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Virtual Currency and the Disruptive Bitcoin

Author: 
Aideen Shortt
Virtual Currency and the Disruptive Bitcoin

In recent months, Bitcoin has exploded onto the radars of companies operating within the digital sphere– a controversial new virtual currency with the potential to be the catalyst for disruptive change. This issue, online gaming consultant, Aideen Shortt, provides an overview of the Bitcoin phenomenon, and explores its potential affiliation with the gambling industry.

Throughout history, countless musicians and bands have claimed that it takes ‘ten years to be an overnight success’. Having originally launched on January 3, 2009, Bitcoin is neither rock and roll, nor yet an unmitigated success, however, in the past few months, it has rocketed into mass consciousness, seemingly from nowhere, to the point where it has recently been the subject of media hype and frenzy, user explosion, financial analyst review and even the key case study of a paper by the European Central Bank (ECB) dedicated entirely to addressing the virtual currency extravaganza.

To say Bitcoin is controversial would be an understatement, and the very fact that it’s founder (or founders – it’s still unknown whether it was an individual or collaborative effort) was now disappeared hacker hiding behind the false name of Satoshi Nakamoto does nothing to lend credibility in the eyes of the doubters.

What are virtual currencies?
Money is an institution that has changed over time, from early barter to the current day trusted fiat system, which is any currency that is recognised, authorised and regulated by a country’s government. Given the evolving nature, it’s hardly surprising that global technological developments, leading to almost 35 percent of the world’s population having Internet access today, have led to the concept of virtual currency.

The ECB highlights that regardless of the form money takes, it is associated with three functions:

1. A medium of exchange.

2. A unit of account where a standard numerical value can be applied to the value of goods, services, assets and liabilities.

3. Store of value that can be saved and retrieved in the future.

A virtual currency is a type of unregulated digital money, the issue and control of which lies with developers rather than a central government or financial institution. In general, there are considered to be three types of virtual currency:

1. Closed schemes which have little or no link to the real economy, and are typically used for online gaming. These currencies can be purchased with real money or earned through game play or loyalty, but only used for purchasing virtual goods, and cannot be traded outside of the game community. For example, World of Warcraft has WoW Gold that players use to equip themselves for ongoing and higher levels of play.

2. Schemes with unidirectional flow where currency can be purchased or earned but cannot be exchanged back to original or real money. The now defunct Facebook Credits was a perfect example of this format.

3. Schemes with bidirectional flow where users can buy and sell virtual money according to established exchange rates. Linden Dollars, the monetary scheme in Second Life, the world where users recreate an entire virtual life online, have value both inside and outside the community as they can easily be converted back to US dollars.

There are several reasons behind the existence of virtual currencies. First and foremost is the generation of revenue through virtual goods, but there are also additional benefits for companies such as locking-in users, increased loyalty, KYC through players earning additional currency by identifying preferences, or simply the creation of a float (in unidirectional and bidirectional schemes).

Bitcoin takes virtual currencies to a new level in that it can be used to buy both virtual and real goods, and its very creation was based on bypassing or overcoming the limitations of traditional monopolistic and centrally controlled currencies.


What exactly is Bitcoin?
Bitcoin is a decentralised encrypted currency that exists only online, stored in a user’s digital wallet that is available to download for free through open-source software. Bitcoin is not pegged to any real world currency; instead, the value and exchange rate are determined by supply and demand in the market at any given time. Each Bitcoin is divisible to eight decimal places, enabling its use in all transactions.

Bitcoin transactions are anonymous and money is simply sent from one computer to another without the involvement of a central clearing house or financial institution. That being said, every transaction and change of ownership of a Bitcoin is registered and recorded, with each Bitcoin permanently carrying its entire history as part of its code, so that in some circumstances (e.g. law enforcement) they may/will be possible to trace.

The legal status of Bitcoin is unclear. In March, the US Financial Crimes Enforcement Network proposed to regulate Bitcoin exchanges; this suggests that the agency is unlikely to shut them down, however, there are no set guidelines as of yet. In Europe, there are arguments being made that Bitcoin should be treated as ‘other currencies’ under the Electronic Money Directive. However, this directive defines electronic money under three independent criteria:

1. Stored electronically.

2. Issued on receipt of funds not less than the value of the monetary value recorded electronically.

3. Accepted as a means of payment. Bitcoin fulfils the first and third criteria, but not the second.


How does Bitcoin work?
Reminiscent of the Gold Rush, Bitcoins are created and introduced into the system through ‘mining’. Mining is the process of validating and time-stamping each Bitcoin transaction through complex algorithms and mathematical solutions. Miners use their computing power to find valid ‘blocks’ and are rewarded in Bitcoins for their crucial effort and contribution. The reward started out as 50 Bitcoins per block uncovered, however, this is (intentionally) halved periodically and is currently at 25 Bitcoins per successful endeavour. At the same time, once again intentionally, the algorithms become more and more complex and difficult as further Bitcoins are released, therefore requiring increasing amounts of power and resource.

