The brave new world of bitcoin and blockchain

Despite the hazy history and criminal controversies, policymakers in Japan and around the world are starting to realise the potential of digital currency technologies, Peter Yeoh writes.

For a system of online exchange, bitcoin’s history to date is an unusual mixture of disdain, scepticism, curiosity, and excitement. It started its journey in October 2008, when a Japanese individual, or at least an entity using the Japanese name of Satoshi Nakamoto, announced to the world the launch of a new electronic cash system.

The system was completely peer-to-peer, enabled by autonomous computers, and best of all, was without trusted third parties (like financial institutions) making profits as middlemen. Normally, inventors in computer technology like Sir Tim Berners-Lee of the World Wide Web, Steve Jobs and Bill Gates are formally recognised and globally celebrated. In the case of bitcoin however, disputes over who actually developed it mean the technology is mired in controversies as competing claims persist without authoritative answers.

Bitcoin users consider it as cash for the Internet, with a mobile app personal bitcoin wallet enabler allowing users to transact in it. At first, no central banking institutions issued, endorsed, or regulated bitcoin. It runs as a decentralised system of trust operating external of the control of any institution.

Bitcoins are created via computer-generated processes known as ‘mining’. The peer-to-peer payment system does not exist in physical form and hence has to be exchanged online. This allows users to remain anonymous while undertaking cross-border deals without exchange rate fees. Users transact through bitcoin, as well as invest in the currency.

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These features have, nevertheless, the downside of attracting individuals and entities undertaking various kinds of nefarious activities, as indeed has occurred. Silk Road, an online trade exchange platform using bitcoin, tanked in 2015. This was attributed to the concern of US regulators over its use by people engaged in the trading of drugs and other harmful substances and illicit services, as well as hacking problems.

Yet despite many controversies surrounding it, bitcoin is still in play. There are about 830 different digital currencies to choose from, but bitcoin with first mover advantage leads the pack and enjoys about 50 per cent of the total market capitalisation as of August 2017.

Tax authorities, enforcement agencies, and financial regulators across the world differ in their regulatory treatments for bitcoin. A lot of jurisdictions choose to wait-and-see. Others allow their legal applications through some version of regulatory oversight, but no jurisdictions accept bitcoins as substitutes for their official legal tender.

Bitcoin-friendly jurisdictions include the Australia, Canada, the US, some member states of the EU like Belgium, Finland, Germany, and the UK. In 2014, Swedish MP Mathias Sundin became the world’s first elected politician to exclusively accept campaign donations in bitcoin. This contributed to the country’s highly liberal regulatory approach to bitcoin. His transition recently from the political arena to being the Chairman of the Board at BTCX, Sweden’s biggest bitcoin exchange, has contributed to bitcoin price moving higher.

More recently, Japan has become open to the idea of normalising Bitcoin. Under new legislation in April 2017, Bitcoin trading in Japan would be treated as income from business activities and subject to capital gains tax but not consumption tax. Bitcoin users will also be subject to Know Your Customer (KYC) procedures from Japanese bitcoin exchanges. The latter in turn will be subject to minimum capitalisation rules to avoid liquidity risks encountered by other bitcoin exchanges.

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Interestingly, the amended Japanese banking legislation now allows foreign virtual currency-cash service providers the opportunity to operate their business in Japan. Owing to bitcoin’s volatility, links to nefarious activities, and perceived threats to the monetary system, Bolivia, Ecuador, Iceland, Kyrgyzstan, Russia, and Vietnam have imposed outright bans on the currency. Others have withdrawn official banking system support for bitcoin trading and employment, as China has for instance, despite a thriving large market of individuals transacting in bitcoins between themselves.

Policymakers, in general, are perturbed by hacking risks, illicit activities, and liquidity issues, as bitcoin holders and investors are not covered by any kind of depositors’ insurance by most bitcoin exchanges and are commonly undercapitalised. Some US$409 million in bitcoins at Tokyo’s Mt. Gox exchange were stolen in early 2014. A 2016 study by Tyler Moore, a cyber security assistant professor at the University of Tulsa, suggests that some one-third of bitcoin trading platforms have been hacked, and around half of these tanked since their launch in 2009 (if not always entirely due to hacking). For the equivalent period, by comparison, the study from Privacy Rights Clearinghouse suggests that only around 1 per cent of 6,000 US banks examined have encountered a publicly disclosed data breach.

While many economies wavered because of the above risk threats, bitcoin prices rose steadily since March 2016 by more than 214 per cent over a 12-month period. This includes a 25 per cent price increase since the start of 2017. This came about largely because of positive developments for bitcoin in Japan and because of the pre-programmed diminishing release of bitcoin. The rising price trend courted further interest in the economic potential of bitcoin.

Now the mantra has switched from ‘no-go’ to ‘go beyond’. Policymakers are starting to realise that the real potential of bitcoin just might be the blockchain technology behind it, which is used to secure online transactions. In-depth analysis by the European Parliament in February 2017 suggests that the potential of blockchain technology is much greater and wider than that of digital currencies. This is because transactions of any kind are usually faster and cheaper for the users when completed by blockchain, while simultaneously benefiting from the protocol’s security, transparency, and immutability.

Bitcoin, together with blockchain technology, arose out of the sharing economy’s vision of connecting individuals with others, replacing middlemen, and relieving people’s daily lives from the relatively costly interventions of financial institutions and states. Such benefits are not risk-free, as shown in the operational risk problems highlighted. The Japanese approach merits replication by other economies in the region as it has reasonable safeguards for the deterrence of participation by those with criminal intent and undercapitalisation threats in bitcoin exchanges. As the May 2017 ransomware attack shows, cyber security risks are not confined to digital currencies. For both traditional currencies and bitcoin, more international collaboration is needed.