In the not-too-distant future, Bitcoin, and the blockchain concept behind it, could change the way organisations of all types and sizes across the world do business.
Understanding its key principles will help you prepare for this significant shift.
Bitcoin and blockchain - the future of trading?
Legend has it that the first exchange-based economies began life when people started fashioning portable, durable commodities such as silver and gold into coins.
Soon, traders were exchanging receipts verifying the wealth they had in bank vaults and widespread growth of the exchange-based model followed. This had the effect of turning immobile stacks of bullion into ready, usable cash.
Then in 2009, Bitcoin came along. While many commentators reared on the traditional view of money still don’t understand Bitcoin, others believe it will transform our economies and political systems.
Unlike any other currency, Bitcoin exists entirely online, residing only on computer hard drives. Despite this, it has become the first worldwide peer-to-peer currency not controlled by a government or central bank.
You can obtain Bitcoin in two ways:
- By purchasing it from a currency exchange using standard payment methods; and
- Bitcoin mining, the process of adding transaction records to Bitcoin's public ledger of past transactions, known as the blockchain (see below). This requires specific hardware and software and high levels of computational power. For this reason, the Bitcoin network remunerates Bitcoin miners by way of newly issued bitcoins and a proportion of the transaction fees received from the transactions they process. The more computing power a Bitcoin miner contributes, the greater their payment from Bitcoin.
Bitcoin is not likely to challenge credit or debit cards as a mainstream means of payment any time soon, nor is it a reliable store of value. However, it is gaining popularity as a means of exchange of goods and services.
Advantages of Bitcoin
The two key advantages of Bitcoin are:
- Decentralisation – decentralised, unregulated and free of any state or institutional control, Bitcoin offers private issuance, invisibility of transactions and immunity to taxation. For many, these are positive attributes; and
- Widespread adoption – in 2013, Bitcoin was approved by the US Congress as a legitimate form of payment. Now the EU, Canada, Russia, Japan, Brazil and South Africa also allow Bitcoin transfers. None of these countries consider Bitcoin to be legal tender or require businesses to accept Bitcoin payments, however businesses and individuals can opt to do so.
Disadvantages of Bitcoin
Factors holding Bitcoin back include:
- Volatility and unpredictability – Bitcoin has not yet proved a reliable store of value. Instead it has been subject to large, sudden fluctuations. In May 2010, the first real world purchase using the currency saw a customer pay 10,000 Bitcoins for two pizzas. By February 2011, a single Bitcoin was worth approximately one US dollar. In the years since, the value of a Bitcoin has swung between USD 4 and USD 1,242;
- No regulatory protection – because Bitcoin transactions are not regulated in the same way as banks and foreign currency exchange bureaus, there is very little protection if anything goes wrong in the conversion process. Similarly, there’s no consumer protection for Bitcoin transfers;
- No lender of last resort – Bitcoin is not issued or controlled by a traditional central bank, so there’s no lender of last resort to act as a fail-safe and protect its value. This also means Bitcoin is exempt from existing laws protecting credit card transfers and bank deposits; and
- Illegal activities – inevitably, a value exchange mechanism that bypasses conventional banking channels and regulation will appeal to those interested in tax avoidance, money laundering and buying illegal goods and services. Bitcoin has a notorious reputation as the preferred currency of drug dealers.
Perhaps even more significant than Bitcoin itself is its underlying software model, the blockchain.
The key principle behind the blockchain is the departure from a central hierarchy to a reliance on decentralisation and algorithmic trust.
Groups of Bitcoin transactions are bundled into blocks and stored in a single, global ledger. This is the blockchain. It holds a copy of every Bitcoin transaction ever made and records who owns what. The ledger takes the form of a shared database. It is not stored in a single location, where it would be vulnerable to attack or loss. Instead, copies of the blockchain are distributed among all Bitcoin users, strongly encrypted to protect it from loss and malicious threats. This means that while no individual entity has sole control, all transactions are publicly viewable and any Bitcoin user can validate any transaction.
The blockchain system has potential applications beyond Bitcoin. In place of one, vast, unified system with anonymous transactions, consider a focused network of companies within a particular industry who do business together. Because all businesses today have their own method of financial record keeping, transactions and dispute resolution can be slow. The blockchain approach offers a record that is both consistent and visible to all members of that network.
In commercial banking, for example, reconciling multiple different ledgers with counter-parties consumes significant time and effort. A single, shared database, which allows all parties to see all changes, would simplify these reconciliation processes.
Bitcoin, blockchain and crypto-currencies (encrypted digital currencies) are still in their infancy. They are at the same stage of development as the commercial internet was in the early 1990s – raw and unshaped as a technology and used mainly by a minority of experts and early adopters.
However, major venture capitalists and large technology companies such as IBM, Microsoft and Accenture are investing heavily to prototype several different concepts and commercial applications. At the same time, many tier 1 global banks are deploying significant resources and dedicating research groups internally to understand, develop and exploit the blockchain technology. The first projects are focusing on inter-bank clearing, pushing towards an open internet for money.
Looking further ahead, technologists see blockchain as a pointer towards a future automation economy and the exchange of value by intelligent machines.
Though yet to establish itself as a mainstream currency, Bitcoin, having been around since 2009, seems here to stay. The US Congress, the EU, Canada, Russia, Japan, Brazil and South Africa all recognise its legitimacy. Its lack of regulation however, is a double-sided coin: invisibility of transaction and potential immunity to tax liability on the one hand versus volatility of exchange value and no buyer protection on the other. However, perhaps its greatest value lies not so much in the currency itself as in the blockchain principle that underpins it. Blockchain could offer a way for complex inter-business networks to create simplified, transparent trading environments.