Although 85% of Germans have not heard of Bitcoin, The Economist calls it “one of the world’s hottest investments”. The so called hackers’ currency, has gained much attention lately again as the price of one bitcoin rose by over 600% to an all-time high of 220 USD (April 9) within less than two months. Currently, it is still almost 200% higher than two months ago and over 2400% higher than a year ago. Authorities are a now alarmed again since the last similar rise from 4 to 29 USD within just one month (May/June) in 2011. The media have already reported much about fears that the ‘currency’ could destabilize the economy, the state of law and even pose a threat to national security. In fact, it is not an official state-issued currency and it is not regulated so far, but it is a medium of exchange – a currency in the broadest sense and common parlance – with a current market capitalization (total number of bitcoins in circulation multiplied with the market price) of 1.3 billion USD (all-time high 2.6 billion in April). Meanwhile, authorities are discussing different interventional measures. Yet, justification is everything but trivial. Canadian authorities lately froze the bank accounts of major bitcoin traders, without explaining their reasoning. It remains unclear whether this can be intrepreted as a tightening restriction on bitcoin trading or is just a regular measure in a criminal investigation. While there is little known about the actual dimension of illegal trades such as drug dealing and money laundering with bitcoins or their role in financing terrorism, it can be safely assumed that illegal actions largely contribute to the rise of the bitcoin market.
First, what is behind bitcoin? It is basically just code – a protocol and software – that determines how the currency’s units (bitcoins, BTC) are generated, transferred and stored. It is therefore nothing tangible but it is very transparent and deterministic, two facts which should comfort us for the moment rather than raising concern. In terms of transparency bitcoin scores because it is open source code, all trades are authentic, verified and visible for everybody at all time (open source information). This is cryptologically ensured. Therefore, the worries of authorities that the bitcoin system is not controllable are debatable. The truth rather is that it is not officially regulated and controlled at the moment. But it could be! One approach would be to change the status of traders from anonymous to pseudonymous. Actually each trade already is assigned to two unique trader IDs and both, the traded amount and the IDs, are decentrally archived and visible for everybody. The clue is just to match the trader ID to an actual real person. This is the part where regulation could make sense. Today, traders can generate as many IDs as they want, even one for each trade, and there is little to nothing that would reveal traders’ real identities. This is, of course, as well a strong privacy feature as it is a pain for law enforcement. Nevertheless, a requirement for traders to register with a fixed ID that could be checked and confirmed by law enforcement under certain circumstances could resolve many worries. This would even have great potential for a better invesitigation and enforcement effectiveness of authorities than they have in the established financial systems today. Yet, this shifts the worries to privacy issues and to questions of trust in the authorities and of effective mechanisms to prevent crimes on both sides. However, it is time to think about effective and reasonable regulation measures other than just banning bitcoin completely.
Even more so because bitcoin has some interesting economic implications. Above I said that bitcoin is very deterministic. It is so because the code dictates a certain path of how many currency units are generated at what time. Often it is misunderstood how bitcoins are generated. It is true that you need computing power for this. But it is not the computing power that creates the bitcoins in the end. Instead the bitcoin system relies on cryptological verification of its trades and this is for what the computing power is ultimately needed. The basic incentive for people to provide computing power is that the system rewards them with newly created bitcoins (that is why it is called ‘mining’). So the money supply is pegged to the provision of computing power – for now. At this point imagine the bitcoin system as a peer-to-peer network of traders and transaction verifiers. What becomes obvious now is that there is no such thing like a central bank issuing money according to its more or less credible and effective monetary policy. The difference is that there is no uncertainty about the monetary policy here. Instead it is a set of fixed rules within the code which allows only very little uncertainty about the money supply over time. The maximum amount of bitcoin units is even limited to 21 million (with units being indefinitely divisible though). When this cap is reached, transaction fees will compensate the loss of incentive for miners to continue providing computing power. Rating uncertainty as a poison for markets, this is an aspect worth thinking about.
Game theory and real world monetary policy show us that central banks actually play with their credibility for sticking to an announced monetary policy or deviating from it. They do so because of an economic phenomenon known as suboptimality of time-consistent policies (see Kydland and Prescott, 1977). Once you have a certain credibility, refraining from what everyone expects from you may be beneficial. The major drawback of such an action is the immediate loss of credibility and the consequence that you may not be able to play the same card again for a long time. Even conservative central banks such as the ECB are loosening their policy further and further. But jeopardizing their reputation for being primarily guardians of price stability limits their policy discretion. The decreasing effectiveness of monetary policy is a supporting argument for those who see the bitcoin system as an alternative to the current global monetary system.
Speaking of price stability, even though the money supply side is no source of uncertainty, Bitcoin is prone to market-induced price changes. There is in fact no way to influence prices other than through the market. That means that governments would have to buy, hold and sell sufficient amounts of bitcoins to intervene – they cannot just produce new money. Another way would be to sabotage bitcoin wallets, computers, the bitcoin system as a whole or the underlying infrastructure, i.e. the internet. There have been numerous DOS attacks on bitcoin exchange and mining platforms as well as hacks into bitcoin accounts and wallets. While the latter is probably more criminally motivated, sabotage may also serve political goals.
To sum up: I believe that it is worth discussing pragmatic possibilities to regulate bitcoin to prevent fraud, crime, economic setbacks and threats to national security. With a current market cap of over 1.3 billion USD this new market should neither be ignored nor – unless based on good reasoning – be prohibited completely. There are some fundamental misunderstandings about bitcoin because the subject is – admittedly also for myself – all but trivial.