Explosion of digital currencies such as Bitcoin creates regulatory headache

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Like it or not, electronic currencies are here to stay, challenging traditional payment channels. Euromoney surveys the contenders for digital dominion as security and regulatory challenges bite.

The cryptocurrency space, of which Bitcoin is chief poster-child, is getting more congested all the time.

Ripple, the Google-backed payments platform by OpenCoin, offers potentially stiff competition, while numerous other digital currency networks have sprung up: Litecoin, Namecoin, Feathercoin, SolidCoin, WebMoney and Ven, to name just a few.

These operate alongside other local currency initiatives. TEM was developed in Volos, Greece, in response to the crisis there. In Vermont and Ithaca, New York, timebank currencies have emerged that use work hours as units of currency for exchange.

It is ironic that the expansion of the global central banks’ balance sheets might not have succeeded in boosting the velocity of money but instead has triggered a dramatic expansion in the number of alternative currencies and payment mechanisms.

Most analysts say the market is on a structural bull run – threatening banks’ traditional payment platforms – amid fears over the integrity of fiat currencies and banking systems as well as the increasing adoption of mobile payments.

It’s early days in the cycle yet but electronic currencies are here to stay. But which digital currency will emerge as the market benchmark?

For now, Bitcoin has the best infrastructure and liquidity, making it the most compelling currency for most traders. “People are not used to a currency that grows in value as opposed to shrinking in value – it’s a different world,” Jeffrey Tucker, executive editor of Laissez-Faire Books and Bitcoin cheerleader, tells Next News Network.

In that sense, Bitcoin is seen by many as digital gold. It is finite, with a fixed upper limit of 21 million Bitcoins than can ever exist. And even this number will shrink, as Bitcoins are accidentally deleted or people die and leave no details of where their Bitcoins are stored, creating a steadily deflating environment.

This will lead to its subdivision, with new derivative currencies emerging based on fractions of Bitcoins as the stock of coins depletes, says Anatoliy Knyazev, managing partner at the Bitcoin Fund, which invests in Bitcoins.

However, he adds it is too early to declare Bitcoin as the winner in the race for the supreme digital currency.

Tucker says: “Bitcoin has all the features of the gold standard without the downside.”

Unlike gold, Bitcoin cannot be confiscated, authorities have no way to block trades and storage costs are negligible, compared to gold – though cyber attacks, viruses and carelessness all ensure Bitcoin does have its own storage challenges.

Many Bitcoin competitors look much like the original, but address specific issues that worry some potential buyers. Litecoin, for example, offers faster execution than Bitcoin – an average of 2.5 minutes compared to around 10 minutes – while there will be around four times more units of the currency in circulation.

Others attempt to improve on Bitcoin's security: Namecoin and Litecoin use a memory-intensive and what is known as a scrypt-based ‘mining proof-of-work’ algorithm, which boosts its security, but hackers will be motivated to overcome any defence mechanisms innovators come up with.

Cryptocurrencies are generally vulnerable to the 51% attack issue, where any one user controlling more than half of the currency network gains the power to take that network down. Many see this as the biggest issue facing electronic currencies generally.

Some currencies claim to have resolved – or at least minimized – the risk, such as Ripple and SolidCoin, but only time will tell how robust their solutions are. Optimists argue, as the currency grows, the chances of any one user controlling such a large proportion get more remote.

Yet the security issue is all the more worrying because of the lack of policing of the Bitcoin community, over which no regulator has authority. While its latest success ensures it will now be of considerable interest to global regulators, subjecting the market to their control will be easier said than done.

Bitcoin developers would have little trouble creating new currencies under new names and transferring Bitcoin balances into them to evade regulatory scrutiny, says Tucker – a truth that accounts for a substantial proportion of the currency’s appeal.

And the hackers might not always be opportunistic techies looking to steal Bitcoins from unsecure wallets. Bitcoin’s illiquidity makes it vulnerable to predatory trading activity.

One analyst even suggests a select group of hedge funds are following a “pump and dump” strategy – driving the price up to unsustainable levels and then selling it short all the way back down. The currency is prone to extreme volatility, though this should settle down as it gains liquidity.

As the market grows and the challenge to established institutions becomes more real, so does the risk of governments or banks hacking the system. And their goal might not be short-term profit, but the complete destruction of the currency.

For some, the increasing attention of traditional financial authorities – regulators, governments, central banks – remains the biggest risk to their Bitcoin investments, threatening the currency’s democratic principles.

“I am not against regulation, as long as market liberalism is protected,” says Knyazev. “Bitcoin operates in transparent conditions, with equal access and rights for everyone. That doesn’t exist in traditional markets, where regulation favours the banks.”

With the attention of regulators and governments comes the attention of the taxman. Judging by the reaction of the Bitcoin community to any suggestion that the IRS or other tax authorities go after their industry, a substantial appeal of the electronic currency is the anonymity it offers.

And as the governments of the biggest economies clamp down ever-harder on tax evasion in offshore financial centres, Bitcoin could offer a solution to those no longer confident in their former offshore banking arrangements.

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