Bitcoin. Opportunities and Risks of a Digital Currency


Bachelor Thesis, 2014

54 Pages, Grade: 1,3


Excerpt

Table of contents

List of abbreviations

List of figures

1. Introduction

2. Fundamentals of monetary theory
2.1 Forms of money
2.2 Functions of money
2.2.1 Payment function
2.2.2 Value retention function
2.2.3 Computing unit function
2.3 Demand for money
2.4 Definition of the money supply
2.5 Money creation

3. Bitcoin
3.1 The story behind Bitcoin
3.2 How Bitcoin works
3.2.1 Basis cryptography
3.2.2 Peer to Peer Network
3.2.3 Wallet and Bitcoin addresses
3.2.4 Transactions
3.2.5 Blockchain
3.2.6 Mining
3.3 Bitcoin in practice

4. Bitcoin and the conventional banking system
4.1 Are Bitcoin Cash?
4.2 Legal framework
4.3 Bitcoin as an object of speculation
4.4 Risks for the banking sector

5. General risks
5.1 Risk
5.2 Risk of prohibition
5.3 Control risk
5.4 Risk of deflation

6. Opportunities
6.1 Opportunity for value enhancement
6.2 Market opportunity
6.3 Cost opportunity

7. Alternative digital currencies
7.1 Cryptic currencies
7.2 Other digital currencies

8. Conclusion

Bibliography

Internet directory

List of abbreviations

ATM - Automatic Teller Machine

BaFin - Federal Financial Services Agency

BTC - Bitcoin

EBA - European Banking Authority

ECB - European Central Bank

FBI - Federal Bureau of Investigation

IP - Internet Protocol

KWG - Banking Act

NGOs ́s - Non-Governmental Organizations

P2P - Peer-to-peer

QR code - Quick Response Code

SEC - U.S. Securities and Exchange Commission

S&P - Standard and Poors

SEPA - Single European Payment Area

SWIFT - Society for Worldwide Interbank Financial Telecommunication

TAN - transaction number

Var - Value at Risk

VÖB - Association of Public Banks

List of figures

Figure 1: Forms of money according to Mankiw (2011)

Figure 2: Forms of money according to Samuelson/Nordhaus (2007)

Figure 3: The money supply in the euro area (end of 2021) (2014)

Figure 4: Simplified illustration of the process of bank money creation (2014)

Figure 5: How a peer-to-peer network works (2005)

Figure 6: Bitcoin Wallet (2013)

Figure 7: A chain of Bitcoin transactions (2012)

Figure 8: Blockchain (2012)

Figure 9: Authentication through mining (2013)

Figure 10: Hashrate Distribution Mining Pools (2014)

Figure 11: Number of transactions per day (2014)

Figure 12: Bitcoin price development in US dollars (2014)

Figure 13: 30 day annualized volatility (2014)

Figure 14: Value at Risk with one day holding period and 95% confidence for BTC and US $ in comparison and gold exchange rates against the € (2014)

Figure 15: Bank-specific risks (2014)

Figure 16: Bitcoin supply to taper to 21m by 2140 (2013)

Figure 17: Total value of all coins in circulation of the top 10 cryptocurrencies (2014)

1. Introduction

The digital currency Bitcoin enjoys a great deal of media interest. Its origin can be traced back to the year 2008. The timing of its introduction was extremely appropriate at the time, as the global economy was still preoccupied with the consequences of the financial crisis and confidence in the existing banking system was shaken. A revolutionary payment system, detached from state control, thus gained a large number of users and supporters within a few years. In addition, the very pronounced critical examination of Bitcoin by the press and regulatory authorities shows the need for states, banks, companies and private consumers to seriously deal with the topic of Bitcoin.

The technically complex design of the Bitcoin system is at first glance very complicated and abstract. In addition, the currency is exclusively available digitally and is therefore difficult for the average consumer to grasp. Nevertheless, the user density, Bitcoin transactions and the number of acceptance points are steadily increasing. As a result, a controversial public discussion has arisen in which banks and even state institutions evaluate Bitcoin differently.

