Can Bitcoin serves as the dominant currency of exchange?
Shortly after the 2008 Financial Crisis, a white paper describing a futuristic decentralized currency was published under the alias Satoshi Nakamoto (Nakamoto, 2008). Piggy backing off negative public sentiments towards the existing financial and monetary systems, this theoretical currency known as ‘Bitcoin,’ was designed to facilitate peer-to-peer transactions in a fashion that bypasses financial institutions and systems.
One major feature of bitcoin is the fact that it is finite. Built into the system, Bitcoin is capped at twenty one million. Thus, each time the chain is updated and coins are rewarded to the miners, the number of bitcoin unminted drops. Serving as a double edged sword, this feature is responsible for much of Bitcoin’s perceived value as well as weaknesses. Overall, what does that mean of Bitcoin and its efficacy and viability as a worldwide transaction currency over existing fiat currencies?
To understand whether Bitcoin can replace fiat currencies, it is important to understand the fundamental purpose of money. According to the Federal Reserve, the three main purposes money are being a medium of exchange, a unit of account and a store of value (Lo & Wang, 2014). Starting with a medium of exchange, it is important to note that cash are classified as a legal tender of debt (Cornell Law School). This means that the government is legally obligated to accept cash as payment for a debt. Trust in its acceptance, as well as the government that supports it, allows for the transactions between individuals and businesses that know little about each other. Yet, this is something that Bitcoin does not have. This means that no individual, business, or government entity is obliged to accept Bitcoin as a form of payment. Thus, while Bitcoin may be freely transferred between individuals when trust levels are high, they might not be accepted when trust erodes. Solutions including the use of "smart contracts" that holds parties accountable are used to try to curb this problem. However, this is notwithstanding the fact that general trust tends to be low in times of conflict and war, despite those being the times when Bitcoin is supposed to serve as a safe haven asset for many. Another problem that arises with Bitcoin as a medium of exchange is its inability to scale. During a Bitcoin conference in 2018, the convention had to halt acceptance of Bitcoin as the blockchain and the miners could not keep up with the transaction load (Price, 2018). Thus, while some point to the fact that Bitcoin allows faster and lower cost international transactions, it is important to highlight that the Blockchain is unlikely to be able to process the daily Foreign Exchange (FOREX) transactions.
Another issue that arises when analyzing bitcoin is its ability to serve as a unit of account. In order to serve as a unit of account, the underlying asset has to be relatively stable. Large volatility in its prices due to tweets from famous individuals undermines its stability and renders the coin ineffective. The instability in accounting of Bitcoin is highlighted by a journal article that found high levels of arbitrage opportunities in the cryptocurrency markets (Makarov & Schoar, 2020). This means that prices of the same cryptocurrency around the world are often priced with slight differences due to inefficiencies resulting in some investors or active market participants being able to exploit and profit. Hence, as a unit of account, cryptocurrencies at large are not as efficient at being consistent cross borders.
Lastly, when thinking of money as a store of value, it is important to explore the finiteness of Bitcoin and how it serves as both a benefit and a weakness. Unlike the Gold Standard, Fiat currencies have the ability to change and adjust with the growth of GDP. Afterall, if more goods are being produced and the amount of money stays the same, the purchasing power of each unit of money will increase. Which is the case with Bitcoin. On one hand, some investors sees this attribute as a desirable trait of Bitcoin. Afterall, aren’t investors constantly seeking for assets that are likely to appreciate in value? However, on the other hand it is important to note that it is important to have a currency that is slightly inflationary. This lends itself to why many government seek to keep their inflation rates at around 2%. In fact, a currency that is inherently deflationary would result in people increasingly saving their coins as things, from their perspective, will get cheaper and cheaper over time. However, when this happens, the economy will stagnate and can often lead to a recession.
