VIRTUAL CURRENCIES ANDBITCOINS: IN FOCUSWHITE PAPERAuthors

Vijay Kumar SLKiran Nandavarapu

2013 was phenomenal year for virtual currencies, with Bitcoins catching the eye of many around the world - receiving attention from law enforcement agencies, the business community, the financial sector and government authorities, all who are trying to understand and analyze how the instrument fits into the existing financial and regulatory frameworks. The nature of virtual currencies, Bitcoins in particular, and their prospects has been keenly and broadly debated. The virtual currency market was valued at US$47.5 billion in 2012 and is projected to grow 14 percent over the next five years to US$55.4 billion in 201725. Without question, the multifaceted virtual currencies market is large and ramping up at a good pace.

Although countries have taken different stances, it is clear that virtual currencies are here to stay and will continue to influence monetary transactions. However, the extent of regulation and how current shortfalls will be addressed remains to be seen. This paper provide a basic overview of virtual currencies and higher level insights about Bitcoins, including its appeal, structural benefits and challenges, and regulations. It also covers investors’ perspectives of Bitcoins and how the virtual currency space is aligning with their own interests. blueocean market intelligence’s study demonstrates that the virtual currency space is undeniably a sizeable and growing one, and it remains to be seen what new applications are developed alongside.

Abstract

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Table of Contents

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Defining Virtual Currency

Evolution of Virtual Currencies

Classifying and Sizing the Virtual Currency Market

Introducing Bitcoins

Currency Needs

Functional Parts of Bitcoins

Transactions and Scripting

Bitcoin Appeal and Benefits

Structural Problems

Theft or Loss of Bitcoins

Bitcoins Venture Capital

Challenges Ahead

Regulations

Conclusion

Defining Virtual Currency?“Virtual currencies” are digital stores of value that can be exchanged for goods and services at places that accept them. They are an exchange medium, other than real or traditional currency, used to facilitate online or other electronic transactions. The concept of virtual currency is not new. In fact, every currency in theory could be seen as virtual, given that for centuries they have been separated from the actual value of the goods or services that they represent. However, traditional currencies are backed by a central banking or financial institution that guarantees the value of the

token (currency notes, checks, electronic card transactions) as a proxy for the actual value. Virtual currency still retains the main characteristic of traditional currency: It is proxy for a value. However, this value can vary and is tied to an existing currency such as the USD. Virtual currency can also be tied to other physical-world commodities such as precious metals (e-gold), or another item of value earned by the loyalty of the participant – e.g. miles flown, locations visited, advertising viewed or groceries purchased. The concept of exchanging value without the need of a central bank is the key benefit behind any virtual currency. In many instances where traditional currencies are too cumbersome and inapplicable (e.g., for retailers, coupons trump cash as a means of delivering value to consumers), virtual currencies are leveraged as a quick and seamless means of exchange between parties.

Virtual currencies can take a variety of forms and use across the payments landscape. Of all the prominent applications of virtual currencies, their use as a marketing and loyalty tool has been the most prolific, helping propel it into widespread use today. Leveraged by enterprises for more than a century, virtual currencies can trace their roots to 1887 as a marketing strategy, when Coca-Cola issued the first-ever coupon.

As the success of Coca-Cola’s bold and creative move was realized and replicated, more advanced forms of corporate-issued currency—such as retail loyalty points and air miles— were soon developed. Then of course, no conversation on the evolution of virtual currencies is complete without highlighting one of the most widely used today - credit card rewards. In 1984, Diners Club unveiled a credit card points and rewards system, and in 1986, Discover introduced a “cash back” program for accumulated points. Credit card points have proven to be a powerful motivator and loyalty mechanism for customers, and they are often seen as the key differentiator for card preference. Since its inception, the credit card-points model has been emulated to varying degrees across a wealth of industries.

Technological advances over the past decade have increased the application and usage of virtual currencies even more. The current landscape is evolving at a rapid pace, especially in these key areas:

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The Evolution of Virtual Currencies

Virtual currencies are digital stores of value that can be exchanges for good and services at places that accept them.

