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Lee Kuo Chuen is professor of fintech and blockchain, Singapore University of Social Sciences. Photo: Abhijit Bhatlekar/Mint
Lee Kuo Chuen is professor of fintech and blockchain, Singapore University of Social Sciences. Photo: Abhijit Bhatlekar/Mint

Know your bitcoin

Edited excerpts from Lee Kuo Chen's book 'Handbook of Blockchain and Digital Finance'

Various innovative money payment systems in the market have arrived with smart phones, internet and digital storage cards. The emergence of this class of digital payment systems has revolutionalised the way values are being transferred. The latest and most interesting form of value transfer was created by Satoshi Nakamoto (2008). Satoshi’s Bitcoin is now a well-known system of cross-border value transfer for untrusted parties without a centralised authority. Bitcoin is a medium of exchange, a store of value and a unit of account. Conventionally, the uppercase ‘Bitcoin’ refers to the network and technology, while the lowercase ‘bitcoin(s)’ refers to units of the currency. The currency is also commonly abbreviated to ‘BTC’, although some exchanges use ‘XBT’, a proposed currency code which is compatible with the ISO 4217 standard.

There are still debates about whether bitcoin and other cryptocurrencies are alternative currencies. From 1 April 2017, Bitcoin has become a legal payment system in Japan with a potential retail base of 260,000 merchants. Chinese regulator, on the other hand, has stopped all cryptocurrency trading by unregulated exchanges at the end of September 2017. To understand cryptocurrency, it is important to comprehend the history and development of centralised digital currency to have a good understand the philosophy underpinning decentralised cryptocurrency. As bitcoin is the first decentralised cryptocurrency, it is important to understand the features of bitcoin before moving on to discuss cryptocurrency, Initial Crypto-Token Offering (ICO) and blockchain. Up to 20% of the material in this chapter is taken from ‘Introduction to Bitcoin’ from the reference book Handbook of Digital Currency with technical details on cryptocurrency and Bitcoin.

There are many types of alternative currencies other than government-issued fiat currency. Hileman has broadly classified them into two categories: tangible and digital. Tangible currencies, closely associated with ‘commodity money’, derive their value from relative scarcity and non-monetary utility. Digital or virtual seems to be used interchangeably as describing currencies based on an electronic medium. However, they are not synonyms. The term ‘virtual’ has a negative connotation, as signifying what is ‘seemingly real’, but not exactly ‘real’. This is not commonly used when referring to a currency, as pretentious, ‘falsely created’ in literal Chinese or interpreted as computer-generated or simulated. A more neutral term digital currency is generally more common. Here, we focus on those digitised currencies for value transfer. For value transfer, we can classify them broadly into four categories.

1. Centralised, not geographically bounded

Examples are loyalty points from financial, telecom or retail companies, air miles from airlines, Second Life’s Linden Dollar and World of Warcraft Gold, which are closed system with transactions within specific entities. This class of currency also includes cross-border pre-paid phone cards and to some extent, cash value smart cards, pre-paid debit and credit cards. These cards can be physical or virtual on mobile devices. Other examples are Alipay RMB wallet that can be used in different countries and even for tax refunds with QR Code or facial recognition. It is more appropriate to think in terms of online (e-wallet) and offline (physical card wallet) digital payments. This is a case of online/offline value transfer and storage unconstrained by location. This class may not be dependent upon governance as in the case of fiat currency and more importantly, it is not geographically bounded.

2. Centralised, geographically bounded

Digitalised national currency are the local or community currencies like e-Brixton Pound and Bristol Totnes Pound that are used in England, and eChiemgaue in Germany. Their purpose is more specific and usually bounded by some social contract or agreement, such as, honouring them for exchange for goods or to limit the supply of goods. The governance is centralised and the value transfer is localised.

3. Centralised, cross-platform

Flooz and Beenz, which are open-market systems, can be transacted with other entities. Note that the crypto debit or credit cards such as TenX are built upon a decentralised system of cryptocurrencies and tokens. Smart contracts allow for the exchange of value between different digital currencies and across the network. The governance structure is centralised on top of decentralised and sometimes with smart contracts. The value is transacted digitally across the platform and can be online or offline.

4. Fully decentralised or distributed currency

This includes the cryptocurrencies such as bitcoin, ether, qtum, zcash, litecoin, and dogecoin. They can be transacted with any outside agents, and the governance and technology are both decentralised due to open source software. There is usually no legal entity responsible for the activities, and therefore they fall outside traditional regulation. Value transfer is online.

Cryptocurrency is a P2P (person to person) programmable digital currency. It allows online payments to be sent directly from one party to another without going through an intermediary. The network timestamps transactions cryptographically and in the case of Bitcoin, using what is known as proof-of-work.

The proof-of-work Bitcoin protocol is basically a contest for decoding and acts as an incentive to reward those who participate. The first participant to crack the code will be rewarded with the new bitcoins. A new block of transactions is formed every 10 minutes approximately. The transaction record is almost impossible to change or too costly to change after six blocks of confirmations. It is straightforward to create a cryptocurrency as an alternative currency or as a token for free because most of them are open source. Many altcoins are created to solve the pain points of bitcoin. There are more than 1,000 cryptocurrencies in circulation with 900 trading actively.

As to why cryptocurrency is gaining tractions, various socioeconomic forces drive their demand including:

(a) Bitcoin has become a legal payment system and classified as an asset for accounting purposes in Japan. The Financial Services Agency has also issued eleven bitcoin exchange licenses in September 2017.

(b) Asset allocators and fund managers are beginning to allocate funds to cryptocurrencies.

(c) Demand for cryptocurrencies due to the launch of many Initial Crypto-Tokens Offerings.

(d) Governments are wishing to have a more centralised control over local governments or to prevent corruption, seeking transparency and control via digital currency built on blockchain or distributed ledger, the underlying technology of cryptocurrency.

(e) Technology and internet as making it much easier to use with improved software and low entry barriers contributing to network effects.

(f) A political economy with disillusionment about inequality, and the notion of traditional banks not willing to embrace financial inclusion.

(g) There is economic uncertainty associated with high debt and quantitative easing with many investors seeking shelter in alternatives.

(h) Environmentalism means ecological concerns and the question of whether we have reached the point of maximum extraction of natural resources, seen as the fundamental backing for some currencies.

(i) The inefficiency of financial architectural with the view that financial services are overpriced, and the whole financial system is too costly to operate.

(j) Financial freedom from using cryptocurrencies with the advantage of transferring value through the internet where control is weak.

(k) The ability to bypass capital controls and may provide safe harbour during a fiat currency crisis.

(l) Speculation with the anticipation that there will be a steep price appreciation due to subsequent wider acceptance.

(m) Acceptance that cryptocurrency is an asset class to hedge against the collapse of fiat currency system in a diversified portfolio.

(n) Acting as base currencies to conduct token (coin) sales or Initial CryptoToken Offerings (ICOs) globally for innovative projects by-passing fiat currency system and control, which is perceived to be too heavily regulated.

(o) Use as a form of tokens to digitise or securitise underlying commodity or ownership rights.

(p) Use as a form of token rights to use the network, to vote, to wrap cash flow, to execute smart contracts or other privileges usually related to the network.

With many alternative cryptocurrencies or altcoins, many will fail and only a few will be globally adopted because of superseding advancements in technology, tighter regulation and insufficient demand.

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