Money is a matter of functions four: a medium, a measure, a standard, a store. Traditionally, “money” is any object that is accepted in payment for goods and services as well as for repayment of debt. Historically speaking, the object has been tangible but as economies developed intangibles (such as written records) became increasingly acceptable. The concept of money has evolved¹ such that it is defined in terms of its functions: “Money is what money does” ( [8] , ( [9] , p. 474) [10] ([11] , p.1)). The functions of money are typically categorized as follows: I. Primary (1) Medium of exchange, 2) Measure of value), II. Secondary (1) Standard of deferred payment, 2) Store of value, 3) Transfer of value), III. Contingent (1) Basis of credit, 2) Mobility and productivity of capital, 3) Distribution of economy’s output, 4) Optimality condition of equalizing marginal utilities and marginal productivities), IV. Motives (1) Transactional, 2) Precautionary, 3) Speculative). In recent economics, the functions of measurement and standard are often combined into the “unit of account” or numeraire. The aforementioned little pithy statement says it all: Money has four (or three if two are combined) important and direct functions². Some of the attributes, not necessarily the functions, of money are portability, ease of portability, durability, forgery-proof (inimitability or difficulty to counterfeit), divisibility, liquidity, stability of inflation, stability of credit, stability of asset prices, trust in its governance, confidence in its prevalence, acceptance and value, etc.

What does the word “cryptocurrency” designate? Is it “hidden and secret” currency? If citizens, a central bank, agencies of governments and supragovernmental agencies know about it, is it hidden and secret? Is it electronic currency? Then, are electronic funds transfers (EFTs) and wire transfers not electronic currency? Is it digital currency? Then, are credit- and debit-card transactions not digital currency? The phrase “virtual currency”, however, has been defined by numerous agencies³. Among these various phrases, the phrase digital currency appears to be most general and encompassing the rest⁴, even though the agencies of the US government seem to prefer the phrase “virtual currency” ⁵. Recognize that a cryptocurrency is one type of digital currency and because it exists in the parallel world of computer network, it is also a virtual currency⁶.

In this paper we review the antecedents of digital currencies, both ancient and recent, and provide an economic/financial overview (instead of dwelling on technological aspects). The regulatory aspects are touched upon in the section on implications. The majority of discussion is in reference to bitcoin⁷, the preëminent cryptocurrency (an exciting version of digital and/or virtual currency) which has spawned fawning attention, copycats, regulatory frowning and governmental constraints. An immense literature, scholarly and otherwise, exists on the technical aspects of cryptocurrencies. Excellent sources such as Antonopoulos [13] , Franco [14] , and Swanson [15] exist. Understandably, however, financial or economic perspective is not their focus. Literature on cashless/checkless society has been available for a long time. Financial perspective on cryptocurrencies is not readily available⁸.

This paper is organized as follows. Section 2 reviews the roots of the “virtual” currency. Section 3 discusses Bitcoin, an ecosystem, which is the focus of the paper. Section 4 discusses the financial and economic aspects of Bitcoin. Section 5 discusses potential and perceived problems and offers an argumentative analysis and solutions. Section 6 concludes the paper.

Many forms of money exist. From the tangible forms of money (e.g., commodity to precious metal to base metal to paper) to traditional intangible forms of money (e.g., traveler’s checks to demand deposits to other checkable deposits) to modern intangible forms of money (savings deposits to other time deposits to deposits in money market funds of banks/thrifts and mutual funds). Aforementioned forms have the imprimatur of the state or the sovereign, thereby making it economy-wide money. For example, in the US, for January 2015, the currency stock (coins and Federal Reserve notes) is only $1266.3 billion; when other items are added, money stock measure M1 becomes $2927.9 billion. For the same period, money stock measure M2 is $11706.5 billion (http://www.federalreserve.gov/releases/h6/current/#t2tg1link). Thus, the coin and currency is 43.25 percent of M1 and only 10.82 percent of M2. Moreover, most of the money is not “real money”; it is in book-entry form (when we had physical account books) or in entries in a digital database (when accounts are kept on a computer). Thus, this digital money is as “virtual” as it gets. We have many other forms of money whose reach may not be economy-wide: 1) company money: commercial paper, stamps, coupons, points and rewards such as frequent flyer miles; 2) craft money: community currencies⁹ (http://www.communitycurrency.org/home); 3) play money: board games (e.g., Monopoly) and computer or online games (e.g., Gods, Gemstone III, Lineage, systems such as Second Life). Some of the online games allow creation of money or other rewards and a player can exchange the real money for play money¹⁰. When the games allow creation of money or spawn a currency to meet the demands of players, this currency is digital. Because an online game world is a virtual world, one can call the associated currency a “virtual currency” ¹¹.