The aim of this work is to make a statement about the future viability of the Bitcoin system by means of a comparison of opportunities and risks. In particular, the effects and existing risks for the conventional banking system will be discussed.

For the classification of Bitcoin, chapter two first clarifies what money is, in what forms it occurs and how it is created. The third part of this work begins with the background and history of the still young currency. In order to be able to understand the Bitcoin system, the understanding of the technical concept is fundamentally important. The functionality is therefore explained in this chapter in order to be able to describe the practical use of Bitcoin in an understandable way. The fourth section looks at Bitcoin from the point of view of the banking sector. It first examines whether Bitcoin can be seen as money and then determines the legal framework. Subsequently, Bitcoin is analyzed as an object of speculation and finally possible specific threats to the banking sector are discussed. Below, the fifth chapter summarizes the general risks of Bitcoin. Where there are risks, there are also opportunities. These possibilities of a positive development of the virtual currency are dealt with in part six. The rapid digital development has an impact on many areas of life, including payment transactions. Although Bitcoin is the first known cryptic currency and pioneer in this field, there are other digital currencies that have a high level of innovation and immense growth potential. In section seven, the cryptic and other digital alternatives to Bitcoin are discussed in order to be able to draw a conclusion in the eighth chapter, both for the banking sector, as well as for Bitcoin in general.

2. Fundamentals of monetary theory

The term "money" is omnipresent in daily life. In general, money is perceived as a banknote or coin in the wallet or as printed numbers on a bank statement. In a broader sense, money is any generally accepted means of exchange and payment. The following chapter will define the basics and tasks of money.

2.1 Forms of money

Money can be categorized differently. This is how Mankiw distinguishes in:

- Merchandise: Goods with an intrinsic value, such as gold and silver
- Nominal money: Medium without intrinsic value, the value is determined by the amount printed on it1

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Forms of money according to Mankiw (2011)

Source: Based on Mankiw (2011), pp. 104.

A modified and more differentiated classification is provided by the definition according to Samuelson and Nordhaus. They see an evolution from commodity money to modern money, which is made up of paper money and book money. Figure 2 shows the distinction in:

- Merchandise: Money as a medium of exchange in the form of goods such as precious metals, animals, food
- Paper money: it derives its value from the limited supply and general acceptance
- Book money: Deposits with banks or other financial institutions2

Abbildung in dieser Leseprobe nicht enthalten

Figure 2: Forms of money according to Samuelson/Nordhaus (2007)

Source: Based on Samuelson/ Nordhaus (2007), p. 719.

Modern money can also be called a conventional currency or fiat currency.

2.2 Functions of money

In practice, money serves as a means of payment. The difference to a simple medium of exchange lies in the general acceptance by private users, companies and state institutions. Money can be used for a further exchange transaction and thus not only satisfies the immediate needs of a single exchange partner. In economics, on the other hand, money is considered functional.3 Basically, a distinction is made between currency-, value retention and computing unit function.4 The stronger a good fulfilling these money functions, the more it is considered money.

2.2.1 Payment function

According to the Bundesbank, money is initially a Medium with which exchange operations of goods can be carried out. But money is also used to grant loans and pay off debts. In these cases, it is not a question of exchanging goods, but of financial transactions.5 One speaks therefore of the money function as a means of payment. The basis for this is the general acceptance of the corresponding form of money.

