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Bitcoins: risks and rewards.
Bitcoins fall outside the scope of UK regualtion, but there are benefits to be gained
in using them
You’d be hard pressed to find anyone who hasn’t heard of a bitcoin but how many
understand where it sits within the UK regulatory remit?
A bitcoin is a unique serial number generated through complex mathematical algorithms.
The algorithm is designed to release a finite number of bitcoins- 21 million by 2140 – and
a bitcoin’s value is dictated by demand. A ‘blockchain’ ledger stored across a peer-to-peer
network on the internet records every transaction and is a permanent record of ownership.
You own a bitcoin when you hold the public and private key pair and a change in
ownership is effected when more than 50 per cent of the network accepts that a new public
key controls the bitcoin. You can use bitcoins with any merchant who accepts them and
exchange bitcoins for national currency through online exchanges.
At the monent, bitcoins are not regulated in the UK. The Financial Conduct Authority
(FCA) says a bit-coin is neither currency nor money so falls outside the scope of the UK
financial services regulatory frame-work. This means they are not subject to the
requirements that apply to cash, e-money or investments such as shares, options and futures.
Bitcoins are not ‘e-money’ as defined in the Electronic Money Regulations 2011, as it is
not issued by an issuing authority on the receipt of funds. Bitcoins are also not ‘funds’ for
the purposes of the Payment Services Regulations 2009, as they are not banknotes, coins,
e-money or scriptural money.
Bitcoins also fall outside the Money Laundering Regulations 2007, which impose a
requirement to verify a customer’s identity.
But as the use of bitcoins grows, expect the regulatory framework to adapt and
draw bitcoins into scope.
Key risks
* Security: theft of the private key is a risk. While the blockchain itself has so far proven
resilient to hacking attempts, digital wallets and online exchanges storing individual
reserves of bitcoin have been hit.
* Loss: if your unregulated and unregistered bitcoin exchange goes bust, you have no
entitlement to compensation under any government-backed scheme.
* Value: bitcoins have a history of fluctuating value; they are not pegged to an exchange
rate and are sensitive to speculation.
While there are risks inherent to owning bitcoins, their use marks a shift away from our
centralised banking system and represents innovation in payments and technology. The
value of a bitcoin is dependent on the trust we place in it, so it may be no bad thing if it is
drawn into the regulatory remit.
Trading in bitcoins is set to grow
A summary and/or evaluation: (150-200words)
Android Security Flaw Puts Bitcoin Wallets at Risk
The security flaw is just the latest highlight of the weaknesses inherent in the highly
fragmented distribution of the Android platform.
Bitcoin, the maker of the digital currency, announced that a security vulnerability within
Google’s Android operating system has exposed Bitcoin users to theft through
several Bitcoindigital wallet applications.
The company said updates are being prepared for wallet apps including Bitcoin Wallet,
where the update is in beta testing now, BitcoinSpinner, for which an update is being
prepared, Mycelium Wallet, for which update v0.6.5 can be installed from Google Play or
the Mycelium Website, and an update is also being prepared for blockchain.info.
“Because the problem lies with Android itself, this problem will affect you if you have a
wallet generated by any Android app,” a note on the company’s Website said. “Apps where
you don’t control the private keys at all are not affected. For example, exchange frontends
like the Coinbase or Mt Gox apps are not impacted by this issue because the private keys
are not generated on your Android phone.”
The company also advised users to enact a “key rotation” procedure, which involves
generating a new address with a repaired random number generator and then sending all
the money in the user’s wallet back to the user. The site also notes that if the user has
downloaded Bitcoin Wallet by Andreas Schildbach, key rotation will occur automatically
soon after the user upgrades, though the old addresses will be marked as insecure in the
user’s address book.
“If you use an Android wallet then we strongly recommend you to upgrade to the latest
version available in the Play Store as soon as one becomes available,” the post said. “Once
your wallet is rotated, you will need to contact anyone who has stored addresses generated
by your phone and give them a new one.”
Cryptography is one of the keys to Bitcoin’s success, according to the Bitcoin Foundation.
If Bitcoin is to be a viable money for both current users and future adopters, the company
needs to maintain, improve and legally protect the integrity of the protocol.
Building upon the notion that money is any object, or any sort of record, accepted as
payment for goods and services and repayment of debts in a given country or socioeconomic context, Bitcoin is designed around the idea of a new form of money that uses
cryptography to control its creation and transactions, rather than relying on central
authorities.
The security flaw is just the latest highlight of the weaknesses inherent in the highly
fragmented distribution of the Android platform. The Android operating system remains a
prime target for cyber-criminals, as Android’s user base expands but security remains weak.
The number of malicious and high-risk Android apps has grown to 718,000 in the second
quarter–a massive increase from the 509,000 high-risk apps found in the previous quarter,
according to the report. These malicious apps are on track to exceed one million by year’s
end, a recent Trend Micro report projected.
A summary and/or evaluation: (100-150words)
Bitcoin — Currency with a future or just a fad?
Utter Economics
Bitcoin is attracting people from all walks of life, from small entrepreneurs to global
investors. But what is it really? And perhaps the most important question of all — is it
reliable?
