Making Sense of Bitcoin

Bitcoin – the name seems vague, inspires confusion and its place in regular and continuous commercial activity seems unclear at best. What are business people, and especially small business owners, to make of it? It proved difficult for us too but after research, critical thinking and discussions here’s where we came out on it.

Bitcoin is but one in a long line of items used historically as a medium of exchange. What is unique about it is that it is a product of the internet age and, more specifically, an outgrowth of cryptography.

Marc Andreessen describes it as “…the first practical solution to a longstanding problem in computer science called the Byzantine Generals Problem. Paraphrasing Andreessen “a group of Byzantine army generals camped with troops around an enemy city must agree on a common battle plan. The problem is that one or more of them may be traitors. The difficulty is to find an algorithm to ensure that the loyal generals reach agreement. Thus B.G.P. poses the question of how to establish trust between otherwise unrelated parties over an untrustworthy network like the Internet.”

The typical questions that come to us currently are “can virtual currencies replace government sponsored currencies, such as the US dollar, as a popular medium of exchange or can it replace gold (or other commodities) as a hedge against inflation?” Our professional opinion, at present, is no!

Though we don’t view bitcoin, or cryptocurrencies (bitcoin is but one of those), as pervasively viable at present, they are not to be ignored. Here’s why. There are numerous startups devoted to their commercial development and that alone indicates that there is clearly something serious afoot in this area.   No less a journalistic authority than “The Economist” magazine published articles (October 31, 2015, pages 13 & 21) explaining the case for bitcoin and its enabling technology – blockchain.   Silicon Valley venture capital luminaries Reid Hoffman (PayPal and LinkedIn) and Marc Andreessen (Mosaic and Netscape) have invested in bitcoin startups. 60 Minutes broadcast a segment on Sunday, November 22nd on the use of M-PESA in Kenya. M-PESA is a mobile phone based virtual currency used by about 19 million of Kenya’s 44 million population to transact business and personal financial activity. This activity does not require a bank account. The transactions are person to person or person to business with no banking intermediary involved. Much to the surprise of many, the Kenyan government declined to require a bank intermediary in the transaction chain for M-PESA. Thus there is a growing wave of activity in support of cryptocurrencies.

“Clearly a reliable regulatory framework will need to emerge to protect users from those who would abuse the medium for things like extortion, illegal drug transactions or hiring hitmen anonymously. Among regulators and financial institutions, skepticism has given way to enthusiasm (note that the European Union has recently recognized it as a currency). A large part of the enthusiasm is the underlying technology that supports cryptocurrencies – the blockchain.”

“Blockchain, in essence, is a shared, trusted, public ledger that everyone can inspect, but which is controlled by no single user. Participants in a blockchain ledger collectively maintain the system and keep it up to date and it can be amended only by strict rules and general agreement. The blockchain prevents double-spending and tracks transactions continuously. This is what makes it possible to have a currency without the intervention of a central bank. It is perhaps one of the most significant unexpected byproducts of cryptography.”

“Blockchains probably don’t sound sexy or exciting but then neither did double entry bookkeeping when it emerged.” As The Economist pointed out however, “it has the potential to transform how people and businesses co-operate. The real innovation may in fact not be the cryptocurrency of bitcoin itself but the trust machine of blockchain that underlies it.”

Why would businesses accept payment in bitcoin or virtual currencies? First, because they have customers who want to pay in them and, unlike credit cards, there is very low transaction fees associated with them. Low transaction fees are what argue in favor of their use versus credit and debit cards. That is one reason that businesses like Overstock.com, PayPal, Dell, Expedia, 1-800-Flowers and over 30,000 small businesses accept bitcoin.

There are accounting and tax issues with bitcoin as well. Financial statements in US dollars require that bitcoin be translated to a dollar valuation. Thus you can have both realized and unrealized gains/losses to account for upon fluctuation in the value of bitcoin. Tax issues pose a problem as well. In the US the IRS treats bitcoin as property, not currency. Many other tax authorities have adopted this approach as well. The UK tax authority has taken the alternative view that bitcoin is to be treated like any other currency. This disparity in tax treatment between major taxing jurisdictions will likely present problems for multinational businesses.

Cryptocurrencies have a long way to go before achieving widespread commercial feasibility and general acceptance. A reliable regulatory framework, stability of price and resolution of differing tax treatments are but a few of the hurdles that will have to be cleared. CFOs and business owners would do well to keep an eye on their progress as the digital age of business advances. There is clearly something here that warrants attention.

 


 

Michaela Gifford is a successful finance leader with 12+ years of strategic planning, corporate development and modeling expertise to bear on client Mergers and Acquisitions efforts. She leads the Financial Planning and Analysis Practice Group, using her extensive language proficiency and financial modeling and analysis expertise to implement plans across multi-cultural environments, realize revenue growth and connect corporate teams in Europe, Asia, Australia and North America. She also co-leads the Mergers and Acquisitions Practice Group.

If you would like to speak with Michaela, please use the Comments section to make a request.

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