Bitcoin has received significant attention because of its dramatic price appreciation, use in illicit transactions, the closure of the once-largest Bitcoin exchange, Mt. Gox, and recent tax guidance on virtual currencies issued by the IRS. The future of Bitcoin is difficult to project. Its utility may remain limited to those users that desire a degree of anonymity, or it could grow to become a globally accepted alternative to conventional money or an investment product. 

Potential regulations and their associated costs could ultimately determine the path that the digital currency takes. However, in order to begin to assess Bitcoin's role in the financial markets and its ultimate trajectory, we analyze where it currently stands as a payment system, an asset, and a currency, relative to conventional alternatives.

Bitcoin Transaction Volumes Increased but Remain Small

Bitcoin’s use as a payment system has increased significantly over the course of the last year, but remains small relative to traditional payment processing companies. Bitcoin’s total volume of transactions in dollar terms increased at a higher rate than companies such as Western Union and PayPal. However, the U.S. IRS recently provided guidance which stated that virtual currencies should be taxed as property. This may cause headwinds for Bitcoin as a payment mechanism as retail purchases can create taxable events for consumers.

In February 2014, total Bitcoin transactions averaged $68 million per day, up over 10 fold from February 2013. As of end-2013, Western Union and PayPal averaged $225 million and $492 million in transaction volume per day, up 4% and 24% respectively during 2013. Despite these increases, Bitcoin’s transaction volumes are insignificant compared to the major credit card companies such as Visa and MasterCard, whose transaction volumes averaged $19 Billion and $11 billion per day in 2013 respectively (see chart).

Bitcoin’s growth in the dollar value of transactions must be put into context with its price appreciation in 2013. An analysis of the number of unique transactions per day as opposed to the dollar value of transactions reveals that much of the increase in dollar volume was driven by price appreciation of bitcoins. In other words, the average size of a Bitcoin transaction (in dollar terms) rose significantly, while the amount of transactions per day remained much more stable. From February 2013 to February 2014, the average size of each transaction rose from about $100 to roughly $1000.

For updated volume from May 2014, click here.

Bitcoin as an Investment

Bitcoin’s historical price volatility is more similar to that of an investment than a payment mechanism or currency. Furthermore, the recent decision by the IRS to tax Bitcoin as property reinforces the view that it is an asset. The price of a bitcoin rose from $13 in the beginning of 2013 to over $1200 per coin in December 2013, and has since fallen to about $545 as of end-February. There is no asset class the same as Bitcoin, but comparing its price swings to other currencies and commodities can put the volatility in context. The Euro versus the US Dollar, gold, and even the Argentine Peso versus the US Dollar experienced much more price stability compared to Bitcoin over the past 14 months. The Euro relative to USD climbed 4.5%, while gold and the Argentine Peso dipped 21% and 38%, respectively.

From a trading perspective, Bitcoin volumes relative to the stock of outstanding bitcoins (money supply) resemble those of equity securities. There was about $68 million in average daily transaction volume in Bitcoin in February 2014 relative to its $6.75 billion money supply as of end-February, meaning about 1% of total market capitalization was traded per day. Over the same period, an analysis of a sample of the largest US equity securities shows that daily trading volumes were approximately 0.6% of total market capitalization. 

Bitcoin’s Current Size as a Currency

As of end-2013, Bitcoin’s size as a currency measured by M1 (money supply) is insignificant relative to major conventional currencies. Bitcoin had a market capitalization of about $6.75 billion as of end-February 2014, compared to $2.71 trillion for USD, i.e. less than 1% of its size. Its size is more similar to currencies of smaller countries, such as Guatemala’s Quetzal.

Since end-2012, the size of the M1 money supply of the US dollar has increased 10.6%. Over the same period, the money supply of Bitcoin has risen from about $143 million to about $6.75 billion as of end-February. Most of the expansion of Bitcoin in Dollar terms is the result of price appreciation and to a much smaller extent by new Bitcoins being mined.

So far Bitcoin is mainly used between private individuals. There are, however, a number of companies that have begun to accept Bitcoin as a form of payment. The majority of these companies immediately transfer their Bitcoin into local conventional currency in order to avoid significant currency risk due to the price instability of Bitcoin. The current price instability is a shortcoming of Bitcoin as a standalone currency.