Bitcoin, unlike traditional currencies, is highly decentralised and functions without
government regulation or central banks, underpinned by a peer-to-peer computer network
made up of its users’ machines. Bitcoins are mathematically generated as computers in the
network crunch numbers to find solutions to an algorithm, a procedure known as “mining”.
The algorithm works in such a way that it becomes progressively harder to
“mine” bitcoins over time. A useful analogy would be the search for prime numbers: it is
fairly easy to find small prime numbers, but finding large prime numbers becomes
progressively harder.
When a solution is found, the miner obtains a transaction fee as well as a fixed amount
of bitcoins, which progressively shrinks as more bitcoins around the world are mined. The
twin effects of increased computational difficulty and a shrinking bounty awarded to
miners combine to reduce the rate at which this crypto-currency is produced (or mined)
over time. The total number of bitcoins that can ever be mined is limited to around 21
million (currently, 12.5 million have been mined) — a feature of the currency that was
thought up to ensure that no central monetary authority can issue a flood of
new bitcoins and devalue those already in circulation.
Being a math-based currency, Bitcoin is governed by cryptography. If you own a bitcoin,
you also own a private cryptography key and an associated public address. Think of the
public address as your bank account number and the private key as your PIN. Together,
the address and the private key enable you to make transactions. Using the math associated
with these keys and addresses, the system’s public network checks every transaction that
happens on the network. If the math doesn’t add up, the transaction is rejected, thus
providing the necessary check and balance for the system to continuously operate.
Starting out as nothing more than a hardcore computer geek’s collectible item, Bitcoin is
now turning the heads of notable investors from the likes of Wall Street. Many online
merchants and even some brick-and-mortar stores are starting to adopt it as payment. In
the past four months, the number of companies accepting bitcoins has more than
quadrupled
from
669
to
2,827,
according
to Bitcoin Pulse,
a
service
that
tracks Bitcoin adoption. Since the first transaction in 2010 when a Florida-based
programmer bought a pizza with 10,000 bitcoins, there have been close to 70,000
transactions per day on the Bitcoin network. Some of these transactions have been rather
exotic, such as Richard Branson’s Virgin Galactic accepting bitcoins for outer space travel.
But like all global sensations, Bitcoin cannot help but raise a few (million) eyebrows along
the way. It allows more anonymity than cash, since the network identifies recipients by
their Bitcoin addresses as opposed to their individual names. Because of this feature, it is
no surprise that the underworld market, the creative and resourceful creature that it is, has
jumped on the Bitcoin bandwagon. In October 2013, the FBI shut down Silk Road, an
online drug portal that shipped drugs to users’ doorsteps and accepted bitcoins as preferred
payment.
Bitcoin’s wild ride at the end of 2013 also makes it look more like a speculative tool than
a currency. The price of bitcoins hit a high of US$1,203 in November 2013, shooting up
800% from its base price of US$128 in October. This price surge, driven by Chinese
investors stashing money offshore, is an indication of a classic bubble where prices
unexpectedly surge before crashing, making multimillionaires out of the few who cashed
in their holdings when the price peaked. A few weeks after its historical high, the price
crashed to US$580, and it has been trading in the range of US$600-US$900 since the end
of 2013.
Extreme volatility of this nature is not the only risk that Bitcoin users face. Numerous
hacks and heists have plagued the system, and one of the most recent and high profile hacks
was Mt Gox. The oldest and largest Bitcoin exchange site halted all services on February
24, 2014 — the troubled company went offline, claiming to protect user accounts from a
“transaction malleability” issue, but rumours are swirling. And they are not kind. Most are
saying that there has been a heist at Mt Gox, comparable only to that of Bernie Madoff’s
ponzi scheme. The price tag? A cool US$426mil. Or 744,000 bitcoins, about six per cent
of all bitcoins in existence.
Bitcoin in Malaysia
Although Bitcoin is quite an international sensation, in Malaysia it is still an obscure
currency. However, many enterprising Malaysians are blazing the trail and
easing Bitcoin into the Malaysian market. For the founder of Bitcoin Malaysia, Colbert
Lau, the attraction of Bitcoin lies in its entire concept. Lau noted that marketing and
awareness, as well as “viral apps on mobile adopting (bitcoins)” are needed to garner more
support for Bitcoin in Malaysia. Reuben Yap, founder of BolehVPN, and Arsyan Ismail,
CEO of online retailer Ked.ai, have very similar views on Bitcoin and its implications on
their local businesses. “BolehVPN’s business involves protecting users’ identities and
privacy online, and being the closest thing to an anonymous form of payment, Bitcoin fits
right into our business model,” explains Yap. For Arsyan, Bitcoin is perfect for his
business: “Bitcoin transactions are easier to implement, pay and integrate, and transactions
are fast and there are almost no fees.” He cheekily adds, “It just feels awesome to be a part
of a disruptive ecosystem.”
Both Yap and Arsyan acknowledge that there aren’t many Bitcoin users in Malaysia yet,
but the numbers are growing. BolehVPN, for instance, gets an average of one to
two bitcointransactions every day. To gauge the market’s reaction towards Bitcoin as a
form of payment, Arsyan’s company organises events and does testing with merchants.
