Why banks should fear for the Bitcoin

Lately, we have seen a growing popularity of the Bitcoin, a new digital currency for making payments on the internet. Over the last year the value of the Bitcoin has exploded. While in Januari 2013 one Bitcoin would cost $ 13, on December 4th the quotation tipped the level of $ 1200, which reflects a gain up to 10,000 per cent. Soon after, however, the quotation collapsed to $ 850, which in turn demonstrates the Bitcoin’s incapability of functioning as a stable currency.

I’m inclined to say that these are startup problems rather than fundamental problems. In my view the fluctuations of the Bitcoin quotation are to be attributed to the inconsistent and ambiguous responses of financial authorities, governments and representatives of the financial sector. They simply don’t seem to know how to cope with this new technology.

So what’s so special about the Bitcoin? In contrast with common electronic banking and credit card payments the Bitcoin is a peer-to-peer solution, which doesn’t require a third party to administer, to check and to confirm the transfer of money. Instead, the money is directly transferred from one account to the other. So, we don’t need banks anymore. Since these days many people are fed up with banks and their inferior products, their bonuses and the billions of tax dollars that were needed to prevent the financial sector from collapsing, the Bitcoin offers an attractive alternative. But if no banks are involved, who then administers the transactions? The answer is: the administration is covered by the network of participants, actually by their computers. Each time when a transaction is proposed it is broadcast in the network and checked by multiple other computers in the network. This is all done in an anonymous way: each of these computers receive a series of meaningless digits, which they have to process according to a standard processing algorithm. After a few minutes the results of all calculations are combined to decide about the correctness of the transfer, e.q. checking if the accounts are true accounts, if the digital signatures are okay, if the sender is the true owner of the bitcoins to be transferred, if these bitcoins haven’t been transferred before, and so on. If the calculation matches, the transaction is confirmed and effected. Altogether it means that the administration of the currency is fully distributed over the network, which thus acts as a self-organised system. It means that the administration is not at a particular location in the network but virtually everywhere.

The idea of self-organisation is an inherent difficult thing to grasp. It is very similar to what happens when many starlings group together to produce these fascinating dynamics patterns in the evening sky. No single starling is leading the flock, directing and synchronising it to produce the patterns. None of the starlings are even aware of the patterns they produce. Instead the patterns are the collective result of very simple individual behaviours that are guided by a simple rule: keep close to your neighbour.

It seems that financial authorities hardly understand what’s going on. The European Central Bank (ECB) wrote an interesting report about electronic currency, be it a bit defensive. Generally the ECB qualifies the Bitcoin as an interesting financial innovation, but it is worried about the lack of supervision. The FED, which is the Central Bank of the USA, likewise qualifies the Bitcoin as a remarquable and promising new technology; it even suggests that it could be used as an official currency by banks and governments. Chinese authorities first embraced the Bitcoin (which led to a strong increase of the quotation), but soon after the Central Bank of China as well as other countries banned it (which made the quotation collapse). The Dutch government explained that the Bitcoin is  neither a currency nor a financial service, because the law requires that there is a party that is responsible for the currency! Obviously, this party is lacking: the Bitcoin is a self-organised network system. It seems the authorities have a hard time, when they cannot see who is responsible. We’ve have seen this impotence before with the peer-to-peer music services of Napster, and more recently with Kazaa and Bittorrents. Today the Bitcoin currency is challenging the system. It seems that current legislation and financial institutions aren’t prepared for emerging 21st century technologies.

The Bitcoin has many characteristics that would make it a perfect currency: it is accepted as a means of exchange; there is a controlled and very limited influx of new new Bitcoins; all transactions are unambiguously checked; no banks are needed as intermediaries; no small print; transfers are fast, efficient and cheap; geografic boundaries become irrelevent; as the system is open source software, anyone can inspect the safety level of encryption. Also it warrants anonimity. Although governments claim to strengthen privacy regulations, the anonimity offered by the Bitcoin is perceived as one of its greatest threads, because it would greatly support criminals to do their arms trading, human and drug trafficking,  and money laundering without being tracked.

Just like other peer-to-peer solutions currencies like the Bitcoin will make there way to the market. Authorities should accept the idea of self-organised systems and create the conditions for its use rather than cling on to existing models.

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