CI First Look - Bitcoin and Virtual Currency Basics

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CI FIRST LOOK

BITCOIN AND VIRTUAL
CURRENCY BASICS

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ABOUT CORPORATE INSIGHT
Corporate Insight (CI) provides competitive intelligence and user experience research to the
nation's leading financial institutions. For over 20 years, Corporate Insight has tracked new
developments in the financial services industry through our Monitor research and custom
consulting services. We are known for our detailed, objective research, unmatched expertise,
and emphasis on the actual user experience. There are no assumptions in Corporate Insight’s
work – we use live accounts at the firms we track to benchmark their effectiveness and give our
clients unparalleled competitive intelligence.
Corporate Insight is continuously tracking and identifying best practices in online asset
management, banking and investing, insurance, annuities, mobile finance, active trading
platforms, social media and other emerging areas. In the process, we have helped our clients -which cover the entire spectrum of financial services -- to stay on top of industry trends and
improve their competitive position.

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Bitcoin and Virtual Currency Basics
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WELCOME FROM CORPORATE INSIGHT
Corporate Insight is the leading provider of competitive intelligence and user experience research to the
nation’s top financial institutions. Our mission is to analyze and understand the evolving technological
landscape across the financial services industry and identify the innovations that will shape the future.
Our research examines the various pathways that prospects, clients and advisors travel when interacting
with their financial institutions. We place a special emphasis on assessing the online customer
experience offered by leading firms as well as the social media and mobile finance initiatives that are
changing the way financial institutions engage with consumers.
Corporate Insight’s analysts also strive to stay ahead of new digital innovations and trends that extend
beyond financial services. John Greenough, a Research Associate on CI’s Banking and Credit Card team,
has been researching Bitcoin and virtual currencies for the past several months. He has explored not
only their rise to mainstream acceptance, but also the user experience behind the mining, exchange and
use of these decentralized, digital forms of currency.
The first installment of his research offers a basic introduction to the world of virtual currencies. We
begin by looking back at the history of the currency and point to past practices and trends in an effort to
show what is required of any currency to be successful. With that context, we then take a closer look at
today’s predominant virtual currency, Bitcoin.
We hope you find this whitepaper valuable!
Sincerely,

INSIDE…
Introduction ................................................................................................................................... 1
What Makes a Currency? A Brief History ....................................................................................... 2
Four Keys to a Successful Virtual Currency..................................................................................... 3
A Closer Look at Bitcoin .................................................................................................................. 4
Benefits of Bitcoin ............................................................................................................... 5
Concerns about Bitcoin ....................................................................................................... 6
Corporate Insight Thought Leadership ........................................................................................... 7
Contact the Author ......................................................................................................................... 8


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INTRODUCTION
In 2013, Ben Bernanke, the chairman of the Federal Reserve, wrote a letter to Congress giving a slight
nod of approval to virtual currencies. Since then, consumers and investors have been debating the new
type of currency’s long-term legitimacy. While some have flocked to use and invest in virtual currencies,
others warn of a possible bubble in the making.
Virtual currencies are a form of “electronic cash” that users send to each other through a peer-to-peer
payment system in exchange for goods and services. These products aim to eliminate the need for a
central bank, therefore introducing an unregulated world currency similar to the exchange of gold.
However, as many skeptics point out, virtual currencies often hold no intrinsic value but are valued
solely on the principle of supply and demand, a factor making its price volatile. Despite the lack of
collateral these currencies hold, merchants and consumers have begun to adopt them into their
everyday life as the number of merchants accepting Bitcoins jumped 81% in the month after Ben
Bernanke made his statement regarding virtual currencies. 1
Today, virtual currencies are being viewed more as an investment device rather than as a legitimate
method of payment. Investors have begun to buy large sums of virtual currency with the hope that more
merchants will begin accepting them, thus driving up their exchange value and price. As more merchants
begin to act as the first adopters of virtual currencies, others may follow, creating an active marketplace.
This whitepaper offers an introduction to the world of virtual currencies. We begin by looking back at
the history of currency and point to successes, failures and trends in an effort to show what is required
of any currency to be successful. With that context, we then provide an overview of the predominant
virtual currency, Bitcoin.