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Online tokens: Thanks to social network games and mobile apps, online token have gained recent attention. In the case of Zynga’s Draw Something and Imangi Studios’ Temple Run, success largely hinges on obtaining virtual coins, which can be either earned by completing tasks within the game or purchased using real money. Under this model, coins can be used to buy various upgrades in the game and, depending on the circumstance, make purchases in the real world. However, this is not just limited to games. HitBliss provides users with virtual points for engaging with targeted advertisements and in turn, they can be cashed in for movie and television show downloads. The emergence of monetization platforms including Tapjoy, SessionM and TrialPay, which provide users with virtual currencies in exchange for engaging with advertisements, also show further promise.

Peer-to-peer currencies: Peer-to-peer currencies have come into the spotlight lately given the uncertainty and diminishing trust surrounding traditional banking systems. At the forefront of this revolution are Bitcoins, which originated in 2009 as an open source, country-agnostic currency that is controlled by its users rather than by a single entity. Despite qualms about its security and legitimacy, Bitcoin are experiencing growing popularity and acceptance today.

Mobile payments and location-based rewards: The proliferation of the smartphone has allowed for new payment structures where merchants reward consumers with tokens if they use their mobile devices to pay or “check in.” LevelUp, for instance, offers users discounts at select merchants when they use their app to pay. Shopkick, on the other hand, provides users with points that can be redeemed for goods by simply shopping in a store or scanning a certain item. As mobile payments and location-based rewards gain traction, virtual currencies will be an essential value-added tool in sparking merchant and consumer adoption.

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Classifying and Market Sizing Virtual CurrenciesThe European Central Bank24 (ECB) defines three schemes for virtual currencies, focusing on their interactions with real money and real economy.

The virtual currencies market includes air miles, coupons, retail loyalty points, credit card points, Bitcoins, game-based currencies and personal information, and ad views/time. In 2012, the virtual currency market was valued at US$47.5 billion and is projected to grow 14 percent over the next five years to US$55.4 billion in 201725. Without question, the multifaceted virtual currencies market is large and set for continued growth.

Bitcoins have suddenly risen to prominence and caught the eye of many, including venture capitalists. This, even as the regulatory bodies are

watching closely for virtual currency’s possible connection to money laundering and other illegal activities.

Closed virtual currency scheme

Real economy money

Real economy money

TYPES VIRTUAL CURRENCY SCHEMES

Real economy money

Virtual Money Virtual Money

Can be used for virtual and real

goods and services

Can be used for virtual and real

goods and services

Ex : Facebook Credits, Airlines’ Frequent-�yer programmes,

Amazon Coins

Ex : Second Life’s Linden Dollars

Bitcoins

Virtual Money

Used only for virtual goods and services

Ex : World of warcraft gold

Virtual currency scheme with unidirectional flow money

Virtual currency scheme with

bidirectional flow

In 2012, the virtual currency market was valued at US$47.5 billion and is expected to grow 14 percent over the next five years to US$55.4 billion in 2017.

Bitcoins are a decentralized open-source, peer-to-peer digital cash system or currency, primarily designed and developed by Satoshi Nakamoto (who ironically has not been heard from since 2011). In October 2008, Nakamoto self-published a paper1 which laid the basis for Bitcoin design and an open-source project registered on the source code repository, SourceForge2. This open source project set the cryptographic protocol for

the Bitcoin system. The genesis block was established on January 3, 2009, and the project was announced on the Cryptographic mailing list3 on January 11, 2009. Since their invention, Bitcoins have gained amazing popularity and a good deal of media attention. At the time this paper was written, approximately 12,232,450 Bitcoins were in circulation with a market capitalization of US$11.5 billion. Approximately US$7 million to US$10 million worth of transactions take place each day in Bitcoin and about 40 Bitcoin exchanges5 exist offering exchange services with many real world fiat currencies, (e.g. EUR, US$, CAD, GBP, PLN, JPY, HKD, SEK, INR, AUD, CHF and so on). Bitcoins’ exchange rate has varied widely, reaching a peak of US$1159 per Bitcoin over the last few weeks (though when this paper was written, it hovered) around US$900 per Bitcoin).

