sveriges riksbank economic review 2014:2 Björn Segendorf holds a Ph.D. in economics and works at the Riksbank s Financial Stability Department. - PDF

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What is Bitcoin? Björn Segendorf* Björn Segendorf holds a Ph.D. in economics and works at the Riksbank s Financial Stability Department. Bitcoin is a so-called virtual currency that has been devised for

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What is Bitcoin? Björn Segendorf* Björn Segendorf holds a Ph.D. in economics and works at the Riksbank s Financial Stability Department. Bitcoin is a so-called virtual currency that has been devised for anonymous payments made entirely independently of governments and banks. In recent years, Bitcoin has generated a great deal of attention on several fronts. Bitcoin payments are based on a new interesting technical solution and function differently to traditional payments. In certain payment situations, Bitcoin can bring advantages in the form of lower costs, rapidity, anonymity, etc. over traditional payment methods. However, usage can also be more risky because Bitcoin is not directly covered by the laws that govern other payment mediation. Weak consumer protection is also a reason for why it may be difficult for Bitcoin to become generally accepted and viable as a means of payment. Use of Bitcoin for payments is low today, and although Bitcoin s future is uncertain, it is an interesting innovation worthy of description. This article explains what a virtual currency is, and how Bitcoin works. Bitcoin use in Sweden which is very limited is also described. Finally, the future of Bitcoin and other virtual currencies is discussed. Responding to new needs? Many areas have undergone rapid technological progress in recent years. Our needs in terms of making payments are also undergoing transformation. For instance, households are shopping online to a growing extent, and the amount of cross-border payments is on the rise. Payment solutions, especially for person-to-person payments, have however not evolved as quickly. Bitcoin can be seen as a response to the lack of such payment solutions and has often been a topic of discussion in the media, at workplaces and among friends in recent years. Various factors have evoked curiosity about how the currency works, such as the supposed anonymity for users, the fact that banks are not involved in the payments and the ability to make payments worldwide. At the same time, it is difficult to understand what Bitcoin really is, and how it works. I attempt to elucidate this in this article. I start by explaining what a virtual currency is, the different types of virtual currency that exist, and where Bitcoin fits into that categorisation. I then go on to describe how Bitcoin works and what we know about its use in Sweden. Finally, I discuss Bitcoin s benefits and risks, and the difficulties it may face in future. * I would like to thank those who have contributed their valuable input. While they are too many to mention, I would like to extend particular thanks to Malin Alpen, Susanna Grufman, Marianne Sterner, Claes Berg and Kristian Jönsson. 71 Virtual currency Bitcoin is what is known as a virtual currency. 1 A virtual currency is a means of payment; that is, units of the virtual currency represent a value. It is intended for use in payments within a specific virtual community, such as a particular website, or in a network of users with special software for managing the virtual currency and making payments. This type of virtual community can thus be said to resemble a voluntary agreement to use a specific item as a means of payment. This is an important difference to national currencies, such as the Swedish krona. For the latter, it has been established in law that the monetary unit in Sweden shall be called the Swedish krona. The virtual currency thus has a different unit of account than national currencies. For Bitcoin, the unit of account is the Bitcoin itself. The issuer of the virtual currency can be a non-financial company or even a private individual, but such an issuer is not under the supervision of a government authority. The issuance of virtual currency is thus not a government-regulated activity. 2 However, each virtual currency has some type of rules of its own governing where and how it may be used, and some form of technical infrastructure in which the payments are carried out. The virtual currency, the own set of rules and the technical infrastructure combined form a small payment system, hereinafter referred to as a virtual currency scheme. There are a large number of virtual currency schemes that have been built up, and function, in different ways. They can be broken down into different categories depending on the extent to which it is possible to buy and sell the virtual currency. Here, we divide them into virtual currency schemes that are closed, with unidirectional flow and bidirectional flows. In closed virtual currency schemes, the virtual currency can be neither bought nor sold, but only earned and used on certain websites (such as World-of-Warcraft Gold). If the virtual currency can be bought for national currency but not exchanged back, the scheme has a unidirectional flow (such as Amazon coins). When the virtual currency can both be bought and sold and used outside of a certain website, the scheme has bidirectional flows. As explained below, Bitcoin is an example of a scheme with bidirectional flows. However, these categories can overlap. 