its long-run worth is now academic.”      J. K. Galbraith (The Great Crash 1929.)  Money circulation 

M x V = P x Q   

•M – total amount of money in circulation

•V – velocity of money

•P – price level 

•Q – indeks of real value of final expenditures

Bitcoin as currency increases amount of money and hence leads to increasing price levels (V and Q constant). Since bitcoin is inherently deflationary it will benefit in a way that its usage will cause value decline of other currencies while bitcoin will experience rise.  

Theoretical background?  

•Theoretical background for bitcoin currency can be found within Hayek’s work „Denationalization of money, free banking and inflation targeting” 1977.  (Claim of bitcoin advocates).

•Hayek claims that the government should be depived of its monopol to issue of money.

•Central argument is that a price level stability can be achieved only by removing national governments of their monopoly to create money.

•Hayek suggests that allowing private enterprise to supply public with other media of exchange is a solution to monopoly problem, and that we need a free market with concurrent currencies.

•In his model, creation of money would be under control of private banks and they would supply the market with various types of currencies, therefore, creating competitiveness.

•In order to acchieve price stability every bank should tie its liabilities to certain basket of commodities for keeping its rate of change in-line with its promises.

•This theory faces strong objections which can be the subject of another lecture, but for now the important fact is that Hayek’s theory is not appropriate in case of bitcoin.