“With eCurrency based on cryptographic proof, without the need to trust a third party middleman, money can be source and transactions effortless.” – Satoshi Nakamoto, Bitcoin Developer

Despite some criticisms and disbelief, Bitcoin has admittedly witnessed huge success over the last two years. The idea of digital currency or virtual cash is by no means a new concept to the security and cryptographic community. As early as 1982, David Chaum6 outlined his blueprint of an anonymous e-cash scheme in his paper – Blind Signatures for Untraceable Payments7. Ever since, numerous academic papers have been published around improving the efficiency and security of digital currency constructions, see [8-15].

One wonders…Despite three decades’ of research on digital currency, why have other digital currency schemes not taken off, while Bitcoin – a system designed the unknown, that does not include sophisticated cryptography, and by no means perfect– has enjoyed a swift rise to success? Looking forward, does Bitcoin have what it takes to become a serious candidate for a sustainable and stable currency, or is it yet another transient fad that will pass by?

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Introducing Bitcoins

Bitcoin is a decentralized open-source, peer-to-peer digital cash system.

Digital currencies existed before the advent of Bitcoin, but what sets Bitcoin apart relative to others, including the fiat currency, is the absence of third-party intermediaries.

“With eCurrency based on cryptographic proof, without the need to trust a third party middleman, money can be source and transactions effortless.” – Satoshi Nakamoto, Bitcoin Developer

Enormous legacy systems, with enormous investments in human and technical infrastructure, have formed the basis of our money systems. The cost to produce, distribute, secure, and collect printed money is in the hundreds of billions. In addition, the majority of our payments take place using credit or debit cards, where banks and card processors generally charge a 2-3% fee, effectively a personal or business transaction tax. Those “swipe” or “interchange” fees amount to over a trillion of dollars every year. Consumers that send money across borders (global consumers remittance transfers are a US$534 billion4 a year business), are also charged an average

transaction fee between 7-9%. These punitive fees are often struck against consumers with the least amount of savings and financial stability. This accounts for trillions of dollars in economic value that is not going into the hands of consumers and businesses for productive use and investment. The need for enabled, secure and easy global payments and money transfers between buyers and sellers become more apparent.

The 2008 financial crisis, which involved many financial institutions, in all likelihood contributed to the need for a more mainstream global digital currency. Consumer trust in financial institutions was shattered at that very moment. It became a practical move for the enterprising inventors to design, build and operate a new globally available, highly secure, and free to use and operate international monetary system and solution. Specific technical and market innovations are paving the way for more of this type of innovation.

There are a number of trends and innovations that have converged in a mutually reinforcing manner and enable breakthrough innovations like Bitcoin. These innovations include: - Mass adoption of mobile phones and smartphones as a core personal computing device - Continued, global hyper-growth in broadband connected households - Advances in distributed and peer-to-peer computing over the past decade - Specific design breakthroughs in the use of cryptographic methods and digital signatures - Significant and continued growth in online payments

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Current Needs

The 2008 financial crisis, shattered the consumers’ trust in financial institutions and in all probability contributed to the need for a global digital currency.

Basics for a new userAs a new user, one needs to choose a wallet that can be installed on a computer or mobile phone. Once the wallet is installed, a Bitcoins address for the exchange is generated; a process as analogous to E-mail communication.

Balances - block chainThe block chain is a shared public transaction log on which the entire Bitcoin network relies upon. All confirmed transactions are included in the block chain with no exception. This assures that Bitcoins transactions can be verified as owned by the spender. The integrity and the chronological order of the block chain are enforced with cryptography.

Transactions - private keysA transaction is the transfer of value between Bitcoin addresses that is included in the block chain. Bitcoin wallets keep a secret piece of data called a private key for each Bitcoin address. Private keys are used to sign transactions, providing mathematical proof of the address owner. The signature also prevents the transaction from being altered by anybody once it has been issued. All transactions are broadcast between users and confirmed by the network in the following minutes, through a process called mining.