Study on Bitcoin Mining, Exchanges, Wallets and
More Coming Soon!
In mid-February, Corporate Insight will release an in-depth
examination of Bitcoin. Our upcoming study features first-hand
analysis of the average investor’s experience using Bitcoin exchanges,
digital mining tools and wallets including Slush’s Pool, Coinbase, Mt.
Gox and Blockchain.info. The study will also explore the future of
Bitcoin, examining growing investment funds, possible government
regulation and competing virtual currencies.

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http://www.coindesk.com/surge-in-real-locations-accepting-bitcoin/



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WHAT MAKES A CURRENCY? A BRIEF HISTORY
While the history of exchange dates back to the bartering system, many historians point to the cowrie
shell as being the first form of currency. By roughly 1,100 B.C.E., the Chinese began to forge imitations of
the widely-used shells out of copper and bronze, which soon led to the notion of metal coins. By 500
B.C.E., the first minted coin was introduced by King Alydattes of Lydia, quickly proving the need to use
precious metals such as gold and silver for their scarcity and intrinsic value. 2
Soon, the minting process spread to the kings and rulers of countries throughout the world. At times,
this led to corruption. By 54 A.C.E. the first notable devaluation of a currency was committed by
Emperor Nero of the Roman Empire, who along with his successors gradually debased the coin known as
a Denarius from roughly 94% silver down to just 0.02%. Eventually citizens saw no value in the Denarius
and it began to die off. 3 More legitimate coins remained the only viable currency in circulation, though.
By 806 A.C.E. the Chinese instituted the first paper money, so-called “flying money,” in an effort to ease
the transfer of funds between merchants across the vast Mongolian empire. To legitimize the “flying
money” currency, Kublai Khan confiscated all gold and silver and decreed that merchants and traders
must accept the currency under the threat of death. However, as the empire grew, Kublai Khan and his
successors were forced to print more money, causing rapid inflation and devaluation of the currency,
and paper money gave way back to coin.23
Five hundred years later, in 1816, England instituted the gold standard, allowing gold to be exchanged
for standard banknotes at a fixed rate. By 1900, the United States followed suit, a very short-lived
practice. In 1933, to help ease massive inflation during the Great Depression, President Roosevelt
suspended the gold standard, banned private ownership of a significant amount of gold coins and fixed
the price of gold at $35 per ounce to make the dollar more attractive. In 1971 the United States was
facing an economic downturn, and President Nixon ended the practice of exchanging gold for paper
money, therefore officially making the dollar a fiat currency. 45
Today, the dollar’s value lies in that U.S. citizens trust in that others will accept the currency in exchange
for goods and services. While not as extreme as Kublai Khan’s threat of death, the government
legitimizes the currency by making its citizens pay taxes with the dollar or be faced with jail time.
However, unlike Kublai Khan’s failed system, there are alternative currencies in the market, such as the
Euro or Yuan.

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http://www.pbs.org/wgbh/nova/ancient/history-money.html
http://dailyreckoning.com/fiat-currency/
4 http://www.econlib.org/library/Enc/GoldStandard.html
5 http://www.fas.org/sgp/crs/misc/R41887.pdf
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FOUR KEYS TO A SUCCESSFUL VIRTUAL CURRENCY
Based on the brief history of currency, there are four major points that can be applied to a successful
virtual currency:

#1 A Currency Must Be Easily Transferrable
As the introduction of “flying money” in China showed, there is a distinct need for consumers to be able
to transfer money between each other over long distances. While paper money may still be
predominant, studies show that electronic transactions are gaining momentum and will soon overtake
cash. Furthermore, virtual currency networks are based around desirable electronic transaction
networks of their own.

#2 Inflation Is Dangerous
Emperor Nero’s devaluation of the Denarius is one of many examples of a government overproducing
currency, resulting in hyperinflation. The primary benefit of many virtual currencies is that they cannot
be easily controlled by a government, who may be tempted to overinflate them. Additionally, the supply
of many virtual currencies is often a finite amount that has been pre-determined by its creator.

#3 A Currency Must Have Value
One of the primary reasons for a currency to fail occurs when society sees no value, as happened to
both the Denarius and “flying money.” In modern society, the paper money exchanged also holds no
intrinsic value, yet is still accepted as a legitimate form of currency because governments enforce taxes
that are payable with those currencies. Virtual currencies often hold no intrinsic value and cannot be
directly used to pay taxes – a problem that many point to as a potential shortfall.

