Bitcoin. Potentials, Problems and Regulatory Issues of the First Mainstream Cryptocurrency

1. Introduction

2. Current State of Knowledge

3. Framework

4. Bitcoin’s Role for Different Economic Actors
1. Private Households and Investors
2. Online Businesses
3. Central Banks
4. National Governments
5. Results

5. Discussion

6. Conclusion

7. References

Abstract

According to conventional wisdom, the cryptocurrency Bitcoin exhibits several improvements compared to the traditional banking system, namely its decentralized structure and a proof-of-work consensus mechanism. However, authors frequently discover problems and propose all kinds of fundamental changes, such as completely new consensus mechanisms by which they want to replace the existing system. That raises the question of how the further development of Bitcoin has to be promoted. We review the most relevant literature concerning Bitcoin’s current role and future potential from different angles. By putting ourselves in the position of involved actors, we find out what they expect from the Bitcoin network and how desirable additional regulatory measures are for them. Although it is generally accepted that appropriate governance can contribute to a more stable and secure currency, cryptocurrencies’ unique characteristics add a new dimension to this idea. That is why we sporadically throw in comparisons to local currency schemes already in existence in order to conclude how the question of regulating a decentralized currency must be addressed.

1. Introduction

In 2008, Bitcoin was launched by a developer known as Satoshi Nakamoto. Since then, the cryptocurrency has not only caught the attention of investors but also of the broad population. Especially in the recent years, its media coverage has increased significantly, its daily transaction volume now amounts to an equivalent of over 17 million US dollars and as at June 2019, there are currently over 17.5 million Bitcoins in circulation (CoinMarketCap, 2019). Primarily in the US, there are even special ATMs for Bitcoin transactions (Figure 1).

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Figure 1: Number of Bitcoin ATMs installed (CoinATMRadar, 2019)

One reason for the popularity of Bitcoin is that the system offers various unique features that are presumably improvements compared to how traditional banking works. The main innovation is the possibility to transfer money within a peer-to-peer network without the need for a central institution which verifies the transaction. This is very attractive to bank customers who have lost their trust in intermediaries, for instance due to the preceding financial crisis. The reference implementation written by Nakamoto explains the functioning of the Bitcoin system which enables the verification of payments within the network via a proof-of-work consensus mechanism (Nakamoto, 2008). Participants who try to solve cryptographic puzzles by contributing the computing power of their own device to the network are called miners. The first miner to solve a problem is authorized to confirm a certain number of transactions which are added to a public ledger (blockchain) containing all transactions that have been verified up to then. In return for his or her contribution, the miner is rewarded with Bitcoins (De Filippi, 2014). The reward payment amount is divided in half every four years, so as to ensure that the total supply of Bitcoins will ultimately stay fixed (Robleh et al., 2014).

The growing popularity of Bitcoin raises the question of its future prospects, but also of existing problems and possible limits in the acceptance and use of the cryptocurrency in everyday life. Conducting a literature review, we will examine the mentioned aspects in order to assess the future role of the Bitcoin in our economy and its potential to become a complementary currency. The second section of this paper will provide an overview of the existing body of knowledge. After setting the framework, we will shed light on the possible wider adoption of Bitcoin from several perspectives in order to find out whether this scenario would be desirable and workable for different actors involved. A comparison to complementary currencies already in existence, such as the German Regiogelder, will facilitate this process. Section 5 and 6 are comprised of the discussion and conclusion of our findings.

2. Current State of Knowledge

Up to now, a large amount of theoretical research has been done that is often focused on problems that the Bitcoin network is facing at present or will be facing soon. Most of those issues can be assigned to a few major categories, one of which is a lack of scalability. For instance, the slow propagation of large blocks of transactions (Decker and Wattenhofer, 2013) currently makes Bitcoin payments unpractical for day-to-day purchases (Karame, Androulaki and Capkun, 2012; Kwon, 2014) and the eventually fixed money supply also appears to be a major obstacle, preventing sustainable network growth (Barber et al., 2012; Robleh et al., 2014; Bohme et al., 2015). Furthermore, e. g. due to missing deposit insurance (Yermack, 2015), the consumer protection provided by digital Bitcoin wallets is very weak and customers are thus vulnerable with regard to theft or loss of Bitcoins (Barber et al., 2012; Tschorsch and Scheuermann, 2016). Additionally, the Bitcoin network itself is fragile in certain respects, too. Several authors have shown the possibility and omnipresent danger of attacks which could undermine the system, in the sense that it would be controlled by a small group of miners after a successful attack (Kroll, Davey and Felten, 2013; Eyal, Ittay; Sirer, 2018).

