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The Green Sheet Online Edition

August 26, 2013 • Issue 13:08:02

Bitcoin - viable currency or flash in the pan?

By Patti Murphy
ProScribes Inc.

Virtual currencies, like bitcoin, which is promulgated by the Bitcoin Project, are a modern-day response to an age-old consumer concern: protecting assets from the vagaries of economic and political uncertainties. But as recent events suggest, volatility and uncertainty surround virtual currencies. Unless or until the situation stabilizes, broad-based merchant acceptance doesn't seem to be in the cards.

"Bitcoin and other digital online currencies have caused a stir internationally because their anonymity supports purported illicit activity," wrote Jeff Green, Director, Emerging Technology Advisory Service at Mercator Advisory Group, in a recent report. "Unless issuers work more closely with government regulators to overcome these concerns, such currencies face a difficult future in open commerce as legitimate currencies for everyday online spending." In a subsequent interview, he added, "It's really just an investment toy right now."

Not surprisingly, John Stahl, a spokesman for the Bitcoin Foundation, a recently launched self-regulatory group, takes issue with such pessimism. "Any merchant that sees value in being able to transact without the burdens of exorbitant credit card fees, chargeback risks, credit card fraud and identity theft falls under the category of businesses that could benefit from bitcoin," he said.

Bitcoin evolution

Bitcoin was established in 2010 by a person (or group - no one knows for sure) known by the pseudonym Satoshi Nakamoto. Bitcoin is a cryptographic cash replacement that bypasses financial institutions and, by extension, the monetary policy influences of the U.S. Federal Reserve and other central banks.

Initially driven by techno-geeks and survivalists, the Bitcoin Project grabbed headlines and public mindshare in March 2013 when a banking crisis in Cyprus triggered concerns that prompted some depositors to empty their bank accounts and purchase bitcoins with the cash.

Bitcoins are inflation proof by design: only a finite number can be created. They have become a hot item with investors, and apparently money launderers, too. The result has been significant price volatility and concerns among government agencies over the legal and economic implications of digital currencies and the exchanges that have popped up to support them.

In late July 2013, the Bank of Thailand, that country's central bank, outlawed bitcoins, citing lack of applicable laws and capital controls, according to a statement from Bitcoin Co. Ltd., Thailand's only virtual currency exchange. The move makes it illegal to buy, sell or transact with bitcoins inside Thailand, as well as to send bitcoins into or out of Thailand.

That news came on the heels of word that the U.S. Securities and Exchange Commission had filed charges against a Texas man for operating a bitcoin Ponzi scheme. The accused, Trendon Shavers of McKinney, Texas, allegedly defrauded investors he had lured with promises of 7 percent interest a week on bitcoin investments.

In an "Investor Alert" issued in tandem with news of the indictment, the SEC urged investors to be on the lookout for similar types of fraud. "We are concerned that the rising use of virtual currencies in the global marketplace may entice fraudsters to lure investors into Ponzi and other schemes in which these currencies are used to facilitate fraudulent, or simply fabricated, investments or transactions," the SEC wrote.

Governmental constraints

The Department of Homeland Security and the U.S. Department of the Treasury have also voiced concerns about virtual currencies. Treasury's Financial Crimes Enforcement Network ruled in March 2013 that anyone who exchanges virtual currencies for greenbacks must register as a money transmitter service and abide by the strict recordkeeping and reporting rules that come with a money transmitter's license.

In May, Homeland Security ordered the digital wallet company Dwolla Inc. to stop sending and receiving wire transfers involving Mt. Gox, a Japanese concern that claims to be the oldest and largest exchange for trading in bitcoins. The department also seized funds that a Mt. Gox subsidiary had deposited with Wells Fargo & Co. to facilitate bitcoin exchanges.

In addition, Mt. Gox was forced to shut down for 12 hours in April after being hit with a distributed denial-of-service attack. That attack precipitated a huge drop in the value of bitcoins, which fell from a trading high of $266 to $105 per share in one day. Today the trading price hovers at just over $100.

Stahl said price volatility is to be expected. He insisted the real news is just how fast bitcoins have taken off, noting that two years ago bitcoins were trading for 30 cents. "If the current market saturation that Bitcoin enjoys is taken into account and compared to its potential, it's clear that volatility will be inherent for the foreseeable future," Stahl said.

For merchants who don't want to deal with volatility but still want to accept bitcoins as a payment option, "there are services that would love to accept bitcoins on their behalf and reimburse them with a more traditional currency," Stahl added.

The nitty-gritty

Bitcoin is a decentralized electronic cash system that relies on person-to-person (P2P) networking (think BitTorrent, the file-sharing system, or Skype), digital signatures and cryptographic security to enable irreversible payments between parties. Individual bitcoins are mathematically generated through a process known as "mining" and are stowed by individuals in (digital) bitcoin wallets. An electronic log entry is made for every bitcoin that's awarded or spent.

Stahl described the Bitcoin system as an equal opportunity payment method. "There are no prerequisites for Bitcoin," he said. "You don't have to fill out an application, give your Social Security Number and trust that a bank will bless your credit score."

Coinbase, headquartered in San Francisco, is possibly the best known bitcoin wallet. Opened in 2009, Coinbase supports P2P payment and merchant transactions - "micro-transactions with zero fees" is how Coinbase trumpets its services. In July 2013, Coinbase reported it had 205,000 users doing 156,000 transactions a month. The company is backed by a group of high-tech investors who are convinced it's a potential goldmine.

