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Networks and the Bitcoin currency

Most currency systems today were designed and started well before the invention of the transistor. The US Dollar is used in our country as well as around the world, but the amount of physical currency in circulation is much less than the combined total of wealth which exists only digitally. However, there is currently no equivalent of physical cash in the online world. If I want to give my friend $5, it is much easier to do in person than online. Existing systems for trading money online are dominated by banks and credit card companies, who almost always charge fees to exchange the money (even if frequently we are on the side that does not get charged). Additionally, the anonymous nature of physical cash can’t be replicated online. If I give someone money online, that action is traced on both sides of the transaction. In this digital age, is it possible to stay anonymous while also exchanging money for little or no fees?
The creators of Bitcoin had many of these concerns in mind when they created the decentralized digital currency in 2009. One can think of Bitcoins as simply another currency; they are actively traded online with traditional currencies, like US dollars, Euros, or Yen. Bitcoins have their own exchange rate that fluctuates every day just as traditional currencies. However, they are vastly different in their pure digital nature. Bitcoins only exist as numbers in a computer. There is no centralized country or bank behind them. Basically, a Bitcoin only has value because a large collection of people have agreed that it does, and are willing to trade traditional currency in exchange for them. Thus, the Bitcoins have an interesting network effect. They are only valuable to someone if other people continue to use and accept them.
This might seem crazy to some, as with no real value the currency seemingly could crash at any moment. However, in many ways, the current state of the US dollar is similar. If for some reason, everyone wanted to get rid of their USD’s for some other currency, and nobody wanted USD’s still, the US Dollar would essentially be worthless. In the past, the USD was backed by precious metals, such as gold and silver, but since 1971 there is not a set amount of precious metal that the dollar can be traded to the government for. In essence, the worth of the USD is also reliant on the network effect. The only difference is the strength and size of the network it relies on (I don’t anticipate the USD crashing down in value in the near future).
The most popular Bitcoin trading site, where users can trade Bitcoins for US Dollars or other traditional currencies, is called Mt. Gox. The site currently handles over 80% of all Bitcoin trade. The site acts as the intermediary trader in a market between Bitcoins and traditional currencies similar to those described in Chapter 11 of the book. The site determines a standard exchange price themselves, but instead matches up buyers and sellers whose prices are acceptable to each other. There is a fixed percentage difference of .06% between the bids, so sellers who are willing to sell 1 Bitcoin for $10 or more are only matched with buyers who are willing to buy 1 Bitcoin for $9.94 or more. This fee is their attempt to maximize their total payoff by balancing keeping a low fee so that the site is competitive with other Bitcoin trading markets, ensuring that people continue to use Mt. Gox to trade their Bitcoins at a high volume and earning a higher payoff on each transaction with a larger fee.
Because the network of the Bitcoin is relatively much more unstable, more interesting network related effects can be observed. Last June, a computer hacker infiltrated Mt. Gox and stole over 500,000 Bitcoins from various account holders on the site (almost 10% of all Bitcoins in existence at the time). At the time they were stolen, that would amount to about $8.75 million! Ironically, the hacker stole so much of the currency that when he turned around and tried to sell the Bitcoins he had just stolen for US dollars, his flooding of the market crashed the exchange rate, and he ended up selling many of the coins back for 1/1000th of their value earlier that day. This creates a dilemma for someone who is trying to get rid of a large quantity of Bitcoins: the more they try to sell, the less the actual currency is worth. While the same phenomena exist in modern financial markets, the effect is rarely visible to this extent due to the scale of the network. An interesting coordination effect is visible in the Bitcoin network because of its small size. Anyone who owns Bitcoins has a vested interest in keeping the value of the currency up, as otherwise what they own themselves will be worthless.
Though Mt. Gox shut down and much of the trading was able to be reversed because of limitations on how fast money could leave the system. The value of the currency dropped by over 25% compared to the US Dollar and has yet to fully regain that value in 2012. This is because the incident caused many to lose trust in the system, and that lack of trust could be seen in the trading price, as many decided to leave the market entirely because they feared future instability.
Bitcoins have a darker side as well, however. One of the most famous sites that is associated with the currency is called the Silk Road. The Silk Road is an online marketplace where buyers and sellers of contraband can trade. The National Public Radio referred to it in an article as the “Amazon.com of illegal drugs”. It is a system that could not occur if the transactions occurred in US Dollars because they would be too easily traced. The site is considered part of the “dark web” as it is only accessible to people using the Tor proxy service. The site actually makes money by auctioning off accounts that are permitted to sell on the site using a first price auction. They hope that this will limit access of seller accounts to committed, legitimate individuals. The site acts as an escrow service between buyers and sellers during a trade. The money is given from the buyer to the website at the time of purchase, and when the buyer approves, the money is then transferred to the seller. This system is intended to mitigate fraud from either side.
Most people who hold Bitcoins are not buying drugs or money laundering, they instead hope for a better online system for peer to peer transactions that is not limited by large financial institutions. The potential nefarious uses of the currency threaten its legitimacy, and whether it will survive in the coming years is very unclear. It is a very interesting idea though, and I think the less legitimate market uses it has enabled show that there is probably always going to be some type of decentralized online currency in active use in the future. Whether or not one ever becomes mainstream remains to be seen.

Sources:
http://bitcoin.org/
http://www.guardian.co.uk/technology/2011/jun/12/bitcoin-online-currency-us-government
http://www.economist.com/blogs/babbage/2011/06/virtual-currency
https://en.bitcoin.it/wiki/MtGox
https://mtgox.com/
http://www.dailytech.com/Inside+the+MegaHack+of+Bitcoin+the+Full+Story/article21942.htm
http://blog.oleganza.com/post/32725987418/bitcoin-non-technical-faq
http://en.wikipedia.org/wiki/Silk_Road_(anonymous_marketplace)
http://www.npr.org/2011/06/12/137138008/silk-road-not-your-fathers-amazon-com

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