Yap is more concerned about government intervention in the Bitcoin market than about
price fluctuations. Thailand and Russia have already banned the usage of bitcoins. For him
and Arsyan, Bitcoin’s transparency is one of its allures. “Transparency is what gives
credibility to Bitcoin. That’s how Bitcoin relates to everyone, not just our business,” says
Arsyan.
But herein lies a problem. Yap gives a concise explanation of what this lack of government
recognition means for Bitcoin users in Malaysia: “The risk is more on people who
use bitcoins to buy things, as opposed to those who accept bitcoins. Bitcoin’s system on
verification is pretty secure and is not subject to fraudulent chargeback requests. So in that
sense, it’s better than credit cards from a vendor’s point of view. However, from the
purchaser’s point of view, in the event that the vendor doesn’t deliver the goods or services,
it’s hard to get legal recourse, so the purchaser really needs to trust the vendor.”
Bitcoin as a global currency
Even though Bitcoin has become a big hit — particularly with online retailers — economists
and central banks continue to urge caution, especially in the wake of the Mt Gox disaster.
Bank Negara Malaysia stated that “Bitcoin is not recognised as legal tender in Malaysia”
and advised the public to be “cautious of the risks associated with the usage of such a digital
currency”.
Economists such as Paul Krugman have been more vociferous in their censure of Bitcoin,
arguing that, if adopted globally, the crypto-currency could spell periods of deflation. With
a fixed supply of bitcoins, set to be reached at around 2030, the cost of mining will become
increasingly expensive. As the cost of mining rises, the value of bitcoins relative to goods
and services also rises, leading to a downward spiral in prices and wages. This in turn could
lead to higher debt burdens, prolonged unemployment and slower economic growth.
Furthermore,
it
remains
unclear
how bitcoins can
be
effectively
saved
for future consumption, as there is no central authority acting as a sink to buy up the
currency in the event that its value crashes. Unlike bitcoins, conventional currency is
backed by central banks that are committed to maintaining the stability of their respective
currencies. Without some authority committed to buying back the currency should its value
fall, there can be no real or psychological price floor for the currency, enabling periods of
extreme volatility and diminishing the currency’s ability to act as an efficient mechanism
to save income.
The heists, drug scandals and continued Bitcoin bashing by economists do not help its
cause, and many opined that the recent closure of Mt Gox would be the final nail in the
coffin. But Bitcoin lives on despite these scandals. SecondMarket, an American online
market place, is also in the process of setting up a new and improved exchange to replace
Mt Gox as Bitcoin’s main trading platform, while the US$/bitcoin trading volume surged
to an average of US$40mil in March, up from US$10mil in September 2013.
In a promising development, the Chicago Board of the US Federal Reserve opined:
“Should Bitcoin become widely accepted, it is unlikely it will remain free of government
intervention. That said, it represents a remarkable conceptual and technical achievement,
which may well be used by existing financial institutions or even by governments
themselves”. While it is still largely considered a new play thing for libertarians,
speculators and drug dealers, this could yet be the genesis of an important new financial
innovation.
[1] www.businessinsider.com/how-bitcoins-aremined-and-used-2013-4?IR=T
[2] www.economist.com/blogs/economistexplains/2013/04/economist-explainshowdoes- bitcoin-work
[3] www.bitcoinpulse.com.
[4] http://blogs.wsj.com/moneybeat/2013/11/22/richard-branson-now-takes-bitcoins-forspacetravel.
[5] http://money.cnn.com/2014/02/14/technology/security/silk-road-bitcoin
[6] www.economist.com/news/leaders/21590901-it-looks-overvalued-even -if-digitalcurrencycrashes- others-will-follow-bitcoin
[7] www.coindesk.com/price
[8] www.wired.com/2014/02/bitcoins-oldestexchange
[9] http://bitcoinmalaysia.com
[10] www.bnm.gov.my/index.php?ch=en%5Fannouncement&pg=en%5Fannouncement
%5Fall&ac=275
[11] http://krugman.blogs.nytimes.com/2013/12/28/bitcoin-isevil/?%5Fphp=true&%5Ftype=blogs&%5Fr=0
[12] www.economist.com/blogs/freeexchange/2014/03/bitcoin#sthash.kEBi8LsC.dpbs
[13] http://finance.fortune.cnn.com/2014/02/25/secondmarket-bitcoin-exchange
[14] www.chicagofed.org/digital%5Fassets/publications/chicago%5Ffed%5Fletter/2013/
cfldecember2013%5F317.pdf
Jason Benjamin
Uses and abuses
Paul Krugman, an American economist, has been more vociferous in his censure of Bitcoin.
Arsyan Ismail, CEO of online retailer Ked.ai.
~~~~~~~~
By Dheepan Ratha Krishnan and Yap Jo-yee
Dheepan Ratha Krishnan is a research analyst at the Penang Institute.
Yap Jo-yee is a research assistant at Penang Institute, and will be pursuing a degree in
Economics at University College London this September.
A summary and/or evaluation: (100-150words)

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