2.2.2 Value retention function

One advantage that money offers is that the time for purchase and sale does not have to be identical if goods are not exchanged directly (goods for goods). In money, the promise of an equivalent value for other goods can thus be preserved and exchanged again at another time in another place. It allows an interregional and intertemporal transport of purchasing power.6 The money thus has a value retention function. The material and value stability of money form the prerequisites for this. This function plays a special role in "saving", as the value is to be stored over time.7

2.2.3 Computing unit function

Money acts as a measure of value. The unit "money" enables us in everyday life to express goods, services and assets in a general reference value and thus to make them comparable. In practice, therefore, it is not a need to determine countless exchange ratios between all goods.8 In a fictitious example, there are 499,500 exchange ratios for 1000 goods (general formula: n(n-1)/2 exchange ratios for n goods). Due to the unit of account "money", one can neglect the 499,500 exchange ratios and receive 1000 prices expressed in monetary units.9 In order to be able to guarantee this function, money must be sufficiently divisible.

2.3 Demand for money

"In monetary theory, the question of what money is can only be answered if one knows the motives of those who use or demand money."10 Accordingly, the theory of money demand explains the need for money. There are various concepts that try to define the money demand of economic agents. In principle, a distinction can be made between (neo-) classical and Keynesian approaches.

The classic approach assumes that the cause of the demand for money is primarily transaction motives. In this view, money has no asset aspect. The transfer of assets into the future takes place exclusively on the basis of securities.11 The demand for the real fund, which represents the real assets, results from the Quantity equation and is determined by income.12

Abbildung in dieser Leseprobe nicht enthalten

The Keynesian approach, on the other hand, in contrast to the older quantity theory, distinguishes purely mentally different motives for keeping money, which are also referred to as liquidity preferences.13

- The sales motive (transaction motive) presupposes that a security about the ongoing deposits and withdrawals are known. The need for money depends on the transaction volume.14
- The precautionary motive comes into play when the transaction needs or payment dates are not exactly known. Therefore, money is being withheld for future, unantipeccited investments.15
- The speculative motive is based on the fundamental consideration of expected interest rate changes and their influence on securities prices. Keynes accepts only interest-rate securities with an infinite maturity (so-called perpetual annuities). Accordingly, for example, in the event of high interest rates, more economic agents will reduce speculative cash holdings in order to speculate on likely falling interest rates in order to be able to benefit from rising bond prices.16

2.4 Definition of the money supply

The term money supply is defined by the Bundesbank as the money stock in circulation of non-banks within an economy.17 In the context of the aggregate demand for goods, the money supply is an important metric in order to derive a long-term assessment of price developments and finally to take adequate monetary policy measures.18 In the European Economic Area, three monetary classifications are distinguished. These are marked with an M for "money" and the digits one to three. The monetary aggregates M1 to M3 build on each other after decreasing liquidity.

Abbildung in dieser Leseprobe nicht enthalten

Figure 3: The money supply in the euro area (end of 2021) (2014)

Source: Deutsche Bundesbank (ed.) (2014b), (see internet directory).

The money supply is composed according to the ECB as follows:

- M1: Sight deposits of non-banks and total cash in circulation
- M2: M1 plus deposits with a term of up to two years and deposits with a three-month notice period
- M3: M2 plus money market fund shares, money market securities, amounts from repo transactions and bank bonds with a maturity of up to two years19

The monetary base, also called M0, plays a separate role. It includes the sum of the cash in circulation and the central bank money holdings of the credit institutions.

2.5 Money creation

Money creation is reserved for the central banks as the bearers of the currency monopoly. In the following consideration, reference is made to the monetary policy of the European Central Bank and, for the simplified consideration, the capital adequacy regulations such as the Basel regulations are excluded. The focus is on scriptural money creation, in which book money is created. Book money creation is relevant for comparison to the Bitcoin system.

The book money (also called scriptural money) is put into circulation in a two-tier banking system consisting of the central bank and commercial banks.20 An abstracted example illustrates the money creation process.

