Economic Aspects of Bitcoins

Shivek Khurana

{khuranashivek@gmail.com}

Report submitted in the partial fulfillment of the requirements for the degree of

B.Tech Innovation with Mathematics an IT

Cluster Innovation Centre

University Of Delhi

Abstract

Bitcoin is a an innovative, decentralized, peer to peer, crypto currency. In this project, we learn the economical

application and aspects of the bitcoins and contrast it with currently existing systems and the potential eruption

that the bitcoin ecosystem is capable of, in the domains of geographic fund transfer boundaries, ownership

of currency, money supply, currency regulating authorities and currency specific taxation policies. Bitcoin is

pseudonymous, i.e. the real life identity of a party is hidden and all transactions are recorded in a public ledger

called the block chain.

Index

Index

1 Introduction

2 Currency

2.1 bitcoin vs other currencies

3 Bitcoin Protocol : An economist’s view

3.1 {bit, lite, peer}coin vs Bitcoin Protocol

4 Money Supply

4.1 bitcoins are mathematically infinite

5 Value of bitcoins

5.1 Determination of exchange rates

5.2 Potential fall of bitcoin economy

6 Bitcoin : A Ponzi Scheme

7 Early Adoption Benefit

8.1 Illegal Usage

8.2 Bitcoin Regulation and Taxability

9 Bitcoin vs Fiat Banking Protocol

9.1 Distributed

9.1.1 Seigniorage and Tracking

9.1.2 Currency Influx to Maintain Local Economic Hierarchy

9.2 Limits , Lifted

References

Economic Aspects of Bitcoins by Shivek Khurana

1 Introduction

Fiat banking systems have been the only form of available currency since long. Bitcoin is an open source peer-

to-peer electronic money and payment network introduced in 2008 by pseudonymous developer "Satoshi

Nakamoto". We study bitcoin from an economist’s point of view. Bitcoin is an internet currency, which lays

power off from currency issuing authority and levies that power to a distributed network of nodes called miners.

The protocol validates itself and provides provision for pseudonymous money transfers, negligible transaction fee,

and dissolved geographical boundaries.

2 Currency

Think of a forest, Where a mouse, Morton, befriended an elephant called Joe. Now Morton would threaten other mice in his clan in the name of Joe and take hold of their food. Other mice were helpless because Morton was backed by a bigger animal, and had no option, but to give away their hard earned food. In the course of time, all mice befriended a bigger animal. Dave befriended Carroll the fox and Alice befriended Ethan befriended Noah the Lion and so on. Assuming all of them were collecting food, each one of them could now threaten everyone else and force others to give away their food. The food each mouse ends up with will be proportional to the strength of their big animal friend.

This is how currencies work. Not exactly, but in a similar sense. You are the mouse. The bank or the currency

issuing authority like the RBI is your big animal friend. And your threatening is the ₹ 20 note. You can threaten

any shopkeeper with a ₹ 20 note and he’ll have to give you a pack of chips which is of equivalent value. Unlike the

mouse’s threatening, this threatening is persistent and could be further exchanged for other goods and services.

Carroll the fox, Joe the elephant and Noah the lion are banks of different states. Just like different animals have

different levels of strength and endurance, the banks of different states have different levels of strength. In the case

of bank, it is measured by the total value of goods and services being produced by that country. The threatening of

mouse with a comparatively powerful animal friend will have more weight. Similarly, a currency associated with

a powerful state will have more value. For example : Dollar is stronger than Rupee but is weaker than Euro.

2.1 bitcoin vs other currencies

A currency is accepted only if the issuing authority is authentic and reliable. If you write 40 * on a piece of paper,

put your signature and a picture of George Clooney on it, you won’t be able to exchange it for a chocolate bar,

but you can easily get a chocolate bar if you get that piece of paper from the RBI, with a picture of M.Gandhi on

it. This is because you are not a reliable issuing authority. You are not a big animal and your threatening doesn’t

threaten other mice in your clan. But bitcoin is different.

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Economic Aspects of Bitcoins by Shivek Khurana

In 2008 came a smart mouse who knew about the happenings in the alienated human world. He was called Satoshi Nakamoto. He thought that he could take on the elephant, fox and lion with a machine gun. So he invested in them, and was able to survive in his population, among other mice with big animal friends. His threatening was way more powerful.

This is bitcoin. Instead of a regular bank issuing currency, a network of mathematically bound computers issues

and control currencies. This network is generally referred as the bitcoin ecosystem. The reliability of the network,

unlike other issuing authorities, increases as more and more people start believing in the network. The network is

controlled collectively by all nodes. Each node owner is called a miner.

