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So you have probably read that Romney’s tax return was supposedly hacked from  the audit company PwC, in order for that information to stay private the hackers are asking for a bribe of $1 million to be paid in a currency called Bitcoins. However, this currency is not so well known yet and for many it must seem like an odd request. Why extort a politician to be paid in an unknown currency?

Introduction
To answer that we need to understand what the currency is, how it works, and then answer why anyone would want to use it. Bitcoin is a digital currency with no issuing central bank. It is essentially a token of exchange and has a value of whatever anyone is willing to exchange it for. That is true of all currencies but it is most apparent with Bitcoin (BTC) as you should ask why would anyone accept these tokens in exchange for anything? As a new currency it needs the trust of its users in order to build its value. It needs participants who are willing to accept it in exchange for a good or service. Here I will provide a general outline of the currency with some insight into how I think the Bitcoin market has developed and what the future may hold. Part of the interest in bitcoin is an academic exercise of understanding how currencies and economics fit together, it is that stage between a computer game and a real currency. The original paper for Bitcoin can be found here: Bitcoin (pdf).

All of the considerations in this article are about bitcoin but essentially apply to any online currency. Before these e-currencies, or crypto-currencies, were created someone has obviously asked “what is the ideal currency?” A list of preferences is probably one that can’t be counter-feited or manipulated, and is freely exchanged internationally. The first two points are about preservation of value due to limitation of supply. The latter point is about the ease of access to said supply. Gold and silver are good examples but not perfect. E-currencies essentially take up no weight and no volume, unlike precious metals. The worry then becomes about security and the ability to protect one’s electronic assets.

The flip-side of this is to consider the demand of any currency, even if you have devised the perfect currency who is to say that anyone would use it. Naturally there has to be a demand to meet the supply.

Would you pay $1 for a loaf of bread? Probably, but now let’s ask: if I give you 1 unit of a new unknown currency would you accept that in exchange for a loaf of bread? Probably not. There needs to be a consensual acceptance of any currency, new or old, in order for a common daily trade to exist. If you don’t know anything about Bitcoin then you may be surprised to learn that 1 BTC is roughly $12 at time of writing. That is to say that 1 Bitcoin is already more valuable than a dollar; it has greater purchasing power. It would be interesting to understand why this is the case.

Supply
So I’ve told you that BTC is a digital currency that has some notionally accepted value, it also has no central bank. To some extent you could say that the currency started as a thought experiment, a nice idea that may not have taken off at all. It wouldn’t be the first good idea to fail at the first stage. I first heard about BTC a couple years ago and had difficulty understanding what it was due to  my stubborn preconceived notions of how a currency should work.

Just like a commodity (say gold)  a bitcoin is brought into a existence via a process called “mining”. Essentially, your computer solves a difficult maths a problem and you are rewarded with a bitcoin. In case you were thinking that this system can be cheated the result requires verification against other members of the community.

This last part is the key strength of the currency, all transactions are verified by the community. The process is automatic and happens electronically. So the more computing power you have then in theory the more problems you can solve and be rewarded for. However, there is a maximum number of bitcoins that can be created every day. It is algorithmically limited and monitored by computers that are connected to the network. This means that bitcoins have an incorruptible supply and are created at a predictable rate.

The actual rate of creation has been predetermined and is fixed within the computer algorithm that generates the problems. The change of solving the problems is always probabilistic but that doesn’t mean random. The rate is approximately 1 BTC every 10 minutes for the entire network. If there are few computers on the network then only a small amount of computing power is necessary to solve the problem, and vice versa for a network of many computers. A large amount of computing power is necessary to get a single bitcoin as more computers attempt to mine the currency. Eventually this rate will decrease to zero such that there is a maximum allowed number of bitcoins in existence (21 million).