The roots of digital currency for the real economy can be found as far back as 1967 when the Rand Corporation published Harrison’s ([18] [19] ) two-volume bibliography of articles and reports on the subject of protecting individual privacy and providing data security in computerized record-keeping systems. This was followed by Hunt and Turn’s [20] annotated bibliography for the years 1970-1973 on the same subject. The Harrison bibliography was part of the testimony before The Senate Subcommittee on Administrative Practice and Procedure on the subject of privacy aspects of the cashless and checkless society [21] . Armer emphasized the point made by Oettinger ( [22] , p. 38] that “Automation affects not the mere mechanics of banking, but the very foundations of banking; not the individual bank, but banking systems and the national and international economies in which they are embedded.” During these times the trends in financial systems were causing economic agents, regulators, and governments some alarm. Lee [23] captures the alarming trend of “checkless, cashless society” quite well in his article. The progress in computing and telecommunications, however, did not take banking system very far. Humes [24] actually discounts the progress made. Nevertheless, Roland [25] lauds the progress made in the industry. Even if we were to ignore Roland’s bold forecasts on the future progress and convergence of numerous technological developments to result in digital watch, computer-aided instruction, impact on employment, smart machines, home-banking, driverless planes and cars, his prescience must be appreciated for he states,

The movement toward [electronic funds transfer] EFT has met a great deal of resistance from the public, which fears that EFT would increase the risk of costly mistakes or theft, reduce privacy, encourage greater government intervention and control or be vulnerable to disaster or sabotage. Progress toward EFT has been hindered by the lack of low-cost, widely available transaction terminals, the high cost of reliable data communications lines, the lack of secure methods of identifying transacting parties, and the lack of adequate back-up systems.

For many purposes, a cashless, checkless society would be highly desirable. Most crimes of gain depend on the use of cash, and organized crime as we know it would probably become impossible if cash were eliminated. If all financial transactions could be monitored by the government, it might be able to intervene more effectively to control inflation and avoid recession. Tax collection could be made automatic and much less painful, both in impact and in the burden of bookkeeping imposed. Sound economic planning by business, government, and individuals might become possible in a way that it now is not. It could permit a more efficient allocation of resources and more accurate investment strategies.

Microcomputer technology and the advent of the [computer] will make the cashless, checkless society feasible and may answer the legitimate objections to EFT.… Trapdoor¹² codes will provide secure communications and positive identification between transacting parties and banks. Low-cost non-volatile memory systems will make possible permanent, non-alterable records of all transactions.

Microelectronic technology makes trapdoor coding economically feasible for use in all kinds of communications and transactions, and trapdoor coding can make all kinds communications and transactions secure against eavesdropping and tampering.

Fast-forward to October 1995 when Alan Blinder, Vice Chairman of the Board of Governors of the Federal Reserve System, testified before the US. House Subcommittee on Domestic and International Monetary Policy [26] :

First, the concept of [digital cash or] electronic money is not new. Electronic transfer of bank balances, for example, has been with us for years. Indeed, some of the new proposals simply make available to consumers and smaller businesses capabilities that large corporations and banks have had for many years.

Second, no one knows how the industry will evolve, either in form or in size. Some of us, for example, can still remember predictions made a generation ago that the United States was on the verge of being a cashless, checkless society. Those predictions, of course, did not come true. At least not yet.

This last point reminds us that, at present, we do not know which, if any, of the many potential electronic innovations will succeed commercially. My testimony this morning will concentrate on stored value cards and other types of so called electronic cash, because they seem to raise the most challenging public policy issues.

In particular, depending on their design, they could amount to a new financial instrument, an electronic version of privately issued currency. But even the concept of private currency is, of course, not entirely new. Travelers [sic] checks are familiar to everyone. And in the 19th century, the United States had considerable experience, not always happy experience, with privately issued bank notes. But widespread use of private electronic currency would certainly raise a number of policy questions.