3 Bitcoin Protocol : An economist’s view

A bitcoin transaction, unlike real world transactions, is not physical fund transfer, but a ledger entry to a global

ledger called the blockchain. Bitcoin transactions require two parties with their own wallets. A bitcoin wallet is

like a bank account with only send and receive payment option. There is no limit to the number of wallets a person

can have. A wallet can be stored online or offline, but offline systems are generally preferred. A wallet doesn’t

reveal a party’s real world identity, it is just a big alpha numeric number. Each user is identified with her wallet

number. A transaction cannot be rolled back, or cancelled as it is the case with fiat banking system.

Making a transaction is equivalent to floating a data set in the network of miners. Suppose Alice wants to transfer

10 BTC to Bob, then she will create a ledger entry crediting 10 BTC from her wallet address to Bob’s wallet

address. This ledger entry will also contain data of 10 or more BTC being credited to Alice at some point of time

before this transaction to ensure that Alice is spending money that she owns. Once the transaction is made, the

transferred bitcoins will appear in receivers wallet after the transaction has been validated by a miner.

The process appears similar to online fund transfer, in any fiat bank system. The real magic happens when a

transaction is validated by a miner. In fiat banking system, this validation happens as the money passes through

a series of institutions, each of which impose a service charge, which is very significant in case of money transfer

across borders. In the Bitcoin system, the miner validates transactions using computer programs. The service

charge in this case is insignificant. The bank imposes service charge to support its operations, but miners don’t

need to impose it as their operations are supported by a reward mechanism (discussed under money supply).

3.1 {bit, lite, peer}coin vs Bitcoin Protocol

Bitcoin (with capital ‘B’) is an open protocol specification. It states and provides code for how the currency

mechanism will be controlled. The bitcoin (with a small ‘b’), peercoin, litecoin and others are an implementation of

that protocol.

4 Money Supply

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Economic Aspects of Bitcoins by Shivek Khurana

Alice made a transaction and Bob received it in about 10 minutes. What happened in this time ? As earlier stated,

miners validate transactions. This is the time when validations occur. A miner’s job is to collect all transactions

that occurred after the previous batch was validated. A miner(solo or as a group) will record all data floated by

all parties and group them into a chunk called block. This is equivalent to a ledger page, which consists of ledger

entries. All nodes in the network can have a slightly different block due to inherent latency in the network. After

the block is created, the miner checks if the party owns the money she is spending(This is done by every miner on

the network.)

After creating a block, the miners job is to add it to the blockchain, or connect the ledger page to the ledger itself.

Because all miners have their own versions of blocks, they compete with each other to add their block to the

block chain. The competition is to generate a proof of work, i.e a number which follows a certain pattern. Once a

miner comes up with a valid proof, his version of block is attached to the block chain (his ledger page is appended

to ledger). In return of this proof, the network rewards the miner with coinbase, a special transaction of 25 BTC

credited to the miner. The miner also gets to collect the transaction fee. This is how new bitcoins are generated. A

coinbase is reduced to half every 210,000 blocks.

The mining difficulty is adjusted such that one block is generated every 10 minutes. There can be no more than 21m

bitcoins in the bitcoin implementation of the Bitcoin Protocol. In case of litecoin , the upper limit is 84m. After

attaching a block to the block chain, miner broadcasts it to the network. After receiving this broadcast, all miners

stop working on the already validated transactions and start working on the new transactions.

4.1 bitcoins are mathematically infinite

Despite of an upper limit on the number of bitcoins in circulation, each bitcoin can be divided into small chunks.

The smallest recognizable unit Satoshi is equivalent to 0.00000001 BTC. The funds can be divided into even

smaller units, but in case of hosted bitcoin wallets, the minimum bitcoin transfer is generally restricted.

5 Value of bitcoins

The bitcoin FAQ states that,”Bitcoins have value because they are useful as a form of money. Bitcoin has the

characteristics of money (durability, portability, fungibility, scarcity, divisibility, and recognizability) based on

the properties of mathematics rather than relying on physical properties (like gold and silver) or trust in central

authorities (like fiat currencies). In short, Bitcoin is backed by mathematics. With these attributes, all that is

required for a form of money to hold value is trust and adoption. In the case of Bitcoin, this can be measured by its

growing base of users, merchants, and startups. As with all currency, bitcoin's value comes only and directly from

people willing to accept them as payment.”