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How do Bitcoins Work?

Person B adds his private key to the message, then sendsthe transaction to the Bitcoin network for verification.

The transaction sent to computers in the network and is added to the ‘block chain’ in a matter of minutes. This makes it part of the public record and ensures that Bitcoins cannot be double-spent.

Person A responds with a message that includes Person B’spublic key, determined by using the public address, andthe number of coins involved in the transaction.

Person B sends Person A his ‘public address’

Processing – miningMining is a distributed consensus system that is used to confirm waiting transactions by including them in the block chain. It enforces a chronological order in the block chain, protects the neutrality of the network, and allows different computers to agree on the state of the system. To be confirmed, transactions must be packed in a block that fits very strict cryptographic rules to be verified by the network. These rules prevent previous blocks from being modified because doing so would invalidate all following blocks. Mining also creates the equivalent of a competitive lottery that prevents any individual from easily adding new blocks consecutively in the block chain. This way, no individuals can control what is included in the block chain or replace parts of the block chain to roll back their own spends.

Once you download and run the Bitcoin client software, it connects over the Internet to a decentralized network of all Bitcoin users and also generates a pair of unique, mathematically linked keys, which you’ll need to exchange Bitcoins with any other client. One key is private and kept hidden on your computer. The other is a public dubbed version of the Bitcoin address given to other people so they can send you Bitcoins. An important security note, it is practically impossible, even with the most powerful supercomputer, to uncover someone’s private key from their public key. Your public and private keys are stored in a file that can be easily transferred to another computer.

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1sd9..1pY3..

1x4F..1qTu..

(....)

(....)

(....)

2.00BTC1x4F..->1pY3..

BitcoinNetwork at a glance

the Block chain(a shared public transaction log)

A Bitcoins address looks something like this: 15VjRaDX9zpbA8LVnbrCAFzrVzN7ixHNsC.Stores that accept provide you with their address so you can pay for goods.

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Transactions and ScriptingOne of the reasons that make the Bitcoins system so powerful is that the input and output of transactions do not require a fixed format, but instead are constructed using a stack-based flexible scripting language. Transaction principals are not named users, but anonymous public keys, which users may freely create in any amount they wish.

Transactions: Transactions encapsulate the movement of Bitcoins by transferring the value received from its inputs to outputs (with one exception: generation transactions have no explicit input at all). An input identifies a previous transaction output (as the hash of the earlier transaction and an index to an output within it), and claims its full value.

An output specifies an amount; the outputs’ total must not exceed the inputs’. Both also contain fragments of executable script, on the input side for redeeming inflows, and on the output side for designating payees.

Script fragments: The scripting language is a stack-based language. Operators include cryptographic processes like SHA1 (which replaces the top item on the stack with its hash), and CHECKSIG (which pops an ECDSA public key and signature from the stack, verifies the signature for a “message” implicitly defined from the transaction data, and leaves the result as a true or false on the stack). For a transaction to be valid, its outputs must not exceed its inputs, and its issuer must show title to each input claimed. Title is tested by evaluating the input script fragment link with the script fragment from the output (of an earlier transaction) that the input references.

Standard transfer: To illustrate how the stack-based scripting language can be used to designate and enforce the recipient of a transfer, we look at the example of the standard Bitcoins transaction used for transfer. To send coins to an address stated as the hash of a public key, the payer (“Alice”) creates a transaction output with the below associated script fragment (recall that since the amount is specified in a special record associated with the output; the script only needs to enforce the recipient):

“DUP HASH160 <recipient-address> EQUALVERIFY CHECKSIG (*)”

The recipient (“Bob”) will notice the remittance since it is widely broadcasted and mark it for spending. Later, so he can spend those received coins, he creates a transaction with an input for redemption, and an output for expenditures. The redeeming input script is:

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The Bitcoin Appeal

“<signature> <public-key> (**)”

Bob will manage to spend the coins received from Alice if his redemption is deemed valid. This is verified by executing the concatenated script (*, **). The input fragment (*) pushes a signature and a key on the stack, and the output fragment (**) makes sure the key hash matches the recipient, and checks the signature against the transaction and key.