On behalf of the entire Board, I want to state clearly at the outset that the Federal Reserve has not the slightest desire to inhibit the evolution of this emerging industry by regulation. On the contrary, the Board encourages innovations in payments technologies that benefit consumers and businesses.

Vice Chairman Blinder wondered “whether the Federal Government should issue its own electronic currency” in order to “probably stem seigniorage losses and provide a riskless electronic payment product for consumers. In addition, should the industry turn out to be a natural monopoly, dominated by a single provider, either regulation or government provision might be an appropriate policy response.”

The issues of privacy and risk of distrust of government were not addressed. These issues, however, have continually exercised the public. Szabo [27] proposed “smart contracts”, a mechanism to “combine protocols with user interfaces to formalize and secure relationships over computer networks”. The mechanism was founded on “legal principles, economic theory, and theories of reliable and secure protocols”. Szabo [28] followed his earlier discussion with “digital bearer certificates” conjoining digital cash and distributed (computing and informational) capabilities. All these are building blocks of cryptocurrencies and E programming language¹³. Szabo [29] released a well-developed concept of digital currency and mechanism of decentralized (distributed) control for “bit gold” which in general is considered the precursor of bitcoin.

In next section we explore the salient features of Bitcoin and bitcoins. The convention is that Bitcoin refers to the ecosystem of the virtual currency whereas bitcoin refers to the digital currency itself.

Bitcoin is an online (therefore it is digital) virtual (because it does not have a real tangible existence) currency attributed to Satoshi Nakamoto [30] ¹⁴. Because the information in the system is cryptographically secured, the currency is typically prefixed with the world “crypto”, thereby attaining a well-defined specific meaning (not in the sense of hidden or secret)¹⁵. The unit of the currency is called bitcoin (BTC). The subdivision of a BTC is: Millibitcoin (mBTC = 10⁻³), microbitcoin (μBTC = 10⁻⁶) and satoshi (10⁻⁸). The ecosystem is founded on peer-to- peer transactions on a decentralized network of computers. Transactions are carried out on network nodes and recorded in a publicly-available and publicly-maintained ledger called the “block chain” (or often simply, blockchain).

Bitcoins (the currency) are created by payment processing work for transactions. Users provide their computing power to record a transaction and payment thereof into a public ledger. This process is called mining and the users who provide the computing power get 1) a fractional amount in bitcoins which are charged to the initiator of the payment as a transaction fee and 2) some newly created bitcoins. A transaction gets propagated to the network but not entered into the shared ledger until it is verified and recorded. Transactions are aggregated into blocks approximately every ten minutes. A block requires an enormous computation power to prove the legitimacy of transactions, but only a small computation power to verify. Mining is done competitively on the network and it creates trust by ensuring that transactions are confirmed transparently. This mining process creates new bitcoins for each block. The quantity of bitcoins per block is fixed and diminishes with time. The money supply is created via mining by a schedule of time and quantity. The process started with 50 bitcoins per block in January 2009 and the reward halves after every 210,000 blocks. New bitcoins were halved to 25 in November 2012 and are expected to be halved to 12.5 sometime in 2016. The rate of new bitcoin diminishes over 64 halving until block 13,230,000 when it reaches the minimum subunit of one satoshi. The mining rewards are expected to diminish until approximately 2040 when all bitcoins, about 21 million (strictly speaking, 20999999.9769 BTC or 2,099,999,997,690,000 satoshis, because the protocol uses fixed-point math where decimals are restricted to eight and the maximum is hard-coded) have been issued. Thereafter no new BTCs will be issued, but miners will continue to get transaction fees.

The Bitcoin ecosystem consists roughly of the following facets¹⁶. 1) A virtual currency with built-in trust- building safeguards via cryptography. 2) Peer-to-peer transactions without any centralized (governmental or regulatory or organized or individual) intermediaries. Transactions are irreversible, fast and negligibly costly. 3) Privacy and anonymity remain the driving force behind the concept and its implementation. 4) A volunteer group of developers provides open-source software for networked nodes (for mining) and for transactions (for wallets or personal accounts). Numerous APIs and interfaces have been developed for various applications. 5) Noncentralized computing network for encrypting (hashing) and for bookkeeping (blockchain). 6) Limited money creation, independent of governmental regulation, thereby limiting manipulation of the value of the currency. 7) National authorities are free to define the boundaries and regulate the use of the virtual currency. 8) A virtual currency with fluctuating exchange rates for major national currencies.

