This is the report accompanying my presentation on Economic Aspects of Bitcoins http://www.slideshare.net/shivekkhurana/economic-aspects-of-bitcoins

1. Economic Aspects of Bitcoins
Shivek Khurana
{khuranashivek@gmail.com}

2. Report submitted in the partial fulfillment of the requirements for the degree of
B.Tech Innovation with Mathematics an IT
Cluster Innovation Centre
University Of Delhi
Abstract
Bitcoin is a an innovative, decentralized, peer to peer, crypto currency. In this project, we learn the economical
application and aspects of the bitcoins and contrast it with currently existing systems and the potential eruption
that the bitcoin ecosystem is capable of, in the domains of geographic fund transfer boundaries, ownership
of currency, money supply, currency regulating authorities and currency specific taxation policies. Bitcoin is
pseudonymous, i.e. the real life identity of a party is hidden and all transactions are recorded in a public ledger
called the block chain.

3. Index
Index
1 Introduction
2 Currency
2.1 bitcoin vs other currencies
3 Bitcoin Protocol : An economist’s view
3.1 {bit, lite, peer}coin vs Bitcoin Protocol
4 Money Supply
4.1 bitcoins are mathematically infinite
5 Value of bitcoins
5.1 Determination of exchange rates
5.2 Potential fall of bitcoin economy
6 Bitcoin : A Ponzi Scheme
7 Early Adoption Benefit
8.1 Illegal Usage
8.2 Bitcoin Regulation and Taxability
9 Bitcoin vs Fiat Banking Protocol
9.1 Distributed
9.1.1 Seigniorage and Tracking
9.1.2 Currency Influx to Maintain Local Economic Hierarchy
9.2 Limits , Lifted
References

4. Economic Aspects of Bitcoins by Shivek Khurana
1 Introduction
Fiat banking systems have been the only form of available currency since long. Bitcoin is an open source peerto-peer electronic money and payment network introduced in 2008 by pseudonymous developer "Satoshi
Nakamoto". We study bitcoin from an economist’s point of view. Bitcoin is an internet currency, which lays
power off from currency issuing authority and levies that power to a distributed network of nodes called miners.
The protocol validates itself and provides provision for pseudonymous money transfers, negligible transaction fee,
and dissolved geographical boundaries.
2 Currency
Think of a forest, Where a mouse, Morton, befriended an elephant called Joe. Now Morton would threaten other mice
in his clan in the name of Joe and take hold of their food. Other mice were helpless because Morton was backed by a bigger
animal, and had no option, but to give away their hard earned food. In the course of time, all mice befriended a bigger
animal. Dave befriended Carroll the fox and Alice befriended Ethan befriended Noah the Lion and so on. Assuming all of
them were collecting food, each one of them could now threaten everyone else and force others to give away their food. The
food each mouse ends up with will be proportional to the strength of their big animal friend.
This is how currencies work. Not exactly, but in a similar sense. You are the mouse. The bank or the currency
issuing authority like the RBI is your big animal friend. And your threatening is the ₹ 20 note. You can threaten
any shopkeeper with a ₹ 20 note and he’ll have to give you a pack of chips which is of equivalent value. Unlike the
mouse’s threatening, this threatening is persistent and could be further exchanged for other goods and services.
Carroll the fox, Joe the elephant and Noah the lion are banks of different states. Just like different animals have
different levels of strength and endurance, the banks of different states have different levels of strength. In the case
of bank, it is measured by the total value of goods and services being produced by that country. The threatening of
mouse with a comparatively powerful animal friend will have more weight. Similarly, a currency associated with
a powerful state will have more value. For example : Dollar is stronger than Rupee but is weaker than Euro.
2.1 bitcoin vs other currencies
A currency is accepted only if the issuing authority is authentic and reliable. If you write 40 * on a piece of paper,
put your signature and a picture of George Clooney on it, you won’t be able to exchange it for a chocolate bar,
but you can easily get a chocolate bar if you get that piece of paper from the RBI, with a picture of M.Gandhi on
it. This is because you are not a reliable issuing authority. You are not a big animal and your threatening doesn’t
threaten other mice in your clan. But bitcoin is different.
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5. Economic Aspects of Bitcoins by Shivek Khurana
In 2008 came a smart mouse who knew about the happenings in the alienated human world. He was called Satoshi
Nakamoto. He thought that he could take on the elephant, fox and lion with a machine gun. So he invested in them, and
was able to survive in his population, among other mice with big animal friends. His threatening was way more powerful.