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Fig 1 : bitcoin exchange rate for past 180 days. Source : blockchain

5.1 Determination of exchange rates

According to bitcoin FAQ, “The price of a bitcoin is determined by supply and demand. When demand for

bitcoins increases, the price increases, and when demand falls, the price falls. There is only a limited number

of bitcoins in circulation and new bitcoins are created at a predictable and decreasing rate, which means that

demand must follow this level of inflation to keep the price stable. Because Bitcoin is still a relatively small market

compared to what it could be, it doesn't take significant amounts of money to move the market price up or down,

and thus the price of a bitcoin is still very volatile.”

5.2 Potential fall of bitcoin economy

The bitcoin is ecosystem is open about potential failures, “History is littered with currencies that failed and are no

longer used, such as the German Mark during the Weimar Republic and, more recently, the Zimbabwean dollar.

Although previous currency failures were typically due to hyperinflation of a kind that Bitcoin makes impossible,

there is always potential for technical failures, competing currencies, political issues and so on. As a basic rule of

thumb, no currency should be considered absolutely safe from failures or hard times. Bitcoin has proven reliable

for years since its inception and there is a lot of potential for Bitcoin to continue to grow. However, no one is in a

position to predict what the future will be for Bitcoin.

A fast rise in price does not constitute a bubble. An artificial over-valuation that will lead to a sudden downward

correction constitutes a bubble. Choices based on individual human action by hundreds of thousands of market

participants is the cause for bitcoin's price to fluctuate as the market seeks price discovery. Reasons for changes

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in sentiment may include a loss of confidence in Bitcoin, a large difference between value and price not based

on the fundamentals of the Bitcoin economy, increased press coverage stimulating speculative demand, fear of

uncertainty, and old-fashioned irrational exuberance and greed.”

6 Bitcoin : A Ponzi Scheme

A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money, or

the money paid by subsequent investors, instead of from profit earned by the individuals running the business.

Ponzi schemes are designed to collapse at the expense of the last investors when there is not enough new

participants.

Bitcoin ecosystem states that , “Bitcoin is a free software project with no central authority. Consequently, no

one is in a position to make fraudulent representations about investment returns. Like other major currencies

such as gold, United States dollar, euro, yen, etc. there is no guaranteed purchasing power and the exchange rate

floats freely. This leads to volatility where owners of bitcoins can unpredictably make or lose money. Beyond

speculation, Bitcoin is also a payment system with useful and competitive attributes that are being used by

thousands of users and businesses.”

7 Early Adoption Benefit

The bitcoin exchange rates rose dramatically from $1 in May 2011 to almost $1ooo in November 2013. There has

been a case of a person who bought $27 worth of bitcoins in 2009 and forgot about them. Now the value of those

bitcoins is more than $1m. Increased interest has caused the mining difficulty to increase so much that mining

hardware limit is reaching saturation levels. But this follows according to “High Risk, High Reward policy”. The

bitcoin FAQ states, “Some early adopters have large numbers of bitcoins because they took risks and invested

time and resources in an unproven technology that was hardly used by anyone and that was much harder to secure

properly. Many early adopters spent large numbers of bitcoins quite a few times before they became valuable

or bought only small amounts and didn't make huge gains. There is no guarantee that the price of a bitcoin will

increase or drop. This is very similar to investing in an early startup that can either gain value through its usefulness

and popularity, or just never break through. Bitcoin is still in its infancy, and it has been designed with a very long-

term view; it is hard to imagine how it could be less biased towards early adopters, and today's users may or may

not be the early adopters of tomorrow.”

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Economic Aspects of Bitcoins by Shivek Khurana

8 Legality of bitcoinsBitcoin has not been declared illegal in any state during the time of compilation of this report, however Financial

Crimes Enforcement Network , United States Department of Treasury has laid strict measures on the usage/

definition of virtual currencies in a guidance note titled, “Application of FinCEN's Regulations to Persons

Administering, Exchanging, or Using Virtual Currencies” .

8.1 Illegal Usage

The pseudonymity of Bitcoins make is lucrative for illegal implementations like drug dealing. The Bitcoin protocol

acknowledges this, as stated in FAQ, ”Bitcoin is money, and money has always been used both for legal and illegal

purposes. Cash, credit cards and current banking systems widely surpass Bitcoin in terms of their use to finance

crime. Bitcoin can bring significant innovation in payment systems and the benefits of such innovation are often

considered to be far beyond their potential drawbacks.

Bitcoin is designed to be a huge step forward in making money more secure and could also act as a significant

protection against many forms of financial crime. For instance, bitcoins are completely impossible to counterfeit.

