We also wrote an article for Retail Week: "What is bitcoin, and should retailers accept it?" to read this please click here.
Virtual currencies have recently been in the news as a result of the US Securities and Exchange Commission’s ruling that offers and sales of digital currencies are subject to federal securities requirements (there has not yet been any equivalent ruling in the UK). Nevertheless, digital currencies have continued to grow in popularity; Bitcoin, the most widely used, has quadrupled in value since the beginning of the year, as a result of the activity of speculators.
The use of bitcoin for transactions has also increased: there are now over 16 million bitcoins in circulation, with between 200,000 and 300,000 bitcoin transactions recorded every day. While bitcoin is not yet accepted by many large retailers, it can now be used in an increasing number of smaller outlets and is accepted by some online merchants.
So what is bitcoin, and should retailers accept it as a means of payment?
Bitcoin is a peer-to-peer cryptocurrency based on distributed ledger technology. It allows one person to transfer virtual currency to another without the need for processing by a financial institution. The technology on which it is based was developed in 2009 and published in a paper purportedly written by Satoshi Nakamoto; it is uncertain whether Nakamoto is a real person or whether the name is a pseudonym.
Bitcoins are produced when members of the bitcoin network, using specialised hardware, solve complex algorithms in a process called mining. Bitcoin miners are rewarded for their work with new bitcoins, created at a fixed rate, so that mining is very competitive. In an attempt to avoid inflation, the rate at which bitcoins are created halves every four years; in 2140, when a maximum of around 21 million bitcoins will have been created, it will be reduced to zero.
The creation and transfer of bitcoins are validated by the use of a public–private pair of cryptographic keys. Bitcoin transactions are confirmed by being included in a block with a mathematical proof of work. A proof of work is hard to generate – and becomes harder as more people become miners – but easy to verify once created. Each block is linked with the previous block in a blockchain, making it very difficult to reverse previously approved transactions.
The blockchain (or distributed ledger) is broadcast to the whole bitcoin network and updated approximately every ten minutes when updates are approved by the bitcoin community. Falsification is said to be almost impossible, because all nodes would reject any block containing invalid data. Blockchains have been described as technologically closed but functionally open: the principles on which the blockchain is based are fixed and cannot be altered (other than by consensus of the whole bitcoin network), but anyone can access the blockchain and become a miner.
Distributed ledger technology has the potential to be used for many other applications apart from virtual currencies, including tax collection, benefit payments, land registries, passport issues and smart contracts. The Australian Stock Exchange, for example, is developing a distributed ledger solution to replace its current platform for clearing and settling trades, and the Republic of Honduras is considering a blockchain-based land registry.
Bitcoin is a virtual currency accepted among the members of the bitcoin community as a digital medium of exchange. It is not legal tender, nor is it issued by any central bank or pegged to any local currency, but it may be exchanged for local currencies against which it has a floating value. Like most currencies, it is materially worthless: its value depends on individuals continuing to believe in its worth, which in the case of bitcoin is based on the mathematical principles it embodies. While bitcoin is a poor store of value, because of its volatility, the Financial Markets Law Committee has concluded that its status as a medium of exchange within a significant user community gives it a good claim to be regarded as money.
Regulation of virtual currencies is not yet developed, with the Financial Conduct Authority in the UK expected to publish proposals later in the year. The European Commission has proposed amendments to the Fourth Money Laundering Directive so as to include virtual currency exchanges and wallet providers in its anti-money-laundering framework, but these have not yet been enacted. In the US, the Securities and Exchange Commission has recently found that tokens offered and sold by a virtual organisation known as ‘The DAO’ were securities and therefore subject to federal securities laws.
In general, the attention of regulators has focused on the use of virtual currencies as an investment, or on providers of virtual currency services, rather than on the bitcoin network itself or those using it for day-to-day transactions. Most authorities are letting the technology mature before regulating such areas as data transfer and security. While it is important that virtual currencies do not prejudice the integrity of the market, and that the interests of users are protected, it is also considered that the development of new technology, which may bring significant benefits in the long term, should not be stifled by premature regulation. The present position, therefore, is that customers and merchants use bitcoin at their own risk.
Users may buy bitcoins at a bitcoin exchange. Payment usually needs to be made by some means other than a credit card or PayPal, because of the risk to the exchange that the transaction could be reversed by a chargeback. Bitcoins are stored in a virtual wallet, usually provided by a third-party application.
Having obtained their bitcoins, a customer can then use their wallet application to make a payment, by entering the recipient’s address and the payment amount and pressing send. Alternatively, if the customer is making a purchase in a shop, the merchant can use a tablet running a bitcoin payment application to display a quick response (QR) code with the merchant’s address and the price. The customer uses their wallet app to scan the QR code on their smartphone, and the bitcoin passes. Notification of payment is almost instant, but there is a delay of about ten minutes before the payment is treated as confirmed by having been included in a block.
In contrast to payments by debit card, the customer will pay a small fee to make a payment by bitcoin, whereas the merchant will pay nothing to receive it. The merchant will, however, usually pay a subscription fee to a third party to use a bitcoin payment application. They will then use that application to convert the bitcoins received into normal currency. It is considered best practice to do this at the end of each day, to avoid adverse effects from currency fluctuations.
What are the pros and cons of accepting bitcoin? Among the advantages are the following:
Disadvantages of bitcoin include the following:
Bitcoin is perhaps best suited to low-value, high-volume transactions, where the fact that no fees are payable to receive it is most advantageous to merchants. While the speed and low cost of transacting with bitcoin make it attractive, its volatility and the ease with which bitcoin could be lost are significant risks, best mitigated by using one or more reputable wallet applications and arranging frequent sweep-ups of bitcoin into local currency.
Despite the risks, the popularity of bitcoin and other virtual currencies continues to grow, and the blockchain technology on which bitcoin is based is likely to be increasingly used for other applications.