Bitcoin, a virtual currency that’s not designed to last

Charlie Shrem, CEO of BitInstant, who became a millionaire by buying Bitcoins for $5 while still in college, was arrested recently for money-laundering; Mt. Gox, the oldest Bitcoin exchange, had to suspend payouts due to a technical glitch; and Russia has explicitly said that the use of Bitcoins is illegal. It is apparent that the most popular virtual currency in circulation is feeling the heat as it increasingly comes under regulatory scrutiny.

Yet there are many who continue to believe that Bitcoins are a godsend and the perfect antidote to global currencies such as the dollar, the yen and the euro that can be printed by governments at will. Geeks populating cyberspace visualise a futuristic world where the only currency in circulation is Bitcoin. And many are wringing their hands in frustration at a missed opportunity.

Governments and central banks are doing a tight-rope walk while dealing with this phenomenon. They do not want to scotch a promising financial innovation but it is obvious that regulatory control will have to increase if virtual currencies are to become more widely accepted and used.

It is naïve to hope this virtual currency − which was created in 2008 by an unidentified individual known only as Satoshi Nakamoto (who has done a disappearing act since then) − will be the medium of exchange anytime in the near future. In fact, there are multiple reasons why Bitcoins can not survive in their current form.

Satoshi, while introducing this new currency, said its best feature is its ability to transfer money cheaply and fast without the intervention of any government or regulatory authority.

Unfortunately, this strength of Bitcoin has proved to be its greatest undoing. Money launderers, drug traffickers, arms dealers and other criminal elements have been quick to adopt this currency for their cross-border transactions, giving it notoriety. Ross William Ulbricht, also known as “Dread Pirate Roberts,” was arrested for operating the billion-dollar Silk Road website, where Bitcoins were used to buy and sell drugs.

Virtual currencies such as Bitcoins, litecoins, bbqcoins and so on are not authorised as a medium of exchange by any central bank or monetary authority. These currencies are not registered in any country and exist only in cyber-space. You might say, “So what? I can still use it as a medium of exchange.” But consider this hypothetical situation: you sell a laptop to your friend for 1 Bitcoin. After a while you realise the digital wallet that stored the Bitcoin on your computer was accidentally deleted. Where do you lodge a complaint to reclaim your money? There is no recourse.

Similarly, if you exchanged $1,100 dollars for one Bitcoin in December last year, re-conversion into dollars will now fetch you only $754. In other words, you lost more than 25 per cent of your investment in under two months. Who’s to blame? No one?

Bitcoins are earned through a process called "mining", in which complex mathematical problems are solved with resources available on the computer. The Bitcoin framework works on the premise the resource is limited in number, which gives them value. The programme defies duplication of the "currency". But there is no underlying asset. So how does one value Bitcoins? It is done mainly on the basis of demand and supply. This has resulted in intense volatility.

Bitcoins could be exchanged for $25 in March 2013. By November 2013, the exchange rate was $1,200. And by the end of December, the exchange value was $584. If you were a trader who had accepted payments for your goods or services in a currency that increases its value 47 times in eight months and then halves in one month, would you be able to sleep in peace? A currency this volatile can never become an accepted medium of exchange.

It is obvious that these currencies can not escape regulation for too long. They will either have to submit to some government or central bank and follow rules or choose to exist in no man’s land.

Choosing the first option will result in slowing down fund transfer times and also increasing the costs involved. This will also reduce their attractiveness to anti-social elements. Existence in no-man’s land will mean limited acceptance and increased skirmishes with regulators.

Even if Bitcoins are subject to regulatory purview, the platform software is designed so that it can mine only 21 million units of this currency. 12.3 million Bitcoins have already been mined. It’s value is likely to shoot to astronomical level as the upper limit is reached, making it the biggest joke of the 21{+s}{+t} century.