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Bitcoin and Disruptive Currencies

· July 30, 2012

Ars Technica reported earlier this month that Bitcoin, the open source cryptographically secured alternate currency, was back to trading at 9 US dollars per bitcoin. The currency had experienced a bubble last year, trading as high as almost 30 USD before crashing spectacularly. Since then, however, it has regained stability and traded within a fairly small range around 5 USD. If Bitcoin can keep its stability, what might it mean for disruptive competition?

Bitcoin is an online currency, but not one that should be confused with prior attempts at the idea. While companies in the past have tried to create their own online currencies, they all more or less relied upon the US Dollar as an underlying base, and were centrally controlled. Bitcoin operates without both of those factors and in the process disrupts what we think we know about money. It rewrites the value rationale for money itself, and undermines the ways in which we think we have to pay for goods over the Internet.

Money today mostly has value because governments say that it does. The scarcity that gives a dollar its value is controlled by the US Government who dictates its supply (if only tangentially through the Federal Reserve) and ensures that it must be accepted as legal tender. Bitcoin, on the other hand, is dependent on no central authority to control supply, instead using cryptography and math to make sure that the volume of bitcoins remains appropriate.

The even more interesting feature of Bitcoin, from a disruptive competition perspective, is that transferring currency from one private party to another using the Bitcoin system is free and instantaneous over the Internet. When one person gives another paper cash or coins, it is easy to see that the giver no longer has the dollar that has been transferred, because there is a physical object that has been exchanged. When you move away from physical objects it becomes much harder to prove that the dollar that was given to one person wasn’t also given to another person at another time. This is known as the double spending problem.

Credit cards and banks overcome this problem by creating a central repository (essentially a big database) that keeps track of who has which dollars and which is checked every time someone tries to purchase something to assure the seller that the buyer has enough money. Paypal performs a similar service in the online world and Western Union does the same couched in terms of sending money long distances. All those services charge a fee for the privilege that can range depending on many factors. This is why many stores will not accept credit cards for transactions smaller than a certain amount.

Bitcoin, in contrast, uses a peer-to-peer network to keep track of payments. When a payment is made, it enters the network and is propagated immediately to clients around the world. The payment is then certified by many different computers in the network using an ingenious cryptographic algorithm. This process ensures that the bitcoins being sent actually belong to the person sending them, and that they haven’t been spent elsewhere first. Having the network as a whole manage this process means that a central arbiter is not required.

This simple fact makes Bitcoin potentially incredibly disruptive to a number of financially centered industries. Credit cards, Western Union, and companies like Paypal exist because of the fact that it is hard to transfer money over the Internet cheaply and securely. Bitcoin, to the extent that it is usable, completely changes that regime. People can use it to connect directly with peers, whether they are friends sitting around the same dinner table, or complete strangers across the globe, and send money cheaply.

Bitcoin, of course, is not perfect. There are problems with its supposed anonymity (many people believe that Bitcoin is perfectly anonymous when that was never a design goal of the system), and with the built-in deflationary aspect of the currency that discourages spending and investment. With that being said, however, it has the potential to cause massive disruptions in the online financial space and could pave the way for real advances in how we move money around.

Competition

Some, if not all of society’s most useful innovations are the byproduct of competition. In fact, although it may sound counterintuitive, innovation often flourishes when an incumbent is threatened by a new entrant because the threat of losing users to the competition drives product improvement. The Internet and the products and companies it has enabled are no exception; companies need to constantly stay on their toes, as the next startup is ready to knock them down with a better product.

Digital Trade

Companies rely on clear, predictable rules that facilitate digital trade to export their products and services around the world. These rules include balancing the competing interests between encouraging investment and enabling information access; promoting the free flow of information online; and maintaining balanced intermediary liability regimes.