Of course, researchers are aware of those problems and consequently, the current literature offers a wide range of proposals in order to address them. Even radical changes to the reference implementation such as new rules for mining rewards (Kroll, Davey and Felten, 2013; Robleh et al., 2014) or the replacement of the proof-of-work system with alternative consensus mechanisms (Kwon, 2014; Bonneau et al., 2015) are suggested. However, the variety of proposals that are mostly based on theoretical considerations turns the process of finding solutions that satisfy all participants in a rather political problem.

Being the first well-known decentralized electronic payment system, Bitcoin is still unknown territory for national governments and law enforcement agencies. More concretely, well-established policy instruments that are usually effective do not work in the Bitcoin market (De Filippi, 2014). For that reason, the question of appropriate governance structures in the Bitcoin system comes up. Until now, software updates and other measures have been performed by the lead developers of the Bitcoin reference implementation, making them a semi-formal open-source government of the network (Kroll, Davey and Felten, 2013). Apart from that, researchers have yet to determine which institution(s) should be in charge of and accountable for further regulatory measures if any are to be taken at all. Due to the understandably thin literature containing practical implications, it is sensible to take a step back and not only take a look at national governments’ responses to the emergence of the Bitcoin network, but also at how similar currency schemes were received in the past and how their organization was conducted.

3. Framework

This paper is aimed at developing a better understanding of the problems and potentials of Bitcoin and at working out the likely consequences of a broader introduction for different parts of the population. This has to be seen separately from replacing traditional currencies with cryptocurrencies, which this paper does not focus on as this would be too hypothetical to draw serious conclusions. In order to reach the goal of this paper, a literature review was conducted. While the evaluation from the perspective of private households and online businesses is based exclusively on past observations, the availability of official statements by banks and national governments allows us to derive findings directly from those opinions.

The short comparisons to local currencies should simplify the process of imagining how Bitcoin would affect the economy if it was more popular in day-to-day business. However, the characteristics of those two types of money are not identical, they only resemble one another as shown by Bech and Garratt (2017) who developed a model to differentiate between various sorts of money. According to them, the main difference from local currencies to cryptocurrencies is that there is no universal access to the former (the e lectronic aspect is negligible as some local currencies can be used online, too).

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Figure 2: A taxonomy of money (Bech and Garratt, 2017)

4. Bitcoin’s Role for Different Economic Actors

In the following, we will successively assess the current role of Bitcoin from the viewpoint of several major economic players. Studying alternative currency schemes that are already in existence, we find out to which extent the possible wider adoption of Bitcoin corresponds to their demands and expectations for the future.

4.1 Private Households and Investors

Usually, private households use money for daily purchases, such as food, clothing and other common goods. However, although it features several advantages, such as lower transaction fees than traditional transactions using Visa or similar alternatives, Bitcoin is rarely used for everyday shopping for various reasons (Robleh et al., 2014). As a unit of account, it is unreliable due to its extreme price volatility and the prices for goods that cost a rather small amount (if denominated in an official currency like the US-dollar) are always decimal prices, making it unpractical as well. Not being a legal tender, the use of Bitcoin as a medium of exchange depends on the willingness of sellers to accept it as a means of payment. In reality, the cryptocurrency is not widely accepted and up to now, only a few physical stores accept payments with Bitcoin (Yermack, 2015). In addition to that, the broad population is not familiarized with the complicated technology underlying the Bitcoin system, including seemingly difficult verification processes. Even basic knowledge, such as how to make payments using a digital Bitcoin wallet, is missing, leading to asymmetric information. In general, it does not fulfil the functions of money in a satisfying way and even if it did, there might still not be enough arguments to successfully incentivize private households to move away from official currencies.

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