This is bitcoin. Instead of a regular bank issuing currency, a network of mathematically bound computers issues
and control currencies. This network is generally referred as the bitcoin ecosystem. The reliability of the network,
unlike other issuing authorities, increases as more and more people start believing in the network. The network is
controlled collectively by all nodes. Each node owner is called a miner.
3 Bitcoin Protocol : An economist’s view
A bitcoin transaction, unlike real world transactions, is not physical fund transfer, but a ledger entry to a global
ledger called the blockchain. Bitcoin transactions require two parties with their own wallets. A bitcoin wallet is
like a bank account with only send and receive payment option. There is no limit to the number of wallets a person
can have. A wallet can be stored online or offline, but offline systems are generally preferred. A wallet doesn’t
reveal a party’s real world identity, it is just a big alpha numeric number. Each user is identified with her wallet
number. A transaction cannot be rolled back, or cancelled as it is the case with fiat banking system.
Making a transaction is equivalent to floating a data set in the network of miners. Suppose Alice wants to transfer
10 BTC to Bob, then she will create a ledger entry crediting 10 BTC from her wallet address to Bob’s wallet
address. This ledger entry will also contain data of 10 or more BTC being credited to Alice at some point of time
before this transaction to ensure that Alice is spending money that she owns. Once the transaction is made, the
transferred bitcoins will appear in receivers wallet after the transaction has been validated by a miner.
The process appears similar to online fund transfer, in any fiat bank system. The real magic happens when a
transaction is validated by a miner. In fiat banking system, this validation happens as the money passes through
a series of institutions, each of which impose a service charge, which is very significant in case of money transfer
across borders. In the Bitcoin system, the miner validates transactions using computer programs. The service
charge in this case is insignificant. The bank imposes service charge to support its operations, but miners don’t
need to impose it as their operations are supported by a reward mechanism (discussed under money supply).
3.1 {bit, lite, peer}coin vs Bitcoin Protocol
Bitcoin (with capital ‘B’) is an open protocol specification. It states and provides code for how the currency
mechanism will be controlled. The bitcoin (with a small ‘b’), peercoin, litecoin and others are an implementation of
that protocol.
4 Money Supply
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6. Economic Aspects of Bitcoins by Shivek Khurana
Alice made a transaction and Bob received it in about 10 minutes. What happened in this time ? As earlier stated,
miners validate transactions. This is the time when validations occur. A miner’s job is to collect all transactions
that occurred after the previous batch was validated. A miner(solo or as a group) will record all data floated by
all parties and group them into a chunk called block. This is equivalent to a ledger page, which consists of ledger
entries. All nodes in the network can have a slightly different block due to inherent latency in the network. After
the block is created, the miner checks if the party owns the money she is spending(This is done by every miner on
the network.)
After creating a block, the miners job is to add it to the blockchain, or connect the ledger page to the ledger itself.
Because all miners have their own versions of blocks, they compete with each other to add their block to the
block chain. The competition is to generate a proof of work, i.e a number which follows a certain pattern. Once a
miner comes up with a valid proof, his version of block is attached to the block chain (his ledger page is appended
to ledger). In return of this proof, the network rewards the miner with coinbase, a special transaction of 25 BTC
credited to the miner. The miner also gets to collect the transaction fee. This is how new bitcoins are generated. A
coinbase is reduced to half every 210,000 blocks.
The mining difficulty is adjusted such that one block is generated every 10 minutes. There can be no more than 21m
bitcoins in the bitcoin implementation of the Bitcoin Protocol. In case of litecoin , the upper limit is 84m. After
attaching a block to the block chain, miner broadcasts it to the network. After receiving this broadcast, all miners
stop working on the already validated transactions and start working on the new transactions.
4.1 bitcoins are mathematically infinite
Despite of an upper limit on the number of bitcoins in circulation, each bitcoin can be divided into small chunks.
The smallest recognizable unit Satoshi is equivalent to 0.00000001 BTC. The funds can be divided into even
smaller units, but in case of hosted bitcoin wallets, the minimum bitcoin transfer is generally restricted.
5 Value of bitcoins
The bitcoin FAQ states that,”Bitcoins have value because they are useful as a form of money. Bitcoin has the
characteristics of money (durability, portability, fungibility, scarcity, divisibility, and recognizability) based on
the properties of mathematics rather than relying on physical properties (like gold and silver) or trust in central
authorities (like fiat currencies). In short, Bitcoin is backed by mathematics. With these attributes, all that is
required for a form of money to hold value is trust and adoption. In the case of Bitcoin, this can be measured by its
growing base of users, merchants, and startups. As with all currency, bitcoin's value comes only and directly from
people willing to accept them as payment.”
