The remarkable growth of the Internet has changed many aspects of the traditional transaction landscape. It has vastly improved the ability to find and trade with geographically distant partners. However, Internet users still need a mechanism to exchange resources of value, most notably cash. Indeed, online commerce has come to rely almost exclusively on financial institutions which serve as trusted third parties to process electronic payments. Although the system works well enough for most transactions, it still suffers from the inherent drawbacks of the trust-based model. Previously, online transactions always required a trusted third-party intermediary. For example, if John wanted to send $100 to Linda online, he would have to rely on a third-party service like PayPal or MasterCard. Intermediaries like PayPal keep a ledger of account holders’ balances. When John sends Linda $100, PayPal deducts the amount from his account and adds it to Linda’s account. In fact, completely non-reversible transactions were difficult to achieve, since financial institutions and third-party services cannot avoid mediating disputes.
However, with the possibility of reversal, the need for trust spreads, as merchants and customers may have valid concerns about the possibility of fraud. These payment uncertainties can be avoided in person by using physical currency, but no mechanism existed to make safe and reversible payments over a communications channel without a trusted party. Accordingly, it became imperative to establish an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.
The quest to fill this void has led to the emergence of many models for electronic payment systems, the most effective of which is proving to be the decentralized and partially anonymous digital currency known as Bitcoin. To be sure, the idea of electronic cash or digital currency is by no means new, as up to three decades of research in the cryptographic community has focused on establishing and improving the efficiency, security, and anonymity of e-cash constructions. However, it took the efforts of a virtually unknown individual known as Satoshi Nakamoto to develop and implement the Bitcoin system in 2009, which almost immediately achieved immense success as a relatively stable and versatile e-cash system that offers the security of transaction irreversibility and other economic incentives to encourage participation.
Resetting the Standards
Unlike previous attempts to develop an electronic payment method, the entire Bitcoin system is dependent on its technical specification which grants it the properties necessary to serve as a form of e-money. Most notably the Bitcoin specification has solved the issue of double-spending which traditionally third-parties in e-payment systems monitored. Coins in the system are simply a chain of digital signatures. Owners transfer coins to each other by digitally signing a hash of the previous transaction with their own private key and the public key of the transferee and add these to the end of the coin. The payee receiving the coin can then verify the chain of ownership of the coin he or she received. A single transaction in the Bitcoin system can have multiple inputs and outputs. This allows users to combine and split value giving bitcoins the divisibility and fungibility properties of money which are crucial to its value as a reliable payment system.
Bitcoin relies on peer-to-peer networking and cryptography to maintain its integrity, and its proponents argue that it has many properties that could make it an ideal digital currency for mainstream consumers and merchants. Among the features that buttress this claim is that bitcoins are highly liquid, have low transaction costs, can be used to send payments quickly across the Internet, and can be used to make micro payments. Individuals participating in the network include, but are not limited to, technology earlier adopters, privacy and cryptography enthusiasts, and speculators. These individuals trade freely with each other and a large number of online merchants including retail providers, web hosts, graphic designers, online casinos, auction sites, and so on. Bitcoin also makes it possible for a number of discreet nonprofit organizations and open source projects to accept donations and conduct their business with relative anonymity. To accommodate growing demand several exchanges have been created, offering exchanges between Bitcoin and traditional currencies, including the U.S. Dollar, Japanese Yen, and Euro.
In a League of Its Own: Bitcoin Outclasses Competitors
The idea of an electronic payment system is neither new nor original.Several attempts have been made in the past to implements such systems. A number of alternative systems currently exist seeking to provide individuals engaged in online commerce with the platform to exchange payments with digital currencies. However, preference for Bitcoin has grown significantly since its implementation, and observers have pointed out a number of reasons why Bitcoin is increasingly considered the digital currency of choice by many participants in the online commerce community, particularly in the micro payment and virtual world markets.