Many of the above are captured in the following table. The information is as of May 18, 2015, unless otherwise stated. This set of information is dynamic and thus gets updated every few seconds.

Table 1 is divided into eight parts. Part I gives information on the BTC economy; Part II on the blockchain;

Sources: I and II http://bitcoincharts.com/bitcoin/. Hashrate is the unit of the processing power of the network. III. https://getaddr.bitnodes.io/. IV. https://blockchain.info/charts/n-transactions-total?timespan=all&showDataPoints=false&daysAverageString=1&show_header=true&scale=0&address=. V. https://blockchain.info/charts/my-wallet-n-users. VI. https://blockchain.info/charts/blocks-size. VII. http://www.ibtimes.co.uk/bitcoin-now-accepted-by-100000-merchants-worldwide-1486613. VIII. https://blockchain.info/stats, as of May 20, 2015.

Part III on the Bitcoin network; Part IV on transactions; Part V on Accounts; Part VI on Blockchain size; Part VII on Businesses using BTC; and Part VIII on the mining cost.

Table 1 shows that slightly more than 14 million BTCs out of a projected 21 million have been minted and they are valued at around USD 3.3 billion. In the previous 24 hours, about 100,000 transactions were carried out and the number of transactions since inception is around 69 million. The blockchain contains around 357,000 blocks requiring 33,765 MB of storage space. The network of Bitcoin has around 6000 reachable nodes; in theory, these nodes can mine the currency and provide proof-of-work¹⁷. The number of accounts since inception is around 3.4 million and the number of businesses accepting BTC is greater than 100,000. The last section on mining cost is quite interesting: In the previous 24 hours, miners earned USD 854579.11 out of which 0.44 percent was earned from transaction fees and the rest was the dollar value of new bitcoins. Note that we are ignoring more technical information on the difficulty level for hashing and how much hashing has been done by the network in terms of time-in-seconds and computing-operations. More detailed information can always be gathered by visiting the sources cited.

The next section discusses the financial and economic aspects of this cryptocurrency.

The introductory section discussed the essential functions and concomitant attributes of money. In this section we discuss how well a cryptocurrency such as Bitcoin performs as money. Recall that Dai, as mentioned above, caught on to the fundamental financial concept that money is any object or any record accepted as payment in exchange of goods and services and as future payment for debt or for future goods and services. Miller, Michalski and Stevens [39] make numerous important points about functions of money and necessary conditions for digital currency to succeed. They write (pp. 11-12) that a range of forms of money exist and not all of which necessarily serve all three of money’s direct functions and that in the future more forms of money (digital and non-digital) will be created and more transactions methods (digital or physical) will be created. They list (p. 18) the difficulties for digital money: “There are many obstacles to realising… peer-to-peer digital money that is network based, transparent, easy to use and highly secure. The difficulty most often raised when considering this [development] is the contention that network transactions will never be able to acquire the virtues of anonymity, accessibility and security that characterise hard cash.… Gradually the same degree of difficulty that now accompanies the recording of serial numbers of hard cash as a way of tracing each transaction will arrive in the digital world, as cryptography, legal safeguards and protocols for erasing identity become widespread and efficient.” They forecast (p. 19) “Digital money will only match the attributes of physical cash if there are major advances in the ease, cost and certainty with which digital transactions are handled. In particular there will need to be considerable progress in the following areas: verification, confidentiality, ease of use, interoperability and reliability??throughout the entire transaction chain.” They are hopeful (p. 19) that “Eventually, with almost all of the current disadvantages of digital money out of the way, the vast share of consumer means of payment could tip over into the digital realm.”

As the previous sections delineated, here we demonstrate that a cryptocurrency such as bitcoin fulfils the functions of money splendidly.