Naturally, if 1 BTC is worth $12 then they wouldn’t be so useful for buying cheap items such as bread. However, this problem was already thought of; this is the problem of granularity. You want the smallest denomination to correctly facilitate the exchange of any item regardless of price. The way that bitcoins have been defined is to allow subdivision by up to 8 decimal places. One unit of this smallest denomination is called a satoshi, named after the founder of Bitcoins (likely a pseudonym). Doing the maths here suggests that there will be 2.1 quadrillion (21*10^14) satoshis in existence once the last bitcoin has been generated.

Demand
One of the most attractive parts of the currency is that the digital wallets where the coins are stored are anonymous. It is very difficult, perhaps impossible legally, to match the address of someone’s bitcoin wallet to their name. Naturally, this will appeal to those that which to save their money in a secure and anonymous location. This is why bitcoin is the currency of choice for the Silk Road, an online market place that facilitates the trade of many illegal substances. Via a secure anonymous log in using Tor people can buy and sell illegal substances on the Silk Road and then deposit their money in an equally anonymous and secure digital wallet.

That’s not to say that all items for sale on the Silk Road are illegal but it certainly attracts those that wish to trade in such items. Obviously, such people chose to use bitcoins because of the security an anonymity they offer although they still require people willing to accept this currency in exchange for dollars (or other) in order to buy items which cannot be purchased via bitcoins.

So now we can understand why someone would want to extort a politician and be paid in an untraceable digital currency. The hackers can  remain anonymous will also being paid for their illegal activity (bribery is illegal but whether it is moral is something to be debated elsewhere).

On the supply side of the currency, the key factors there are the predictable rate of creation and the subsequent storage of a secure digital currency. From a previous article we take Ray Dalio’s approach to finding the fundamental price of an item; that is, the price (P) equals the total number of dollars ($) (and equivalents) chasing the item divided by the total number of such items in existence (Q): P = $/Q. Basically, price equals demand divided by supply. If the supply of bitcoins increases until it hits a maximum then this will act as a weight upon the price (keeping it down). Consequently, as the currency becomes more famous and more in demand then the number of dollars chasing the currency will also increase. Classic supply versus demand in order to determine the price.

I tried to do this calculation but opted for the easier although not quite so useful re-arrangement where I took the market price (P)  around $12-13 and a total supply (Q) of about 10 million bitcoins to arrive at $120 million as the effective market capitalization of the whole market (something like the $ in the above equation). Ideally this market cap would be compared to the actual number of dollars chasing the currency and we could determine whether the currency is under or over priced (according to Dalio’s model).

This also means that the price will drop, as currency is created, but not enough new adopters of the currency are found. Like all financial assets bitcoin has already seen its first bubble when the price spiked up to $30 then fell over the following months to around about $2 (now back up to $12 as already noted). The price raced higher as mania took over. The supply fundamental are fixed so it wasn’t from a supply shock but from an excessive increase in demand that saw the price rocket. It rose far quicker than is sustainable by the current marketplace, hence the price eventually dropped.

Transparent and secure
It is also worth noting that the code which generates the currency is open source. Therefore absolutely anyone can download the code and pick it apart, and even create their own currency using the same algorithm. All of these factors added together are what has given traction to the currency as a valid form of exchange. The currency has a predictable supply which is transparent and free from human intervention.

The whole process is automatic and highly resistant to efforts of corruption. No central bank and no artificial creation of new currency once the last coin has been created. In this age of central banks grabbing all the headlines for “printing” new money people have become fed up. There is a lot of talk about gold and silver being used as currencies since they don’t have a central bank either; however, they are still not entirely free of manipulation. Fake gold bars with tungsten centers have been found and the question of how to relate cuisrrent real currencies to gold is an issue. Currently it seems impossible to clone bitcoins and the role they play is very similar to that of a gold, or silver, backed currency.

It is a government-independent currency that was created and maintained by a community of people whom are interested in having an independent currency. Here is an article about how to preserve anonymity: How can one preserve anonymity?