A bank grants a loan of €10,000 to a company A, pays this sum into the current account of company A and thus initially brings €10,000 as book money into the economic cycle (marked with 1a in Figure 4). For this loan, the bank must deposit one percent of the loan amount, i.e. €100, as a minimum reserve with the central bank (1b). Company A will not leave the € 10,000 in a non-interest-based current account, but will make investments or settle liabilities. The example assumes that the entire amount is used to pay wages (2). The private individuals buy goods worth 10,000€ by bank transfer or electronic payment. For easy comprehensibility, it is assumed that the goods are purchased exclusively from company A (3). The company thus pays the loan back to the bank and thus the electronic money is destroyed again (4).

Abbildung in dieser Leseprobe nicht enthalten

Figure 4: Simplified illustration of the process of bank money creation (2014)

Source: Own depiction based on Siedendiebel (2014), p. 2, (see internet directory).

Accordingly, the bank drew on €100, which it had to hold as a minimum reserve at the central bank until the loan was reported, to take out scriptural money worth €10,000. If, for example, the bank is unable to raise the minimum reserve, it would borrow the amount over €100 from the central bank at the main refinancing rate of currently 0.15%.21 To do so, it would have to deposit eligible collateral with the ECB in the form of clearly defined securities. Thus, the central bank money stock would have increased by 100 €.

If the created amount of book money were to end up with another bank, it could now trigger a new money creation process with this deposit. Accordingly, in the repeated case, an infinite amount of scriptural money could theoretically arise.22 The minimum reserve limits this theoretically uncontrolled creation of scriptural money, since it requires a deposit of one percent on certain sight, term and savings deposits with the central bank. In addition to minimum reserves, the cash ratio is another restraining factor for money creation. This quota must be kept available by the commercial banks for daily cash withdrawals.23

3. Bitcoin

Unlike traditional currencies issued by central banks, Bitcoin (BTC) is not subject to a central authority. This decentralized, digital currency relies on a cryptographic algorithm, as a result of which the creation of Bitcoin is limited due to the software programmed by the initiator. In this chapter, the background of the cryptocurrency is first determined and then the functionality is explained in order to be able to filter the relevant properties.

3.1 The story behind Bitcoin

The concept of Bitcoin was first presented to the public in 2008 in an essay by Satoshi Nakamoto. To this day (as of 10.07.2014) it is unclear whether the initiator Nakamoto is a real person or just a pseudonym, as he has not yet appeared in public.24 According to a well-known user profile of the network provider P2P Foundation, in which a blog entry on Bitcoin was written under this name on February 11, 2009 and in it on the standard work "Bitcoin: A Peer-to-Peer Electronic Cash System", Nakamoto is 39 years old and hails from Japan.25 The inventor's anonymity provides room for speculation regarding the interests that might be behind the motives of bitcoin's development.

Against an abuse of the Bitcoin system on the part of the developer speaks that the publicly freely accessible system is based on the open source principle and thus allows a complete transparency with regard to the software logic. Satoshi Nakamoto first critically describes the basic problem of modern currencies and tries to provide a solution with his system. Nakamoto argues that conventional currencies must have a basic level of confidence in central banks in order for them to maintain the currency's value. In addition, the banks must be trusted in their functions, which means that the money provided is properly stored and transferred. As a model for the newly created digital currency, the technical development of established password encryption on the Internet, which is inaccessible to third parties, serves.26

The initiator describes the basic problem of mutual trust in the transaction between two unknown partners in his standard work "A Peer-to-Peer Electronic Cash System". "What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party."27 In the conventional monetary system, this trust is placed in governments and central banks, and the value of banknotes is generally accepted. The Bitcoin system, on the other hand, is based on a decentralized network, which is described in more detail in the following chapter.

3.2 How Bitcoin works

The Bitcoin system is built like a collective accounting system. "A kind of worldwide invoice book records every transaction and the whereabouts of each virtual coin."28 Although a Bitcoin only exists in the computer, the system limits the coins and ensures that no one can fake them or spend them twice.