Bitcoin as a medium of exchange. Given the data in Table 1, it is clear that BTC serves as a medium of exchange. Given Bitcoin’s emphasis on privacy and anonymity, BTC could be more than a medium of exchange; as governments fear, Bitcoin could be used for illicit transactions. (But, then, what is illicit depends on the whim of regulators and governments.) Currently it has a small number of users, compared with conventional (real) currencies. The ecosystem will take a few more years before it reaches a critical mass of adoptions. Cuthbertson [40] reports that BTC is accepted by 100,000 merchants worldwide. We expect this number to increase rapidly.

Bitcoin as a unit of account. Much debate rages on blogosphere whether BTC fulfils the function as a unit of account (i.e., a measure and a standard). Not many goods and services are quoted in BTC. Not many contracts are denoted in BTC. Whether one would promise to deliver or pay in BTC in the future is open to question.

Nevertheless we must remember that BTC can be exchanged for approximately 40 national fiat currencies (http://bitcoincharts.com/markets/). Exchanges (money-changers) exist in many countries and many currencies. Thus, one can buy BTC to start an account (wallet in Bitcoin parlance). We expect the possibilities of exchange to increase steadily.

As the innovation diffuses into various populaces, the adoption will improve the functionality as a numeraire. The importance of BTC is not diminished just because it is not a numeraire yet. There is no BTC-as-a-fiat-cur- rency economy and therefore it has not found the use as a numeraire. It can, however, still function as an exchangeable currency and owners will learn to manage the exchange risk.

The criticism that BTC is not a numeraire because of its volatility against USD and Euro is to miss the point of being a numeraire. Volatility and unit-of-account are two different and separable issues. A commodity with one of the largest global markets is crude petroleum and it is common knowledge that crude is quoted in US dollars. The market still functions quite well for non-USD currencies¹⁸. All the great trading centers of the world ―ancient, medieval or modern―are accustomed to trading in multiple currencies while the prices of merchandise are quoted in a currency of convenience. Koning [42] provides an interesting lesson from medieval European history on the separation of medium-of-exchange function and unit-of-account function. A modern-day example is the Arab Monetary Fund; it is unique in its accounting system. The Arab Accounting Dinar, its unit of account, is equivalent to three SDRs (http://www.medea.be/en/themes/economy-and-trade/arab-monetary-fund/)¹⁹.

Bitcoin as a store of value. Scarcity makes money and scarcity lets the money hold its value for a longer period. The supply of bitcoin is limited, both theoretically (about 21 million BTC) and actually (about two-thirds has been mined/minted/issued by May 2015). Despite the exchange rate fluctuations, BTC indeed functions as a store of value. We recognize that the functions of medium of exchange and store of value are complementary. As the adoption grows the currency will grow in value (intrinsically and perhaps in exchange) and be more stable.

Often the volatility of BTC’s exchange rate is said to militate against its function as a store of value. Once again such an argument misses the point about a function of money. Commodity-backed money holds a stable value until the value of the commodity changes. In our opinion, fiat-money has never held a stable value because the governing authority manipulates the money supply to suit its own political and economic objectives. Inflation is recognized as the worst enemy of stable value! Volatility, its causes and consequences are discussed later in the context of motives for holding cash.

Bitcoin and motives to hold a (cash) balance. We have learned that conventionally individual economic agents have three motives to hold a currency, viz., 1) transactions, 2) precautionary, and 3) speculative. BTC is a new currency in a new format. The impetuses for its creation and use are different than those for a national fiat currency. The goals of privacy and trust over a public network for transactions drive the large global community of adopters and innovators to continue to use, develop and refine this virtual currency. To quote Andreessen [43] , “Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer.”

Although not widely spread, BTC is indeed used for transactions as is shown in Table 1. Two-thirds of bitcoins are already mined. How much of this money supply is spent and how much unspent is debatable. The velocity of BTC qua currency is not interesting enough for comment. Suffice it to say that a goodly bit of transactional demand for BTC exists. Holding of BTC for precautionary motive is not easily defended. Until BTC becomes a quasi unit-of-account (for measure and standard) and a more-or-less stable store of value, individuals will be reluctant to hold it for reasons of safety. Yet there is no denying that some individuals may hold BTC as a part of cash and cash equivalents in a diversified portfolio.