To make sense of Bitcoin’s comparative advantage over similar e-cash systems, it is important to understand one of the main problems that it was created to solve – the double payment problem. Before the implementation of Bitcoin, digital money could be spent twice unless there were trusted intermediaries with ledgers to manage transactions. If there were no intermediaries with ledgers, and digital cash were simply a computer file, just as digital documents are computer files, the hypothetical John could send $100 to Linda by attaching a money file to a message. But just as with email, sending an attachment does not remove the file from one’s computer. This means that Jane would retain a copy of the money file after she had sent it. He could therefore easily send the same $100 to another recipient. This is known as the “double-spending” problem, and until Bitcoin was introduced, it could only be solved by employing a ledger-keeping trusted third party.
The invention of Bitcoin is therefore revolutionary because, for the first time, the double-spending problem can be solved without the need for a third party. Bitcoin achieves this by distributing the necessary ledger among all the users of the system through a peer-to-peer network. Every transaction that occurs in the Bitcoin economy is registered in a public, distributed ledger, which is known as the block chain. New transactions are checked against the block chain to ensure that the same bitcoins have not been previously spent, thereby eliminating the double-spending problem. The global peer-to-peer network, composed of thousands of users, takes the place of an intermediary; Alice and Bob can transact without PayPal.
A key point to note is that transactions on the Bitcoin network are not denominated in dollars or euros or yen as they are on PayPal, but are instead denominated in bitcoins. This makes it a virtual currency in addition to a decentralized payments network. The value of the currency is not derived from gold or government fiat, but from the value that people assign to it. The dollar value of a Bitcoin is determined on an open market, just as is the exchange rate between different world currencies.
Locating the Appeal of Bitcoin
Much of the success of Bitcoin lies in its appeal to a broad and diversified range of interest groups and individuals engaged in different kinds of businesses, including online commerce and (increasingly) traditional trade. Because there is no third-party intermediary, Bitcoin transactions are substantially cheaper and quicker than traditional payment networks. And because transactions are cheaper, Bitcoin makes micro payments and other innovations possible. In addition, Bitcoin holds much promise as a way to lower transaction costs for small businesses and global remittances, alleviate global poverty by improving access to capital, protect individuals against capital controls and censorship, ensure financial privacy for oppressed groups, and spur innovation.
Bitcoin is attractive to cost-conscious small businesses looking for ways to lower the transaction costs of doing business. Credit cards have greatly expanded the ease of transacting, but their use comes with considerable costs to merchants. Businesses that wish to offer the option of credit card payments to their customers must first pay for a merchant account with each credit card company. Depending on the terms of agreement with each credit card company, businesses must then pay a variety of authorization fees, transaction fees, statement fees, interchange fees, and customer-service fees, among other charges. These fees quickly accumulate and significantly increase the cost of doing business.Since Bitcoin facilitates direct transactions without a third party, it removes costly charges that accompany credit card transactions.
Accepting credit card payments also makes businesses vulnerable to charge-back fraud. Merchants have long been plagued by fraudulent “charge-backs”, or consumer-initiated payment reversals based on a false claim that a product has not been delivered. Merchants therefore can lose the payment for the item and the item itself, and have to pay a fee for the charge-back. As a non reversible payment system, Bitcoin eliminates the possibility of fraud inherent in the misuse of consumer charge-backs. In general, while many small businesses are beginning to adopt Bitcoin to exploit the low transaction costs advantage, others have adopted the digital currency for its speed and efficiency in facilitating transactions.
As an inexpensive funds-transfer system, Bitcoin also holds promise for the future of low-cost remittances. Accordingly some estimates, in 2016, immigrants in developed countries sent approximately $581 billion in remittances back to relatives living in developing countries. Most of these remittances are sent using traditional brick-and-mortar money transfer wire services such as Western Union and MoneyGram, which charge relatively high fees for the service and can take several business days to transfer the funds. In the first quarter of 2016, the global average fee for sending remittances was 9.05 percent. In contrast, transaction fees on the Bitcoin network tend to be less than 0.0005 BTC, or 1 percent of the transaction. This entrepreneurial opportunity to improve money transfers has attracted attention from various quarters, and represents one of the key ways that Bitcoin can gain a wider range of users in the near future….