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7. Economic Aspects of Bitcoins by Shivek Khurana
Fig 1 : bitcoin exchange rate for past 180 days. Source : blockchain
5.1 Determination of exchange rates
According to bitcoin FAQ, “The price of a bitcoin is determined by supply and demand. When demand for
bitcoins increases, the price increases, and when demand falls, the price falls. There is only a limited number
of bitcoins in circulation and new bitcoins are created at a predictable and decreasing rate, which means that
demand must follow this level of inflation to keep the price stable. Because Bitcoin is still a relatively small market
compared to what it could be, it doesn't take significant amounts of money to move the market price up or down,
and thus the price of a bitcoin is still very volatile.”
5.2 Potential fall of bitcoin economy
The bitcoin is ecosystem is open about potential failures, “History is littered with currencies that failed and are no
longer used, such as the German Mark during the Weimar Republic and, more recently, the Zimbabwean dollar.
Although previous currency failures were typically due to hyperinflation of a kind that Bitcoin makes impossible,
there is always potential for technical failures, competing currencies, political issues and so on. As a basic rule of
thumb, no currency should be considered absolutely safe from failures or hard times. Bitcoin has proven reliable
for years since its inception and there is a lot of potential for Bitcoin to continue to grow. However, no one is in a
position to predict what the future will be for Bitcoin.
A fast rise in price does not constitute a bubble. An artificial over-valuation that will lead to a sudden downward
correction constitutes a bubble. Choices based on individual human action by hundreds of thousands of market
participants is the cause for bitcoin's price to fluctuate as the market seeks price discovery. Reasons for changes
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8. Economic Aspects of Bitcoins by Shivek Khurana
in sentiment may include a loss of confidence in Bitcoin, a large difference between value and price not based
on the fundamentals of the Bitcoin economy, increased press coverage stimulating speculative demand, fear of
uncertainty, and old-fashioned irrational exuberance and greed.”
6 Bitcoin : A Ponzi Scheme
A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money, or
the money paid by subsequent investors, instead of from profit earned by the individuals running the business.
Ponzi schemes are designed to collapse at the expense of the last investors when there is not enough new
participants.
Bitcoin ecosystem states that , “Bitcoin is a free software project with no central authority. Consequently, no
one is in a position to make fraudulent representations about investment returns. Like other major currencies
such as gold, United States dollar, euro, yen, etc. there is no guaranteed purchasing power and the exchange rate
floats freely. This leads to volatility where owners of bitcoins can unpredictably make or lose money. Beyond
speculation, Bitcoin is also a payment system with useful and competitive attributes that are being used by
thousands of users and businesses.”
7 Early Adoption Benefit
The bitcoin exchange rates rose dramatically from $1 in May 2011 to almost $1ooo in November 2013. There has
been a case of a person who bought $27 worth of bitcoins in 2009 and forgot about them. Now the value of those
bitcoins is more than $1m. Increased interest has caused the mining difficulty to increase so much that mining
hardware limit is reaching saturation levels. But this follows according to “High Risk, High Reward policy”. The
bitcoin FAQ states, “Some early adopters have large numbers of bitcoins because they took risks and invested
time and resources in an unproven technology that was hardly used by anyone and that was much harder to secure
properly. Many early adopters spent large numbers of bitcoins quite a few times before they became valuable
or bought only small amounts and didn't make huge gains. There is no guarantee that the price of a bitcoin will
increase or drop. This is very similar to investing in an early startup that can either gain value through its usefulness
and popularity, or just never break through. Bitcoin is still in its infancy, and it has been designed with a very longterm view; it is hard to imagine how it could be less biased towards early adopters, and today's users may or may
not be the early adopters of tomorrow.”
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9. Economic Aspects of Bitcoins by Shivek Khurana
8 Legality of bitcoins
Bitcoin has not been declared illegal in any state during the time of compilation of this report, however Financial
Crimes Enforcement Network , United States Department of Treasury has laid strict measures on the usage/
definition of virtual currencies in a guidance note titled, “Application of FinCEN's Regulations to Persons
Administering, Exchanging, or Using Virtual Currencies” .
8.1 Illegal Usage
The pseudonymity of Bitcoins make is lucrative for illegal implementations like drug dealing. The Bitcoin protocol
acknowledges this, as stated in FAQ, ”Bitcoin is money, and money has always been used both for legal and illegal
purposes. Cash, credit cards and current banking systems widely surpass Bitcoin in terms of their use to finance
crime. Bitcoin can bring significant innovation in payment systems and the benefits of such innovation are often
considered to be far beyond their potential drawbacks.
Bitcoin is designed to be a huge step forward in making money more secure and could also act as a significant
protection against many forms of financial crime. For instance, bitcoins are completely impossible to counterfeit.