Despite three decades’ research on digital currency by the cryptographic community and Bitcoins’ success, Bitcoins are by no means a perfect system. Though, the design actually reflects a surprising amount of ingenuity and sophistication.

Decentralization: Bitcoins have a completely distributed architecture, without any single trusted entity. It assumes a majority of the nodes in the network are honest, and resorts to a majority vote mechanism for double spending avoidance and dispute resolution. In contrast, most of the cash schemes require a trusted centralized bank for purpose of cash issuance and double-spending detections. This aspect appeals to those who wish to freely trade currency being controls put in place by banks, governments or authorities. Analogous to the spirit and original motivation behind the creation of the internet, such a purely decentralized system guarantees that no single entity, no matter how initially benevolent, can succumb to the temptation or be coerced by a government into subversion for its own benefit.

Incentives and economic system: Ingeniously designed, the Bitcoins’ system ensures that users are receiving an economic benefit to their participation. First, the generation of new Bitcoins happens in a distributed pattern at a predictable rate. Bitcoins’ miners solve computational puzzles to generate or create new Bitcoins, and this process is closely coupled with the verification of previous transactions. At the same time, miners also earn optional transactional fees for their contribution in vetting the said transactions. This gives users (payers and payees) clear economic incentives to invest spare computing cycles in the verification of Bitcoin transactions and the generation of new Bitcoins.

Predictable money supply: The Bitcoins system ensures that new coins are minted at a fixed rate, e.g. the larger the Bitcoins community and total computational resources devoted to coin generation, the more difficult the computational puzzle becomes. Early adopters of the system are provided with strong incentives – the earlier in the game, the cheaper the coins minted.

Divisibility and Fungibility26: One practical appeal of Bitcoins is the ease with which coins can be divided and recombined to create essentially any denomination possible, unlike other cash systems. And one bitcoin, is considered the same as any other bitcoin when it comes to price and acceptance.

Versatility, openness and vibrancy: Bitcoins are remarkably flexible partly due to their completely distributed design. The open-source nature entices the creation of new applications and spurs new businesses. Indeed, a rich extended ecosystem surrounding Bitcoins is flourishing. For example, mixer services have hatched to cater to users who need better anonymity guarantees. There are payment processor services that offer gadgets that vendors can embed in their webpages to receive Bitcoin payments alongside regular currency.

Scripting: Another salient and very innovative feature allows users (payers and payees) to embed scripts in their Bitcoin transactions. Although today’s reference implementations have not fully utilized the power of this feature, in theory, one can realize rich transactional semantics and contracts throughscripts, such as deposits, escrow and dispute mediation, assurance contracts, including the use of external states, and so on. It is conceivable that in the future, richer forms of financial contracts and mechanisms are going to be built around Bitcoins using this feature.

Transaction irreversibility: Bitcoin transactions quickly become irreversible, attracting a niche market of those concerned about credit-card fraud and chargebacks. A vendor selling specialty magazines mentioned to blueocean that he could not conduct business with customers in certain countries where credit-card fraud prevails. However, with Bitcoin, he is able to extend his business to these countries due to the protection he obtains from the irreversibility of transactions.

Low fees and friction: The Bitcoins verifiers’ market currently bears very low transaction fees (which are optional and chosen by the payer), an alternate with micropayments where fees can dominate. Bitcoins are also considered appealing for their lack of additional costs traditionally included with international money transfers due to disintermediation.

Readily available implementations: Last but not the least, in comparison with other cash schemes, Bitcoin has provided readily available implementations, not only for the desktop computer, but also for mobile phones. The open-source project is maintained by a vibrant community with healthy developments.

In theory, Bitcoins are an elegant solution to a difficult and technical problem. Unfortunately, that alone won’t move millions of people towards adoption. Bitcoin has three advantages capable of driving its adoption:

1) Decentralizes trust and reduces the control of governments and banks over the money supply;2) Offers anonymity and freedom from censorship over individuals’ use of their money;3) And reduces the fees on online purchases and money transfers.