The number of Bitcoins that will be released has a finite cap of 21 million (there are currently 11 million in circulation) and the rate of block creation is roughly constant over time – six per hour. With he regular reductions (approximately every four years) in Bitcoins per block, the currency is expected to reach capacity in around 2040, at which time it falls entirely into the realm of the economic theory of supply and demand, and miners on an ongoing basis are expected to generate revenue at that time through transaction processing fees.

Anybody can become a miner and, indeed, there was a rush of participants recently both causing and following the media hype. However, there are countless reports that for the most part, given the continuously increasing costs of both hardware and electricity to meet the continuously increasing complexities of the algorithm, individual small-time miners are spending more than they are earning in the process.

Once the Bitcoins are released and owned, their value comes from use as a purchase medium or trading them on newly-formed exchanges. Currently, the problem with Bitcoin as a viable currency for buying goods and services is that there are only 100 or so retailers or outlets that accept it, and unless a tipping point is reached where Bitcoin has a widespread use comparable to real-life currencies, this will limit and inhibit its acceptance in the mass market.

The emergence of Bitcoin has led to the establishment of numerous exchanges where Bitcoin can be traded, the largest of which, Mt.Gox, operated from Tokyo, caters to 80 percent of all transactions. In 2012, Mt.Gox saw an average of 9,000 to 10,000 new accounts created every month. This number doubled in January, tripled in February, and sextupled in March (when over 57,000 new accounts were created).

Trading Bitcoin is both volatile and risky; in fact, there have already been several boom and crash cycles in the value of Bitcoin, mainly caused by cyber attacks. The first significant crash, involving approximately 400,000 Bitcoins worth almost USD$9 million at the time, took place in June 2011 when the value was knocked from USD$17.50 to USD$0.01 within minutes when the Mt.Gox exchange was hacked.

In early April 2013, a DDoS attack crippled the system, followed a few weeks later by a technical hiccup that slowed transactions and caused widespread panic selling, which in-turn caused the price to plummet from a high of $260 to
approximately $60 in a matter of days. The value temporarily recovered and reached $120 to $140, and has now stabilised, for the moment, at around $80 per Bitcoin.

The technical slowdown in April was caused by a dramatic rise in traffic and trades, with the number tripling in the 24 hours before the panic sales frenzy and accounts created in the first few days of April significantly surpassed the entire total for March. Keeping up with demand is problematic, and the fact that the load is borne primarily by one exchange is a red flag to many, as any issues (internal or external) at Mt.Gox can be seen to cripple the currency.

Aside from a desire to destabilise the Bitcoin currency in general, the DDoS hackers’ motivation is to abuse the system for profit. Creating a situation where everybody panic-sells; they wait for the price to drop to a certain amount, then stop the attack and start buying as much as they can.

This volatility, along with general scepticism about the currency, have led to comparisons being drawn between Bitcoin and Tulip Mania; the period of time in the Dutch Golden Age during which contract prices on the newly introduced tulips reached extraordinarily high levels and then suddenly collapsed – which is widely considered to have been the first speculative ‘bubble’.


The problems with Bitcoin
Aside from the wildly fluctuating value described earlier, there are many problems with, and concerns about, Bitcoin.


Security
The Bitcoin algorithms have never been compromised, and due to the authenticated history attached to each and every Bitcoin, counterfeiting is virtually impossible, but security in general is a huge issue, even beyond the exchanges. Each coin is a series of digital signatures with a public and a private key. Any loss or deletion of the key causes those Bitcoins to be lost entirely – and there have been losses, some due to lack of back-up and wallet management by the owner, but mostly due to hackers and thieves using Trojans to access computers. The Winklevoss twins, arch-nemeses to Mark Zuckerberg after the legal battle in the early days of Facebook, are significant owners and investors in Bitcoin and they have been public about their advice to other owners, and admittedly store their wallets offline on hard drives and USBs located in three different safes in three different locations– such is their perception and evaluation of the security risks.


Liquidity
While there is no hard data available, it is estimated that the number of owners of the 11 million Bitcoin in circulation is only in the tens of thousands, and of those, the majority (reportedly just under 80 percent) are simply holding on to their money. It would appear that right now, mining is the end-game and owners are unwilling to part with their Bitcoin in anticipation of significant value hikes. This may change given the recent crashes, however, Bitcoin was designed to be continually appreciative, and so much of the currency will always remain illiquid and kept as investment.


Usability
The ‘last mile problem’ is a major one for Bitcoin at the moment. Its use as a tool of purchase is extremely limited. Mass acceptance will only occur when Bitcoin has the value and approachability of real tender in the marketplace – and this ranges from retail outlets to ATMs.