The Bitcoin community sees itself as a community and as long as the majority of users are interested in the permanence of the currency, digital accounting cannot be manipulated.29 Bitcoin exists in this worldwide accounting system only as transactions that are visible in a peer-to-peer system for all clients on the network. In connection with the network, with the intention of transferring an amount from one Bitcoin address to another, a message is sent to all users. Each user can create as many addresses as they like. An address always has a public digital key to receive and send Bitcoin and a private key to authorize the corresponding transaction. A public history shows which sales have flowed at each individual address and which way a single Bitcoin has taken since mining.30

The term mining has become established in reference to the mining of gold or other precious metals. You can get the digital currency in two ways. Either you buy them from other users, for example via a trading platform, or you make the Bitcoin yourself. Since there is no central institution, new Bitcoins are created exclusively through mining. Bitcoin mining requires a complicated algorithm to be solved, which requires the use of special hardware. Currently (as of 10.07.2014) there are 13 million Bitcoin in circulation.31 However, the mathematical formula of the software limits the maximum possible quantity to 21 million pieces. Since the computing effort increases with each Bitcoin created, the money supply gradually grows more slowly. The 21 millionth and thus last Bitcoin is to be calculated in the year 2040.32

To understand how the digital currency works, it is necessary to know some basic concepts of computer science. The following section gives an overview of the technical requirements for establishing and transferring Bitcoin.

3.2.1 Basis cryptography

The basis for the security of the Bitcoin system is the transmission with encrypted information. The origins of cryptography lie in ancient Egypt, where it was used for secret writings. The concept of the well-known encryption machine "Enigma", which was used by Germany during the Second World War, was also based on a cryptographic technique.

Modern cryptography works asymmetrically. This means that a digital key pair is used. The public key encodes the message and the user-held private key is used to decrypt the message.33

Bitcoin are also based on this asymmetrical method. The private key allows the holder to decrypt data encoded with the public key. In addition, the private key can create digital signatures and authenticate transfers. Therefore, this is comparable to a personal signature. The digital signature is calculated from the private key and the data or hash values to be signed.34

A hash value or hash algorithm is a data set with a predetermined length, which is encoded as a hexadecimal string and can be obtained from any input data. It is calculated using an algorithm that maps a large amount of input to a smaller target set. The name comes from the English "to hash", in the German translation "Zerhacken", which applies to the input data. It is theoretically not possible to infer the underlying amount of data from a hash value. In addition, a hash value is always unique, which is why computer scientists speak of the finality of a hash value in the context.35 This feature makes the system very interesting for the treatment of sensitive data, such as passwords.

3.2.2 Peer to Peer Network

The Bitcoin network is based on the decentralized peer-to-peer network technology. This forms a network of equal computers. Each unit on the network sends and receives data. In addition, all units act as client and server at the same time. A central server is not necessary for this.

Abbildung in dieser Leseprobe nicht enthalten

Figure 5: How a peer-to-peer network works (2005)

Source: Own representation based on Eberspächer/ Schollmeier (2005), p. 36.

In a general peer-to-peer network:

- resources are shared between peers,
- access to resources occurs directly between the peers and
- each peer is both provider and requester of data.

In addition, especially for decentralized peer-to-peer networks:

- Any peer-to-peer functions also apply.
- The functionality of the entire network is not compromised by the removal of a single unit.
- There is no central unit.36

The distribution of the messages takes place via a so-called flooding algorithm. A node in the system sends a message to all known nodes. This in turn to all his known nodes, except for those from which he received the message. In the peer-to-peer network, all participants are quickly reached via the linking of the nodes.37

3.2.3 Wallet and Bitcoin addresses

In order to participate in the Bitcoin system and the associated transactions, a client software is required. In this, a wallet (English for wallet), comparable to a purse or a bank account, is integrated. The user interface varies depending on the provider. Figure 6 shows a pattern of a Bitcoin wallet. The download of the free software is absolutely anonymous, in contrast to a bank commitment.38

Abbildung in dieser Leseprobe nicht enthalten

Figure 6: Bitcoin Wallet (2013)

Source: Shaw (2013), p. 2, (see internet directory).