Legality
What has yet to be completely determined is whether the currency is, or can be, considered legal and what implications would that have for (say) tax and regulation. There is no regulation of transactions concerning bitcoin other than verifying that genuine bitcoins were exchanged. As a bitcoin is both like currency and a commodity then it should probably fall under the same regulation that currencies and commodities do. Bitcoins may not yet exist in current legislation, anywhere, but that’s not to say that a problem won’t arise when a government will try to regulate (and, of course, tax it). Taxation and  regulation of the currency I can forsee as being difficult; however, governments can attempt to restrict who has access to the currency. If someone set up a bitcoin investment company then you’d expect it to be regulated. That said, you don’t expect World of Warcraft currency investment to be regulated by a government. It is definitely an interesting topic with regards to regulation of entities involved trading the currency even if the currency itself is not regulated by any government.

Due to the anonymity of the currency there is a question of whether the currency faciltitates money laundering, but that is of course an issue of who trades the currency rather than the currency itself. Unlike Liberty Dollars, BTCs have no resemblance to dollars so there is attempt at defrauding the public. I found an interesting blog covers the possible regulations of bitcoins, see the Bit Titan blog.

Tax

If someone makes a lot of money in a computer game is it considered an investment, an income, profit or something else? Even if an in-game currency loses value (no capital gain) then generally there are some items (rare items) that rise in value: part of the dynamic is the lose of value due to the currency the other part will be from the supply / demand of a rare item. Such items can in theory be sold for real money which would eventually lead to a real, and potentially taxable, income. My thoughts with regards to bitcoin would be the same, it can potentially only be taxed once it is traded out for a real currency. Part of the problem here for tax agencies is the anonymity of the bitcoin currency. How easy is it to prove that someone sold millions of dollars of bitcoins?

If bitcoin is taxable then it could mean that losses from bitcoins can also be written down against tax due. Furthermore, if bitcoins are a currency, or commidity, then presumably they are taxed as a capital gain. Some of this is outlined in the bitcoin wiki in the myths section.

Exchange

Purchasing BTCs using real currencies is becoming easier with the existence of large international exchanges that are willing to accept several different types of currency via bank deposits, paypal and similar methods. It is also possible to find the coins on Ebay and from local sellers in person using bitlocal site (check address).

The BTCs are then held in online digital wallets (not necessarily online) until you wish to exchange them. There are several sites that facilitate the exchange of real items for BTCs, not just Silk Road, but other websites that host auctions similar to Ebay.

Banking

This is one of the more straight forward parts of the Bitcoin network. As the entire currency is digital and online then your electronic wallet is essentially your account and your bank. I'll note that there are some 'physical' versions of bitcoins but the electronic part is what counts (a special code).

Mining

See my later article about mining here: Bitcoin and Litecoin Mining

Hedging

As with all financial assets people desire methods of hedging themselves against the currency losing value. Not just speculators but companies that trade across borders seek to protect their income and assets from currency movements that go against their desires. As you would expect from a new currency there aren’t a lot of ways to actually hedge the risk of holding the currency. Some sites are beginning to offer Options and shorting as a means of hedging the currency; however, that risks trusting a third party to honour the agreement you have with them. In an unregulated environment you place accept a lot of unnecessary risks.

Perhaps unbeknownst to most people there is actually a way of shorting the currency without accepting counter-party risk. Anyone that understands shorting will have already figured it out, anyone that hasn’t will need to figure it out or live without it. That said, would you want to short BTC if you believe it is going to rise in price? It would be smarter to go long/short another currency using the widely available foreign exchange brokers.

Leveraged Trading
Leveraged trading is starting to become possible but not something I’d fully trust yet. The anonymity of the market participants doesn’t encourage trust in all aspects.

Bitcoin Equities (stock market)

Surprisingly, a stock market already exists and can be invested in using bitcoins. A fuller analysis of this will be provided in a later article. Edit: The day after I pened this article the biggest stock exchange was taken down (GLBSE), I believe there might still be one online but there are several challenges to overcome.