Independence
The very nature of Bitcoin, its independence and decentralisation, is also working against it, in the short-term at least. Trust is a major issue with money, without which a currency is ultimately worthless, and this is where a government-recognised, centrally managed currency will always have the advantage over Bitcoin; although the level of this advantage may change under circumstances such as those in Cyprus recently, when the government froze bank accounts. Bitcoin advocates will be hoping for more instances of instability like this to see their pet project gain traction.


Reputation
Currently, the highest use of Bitcoin in a single marketplace is on Silk Road. Silk Road is hidden in an anonymous part of theweb called Tor, where the main products for purchase are illegal drugs. This is tarnishing the reputation of the virtual currency to both potential retailers and users.

In addition, the anonymous nature of Bitcoin has led to allegations of all manner of other unsavoury purposes, such as tax evasion, money laundering and terrorism financing.


Ponzi scheme
Many analysts and commentators suggest that Bitcoin has the characteristics of a Ponzi scheme in that users buy into the system using real money, but can only leave and reclaim their cash if there are sufficient numbers of other people that want to buy their Bitcoins; i.e. if new participants enter the system. This point is arguable on both sides, however, with the losses from Ponzi schemes in the past few years, there is much scepticism around anything that might appear to be dubious.


Bitcoin and gambling
Bitcoin is interesting with respect to its role in the gambling industry. While larger, licensed operators do not accept the virtual currency, and none have publicly come forward with any sort of opinion in either direction, there are some new and smaller gambling companies that are accepting Bitcoin, such as the Bitcoin-only online poker site, sealswithclubs.eu. Advantages for operators are low transaction costs, access to new markets and demographics that new payment partners always bring, and the fact that there is a likely correlation between early Bitcoin adopters and gamblers – mining or owning Bitcoin is a significant gamble. Users could probably get better odds in Vegas and at least in Sin City rather than a server warehouse, their drinks would be free, so it is likely that this small base of Bitcoin punters would be sports bettors, casino players and poker nuts as well.

The downside and risks of Bitcoin, however, cannot be underestimated – especially for companies with reputations, P&Ls and licenses to protect.

The anonymous nature of Bitcoin and trouble, for now at least, of identifying where the money has come from goes against every KYC and fraud management requirement and effort made by operators, and until this feature can satisfy reputable regulators and legislators throughout the world, it is hard to imagine this currency being available as a standard.

In-line with licensing requirements, operators need to have funds available to cover potential outlays. With liquidity an issue, it is unlikely that any single entity would have sufficient Bitcoin to cover its risk, and going to the marketplace, with all its volatility, bears unpalatable risk.

For unscrupulous operators, Bitcoin deftly gets around the implementation of UIGEA quite simply by not involving financial institutions, and if this becomes a real problem it will not only tarnish the currency, but may have wider implications in the rollout of US legislation which is currently in its nascent stage.


Future
Bitcoin has been compared to Napster, the music file sharing system, in that it operates on the same peer-to-peer principle. Napster forced the music industry to change, but it doesn’t play a major role in comparison with current leaders such as Spotify or iTunes. Like Napster, Bitcoin could crash out, shut down or disappear, but it in that case, it is likely to leave a lasting legacy. Indeed, there are already Bitcoin copycats such as Litecoin, Zerocoin or Ripple/OpenCoin that are eager successors, and/or there may be a role for the larger payment behemoths such as VISA – which recently acquired PlaySpan, a company whose platform handles transactions for digital games and goods on several worldwide social networks – or Amex, which bought Sometrics that works with video game makers to establish virtual currencies within their games.

Who knows what the next few months or years will see. Essentially, Bitcoin is, at present, an Internet experiment that some anticipate will become a full blown alternative currency while others expect it to disappear like pixie dust in a fairytale. The reality is that many of the advancements we enjoy today started out innocuously and without consideration or knowledge of where they would end up. Let’s not forget that connecting computers and the very Internet itself started out as a technical experiment – and look where we are today.

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About the Author
Aideen Shortt is a veteran of the gambling industry having been involved in a range of senior roles since the outset of online betting and gaming. Her experience straddles both operator and supplier sectors, she is an active participant and speaker at industry events and has an extensive network of contacts.

She was originally employed as part of the marketing team that launched flutter.com (now Betfair) and from there moved to Coral Eurobet (part of the Gala Group) as a senior member of the marketing team, progressing during her time there to the position of Marketing Director for the online business.

In addition, Aideen has held director level roles at Skybet (part of BSkyB) and Chartwell Technology, and has now set up as a private consultant working for a range of different sectors within the industry including Paddy Power, fantasy gaming company Clever TV, Jersey’s leading IT and data centre, Foreshore Limited, and also media companies Bluff Europe and Sport Business.

Aideen is a graduate of University College Cork (Ireland), and has a Master’s Degree from Kingston University in the UK.

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