Understanding Bitcoin: A Digital Currency For Transactions And Investments

Introduction to Bitcoin

Discusss about the Research and Challenges On Bitcoin.

Bitcoin is a type of crypto currency or digital currency which is used to in the market to transact business. The Bitcoin is different from the traditional currency notes as it does not have physical form like traditional currency notes (Dwyer, 2015). Bitcoins are held in the form of digital currency in an account of the holder and transfers of Bitcoin are made electronically from one account to another to transact the business. It was first developed by Satoshi Nakamoto in the year 2009 with an idea to bring digital currency so that the shortcomings of the traditional currency system could be overcome. The traditional system of currency suffers from many shortcomings such as high transaction cost, time taking process and risk of default by third party. One of the purposes of introducing the Bitcoins was to overcome the issues of traditional currency system (Nian and Chuen, 2016).

In order to hold Bitcoins in the account, the holder of the account is required to authenticate the account with digital signatures. As the digital signatures are unique therefore it creates a unique account for each person holding the account (Naware, 2016). It is interesting to note here that the typically the Bitcoins are held in the wallet account in the form of numbers. The transfers of Bitcoins from the wallet account are made using the encryption and decryption technology which is based on the public key and private key. In this technology the public key is used as the public address of the Bitcoin holder while the private key works as the password. Using the private key, the Bitcoin holder can access the Bitcoin balance in the account and transfer the Bitcoins to transact business (Sherlock, 2017).

a person after creating a wallet account of Bitcoin can purchase Bitcoins from the Bitcoin exchange by paying required amount of physical currency (Sherlock, 2017).

As the Bitcoin account operates through internet thus the users could access wide range of market all over the world which is one of the biggest benefits of holding Bitcoins. In order to transfer Bitcoin from one account to another, the transferor uses a unique code and public of the transferee (Sherlock, 2017). Now, the transferee can access the balance in his account by applying private key to ensure that whether the transfer has taken place correctly. Thus, due to the use of encryption and decryption technique the security of money is of high level in the use of Bitcoin. Further, the most crucial advantage of using Bitcoin is the saving in time and transaction in the fund transfers (Sherlock, 2017).

How Bitcoin Works

There certain risk also in using the Bitcoins the biggest among them is that the Bitcoins are not backed by the government guarantee. Bitcoin is a private currency and hence the loss in value of Bitcoin is always a danger for the holder of Bitcoins. The Bitcoin currency operates under stringent regulations which also could make its use less desirable (Sherlock, 2017). 

There has been debate over the matter that whether the Bitcoins are to be considered currency (money) or investment. Initially Bitcoins were introduced as currency or the alternative to the currency to transact business but over the past few years there has been observed significant amount of trading in the Bitcoins. Due to significant trading in the Bitcoins, the price of Bitcoins has also gone mount high. In the year 2016, there was observed a hike of 140% in the price of Bitcoin on the Bitcoin exchange (Dorfman, 2017). The people have traded in the Bitcoins making it a form of investment.     

According to an article published on the website of Forbes, the Bitcoin can not be considered as currency for two prominent reasons (Dorfman, 2017). First is the unstable value of Bitcoins and second is way slow processing of transactions in Bitcoins. From the economic view point, the most important for something to be called is the stability in its price. However, the price of Bitcoins has been observed to be changing so rapidly that it can not be accepted as currency. Big and too frequent changes in the price of Bitcoin would lead to very high inflation and instability in the economic system is Bitcoin is accepted as currency. This is also the prominent reason that the government has not backed the Bitcoins for issue as currency in the economic system (Dorfman, 2017).

Further, facilitation of transactions in a hassle free and quick is also a notable feature of currency. Hence, it is necessary to facilitate quick transactions for something to be called currency. However, in case of Bitcoins, the processing becomes slow due to number of regulatory compliances (Dorfman, 2017). Further, there is limit on the number of transactions which also makes it less desirable to use as currency. So, clearly Bitcoins can not be said to be substitute for traditional currency. However, Bitcoins could be used as one of the means of investments and it could also be used to speculate in the market and make gains. The trend seen in the recent years also suggests that the Bitcoins have been increasingly used to speculate. The speculation on the Bitcoins is the most prominent reason for quick surge in its price in the short span of time (Wolla, 2018).  

Advantages of Bitcoin

However, few people have also regarded Bitcoin as currency on the premise that it facilitates exchange of goods and services which is the primary function of currency (Ramasastry, 2014). The courts in US have given arguments clarifying the legal position as to whether Bitcoin is currency or money. In the year 2013 in a case against Trendon Shavers, the district court of Texas opined that Bitcoin is a currency. The judgment was based on the facts that Bitcoin facilitates exchange of goods and it acts as denominator of value which sufficient to call it a form of currency. However, there many views of courts which suggest that Bitcoin though permits exchange of transaction and though it may be regarded as currency in some instances but it can be accepted as a concrete form of currency. Therefore, going through the legal views and economic perspective, Bitcoin can not be considered as a form of currency. So, it would be rather suitable to call it a form of investing asset (Ramasastry, 2014).