3 A further distinction that can be made is whether the virtual currency is centralised or decentralised. As with banknotes and coins, payments with virtual currency units are made by means of them changing ownership. The ownership structure must therefore be registered somewhere, otherwise it might be tempting for a virtual currency unit holder to duplicate it and use it multiple times. A centralised virtual currency scheme has a centralised 1 The term virtual currency is used by the ECB (2012) and we use their terminology. Other terms are sometimes used in other articles, such as digital currency. However, it is doubtful as to whether Bitcoin is a currency in the proper sense, see Yermack (2014). 2 The issuance of virtual currency must be distinguished from offering different forms of payment service in virtual currency. The providers of financial services, such as exchanges, in virtual currency are subject to anti-money laundering regulation. Regarding payment services, the main regulation in Sweden is the Payment Services Act (2010:751) which sets out the rights and obligations of both mediators of payments and users of payment services. It applies to payment services in Euro or other EES-currencies but could in principle be extended to other currencies, including virtual currencies. 3 See Segendorf (2014) for a more detailed description of the various categories. 72 system for verifying and executing transactions, often with the issuer. In practice, the latter administrates all of the accounts through which the payments are made. In a decentralised virtual currency scheme, like Bitcoin, the transactions are instead verified and executed via the network of users that carry out some form of activity to this end. The right to register events is thus delegated to the network s participants. 4 The decentralised virtual currency schemes are not uncommonly based on an exchange of encrypted messages and are therefore usually called cryptocurrencies. The anonymity and security that this provides are the fundamental concepts on which Bitcoin rests. How Bitcoin works Bitcoin is a decentralised virtual currency scheme with bidirectional flow, and a cryptocurrency. 5 It was devised to be independent of governments, banks and other institutions. At an overarching level, Bitcoin works rather like a type of electronic cash. Bitcoins can be purchased on special websites, both abroad and in Sweden, where they are exchanged for national currency. 6 7 The exchange rate for Bitcoin is determined by the market as a function of supply and demand. Bitcoin payments can be made between anybody with the requisite software on their computer, smartphone or tablet. This software is called a wallet. Yet, Bitcoin should not be considered to be a type of digital cash. The reason is that Bitcoins are not digital units of value stored on e.g. a computer. A Bitcoin is thus not a digital note or coin and should not be compared to regular notes and coins. Rather, Bitcoin should be viewed as funds in an account. When a payment is made, the payer thus does not send digital notes and coins to the recipient; rather, the payment occurs by means of debiting the sender s account and crediting the recipient s account. Payments are made by means of exchanging encrypted messages and are verified within the user network. I describe this process below. 4 Also, traditional retail payments can be divided up into centralised and decentralised systems. Cash is a decentralised system. It suffices for the paying and receiving parties to agree on the validity of the payment for its acceptance. Other retail payments such as credit transfers, direct debits, cards and cheques are centralised in that they are centrally cleared and the payments are settled at a settlement institution, commonly the central bank. See Sveriges Riksbank (2013) for an account of clearing and settlement of retail payments. 5 Bitcoin was launched in 2009 by Satoshi Nakamoto, which is possibly a pseudonym. Until 6 March 2014, when Newsweek claimed that it had found the real Satoshi Nakamoto, there was a general conviction that the true founder, or group of founders, was unknown. The identified man has denied that he is the true Satoshi Nakamoto. It is currently uncertain whether or not it was the true Satoshi Nakamoto who was found. Source: and 6 Different exchange sites offer slightly different services. Some only exchange, while others can offer accounts. There are also websites that match buyers and sellers geographically. In Sweden and most other countries, companies that offer exchange services are regulated and come under supervision. 