Another major issue with Bitcoin is the unsustainable nature of its operations. Specifically, this refers to the proof of work method that was mentioned earlier. In order for miners to earn coins, they have to complete a complex mathematical equation before all the other miners. Overtime, this led to miners setting up large operations with energy consuming servers and computers just to increase their chances of solving those mathematical equations first. As of late 2021, the mining process was calculated to consume about 91 terawatt hours of electricity annually. For reference, this amount of energy surpasses the total annual energy used by countries like Finland with a population of about five and a half million (Huang & Tabuchi, 2021). Furthermore, it is important to note that due to the decentralized nature of the system, these operations are hard to track. Additionally, Bitcoin mining operations, unlike traditional business operations, are able to function anywhere with energy and does not have to be close to their end users (Carter, 2021). This means that they are technically able to move around the world to lower their costs of energy without much consideration for how the energy is being generated. Many people worry that the energy intensive nature of the operations coupled by the constant need to increase scale of operations to remain competitive amongst miners can be detrimental to the environment. This worry has not only been highlighted by the general public, but it has also been recognized by the cryptocurrency community with other cryptocurrencies attempting to implement alternative methods of ‘mining’ to accommodate the problem as will be mentioned later.
Other than Bitcoin’s inability to fully function as a worldwide currency as well as its impact on the environment due to its energy intensive operations, it is worthwhile to dive deeper into the decentralized nature of the currency that made it so appealing in the first place. As mentioned previously, the white paper was published shortly after the financial crisis in 2008 when people’s trust in the government and financial systems were low. Thus, it is no surprise that a currency based on a decentralized platform that gave authority to no one individual or entity would appeal to the masses. However this has not necessarily been the case for Bitcoin. Instead, a concentration in power can be seen through the way Bitcoin is mined. Due to the nature of proof of work, operations of mining inevitably began to concentrate. By 2021, seven mining groups owned nearly eighty percent of all computing power on the network (Huang & Tabuchi, 2021). This leads to several problems including the fact that based on the structure of the system, it is possible for a single entity with more than half of the computing power to actually disrupt and the chain and override certain features such as allowing themselves to double spend a single coin (Castor, 2022). This is another reason why other cryptocurrency platforms such as Ethereum are considering changing to a proof of stake format. With this method, ‘miners’ now known as ‘validators’ do not compete through sheer computing power. Instead, they compete through putting native coins or tokens up as stake, while the validator that is willing to put the most at stake wins the task of facilitating the recording of the chain. While this does have significant benefits such as reducing carbon emissions, as the process no long requires large amounts of energy, some also believe that it helps maintain the decentralized nature of the system as it is far less likely for a single validator to hold half of the total coins than it is for a single miner to have half of the computing power. However, regardless of which method, it is still clear that the system itself breeds inequality as those with more resources are the ones that are capable of receiving even more coins.
Furthermore, not only is it hard, or borderline impossible, to have a truly equal system where everybody has the same amount of power, one must also ask whether it is even beneficial to have a decentralized currency in the first place. According to Eswar Prasad, an Economics professor at Cornell University, one possible negative outcome of a theoretical wide adoption of Bitcoin includes the undermining of countries’ monetary and fiscal policies. (Prasad, 2021). For example, today Central Banks are able to use monetary policies to maintain reasonable inflation rates using tools that affect money supply. However, due to the decentralized and unregulated nature of Bitcoin, a country wide adoption of Bitcoin would mean that the Central banks’ ability to control and regulated money supply will be severely hindered. This is notwithstanding the negative impacts on fiscal policies as well. For example, a large portion of a country’s revenue is typically through taxes. However, if there was a country wide adoption of Bitcoin, then the anonymity of transactions will actually make the government’s job a lot more difficult.
Other than monetary and fiscal policies, the decentralized and anonymous nature of Bitcoin has also led to many question raised regarding increase risk to society. These risks include the use of cryptocurrency to facilitate transactions derived from illegal activities including money laundering as well as the financing or purchasing of illegal goods and services. This concern is highlighted by recent trends of governments trying to increase oversight over cryptocurrency as seen with the “Biden Executive Order for federal agencies to officially report digital currencies and consider new regulations” (Sun, 2022). Furthermore, similar fears are also increasingly common among crypto firms. This can be observed through the increase business that companies like Elliptic Enterprises, a blockchain analytics firm that provides information regarding crypto-related criminal activity,” have received.
