The Logic Group Blog

Any of you heard of Bitcoins?  This relatively new method of online payment has really exploded onto the world stage during 2011, thus I thought it was worth looking into what all the fuss is about.

Bitcoins are one of a number of digital P2P payment methods whose aim is to recreate cash for the digital age.  Bitcoin refers to three things:
1) The decentralized, peer-to-peer network that carries the transactions
2) The digital currency itself that users exchange over the above-mentioned network
3) The client software which users use to access the network and carry out transactions

The Bitcoin system is supposed to have two main advantages over established digital payment methods:

1) Low cost – as no need for a large scale centralised secure payments infrastructure
2) Anonymity - which helps you keep your financial transactions away from prying eyes

And they have certainly become a successful (if still niche) payment system with apparently over $300 million worth of Bitcoins being traded in 2010 in just one of several exchanges of this particular virtual currency.

But all is not rosy for this fledgling payment revolutionary.  Over the last few months Bitcoins have garnered quite a lot of negative press on various issues including:

1) The anonymity of the transactions putting Bitcoins outside of the oversight of financial institutions and governments.  That means that governments can’t tax these transactions and can’t check these transactions for fraud (e.g. money laundering etc.).  That has prompted politicians to call for a crackdown on the payment system in the belief that it is mainly used by drug dealers or potentially terrorists to transact with impunity.

2) Bitcoin mining (the production of new Bitcoins) has also come under fire for being akin to a pyramid scheme.  The Bitcoin system does not have a centralised issuing authority.  Instead to get bitcoins users need to spend computer processing time solving complex mathematical problems.  The issue is that as time goes by, it gets harder and harder to mine new bitcoins.  That puts early adopters at a distinct advantage over new entrants and contributes to Bitcoin hoarding, which restricts the growth in usage.

3) The volatility of Bitcoin trading has turned the media and a lot of economists into dismissing the currency as mere gambling.  Even Bitcoin insiders have expressed criticism over the Bitcoin trading system, which they say leaves the currency open to speculators.

4) The security of the Bitcoin wallets has also come in for criticism with several alleged frauds perpetrated both in order to steal Bitcoins and to commandeer PCs into botnets used to mine the currency.

But let’s take a step back and look at the one fundamental issue at hand.  Bitcoins are the closest we have to the digital version of cash today.  But what about cash itself?  Does that not have issues?  The answer is - it has plenty:

1) Remember the times, before banking became prevalent, when people used to keep all their life savings ‘under their mattresses’?  What happened to those savings if someone robbed their house or it burned down in a fire?

2) Remember the times when you were scared to take too much cash abroad in case you got robbed on the street?

3) Remember all the publicity about how the illicit “cash in hand” economy is aiding tax evasion and empowering criminals of all types?

4) Remember that feeling you have when you are withdrawing money from a cash machine late at night on a quiet city street?

I could go on with examples, but the fact is that cash, like Bitcoins, is totally anonymous.  With such anonymity comes a price.  That price is risk.  Risk in currency storage and risk in currency transaction.

It is these risks that have prompted the development of bank accounts, credit and debit cards and now new technologies such as contactless and mobile payments.

Bitcoins for all of its digital encryption and high tech transaction methods is actually harking back to a model people started moving away from years ago.

Yes, traditional payment channels mean you will be taxed (IMHO most law-abiding citizens do not want to evade tax, just make sure that the tax they do pay goes on the things they care about).  Yes, traditional payment channels probably cost more than the anonymous and de-centralised model presented by Bitcoin.

But with these traditional payment channels comes transaction protection that few consumers would be prepared to go without.  After all, we can’t both have our cake (free payment processing) and eat it (secure and guaranteed/underwritten transactions).  Thus in the humble opinion of this commentard, unless Bitcoins introduce protections akin to the established transaction channels, they will remain in the periphery of payment technologies.