7 The largest international exchange site by far has long been Mt.Gox. At the end of February 2014, a major theft/fraud was uncovered, whereupon Mt.Gox became insolvent and was declared bankrupt. 73 Asymmetrical encryption gives safe payments I start by explaining the concept asymmetrical encryption and how the sender (person A) and the recipient (person B) of encrypted messages can be securely identified. Asymmetrical encryption is based on A and B having two encryption keys each. The encryption keys are unique and nobody can have the same keys as anybody else. One of the keys is public; in other words it is or could be made publicly known. The other is private, or secret in other words. When A wishes to send an encrypted message to B, he uses B s public key to encrypt the message which can then only be de-encrypted using B s private key. So, B is the only person who can read the message. Asymmetrical encryption can also be used for signing. If A uses his private key to encrypt a message, this can only be de-encrypted using A s public key. The person deencrypting the message can then be sure that it was sent by A nobody else has access to A s private key. This is comparable with A having signed the message. Assume that A is to pay 1 Bitcoin (BTC) to B. A and B both have their wallets on their computers, and each such wallet has a private and a public encryption key. A wallet is associated with its public encryption key, which serves as an address or an account number. A and B communicate through their wallets. The transaction is verified by the network The transaction commences by B sending his public encryption key (account number) to A. A, or more precisely A s wallet, now writes a payment order for 1 BTC to B and signs it with A s private key. The payment order is issued to the network of Bitcoin users. One could say that the transaction between A s and B s wallets is proposed to the network, which now has to confirm/verify the transaction for it to become valid. The method used to send the message to the network is based on technology similar to file sharing (BitTorrent), which is common for spreading/sharing films, music, etc. online. The verification process is as follows: Every tenth minute, a certain type of participant in the Bitcoin network gathers the transactions proposed in the last ten-minute period. This occurs automatically, and the round of gathered transactions is called a block and the special participants are called miners. 8 They have the task of verifying the transaction by adding the new block (the transactions) to what is known as the blockchain, which is the official list or register of verified Bitcoin transactions. Because the blockchain contains information about sending wallets, receiving wallets and amounts, it can be used to verify how many BTC belong to a specific wallet. It is the same as being able to calculate the balance of a normal bank account if one has access to all the incoming and outgoing transactions of that account. A wallet can therefore be viewed as an account, for which the public key serves as an account number for the wallet. A Bitcoin transaction is not 8 Anybody can become a miner; it s the choice of the individual. They are called miners because their activity has been likened to gold digging, because they are rewarded with new Bitcoins. It is an ill-fitting comparison, however, because Bitcoin, unlike gold, has no intrinsic value. For gold, this value comes from the ability to use it for jewellery, in industrial processes, etc. 74 completely anonymous. Because it is added to the blockchain, it is registered and readily available online. It is thus fairly simple to identify the wallets between which a transaction has been made. However, it is very difficult to link wallets to individual users, which means that the transaction is in practice anonymous. The payments are verified by means of miners solving a mathematical problem for which the solution is difficult to calculate, but easy to verify once calculated. In order to better understand the verification, the concept hash function must be explained. A hash function is a function that converts an arbitrary-length number or text into a given-length number. 9 For example, the individual figures in a number can be added together and if the sum exceeds a one-digit number, the components of the sum are added together, and so on. The number is thus =31, and 31 is 3+1=4. Hence, the multi-digit number has been converted into a single-digit number. Let x denote the original blockchain, y the transactions to be verified and z a different number. The mathematical problem to be resolved can be formulated as f(x,y,z) v where f is a hash function and it is a case of finding a number z so that the hash function assumes a lower value than v where v can in this case be interpreted as the degree of difficulty of the hash function. Miners compete with each other over who can find a solution fastest. When a miner has found a solution, the proposed solution is sent out in the network, in which other miners can simply verify whether or not the solution is correct. A decision to accept a solution is taken