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Transactions and Scripting

Bitcoin Benefits

Whether by accident or design, the Bitcoins system in the present defines a currency with extreme deflationary characteristics built-in. Coins are minted by verifiers (i.e., block creators, or “miners”) as an incentive to keep the Bitcoins ecosystem running, but minting is poised to expire gradually (and rather soon) resulting in a hard cap on the coins total. Moreover, coins whose private key has been forgotten or destroyed—or “zombie” coins—can never be replaced, resulting in further shrinkage of the money base. For perspective, of the 21 million coins maximum, 12.5 million have already been minted; and of those, tens of thousands have reportedly become zombies.

The potential deflationary spiral in a decentralized system like Bitcoin has security implications that should not be neglected.

Deflationary Spiral: In capped supply, Bitcoins have no choice but to appreciate rapidly should the system ever gain more than marginal acceptance. Even in a “mature market” scenario with, let’s say, a stable 1% of the US GDP transacted in Bitcoins and 99% in dollars, the real purchasing power of coins would still increase over time, as each coin would capture a corresponding constant fraction of the country’s growing wealth. Put another way, while the Federal Reserve can increase the number of dollars in circulation to accommodate economic growth, in a Bitcoins economy the only outlet for growth would be the currency appreciation. While it has been observed that the money supply cap could lead to a severe deflationary spiral, ironically, the intrinsic strength of the Bitcoin currency could be its greatest weakness, causing even more catastrophic unraveling than through “mere” deflation.

Hoarding: Bitcoins, much more than any other currency, derive their value from the presence of a live, dynamic infrastructure loosely constituted by the network of verifiers participating in block creation. Due to their appreciation potential, Bitcoins will tend to be saved rather than spent. As hoarded Bitcoins vanish from circulation, transaction volume will dwindle and block creation will become less profitable (fewer fees to collect). If circulation drops too much, it can precipitate a loss of interest in the system, resulting in “bit rot” and verifier dearth, until a point at which the system will become too weak to heal or defend. Of particular concern is unavoidable large-scale fraud that we describe in the next section, and whose aftermath includes sudden loss of confidence, collapse of value, and repudiation.

Towards decentralized organic inflation: An antidote to this above-mentioned predicament could take the form of Bitcoins-like electronic currency with a built-in, decentralized inflationary feedback that could control the global minting rate based on transaction volume statistics. While we leave the devising of monetary parameters for such an “organically inflationary” currency as an open problem, we will show next how deflationary expectations negatively impact the long-term structural security of the Bitcoins system.

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Structural Problems

Despite wider adoption of Bitcoins around the world, this success has also attracted the attention of fraudulent parties who have taken advantage of operational insecurity and transaction irreversibility. Since Bitcoins are public knowledge (in the form of unredeemed transaction outputs), what enables a user to spend a coin is the actual possession of the associated private key. Theft or loss of private keys, or signature forgeries, will equate to loss of money. In its relatively short lifespan, Bitcoin wallets and processors have been a target for hackers. In fact, recently, one of the most prominent European exchanges reported it had lost over US$1 million worth of Bitcoins to hackers.

Apart from malware, system failures or human errors can cause the accidental loss of the wallet file (which stores the private keys needed to spend coins) that in turn leads to the loss of coins (turning them into zombies). For example, Bitomat, the third largest Bitcoin exchange, recently lost about $200K worth of Bitcoins (at the exchange rate at the time) due to the loss of its private wallet file — the cause was later identified to be human error, as the developer hosted the wallet on non-persistent cloud storage.

Venture capitalists (VCs) see a much larger narrative surrounding Bitcoins, and future potential capital exceeds the US$1.4 billion of Bitcoins’ value currently in the system. In 2014, more than US$100 million of venture capital is expected to flow into Bitcoin startups.

There are three major vectors for investment: 1) exchanges, 2) service offerings for individuals, and 3) service offerings for businesses. The first is the gateway for the Bitcoins system, allowing users to swap Bitcoins for dollars, euros, or whatever form of money they choose. The other two make it convenient and safe for people and institutions to use the system.

