Bitcoins and Federal Reserve notes: What are the differences?

New forms of currencies, called virtual currencies, are competing with the U.S. dollar as mediums of exchange for transaction purposes. While miniscule in size relative to the dollar at the moment, they are growing rapidly, with the most popular U.S. version being the “Bitcoin” and about 36 others operating in worldwide markets.

European Union authorities, however, have shown concern of the potential for money laundering of these currencies and the dangers of speculative trading in them. U.S. officials have rung similar alarms and are said to be watching them with intense care. What are these mysterious non-bank institutions that issue their own currencies and win citizen acceptance as mediums of exchange?

 

BECAUSE INFORMATION on these companies is scattered and usually private, and beyond the radar of government regulators, little has been compiled on their performance characteristics, economic well-being and motives for launching. But some highlights can be noted.

In many ways, Bitcoin transactions resemble ordinary dollar exchanges for goods and services. Anyone can establish a Bitcoin, or a Bitcoin-like coin currency. The currency trades mainly online, but some actual coins are issued. There is even a website, Bitcoin Forum, where the reader may communicate with the “geeks” running these operations. Licenses, certificates of qualification, fees or special taxes are not required. These enterprises are not subject to regulatory examinations.

Bitcoins are sold to the public where they may be deposited with the seller like an ordinary bank deposit. The buyer can make purchases using his Bitcoins with any vendor that accepts them. Likewise, the accepting vendor can make purchases or deposits with any vendor that accepts Bitcoins. But why would a buyer want to buy Bitcoins to exchange them for goods and services from the very limited number of vendors that accept them? The buyer might want to do this because, for one thing, the costs of credit- and debit-card transactions involving deposit accounts are avoided.

 

MOREOVER, LIKE Federal Reserve notes, they have no intrinsic value. Neither gold nor silver or any other commodity is behind them. They are fiat money. But unlike FRNs, they lack legal tender status, which enables the FRNs required to be accepted in settlement of all debts and obligations. But personal checks, of course, are not legal tender. In short, people are not legally required to accept Bitcoins to settle transactions.

Bitcoins’ supply increases at a rate that declines with time and eventually stops. A mysterious mathematical algorithm governs this process. The supply is allegedly currently capped at 21 million. (If only Federal Reserve Chairman Ben Bernanke would produce his algorithm for determining the U.S. money supply.)

 

IN THIS MILIEU there exists a market for Bitcoin funds. The price of a unit in the year 2013 has ranged from a low of $20 in January to more than $1,100 in November, with marked fluctuations. Obviously, Bitcoin markets are very speculative, leading the Bank of France to warn that the Bitcoin “represents a clear financial risk for those who hold it.” Indeed it does.

Certain other advantages are offered by the network. In addition to a strictly limited supply, transactions on the digital network are difficult to trace, which pleases drug dealers and others transacting business at the edge of the law. Despite virtually preserving anonymity, embodied is a process which enables verification that a transfer of title to property has taken place. This is quite a technological feat even though it’s supported by an open source code.

 

AS IF WE DO not have enough difficulties understanding the markets for Bitcoin, the IRS has yet to set forth its regulations on the taxability of such transactions. If the transaction is deemed a capital gain, then capital gain rules apply; but if it is ruled to be a currency, then it is treated as ordinary income. According to Mindi Lowy of PriceWaterhouseCoopers in New York, however, there could be a taxable gain if the Bitcoin is employed to purchase services or goods! Indeed, a consumer or investor is advised to obtain income tax advice before plunging into this activity.

 

SOME ECONOMISTS point out that Bitcoins cannot be money since they do not satisfy a crucial requirement of money: They fail to be generally acceptable by a wide portion of society. This is true, but to a niche of society they do serve as a medium of exchange. And to members of this group, whether Bitcoins satisfy the definition of money is – well, irrelevant.

Bitcoin is not alone as an issuer of virtual currencies. In the United States, Peercoin and Litecoin, for example, are two of its most vigorous competitors.

 

THINGS CAN become hairy, however, when one attempts to investigate how performers in the Bitcoin producing-management process earn profits. Mysterious “gnomes,” called “miners,” perform arcane functions, including the issuance of Bitcoins, for which they might earn a return of $15,000, at least in the November 2013 market. An interesting tidbit but still we know so little, which means that this area can be so dangerous to the consumer or investor. Some academics – including Dr. George A Selgin of the University of Georgia, who provided invaluable counsel on this article – are researching this field, so in due time we can expect to benefit from their findings.

 

TWO SIGNIFICANT implications warrant attention. First, the recent surge in acceptability of virtual currencies illustrates that intrinsic value, or Federal Reserve System backing, is not necessary to assure public acceptability of a currency. Second, the difference between a regime of virtual currencies and our own FRS monetary system is a matter of degree: The FRS money has the advantage
of being legal tender but it is more costly, in many forms of exchange, than Bitcoins for settling transactions. But many consumers still have options to use dollars and avoid transaction costs.

 

(The writer is a professor emeritus of financial economics at the University of Georgia. He lives in Aiken, S.C.)

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