by majority decision, in which the voting strength of a miner depends on the extent of calculation capacity, or computing power, he brings to the network. When a solution is supported by miners who represent a majority of the network s computing power, the solution is considered to be accepted. The proposed transactions are now added to the blockchain, which becomes one block longer. Now that the transaction between A and B has been accepted, B is the owner of the transferred 1 BTC with which his wallet was credited. At the same time, 1 BTC has been debited from A s wallet. Miners get new Bitcoins for their efforts The incentive for miners to invest computing power in the verification process is that, as compensation, they may create new Bitcoins. The process is as follows: the miner that resolved the hash function quickest, in other words who first computed z, as a reward also adds an extra transaction to the block to be verified (y). This transaction credits the miner s wallet with N amount of BTC without anybody else s wallet being debited. In order words, N amount of new Bitcoins is created with the winning miner as the owner. Every other week, the set of rules (the protocol) 10 governing Bitcoin adjusts the degree of difficulty v of the hash function and the amount of Bitcoins (N) created in each verification. The adjustment is to ensure that the network can verify transactions once every ten 9 The specific hash function used in the Bitcoin protocol is SHA-256. For more information about this function, see 10 A protocol is a set of rules that helps the computers concerned to communicate online. Nobody owns a protocol; rather, it is created to be a usable standard. 75 minutes. If computing power in the network increases, so will the degree of difficulty, and vice versa. The amount of Bitcoins created decreases over time through N being halved after 210,000 blocks, which equates to around 4 years. The initial amount was N=50 and now it is N=25. Because N decreases over time, there is an upper limit of 21 million on the number of Bitcoins that can exist. This limit can be seen as a mathematical threshold that is never reached, even if the amount of BTC can get arbitrarily close. At 30 June 2014, there were around 13 million BTC. Because of this way of creating new Bitcoins, there is, unlike for national currencies issued by central banks, no central Bitcoin issuer the creation of new Bitcoins being governed by its protocol. Hence, neither is Bitcoin a monetary claim on another party. Swedish notes and coins are formally a claim on the Riksbank and bank balances are a claim on the bank, backed by its balance sheet. The value of a Bitcoin is thus not based on any type of claim or underlying asset. Rather, its market value depends entirely on an expectation that it can be used in future transactions. Payments are not in real time A Bitcoin payment is not a real-time payment. It can take up to ten minutes for a payment to be verified, and the general rule is that one should wait six verification rounds to be sure that the payment was actually added to the blockchain. 11 Obtaining verification for a Bitcoin payment can thus take up to around an hour. Depending on the situation, this can be perceived as a long or short space of time. It is also worth noting that, due to the file sharing technology and the verification process, there is no central storage location for the blockchain. Each network participant has information about all or parts of the blockchain. 11 The recommendation comes from Bitcoin.se. The underlying reason for why waiting a couple of verification rounds is recommended is a consequence of the decentralised verification process. Expressed simply, different versions of the blockchain can occur. In such cases, the longest blockchain is considered to be the proper one. The transaction that was just verified is registered in the final block of the blockchain. Should duplicate versions occur, there is hence a risk of the other version of the blockchain being selected as the proper one by the network, and hence of the final block being different. If the transaction is no longer included in the blockchain, it is not verified either. It is therefore wise to wait a couple of verification rounds to eliminate the risk of the blockchain changing. 76 Box 1. Electronic money is not virtual currency The concept electronic money should not be confused with virtual currency. Electronic money is an electronically stored money value that represents a claim on the issuer, has a value that equals no more than the amount for which it was purchased, and which is accepted by parties other than the issuer. 12 By the latter, it is meant that the e-money must be accepted by a sufficiently broad circle of companies. Bitcoins are thus not electronic money, one reason being because they do not represent a claim on the issuer. In general, a virtual currency can fulfil a couple of the above criteria, but not all. For example, most virtual currencies do not fulfil the requirement of a sufficientl
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