Venture capitalists face a tremendous challenge in making Bitcoins user-friendly and secure enough to be ready for mainstream consumers.

Bitcoin hackers are ferocious, attacking the weakest link in the system to drive prices down, then scooping up the currency during the confusion and waiting for the rebound. The fact that shorting Bitcoins is difficult at best is one of the saving graces at the moment. They can most easily profit by eventually betting that prices will rise again. In turn, that actually limits the damage because no one benefits from Bitcoins going to zero.

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Theft or Loss of Bitcoins

Bitcoins Venture Capital

There are three major vectors for investment: exchanges, service offerings for individuals, and service offerings for businesses. US$100 million of venture capital is expected to flow into Bitcoin startups in 2014.

VCs must address the system security issues first, and then work on making Bitcoins a relevant currency for global financial transactions. Progress on both fronts would remove a good deal of the price volatility, since “real” transactions would have a more weights versus buy and sell side orders. Right now, the Bitcoins market is thin and limited on supply unless there is a panic. That’s not to say that the currency upward bias of Bitcoins prices is irrelevant, for it does validate the sustainability of the currency while VCs get their ducks in a row and make their initial investments.

The Bitcoin ecosystem is implicated by speculation and hoarding, hyper-deflation problem and security attacks.

Digital currency is part of our future, even if in a less revolutionary form than Bitcoin’s decentralized, algorithm-based variety.

• The Bitcoin ecosystem is dominated by speculation and hoarding, and it remains to be seen whether it can transition to an everyday currency for consumers. If it does go mainstream, it will likely lose some of its most revolutionary aspects. However, it can still act as a hedge against the global monetary system (if not replace it) and the potential implications are about as easy to predict as the effect of the Internet during the days of ARPANET. If nothing else, Bitcoins make an interesting test case for the implications of future digital currencies. • The hyper-deflation problem has to be countered. Basi cally, with Bitcoin prices surging, no one will want to purchase but save instead. Conversely, when Bitcoins collapse, nobody will want to sell. • Bitcoins has powerful, well-funded opponents who can cripple the system, including payment processors, banks and governments. For example, business accounts of the Canadian Bitcoin exchanges CADBitcoin and Canadian Bitcoins were frozen by Royal Bank of Canada and TDBank. • The Bitcoins system has to protect itself from the various kinds of attacks possible, including protocol attacks, price manipulation, regulatory attacks, and hacking.

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Challenges Ahead

Although Bitcoins may seem like an unstoppable force in digital payments, they can still be impacted, sometimes severely, by regulatory authorities, depending on the nature of the platform and the point at which virtual currencies interact with real-world currencies.

In March of 2013, the US Financial Crimes Enforcement Unit (FinCEN) announced that businesses acting as brokers or transmitters for virtual money services must be registered as Money Service Business (MSBs). This

year, two separate accounts (one with Wells Fargo and one with online payment provider Dwolla,) held by Mt. Gox. the world’s biggest Bitcoin currency exchange, were seized by the Department of Homeland Security, reportedly due to the fact that Mt.Gox did not register as an MSB. Such moves by regulatory bodies highlight the fact that while trade for goods and services in virtual currencies cannot be directly regulated, the point at which these currencies interact with real currencies remains directly under strict financial controls.

“It will be everywhere, and the world will have to readjust. World governments will have to readjust.” – John McAfee, founder of McAfee Inc.

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Regulations

Countries around the world have taken varying stances to regulating the Bitcoin operations, a few of them even deciding to play wait and watch.

When this paper was written, FinCEN was the only US federal regulator to release official guidance on the use of Bitcoins. In March 2013, FinCEN published interpretive guidance clarifying the application of the Bank Secrecy Act and the USA PATRIOT Act to Bitcoins and other convertible digital assets by stating that any administrator or exchanger of Bitcoins (or other convertible digital asset) must be a registered MSB under FinCEN's money transmitter regulations. The release indicated that individual users of Bitcoins not operating a business would not be considered MSBs, and therefore would not be required to register, report or perform recordkeeping. Such clarification also requires administrators or exchangers of Bitcoins to comply with applicable state law and register with certain state regulatory agencies.