Bitcoin are stored as a transaction between Bitcoin addresses. In the wallet, any number of Bitcoin addresses can be created. The personal account balance results from the balance of the transfer transactions. A proof of ownership is marked with the owner's public key. In the wallet, the key pairs are collected, i.e. the public and the corresponding private key. These key pairs stored in the wallet are sufficient to have the virtual currency. Accordingly, a loss of the private key also means the loss of the associated Bitcoin.39 The client software can be used to generate any number of key pairs that are stored as a digital keychain in the binary file "wallet.dat".

3.2.4 Transactions

Transfers are made by users through the client software. To execute a transaction, the recipient's address must first be known by their public key. The payer then signs the payment amount with his private key and publishes the information in the Bitcoin network.

[...]


1 cf. Mankiw (2011), p. 204.

2 cf. Samuelson/ Nordhaus (2007), p.719.

3 cf. Crowther (1948), p. 20.

4 cf. Borchert (2001), p. 28.

5 cf. Deutsche Bundesbank (ed.) (2014a), p. 10.

6 cf. Borchert (2001), p. 29.

7 cf. Deutsche Bundesbank (ed.) (2014) (a), p. 11.

8 cf. ibid., p. 10 f.

9 cf. Issing (1998), p.2.

10 Borchert (2001), p. 111.

11 cf. ibid., p. 111f.

12 cf. Borchert (2001), p. 113.

13 cf. Issing (1998), p. 41.

14 cf. Keynes (2009), p. 144.

15 cf. Keynes (2009), p. 144.

16 cf. Issing (1998), p. 41.

17 cf. Deutsche Bundesbank (ed.) (2014b), p. 1, (see internet directory).

18 cf. ibid., p. 1, (see Internet directory).

19 cf. European Central Bank (ed.) (2014a), p. 1, (see internet directory).

20 cf. Deutsche Bundesbank (ed.) (2014c), p. 2, (see internet directory).

21 cf. Siedendiebel (2014), p. 2, (see internet directory).

22 cf. Rothengatter/ Schaffer/ Spring (2008), p. 184.

23 cf. Rothengatter/ Schaffer/ Spring (2008), p. 182.

24 cf. Olson (2014), p. 1, (see internet directory).

25 cf. Nakamoto (2009), p. 1, (see internet directory).

26 cf. ibid., p. 2, (see Internet directory).

27 cf. Nakamoto (2008), p. 1, (see internet directory).

28 Bögeholz /Scherschel (2013), p. 146.

29 cf. ibid., p. 146.

30 cf. Jädicke (2014), p. 3f, (see internet directory).

31 cf. Bitcoincharts.com (ed.) (2014a), p. 1, (see internet directory).

32 cf. Woo/ Gordon/ Iaralov (2013), p. 2, (see internet directory), p. 2.

33 cf. Schneier (2006), p. 74.

34 cf. Kerscher (2013), p. 22.

35 cf. Sedgewick (2002), p. 273 f.

36 cf. Eberspächer/ Schollmeier (2005), p. 36.

37 cf. Heller (2009), p. 15.

38 cf. Reid/ Harrigan (2011), p. 3.

39 cf. Bögeholz/ Scherschel (2013), p. 147.

Excerpt out of 54 pages

Details

Title
Bitcoin. Opportunities and Risks of a Digital Currency
College
Berlin School of Economics and Law
Grade
1,3
Author
Year
2014
Pages
54
Catalog Number
V1151960
ISBN (eBook)
9783346534934
Language
English
Tags
bitcoin, opportunities, risks, digital, currency
Quote paper
Oliver Cherek (Author), 2014, Bitcoin. Opportunities and Risks of a Digital Currency, Munich, GRIN Verlag, https://www.grin.com/document/1151960

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