The volatility of BTC exchange rate has been commented upon earlier. The holdings of unspent BTC is considered quite high (Ron and Shamir [44] ). The Ron and Shamir analysis has a few methodological drawbacks and their conclusions about the dormancy of BTCs and the size of transactions are not exactly valid (https://gist.github.com/jgarzik/3901921 and https://bitcointalk.org/index.php?topic=118797.msg1280496#msg1280496). The holdings of BTC may actually be considered as either savings (precautionary motive) or capital for speculative purposes (speculative motive). If the owners think of BTC as an investment, then as rational individuals they would hold them until their investment criteria are satisfied. The volatility of BTC exchange rates and the holding of BTC as speculative capital go together as they feed on each other. We recognize that similar for fiat currency, these motives are necessarily mutually exclusive.

In sum, it would not be an exaggeration to assert that BTC fulfils the essential functions of money adequately, if not fully, for the ecosystem designed. Whether BTC can fulfil the essential functions admirably for a general economy remains to be seen. It will need to overcome many pitfalls and perceived problems before it could do so. The next section provides an exposition of problems and likely solutions.

This section discusses the real and perceived problems of cryptocurrencies, exemplified by Bitcoin. The section provides an exposition of issues and argumentative analysis while suggesting solutions and recommendations. The essential functions of the cryptocurrency as money were discussed in the previous section; the attributes of the cryptocurrency as money were mentioned an earlier section. This section, therefore, discusses problems and solutions in the context of functions of money, of attributes of money, of technology and of socio-politico environment.

Money, hundi, hawala, credit over time and space, fiat money, central banking, fractional-reserve banking system all have been truly disruptive financial innovations. In that tradition, we must add virtual currencies of which a cryptocurrency such as Bitcoin is a prime example. Bitcoin is a complete private transaction- and payment-oriented ecosystem with built-in trust-building and account-keeping features. Interestingly enough, these features intrinsically preserve confidentiality of parties. It may not be considered a perfect system. Which system has been perfect ab initio? And, which system has remained perfect after some use? Until the participants of the system gain experience in using a system, it is quite impossible to effect changes in the system. The attention gathered by Bitcoin is proof that participants consider it to be a system with which they can work. In general, most of the regulatory structures are not anticipatory in nature; therefore it is no surprise that legislatures and regulatory authorities of the US and other developed countries are trying to figure out the costs, consequences and interrelationships of the new cryptocurrencies. Supranational monetary authorities are facing similar quandaries.

Bitcoin ecosystem, and other cryptocurrencies, will prove to be a disruptive innovation in the financial world. We expect Bitcoin to maintain its advantages as the first mover. Competing cryptocurrencies might offer an advantage in one feature or other, but a radically distinct cryptocurrency is not on the horizon. There is only one foe Bitcoin must tame: The government. The government’s ill-considered regulation could kill not only Bitcoin but also the whole idea of cryptocurrencies⁴¹. The real issue is one of centralized authority exerting control versus a decentralized operation of a system. We hope that the modern governments and monetary authorities will show wisdom by not killing a competing decentralized system in its infancy. Secondly, the government’s insistence on surveillance and its uncontestable, unchallenged cryptographic prowess will vitiate the trust of people in a system they have built on their own to steer clear of the government’s heavy hand of control.

The implications for financial services marketplace are many and some of them beyond imagination. First, a major effect will be felt on the payment systems of the world in terms of ease, confidentiality, cost and time. Second, a major effect will be the development of concepts and tools for using Bitcoin for purposes not envisaged by Nakamoto or the volunteer team. Third, more and more individuals and organizations will become comfortable dealing with a decentralized system in which they participate but nobody controls directly. That the system has been able to overcome the problems of trust is a signal achievement. As more experience is gathered and solutions to the inherent problems such as scalability, lost coins (for whatever reason), money supply, and interfaces with regulatory regimes are found, the system will be enhanced. In this enhancement, we expect more disruption, especially in the regulation of financial activities.

The overall assessment is that cryptocurrencies are a welcome development in the financial field. They are here to stay. It may never become a universal currency, although it might become close to it. The disruption they cause to monetary system, banking system, financial system, regulatory system, political and government system, etc., is expected to be more beneficial than deleterious to the functioning of the economy.

GautamVora, (2015) Cryptocurrencies: Are Disruptive Financial Innovations Here?. Modern Economy,06,816-832. doi: 10.4236/me.2015.67077