Users are in full control of their payments and cannot receive unapproved charges such as with credit card

fraud. Bitcoin transactions are irreversible and immune to fraudulent chargebacks. Bitcoin allows money to be

secured against theft and loss using very strong and useful mechanisms such as backups, encryption, and multiple

signatures.”

Some concerns have been raised that Bitcoin could be more attractive to criminals because it can be used to make

private and irreversible payments. However, these features already exist with cash and wire transfer, which are

widely used and well-established. The use of Bitcoin will undoubtedly be subjected to similar regulations that

are already in place inside existing financial systems, and Bitcoin is not likely to prevent criminal investigations

from being conducted. In general, it is common for important breakthroughs to be perceived as being controversial

before their benefits are well understood. The Internet is a good example among many others to illustrate this.

8.2 Bitcoin Regulation and Taxability

Bitcoins received as payments in return of a product of service are taxable as per the law in that state.This type of

payments will be treated as income and bitcoins earned as a result of trading bitcoins are treated as capital gains.

Taxing the mined bitcoins is a tricky scenario, as stated by the Bitcoin Tax Compliance wiki, “ Bitcoins are really

the first digital currency that was created in this manner and actually have a significant value in relation to other

currencies. Essentially it is somewhat uncharted territory. Literally bitcoins, and even digital currencies are so

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Economic Aspects of Bitcoins by Shivek Khurana

new, that there is little to no precedent for some aspects of bitcoin mining, from a tax perspective.

Since Bitcoins are currently traded in various online marketplaces, when someone receives a Bitcoin, they can

reasonably calculate its value in the local currency. Because of this, it is possible that the taxing authority will

treat the receipt of a Bitcoin through a mining pool, or from an individual mining operation, as a taxable event. At

that time, the taxpayer would be required to estimate the value of the Bitcoins in dollars and record that amount.

This would have to be done either daily or weekly depending on the value of the Bitcoins if their value keeps

fluctuating as much as it has the past few weeks. These amounts would be recorded as revenue from bitcoin

mining operations and would be taxable less allowed expenses.

When selling mined Bitcoins, however, you would also be taxed on the increase between the value you recorded

them at when you first received them, and the value you sold them for.Another possibility is that the government

will consider mined Bitcoins ‘intangible personal property’. As a rule, however, financial instruments are

excluded from this particular category. The question is, are bitcoins a financial instrument, or rather, will the

taxing authority consider them a financial instrument? We will have to wait and see if bitcoins become popular

enough for a position to be taken on that.”

9 Bitcoin vs Fiat Banking Protocol

9.1 Distributed

Bitcoin is not backed by a state, but an ecosystem of miners. Miners are fundamentally computers running mining

software and constantly validating transactions happening in the network. This is better than fiat banking system

because it saves manpower and resources required for the operations of a bank. Another advantage is that,

due to openness of the network, anybody can take part in it, i.e. anybody with a decent computer can validate

transactions for the ecosystem.

9.1.1 Seigniorage and Tracking

Seigniorage is the profit that a money issuer makes from printing and spending money. And if the only issuer of

money is the central bank or the “government / central bank machine”, then the latter machine profits when the

money supply is expanded. Or put another way, the new money can be spent on the usual public sector items,

education, infrastructure, etc, which means that the entire community “profits”.

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Economic Aspects of Bitcoins by Shivek Khurana

In case of bitcoins, because no one is minting bitcoins, and there is no issuing authority at all, the government loses

seigniorage, which the legendary British economist, William Goodhart, in his book “Two Concepts of Money”,

considers to be one of the major income source for a government.

9.1.2 Currency Influx to Maintain Local Economic Hierarchy

Value of a currency in general is equal to the total goods and services produced in that country. The currency

differs across countries because different countries produce different amounts of goods and services. Now if a

country is lagging on the global scale, the currency issuing authority can influx the country with more currency

notes. This will decrease a country’s value on a global scale, but will keep it locally unaffected. This modulation is

not possible in the bitcoin econmy.

9.2 Limits , Lifted

The fiat bank limits access to your own money. Your money can be seized by the legislature or the judiciary or

sometimes the bank itself, if the bank feels so (and is able to back it with evidence). Limits are also imposed on

transfers and relatively large transfers are tracked. This cannot be done with bitcoins as your account is local, and

belongs to you and you alone.

References

[1] Leo Kelion, “Bitcoin : Experts Crash Over CryptoCurrency”, http://www.bbc.co.uk/news/technology-

25130261

[2] Satoshi Nakomoto, “Bitcoin: A Peer-to-Peer Electronic Cash System”,

http://bitcoin.org/bitcoin.pdf

[3] Bitcoin Website and Wiki, http://bitcoin.org

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