The attitude of Australian government has been positive towards Bitcoin since the concept of crypto currency came into existence. The Australian government is framing and amending rules and regulations so that Bitcoin could be introduced in the market in a mechanically controlled way. Recently, the Australian government has passed a new anti money laundering law which shows governments interest in the Bitcoin currency (Chau, 2017). The new law provides for registration of Bitcoin exchanges in Australia and ensures controlled and fair dealing in the Bitcoins in the market. Further, the Australian Criminal Intelligent Commission is advocating for regulating the digital currencies and provide for stringent rules and regulations for transactions in Bitcoin so that white color crimes could be triggered with ease (Chau, 2017).          

At present Australia is not the biggest of markets for transacting Bitcoins but it is growing rapidly to become so. Looking at the positive attitude of Australian government towards Bitcoin, it surprises that Australia has been ranked at 14^th place in the world in terms of volume traded in the Bitcoin currency. Japan is on top when we talk about volume traded in the Bitcoin currency (Pollock, 2018). However, Australian government is taking serious steps to enhance Bitcoin currency trading in the country. A call from labor senator and liberal senator has given a push to reserve bank of Australia to speed up the process towards adoption of Bitcoin as a legal and official form of currency (Helms, 2017).    

Disadvantages of Bitcoin

Further, the government in Australia has announced tax rate cuts on the gains from the Bitcoin currency transactions in the federal budget 2016 which is an appreciable step towards enhancement of Bitcoin transaction volume in the country. As per rules prescribed by Australian taxation office, transaction in Bitcoin attracts goods and service tax (GST) and capital gains tax apart from fringe and benefit tax (Dudley-Nicholson, 2016).

First of all, unlike Australia, Crypto is not a legal currency in the United States of America (Kaplanov, 2012). The government of USA has had a mixed response to the sudden emergence and advent of Bitcoin. There are various leading financial regulators that have expressed their uneasiness towards the growing currency. In fact, the federal law may not be fully entirely equipped to deal with the virtual currency at the moment. In the US, the SEC (Securities and Exchanges government) regulates all securities including Bitcoin. Back in 2015, the SEC determined that Bitcoin is a commodity and can be regulated under the federal law.

On the other hand, the spot market for Bitcoin is not yet regulated and there have been no specific standards set for those markets. But in order to counter the impact of not being able to regulate the currency, the US government has been now targeting investors for taxes. This tax can be anything in between 10% to 39.6%. This is because the government of the US does not essentially treat Bitcoin or crypto currency as ‘currency’ per se but rather treats this investment as property or commodity.

At present, the country understands the extent of growth of the currency and has been putting efforts in regularizing the currency. Treasury secretary has been taking a lead on bringing federal governments together to coordinate the regulation of crypto currency.

Bitcoin has posed its share of disadvantages to various financial institutions across the globe. One of the biggest challenges faced is the lack of regulation and user protection. It is impossible for any institute to trace back the origin of any Bitcoin traded from any part of the globe (Herrera-Joancomartí, 2015). This creates a loophole which may allow a room for illegal money laundering. Financial institutions are creating awareness about importance of data safety and security among investors. Data theft is a reality and it has been posing a major threat to all Bitcoin investors making it a risky and unsafe transaction. Making the consumer aware and regularizing the crypto exchanges are the efforts that the financial institutions would continue to put to reduce the level of risk on Bitcoin transactions.

Is Bitcoin a Currency or an Investment?

Bitcoin has created a wave of investment which has touched numerous investors across the glove who have now attempted to diversify their investments from other securities into crypto currencies. This has had an overall adverse impact on various currency and equity markets by reducing their overall value. There are various investors who have removed a chunk of their investment from the equity market and invested the same in several crypto currencies. This is also because equities and mutual funds are unable to match the return provided by Crypto currency investments. If this continues to the point where it largely impacts equity investments then the overall economy of the country would hurt.  Moreover, Bitcoin is a virtual currency which is being traded on sheer investor speculation. This increased speculation creates a certain level of instability in the financial markets (Bouoiyour et. al., 2014). In order to counter the same, financial markets are generating awareness and enhancing knowledge about different crypto currencies thus allowing investors to make informed decisions.

Bitcoin and other crypto currencies have led to an emergence of new markets all together which unlike the present money market is controlled by no one (Walch, 2015). The near zero transaction costs has made these currencies superior and their markets disruptive. Therefore financial institutions are attempting to regularize the market and levy taxes on investors. In the future as well, these financial institutions would introduce stricter rules to trade the crypto and levy heavy taxes on profits. Attempts are also being made to track the transactions made on the currency but no such attempt has been successful as yet.