The rate of Bitcoins adoption of Bitcoins will directly relate to storefront acceptance – both on and offline. If the currency can fall, or rise in value dramatically, it will be exceedingly difficult for stores to charge using the currency due to its relative value vs. traditional standards, such as the US Dollar. If Bitcoins continue to realize any further traction, however, there will be more flux in this marketplace before there is less.

For a crypto-currency to thrive, it needs to detach from a cross paper currency altogether. If Bitcoins were only exchangeable with virtual currencies (crypto currencies), there might be an opportunity for a legitimate currency system. It would weed out speculators and possibly create some stability in crypto-currency markets.

There are two perspectives about the future of Bitcoins. First, the short-term: if this is a bubble, when will it burst? It’s notoriously difficult to predict the end of a speculative bubble. Those lucky enough to time it correctly can make a lot of money, but that won’t be true for the everyday person. The price chart for Bitcoins reminds us of the NASDAQ from 1995 to early 2000.

Second, the long-term: what will the Bitcoins market look like in 5-10 years? That’s even harder than calling the peak of a bubble. A significant contribution of the Bitcoins market is the proof-of-concept for a decentralized crypto-currency. Two Bitcoin benefits are transactions are inherently deflationary and anonymous. Given the recent slew of fiscal chaos and increasing concerns about online privacy, these are two strong points in its favor—or whatever future crypto-currency arises.

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Conclusion

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1. http://bitcoin.org/bitcoin.pdf2. http://sourceforge.net/projects/bitcoin/3. http://www.mail-archive.com/cryptography@metzdowd.com/maillist.html4. http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTFINANCIALSECTOR/ EXTPAYMENTREMMITTANCE/0,,contentMDK:22121552~menuPK:5978015~ pagePK:210058~piPK:210062~theSitePK:1943138,00.html5. http://en.wikipedia.org/wiki/Bitcoin#Exchanges6. http://en.wikipedia.org/wiki/Ecash7. http://www.cs.ut.ee/~lipmaa/crypto/link/protocols/ecash.php8. J. Camenisch, S. Hohenberger, and A. Lysyanskaya. Compact e-cash. Proc. Eurocrypt,2005.9. S. Canard and A. Gouget. Divisible e-cash systems can be truly anonymous.Eurocrypt 2007.10. D. Chaum. Blind signatures for untraceable payments. Proc. Crypto, 1982.11. R. Gennaro, S. Jarecki, H. Krawczyk, and T. Rabin. Secure distributed key gen eration for discrete-log based cryptosystems. J. Cryptology, 2007.12. B. Laurie. Decentralised currencies are probably impossible but let’s at least make them efficient. www.links.org/files/decentralised-currencies.pdf.13. P. MacKenzie and M. Reiter. Two-party generation of DSA signatures. Proc. Crypto, 2001.14. S. Nakamoto. Bitcoin: A peer-to-peer electronic cash system. www.bitcoin.org.15. T. Okamoto. An efficient divisible electronic cash scheme. Proc. Crypto, 1995.16. http://thegenesisblock.com/17. http://markets.thegenesisblock.com/18. http://mining.thegenesisblock.com/19. http://techcrunch.com/2013/04/05/why-do-vcs-care-about-bitcoin/20. http://www.cbinsights.com/blog/trends/bitcoin-industrystartups21. http://www.tripwire.com/state-of-security/top-security- stories/hackers-hit-european-bitcoin-payment-processor-bips-1-million/22. https://www.privateinternetaccess.com/blog/2013/12/the- present-status-of-bitcoin-regulations-in-the-united-states/23. http://techcrunch.com/2013/12/03/india-wakes-up-to-bitcoin/24. http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf25. http://www.mobilemarketingwatch.com/mobile-users-prefer-ad- engagements-over-paying-to-receive-premium-content-32719/#more-3271926. http://www.investopedia.com/terms/f/fungibility.asp

Sources

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