#4 Everyone Must Accept It
Kublai Khan’s threat of death to those that rejected “flying money” recognizes the need for widespread
acceptance of a currency for it to be legitimate. Currently, this is one of the biggest problems that virtual
currencies are facing. While more merchants are slowly beginning to accept virtual currencies, they
cannot be legitimized until they are accepted on a large scale.



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A CLOSER LOOK AT BITCOIN
Bitcoin is the predominant virtual currency available, recently garnering attention due to its dramatic,
and highly volatile, rise in price over the course of 2013. Bitcoin embodies the main benefits of virtual
currencies – it is easily transferred and has no central bank controlling its supply. However, its volatility
and lack of government or commodity backing can be weaknesses as well. The following examines the
origins of Bitcoin and explains the process of obtaining, storing, trading, and using a Bitcoin.

Brief Overview of Bitcoin
Bitcoin was created in the wake of the 2008 financial crisis by an unknown cryptographer acting under
the pseudonym Satoshi Nakomoto. Nakomoto posted a report explaining his idea for a “cryptocurrency”
in which users would combine computing power to run a peer-to-peer payments system using Bitcoins
as a currency.
The Bitcoin network is available to the public through open-source software (a program that is published
online and able to be taken and manipulated by anyone). The network is designed to be decentralized,
meaning that it requires individuals to dedicate their computing power to help run the system by
processing and verifying the transactions that occur. In order to incentivize people to help run the
system, the network releases a certain number of Bitcoins to users who have dedicated their computing
power to process other Bitcoin users’ transactions. The network rewards Bitcoins to the first users to
solve a complex algorithm that helps to consolidate the transactional information to be stored within
the Bitcoin public ledger, referred to as the blockchain. This highly complex process is known as mining
and will be detailed in our upcoming study.
When he developed the Bitcoin system, Nakomoto decided on a finite amount of 21 million Bitcoins to
be released slowly over time. To ensure that the Bitcoins cannot be mined all at once, Nakomoto put
into place two guards for the system. The first is that when more “miners” join the network, the
difficulty of the algorithm goes up to make sure that each algorithm is solved once roughly every ten
minutes. Currently, a user is awarded with 25 Bitcoins for solving the algorithm first.
Nakomoto’s second guard was to have the system automatically halve the number of Bitcoins per
algorithm solved every four years. For example, by 2017 a user will be awarded 12.5 Bitcoins per
algorithm solved and by 2021 will be awarded 6.25.
Once the Bitcoins are dispersed, the user’s digital wallet stores a 64-digit code linking their account to
the Bitcoin network and their associated Bitcoins. This code is also referred to as a private key.
Customers must hold the private key, while the previously-mentioned blockchain holds the public key, in
order to access a Bitcoin. Wallets are available online, on a mobile platform and in the form of a QR
code on paper making for use at a brick-and-mortar store.



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Benefits of Bitcoin

The Bitcoin Network
Source: Bitcoin.org

The key benefits of the Bitcoin peer-to-peer system arise from its decentralized, open-source network:

#1 Bitcoins Are Not Controlled by a Central Bank
Bitcoins do not rely on government action or regulation. Currencies such as the dollar fall in value with
politicians’ poor economic choices. Bitcoin is able to keep the power of the system with the users.
Additionally, the set limit of Bitcoins released ensure there is no inflation for the value of one Bitcoin.
Instead, Bitcoins will be deflated over time as the demand for Bitcoins rises. That process has already
resulted in labels for fractional Bitcoins, such as one “satoshi” being equivalent to 0.00000001 of a
Bitcoin or currently less than one one-hundredth of a penny.

#2 Bitcoins Are the First World Currency
The open-source Bitcoin software has created a network in which anyone with computing power can
mine for or obtain a Bitcoin, therefore making it arguably the first “world currency.” Many believe that
Bitcoins and other virtual currencies will offer those in underbanked areas a more reliable currency that
cannot be physically stolen or taken by a corrupt government. For instance, the Economist reports that
over two-thirds of the adult population in Kenya hold a mobile wallet capable of accepting Bitcoin. 6
Because of this, services such as BitPesa have emerged giving Kenyans working abroad the ability to
send money home in the form of Bitcoins.