Lastly, Bitcoin transactions are irreversible and cannot be undone ever (Maurer et. al., 2013). Moreover, even the passwords of the Bitcoin wallets are irrecoverable. The fact that Bitcoin currency is not backed by any government or trusted security makes it a very risky investment. Governments and financial institutions are keeping a track of the crypto currency in order understand the market and levy the right regulations and taxes to the investors to instil safer transactions.

The diversification of risk is achieved by apportionment of the total amount available for investment in different investment alternatives. It is always considered better from the risk diversification view point to invest in a basket of securities rather than investing in any one security (Lhabitant, 2017). For this purpose, a portfolio of investment is formed comprising different sets of securities and other investment options. Further, in order to achieve perfect diversification of risk, it is pertinent to select securities having different risk and return characteristics. The perfect risk reduction is achieved when two securities in a portfolio have negative correlation. Further, the main objective of forming a portfolio is to optimize the risk and return of the investor. Thus, if a portfolio is formed with negative correlation of securities, it would lead lower standard deviation (risk) and lower expected return (Pfaff, 2012).

Legal Status and Regulation of Bitcoin

In the current case, Darren has with him three securities such as All Ordinary index, Gold, and Bitcoin. These securities have different risk and return characteristics. Darren has formed three portfolios with different weights such as portfolio-X, Y, and Z. The portfolio-X comprises security All Ordinary and Gold in 70% and 30% proportion respectively. The monthly expected return of portfolio X is 0.41% while the standard deviation is 0.02%. However, if we analyze the return and risk individually of All Ordinary and Gold, the situation would be different. All Ordinary, shows a monthly return of 0.52% with standard deviation of 3.29% and Gold shows return of 0.17% with standard deviation of 4.67%. Thus, it can be observed that the risk (standard deviation) is reduced to a significant level when investment is made in portfolio X. However, simultaneous return is also reduced but comparative to the investment in individual securities, the investor is in a better position. The risk reduction is achieved significantly in portfolio X due to negative correlation of -0.1356 between All Ordinary and Gold. 

So, higher the negative correlation between the securities, lower will be the risk (Gaudecker and VON, 2015). The portfolio Y has expected return of 3.67% and standard deviation of 1.44%. This portfolio comprises All Ordinary and Bitcoin in 85% and 15%. The correlation between All Ordinary and Bitcoin is 0.0582. Since, the correlation between the securities is positive, the standard deviation is also higher as compared to portfolio X. Further, the portfolio Z comprises of Gold and Bitcoin in 75% and 25% ratio shows an expected monthly return of 5.50% with standard deviation of 2.68%. Though the correlation between Gold and Bitcoin is -0.0735 but the standard deviation is high due to composition of high risk securities in the portfolio. The Bitcoin alone has standard deviation of 69.72%.     

References

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Chau, D. 2017. Bitcoin one step closer to being regulated in Australia under new anti-money laundering laws. [Online]. Available at: https://www.abc.net.au/news/2017-10-23/bitcoin-one-step-closer-to-being-regulated-in-australia/9058582 [Accessed on: 09 May 2018].

Dorfman, J. 2017. Bitcoin Is An Asset, Not A Currency. [Online]. Available at: https://www.forbes.com/sites/jeffreydorfman/2017/05/17/bitcoin-is-an-asset-not-a-currency/#28024ab92e5b [Accessed on: 09 May 2018].

Dudley-Nicholson, J. 2016. Federal Budget 2016: Turnbull announces tax cut on Bitcoin. [Online]. Available at: https://www.heraldsun.com.au/news/national/federal-election/budget2016/federal-budget-2016-turnbull-announces-tax-cut-on-bitcoin/news-story/45148197bcfc1f287a41b3eb751afd84 [Accessed on: 09 May 2018].

Dwyer, G.P., 2015. The economics of Bitcoin and similar private digital currencies. Journal of Financial Stability, 17, pp.81-91.

Gaudecker, H. and VON, M., 2015. How does household portfolio diversification vary with financial literacy and financial advice?. The Journal of Finance, 70(2), pp.489-507.

Helms, K. 2017. Australian Senators Push to Make Bitcoin Official Currency. [Online]. Available at: https://news.bitcoin.com/australian-senators-reserve-bank-bitcoin-official-currency/ [Accessed on: 09 May 2018].

Herrera-Joancomartí, J., 2015. Research and challenges on bitcoin anonymity. In Data Privacy Management, Autonomous Spontaneous Security, and Security Assurance (pp. 3-16). Springer, Cham.

Kaplanov, N., 2012. Nerdy money: Bitcoin, the private digital currency, and the case against its regulation. Loy. Consumer L. Rev., 25, p.111.

Lhabitant, F.S. 2017. Portfolio Diversification. Elsevier.

Maurer, B., Nelms, T.C. and Swartz, L., 2013. “When perhaps the real problem is money itself!”: the practical materiality of Bitcoin. Social Semiotics, 23(2), pp.261-277.

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