While it may appear that Bitcoin is still severely lacking when it comes to competing against its incumbents, it must be noted that this innovation does possess many benefits. For example, while it may appear to undermine government’s monetary authority, Bitcoin has allowed many people to “escape extreme cases of monetary oppression, hyperinflation and capital controls” (Carter, 2021). Additionally, Bitcoin has also created an innovative bookkeeping system that allows for transparency and efficiency. As books are updated among all ledgers concurrently, all parties are able to have equal access to all transaction breeding trust in the system. Lastly, Bitcoin has also brought about innovative leaps with regards to reducing costs and risks especially when exchanging currency. As of 2017, Bitcoin spread in currency exchange were roughly 2% less than the FOREX. Furthermore, its features allow for an instantaneous transaction that requires no intermediation reducing risks created by time differences among other inefficiencies with the Forex market around the world (Kim, 2017). Thus, while it seems unlikely that Bitcoin will go on as the currency of the world, it’s innovative structure and features are likely capable of outliving its predecessor while changing the world of finance for the better.
One major example of this includes the use of the decentralized transparent record keeping system known as the Distributed Ledger Technology (DLT). The DLT is a database spread over various locations (Deshpande et al., 2017). Much like the blockchain itself, the DLT offers several desirable features including the immutability, disintermediation, and lack of central control of the system. Together, this leads to an efficient and transparent system that breeds trust and prevents information asymmetry and abuse of power. Furthermore, another innovative decedent of the blockchain technology that is making strides is the Smart Contract. Smart contracts are programmed contracts that allow for two parties to put up their stake of the deal and ensuring that the transaction only occurs if the stipulated requirements are met (Deshpande et al., 2017). Much like a banker’s acceptance today, this contract allows for parties with little information about each other to have trust that the other party will likely hold up their end of the deal. Practically, the DLT technology and its smart contract functions has already found life in government agencies today. One example of this includes the Monetary Authority of Singapore’s Project Ubin (Monetary Authority of Singapore, 2020). The project involved local and international banks including JP Morgan, Mitsubishi UFJ Financial Group, and DBS to name a few. In 2017, the MAS announced the success of the pilot in utilizing DLT for clearing and settlements of payments with superior processing times as well as lower costs. This project would later test DLT’s capability in cross border payments between countries as well.
Other than DLT, many governments worldwide are also appreciating the various innovative features that Bitcoin brought about, and are looking for avenues to morph it with their own currencies. Commonly referred to as Central Banks Digital Currencies (CBDCs), countries around the world including Sweden, China and the United States are experimenting and researching the applications and drawbacks of such a currency. In theory, such a currency would have the benefits of low cost, greater financial inclusivity, and greater transparency while maintaining the backing of a government entity. Countries that adopt this hope to create a currency that works like Bitcoin but with a much stabler value. Furthermore, a digital currency like this would also be able to help governments better deal with tax evasion as well as monitoring of illegal activities (Bordo & Levin, 2017). As of January 2022, the Federal Reserve has released a paper discussing the pros and cons of a CBDC as they announce that they are openly considering but have not come to a decision regarding its issuance and application (Board of Governors of the Federal Reserve System, 2022).
Overall, this report aimed to identify reasons why it is unlikely for Bitcoin to usurp the fiat currency’s role as the main form of global payment transaction. Firstly, the report points to Bitcoin’s inability to store value, account for units, or serve as a medium of exchange. Next, the report discusses the sustainability issues regarding Bitcoin as well as whether the decentralization of Bitcoin is necessarily good. Finally, the report points to the innovative descendants of Bitcoin such as DLT and CDBDs and how they are currently affecting and possibly improving the world of Finance today. Overall, it must be noted that Bitcoin is trading at $40,000 as of April 2022 (CoinDesk, 2022). This number represents the value that many investors around the world has placed on the coin. Thus, it is difficult to say whether the coin will ever go extinct. Instead, the findings in this report aims to postulate that Bitcoin will continue to serve as a safe asset for some people but will fall short if used as the global currency.
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