Regulatory Developments

One of the risks to Bitcoin’s future growth is its potential role in facilitating money laundering, tax avoidance and other inappropriate activity. Recent publicity around high-profile cases highlighted the use of Bitcoin in illegal transactions. It is particularly the ease with which large volumes can change hands with a degree of anonymity that attracts criminals to use this tool for illegal purposes.

Regulatory attitudes vary from country to country. Most western authorities show some appreciation for a new technology that may promise valuable innovation, but they have also published statements warning consumers and firms of the dangers involved in using such unregulated means of payments. The authorities in some countries, such as the US, are consulting on public concerns around consumer safety, illicit transactions, tax evasion and others to assess the appropriate regulatory treatment of virtual currencies.

At this stage one can only observe that government responses can vary significantly. One example is that the Singaporean authorities classified Bitcoin as a good rather than a currency and imposed a tax whenever Bitcoin is used for trading or as a payment for services. In contrast, the Russian Prosecutor General’s office declared all Bitcoin transactions illegal, as they are deemed surrogate currencies to the Ruble.

The future of digital currencies will partially depend on the way public concerns are addressed. It is possible that, if the use of Bitcoin were to be regulated as tightly as the use of conventional currency, Bitcoin’s appeal as a low-cost means of exchange would decrease significantly.

Appendix: Bitcoin and Other Digital Currencies

Bitcoin’s appeal to a large group of users stems partly from the degree of anonymity it provides to users while transferring money. Included in this group are users who take advantage of this anonymity through illegal transactions, as they are difficult to trace. Outside of illicit activities, Bitcoin is popular because of its ease-of use and its technical design to be independent of both public and private institutions. Furthermore, some users are attracted by the limitation on the creation of additional Bitcoins.

The Bitcoin network is run by computer programmers known as “miners”. Miners confirm all transactions that take place in the Bitcoin network through a mathematical proof of work process, eliminating the need for a central authority overseeing the network. Miners that solve the proof of work formula are rewarded with newly minted bitcoins. Currently, miners are rewarded 25 bitcoins for each confirmed block of transactions, which occurs on average every 10 minutes. About every four years, the reward is halved, resulting in a finite money supply of 21 million bitcoins which is expected to be completely mined by the year 2140. At that point, it is expected that miners will be rewarded with transaction fees from individual payments rather than newly minted bitcoins to incentivize them to continue mining. There are currently about 12.1 million bitcoins in circulation.

All Bitcoin transactions are recorded on an online public ledger known as the block chain. Each transaction since Bitcoin’s inception in 2009 is available on the block chain, preventing double-spending of a bitcoin. One stores their bitcoins in a “wallet”, which has access to multiple Bitcoin addresses. For Bitcoin users, a wallet keeps track of one’s ownership of bitcoins. It functions very similarly to an ordinary current account. Users can initiate a transfer or receive bitcoins from other users’ “wallets.” Bitcoins can be transferred between wallets in exchange for a service or as a donation. One can also acquire Bitcoins by exchanging a conventional currency into bitcoins at a private online exchange. Finally, bitcoins can be earned by ‘mining’, but the need for large computing power prohibits ordinary users from earning bitcoins via mining.

To send and receive bitcoins, the payee sends their address (or public key) to the payer who signs the transaction with his private key (known only to him) which is then time stamped and broadcast out to the network (see figure below). Each address consists of a series of 27-34 alphanumeric characters which has its own balance of bitcoins. One does not need to provide identifiable information such as their name or home address, so it is possible to remain largely anonymous while sending and receiving bitcoins.

Other Notable Digital Currencies

While Bitcoin is the most widely known and used digital currency today, there are several dozen more digital currencies available, such as Ripple, Litecoin and Peercoin. Most of them are based on the same technology that Bitcoin pioneered. Adaptations mostly involve weaknesses identified with the Bitcoin network. For example, to improve speed and reduce computing cost an alternative encryption standard to the one used by Bitcoin may be employed. Other digital currencies differentiate themselves by the degree of anonymity, the process of transaction verification and the dynamics of money supply. 

Footnote: Bitcoin data sources: Blockchain.info, Coindesk.com