Users are in full control of their payments and cannot receive unapproved charges such as with credit card
fraud. Bitcoin transactions are irreversible and immune to fraudulent chargebacks. Bitcoin allows money to be
secured against theft and loss using very strong and useful mechanisms such as backups, encryption, and multiple
signatures.”
Some concerns have been raised that Bitcoin could be more attractive to criminals because it can be used to make
private and irreversible payments. However, these features already exist with cash and wire transfer, which are
widely used and well-established. The use of Bitcoin will undoubtedly be subjected to similar regulations that
are already in place inside existing financial systems, and Bitcoin is not likely to prevent criminal investigations
from being conducted. In general, it is common for important breakthroughs to be perceived as being controversial
before their benefits are well understood. The Internet is a good example among many others to illustrate this.
8.2 Bitcoin Regulation and Taxability
Bitcoins received as payments in return of a product of service are taxable as per the law in that state.This type of
payments will be treated as income and bitcoins earned as a result of trading bitcoins are treated as capital gains.
Taxing the mined bitcoins is a tricky scenario, as stated by the Bitcoin Tax Compliance wiki, “ Bitcoins are really
the first digital currency that was created in this manner and actually have a significant value in relation to other
currencies. Essentially it is somewhat uncharted territory. Literally bitcoins, and even digital currencies are so
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10. Economic Aspects of Bitcoins by Shivek Khurana
new, that there is little to no precedent for some aspects of bitcoin mining, from a tax perspective.
Since Bitcoins are currently traded in various online marketplaces, when someone receives a Bitcoin, they can
reasonably calculate its value in the local currency. Because of this, it is possible that the taxing authority will
treat the receipt of a Bitcoin through a mining pool, or from an individual mining operation, as a taxable event. At
that time, the taxpayer would be required to estimate the value of the Bitcoins in dollars and record that amount.
This would have to be done either daily or weekly depending on the value of the Bitcoins if their value keeps
fluctuating as much as it has the past few weeks. These amounts would be recorded as revenue from bitcoin
mining operations and would be taxable less allowed expenses.
When selling mined Bitcoins, however, you would also be taxed on the increase between the value you recorded
them at when you first received them, and the value you sold them for.Another possibility is that the government
will consider mined Bitcoins ‘intangible personal property’. As a rule, however, financial instruments are
excluded from this particular category. The question is, are bitcoins a financial instrument, or rather, will the
taxing authority consider them a financial instrument? We will have to wait and see if bitcoins become popular
enough for a position to be taken on that.”
9 Bitcoin vs Fiat Banking Protocol
9.1 Distributed
Bitcoin is not backed by a state, but an ecosystem of miners. Miners are fundamentally computers running mining
software and constantly validating transactions happening in the network. This is better than fiat banking system
because it saves manpower and resources required for the operations of a bank. Another advantage is that,
due to openness of the network, anybody can take part in it, i.e. anybody with a decent computer can validate
transactions for the ecosystem.
9.1.1 Seigniorage and Tracking
Seigniorage is the profit that a money issuer makes from printing and spending money. And if the only issuer of
money is the central bank or the “government / central bank machine”, then the latter machine profits when the
money supply is expanded. Or put another way, the new money can be spent on the usual public sector items,
education, infrastructure, etc, which means that the entire community “profits”.
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11. Economic Aspects of Bitcoins by Shivek Khurana
In case of bitcoins, because no one is minting bitcoins, and there is no issuing authority at all, the government loses
seigniorage, which the legendary British economist, William Goodhart, in his book “Two Concepts of Money”,
considers to be one of the major income source for a government.
9.1.2 Currency Influx to Maintain Local Economic Hierarchy
Value of a currency in general is equal to the total goods and services produced in that country. The currency
differs across countries because different countries produce different amounts of goods and services. Now if a
country is lagging on the global scale, the currency issuing authority can influx the country with more currency
notes. This will decrease a country’s value on a global scale, but will keep it locally unaffected. This modulation is
not possible in the bitcoin econmy.
9.2 Limits , Lifted
The fiat bank limits access to your own money. Your money can be seized by the legislature or the judiciary or
sometimes the bank itself, if the bank feels so (and is able to back it with evidence). Limits are also imposed on
transfers and relatively large transfers are tracked. This cannot be done with bitcoins as your account is local, and
belongs to you and you alone.
References
[1] Leo Kelion, “Bitcoin : Experts Crash Over CryptoCurrency”, http://www.bbc.co.uk/news/technology25130261
[2] Satoshi Nakomoto, “Bitcoin: A Peer-to-Peer Electronic Cash System”,
http://bitcoin.org/bitcoin.pdf
[3] Bitcoin Website and Wiki, http://bitcoin.org
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