#3 Bitcoins Are Inexpensive to Transact
Another benefit of the open-sourced peer-to-peer network is the low middleman fees that are
associated with transacting payments. Because the network is decentralized, the cost for sending
Bitcoins is very low relative to the cost of a wire transfer.
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http://www.economist.com/blogs/economist-explains/2013/05/economist-explains-18



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Concerns about Bitcoin
The concerns many have with Bitcoin may outweigh the benefits that they hold. Here are the three
biggest issues facing the virtual currency:

#1 Bitcoins Are Anonymous
From the eyes of the government, the biggest threat of Bitcoin is that it provides a level of anonymity
that can mask criminal activity. Before their rise in price in 2013, Bitcoins were primarily used for illicit
activity. The most notable occurrence was on Silk Road, a recently shut-down website that had
facilitated the transfer of illegal goods such as drugs, weapons and fake documents. Governments are
also concerned that the currency could be used to facilitate money laundering and tax evasion.

#2 The Price of Bitcoins Is Highly Volatile
Bitcoins’ pricing relies strictly on supply and demand. While the supply is finite, the demand is constantly
fluctuating, primarily due to the number of merchants that accept Bitcoins. The more merchants who
accept Bitcoin, the higher their value becomes. Recently, Zynga announced they would accept Bitcoins
for their gaming platforms, and the price skyrocketed. Conversely, China announced in December that
they would not allow financial institutions to accept Bitcoin, halving the price in two days.

#3 Lack of Merchants Accepting Bitcoin
Currently, very few merchants accept Bitcoins. However, that number is rapidly growing as the currency
gains more legitimacy. Interestingly, Bitcoins are becoming widely accepted by charities or for other
donations, such as political campaigns. However, the lack of merchants trading physical goods hinders
Bitcoin’s ability to be seen as a legitimate currency.



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CORPORATE INSIGHT THOUGHT LEADERSHIP
Next-Generation Investing: Financial Startups and the Future of Financial Advice
CI tracks over 100 startups that cover a wide range of new ideas across financial
advice and investing. The study, which is out now, focuses on each idea, compares
them to what established financial institutions offer and examines the potential
impact on the industry. Download the study preview featuring excerpts now!
Tablet-Friendly Web Design: Best Practices for Financial Services
The study examines the tablet-friendly website features provided by four leading
firms across financial services and provides recommendations for financial
services firms building tablet-optimized websites.

Online Personal Financial Management: A Closer Look at Manilla and Mint
This slide deck analyzes two of the major players in the PFM space: Manilla and
Mint. While different in terms of functionality and purpose, both PFMs offer userfriendly websites and apps that are popular with consumers and continue to
grow.
Alternative Investments: How Asset Management Firms Frame Their Funds
This whitepaper examines the online content leading firms are using to educate
investors and financial advisors about alternative investments and takes a look
ahead to what's next for these products.

Peer-to-Peer Lending: Examining the industry and the Borrower experience
This slide deck offers background on the P2P lending industry and takes a closer
look at the borrower experience by profiling two leading firms in the space –
Prosper and Lending Club. Five key takeaways and tips for P2P lenders are also
highlighted.
2013 Mobile Finance Trends and Innovations
This study includes commentary on mobile developments, key takeaways for
financial services firms and thoughts on what’s next for mobile finance.



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CONTACT THE AUTHOR
JOHN GREENOUGH

RESEARCH ASSOCIATE
BANK AND CREDIT CARD MONITOR
John Greenough is a Research Associate for Corporate Insight’s Bank Monitor
and Credit Card Monitor research services which analyze the online user
experience and products offered by leading banks and credit card issuers.
One of John’s passions is researching digital innovations in the financial services
industry. In 2013, he released thought leadership pieces on the rapidly growing
peer-to-peer lending industry and online personal financial management
systems, reviewing top providers in each space.
John has conducted extensive research on Bitcoin and virtual currencies over
the past several months. The second installment of John’s research, set for
release in mid-February, will focus on the user experience behind the mining,
exchange, storage and use of Bitcoin.
John graduated from Trinity College in 2013.

CONTACT JOHN
T: 646-751-6963
E: jgreenough@corporateinsight.com

CONNECT WITH CI



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