The mathematics behind Bitcoin is also a bit like gold mining. It limits to 21 million the grand total of bitcoins that can be mined. The closer to that limit the market reaches, the more difficult the mathematics. At present there are just over 11.5 million bitcoins in circulation with a combined value totaling $1.1 billion, Stahl said. He estimated it will take until the year 2140 before the 21 million limit is reached. Mining bitcoins can be done individually. However, given the large amount of computing power required and the fact that bitcoins are awarded in blocks of 25, it's more common for individuals to join mining "pools," Stahl said. A pool member earns shares of the bounty (deposited to their bitcoin wallets) based on their computers' contributions to the mining process. People also can purchase bitcoins on digital exchanges like Mt. Gox.

Merchant accounts

A handful of ISOs and merchant level salespeople are working with businesses that want to accept virtual currencies. Maria Sparagis, Chief Executive Officer at DirectPayNet, said much of the demand comes from high-risk businesses. "I'm seeing merchants who are unable to obtain merchant accounts because of poor credit or financial issues, or who find card acceptance unfeasible because of high reserves imposed by acquirers," she said. These merchants are looking for alternative currencies like bitcoin because constraints to acceptance are limited.

"Also, bitcoin is a final payment so there is no risk of chargebacks to the merchant," she said. And although the fees charged for processing bitcoin transactions are minimal (less than PayPal Inc., proponents like to point out), opportunities exist for value-adds, like up-to-the-minute exchange rates, added security and currency choices, Sparagis noted.

DirectPayNet, which specializes in e-commerce transactions, primarily serves merchants in Canada, Europe and South America. The company acts as a direct agent for several acquiring banks in Europe and South America, and as a reseller for several U.S. ISOs, Sparagis said.

A big push for virtual currencies could come from businesses looking to grow internationally. "Bitcoin is growing in popularity in places where there is a lot of economic corruption and limited banking services," Sparagis added.

Potential reach

Further evidencing worldwide appeal, the two leading money transfer networks - The Western Union Co. and MoneyGram International - have said they are looking into whether they can support P2P payments in bitcoins. However, Green said it's a posturing move, writing that "neither has any immediate plans to support bitcoin exchanges." Green's insights are contained in a June 2013 Mercator report titled Alternative Currencies: Is There Staying Power?

Today there are two major roadblocks to widespread adoption of bitcoins: government regulation and trust. Consumers must be able to trust the businesses they're paying with bitcoins, since they have limited recourse. Businesses need assurances that digital currencies are not just a flash in the pan that will end up being worthless. And governments need to be assured that digital currencies are not being used for illicit purposes, Green said.

Opinions diverge on whether bitcoins could ever become as common as government-backed currencies. However, the potential such innovations have to affect the future of commerce is part of what makes our industry so endlessly fascinating.

Bitcoin to merchants: We're no PayPal

Several comparisons have been made between the Bitcoin Project and PayPal. However, Bitcoin champions have countered that the only thing Bitcoin and PayPal have in common is that they are both payment systems, said John Stahl, a spokesman for the Bitcoin Foundation.

When The Green Sheet asked Jon Matonis, the foundation's Executive Director, about the comparisons, he referred us to an article he wrote for Forbes magazine in which he discussed issues that would arise if PayPal were to incorporate bitcoins into its network. PayPal's practices of freezing accounts for "suspicious" activity and linking transactions to specific accountholders don't work with the fundamental premise of anonymity that Bitcoin is built upon, he said. That's also why banks can't compete with Bitcoin.

"My advice to PayPal and other conglomerates 'looking into' Bitcoin with a shoehorn approach is to understand how authorization, clearing and settlement occur nearly simultaneously within the Bitcoin distributed transaction network," Matonis wrote. "Enhancing, rather than diminishing that feature is the key to success. Bitcoin doesn't need PayPal to be mobile, but PayPal probably needs Bitcoin to become seamlessly mobile."

It's not just Bitcoin

Bitcoin is one of a flock of virtual currencies spawned by the Internet and consumers' misgivings about government. "Distrust of government-issued currencies, or competitive threats involving businesses, for years has prompted the occasional alternative currency to emerge, but few have had much staying power," Mercator's Jeff Green said. He pointed to research by Carnegie Mellon and Southern Methodist universities indicating 45 percent of Internet exchanges that support bitcoins fail, often following security breaches.

The social network Facebook, meanwhile, is retiring its virtual currency, known as Credits. Users had complained it was too complicated and usage had waned, according to reports. In an ironic twist, news of the demise of Facebook Credits was followed by Amazon Inc.'s launch of a virtual currency, known as Coin. To promote its new currency, Amazon gave away millions of "coins" to owners of Kindle Fire devices in hopes those individuals would use them to purchase games and apps using their devices.

Here's a sampling of other alternative currencies in use today.

  • OpenCoin is a London-based network that supports P2P payments in any currency, including bitcoins. The exchange rate charged is one ripple (or one-thousandth of a cent). OpenCoin claims transactions settle in seconds. Individuals also can mine ripples, and like bitcoins, there's a limit to how many ripples are mined.

  • LiteCoin is based on the Bitcoin Project protocol but differs in that litecoins can be mined using consumer-grade computers; bitcoin mining requires significantly more computing power. LiteCoin also claims faster transaction confirmations than Bitcoin.

  • Feathercoin was created to one-up LiteCoin. There are 336 million potential feathercoins, which is about three times the total available litecoins.

  • PPCoin (also known as PeerCoin, Peer-to-Peer Coin and PPC) is a virtual currency much like the others. Ppcoins are mined, and there is a finite number. Unlike other digital currencies, ppcoins can be exchanged for different digital currencies, as well as government-controlled currencies (commonly referred to as fiat currencies). PPC also has adopted rules to ensure no one person/organization secures a monopoly on the currency.

end of article

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