From the quantity theory of money we know, that there is a link between inflation and the money supply. A substantial growth of the money supply through money printing at some point is going to cause a loss of purchasing power. Therefore it is interesting to take a closer look at how money is created in the Bitcoin world and how the Bitcoin money supply grows.

Money creation of a fiat currency

While Bitcoins are mined, producing fiat money is called money creation. In a simplified view, there are two different types of money creation. Money is either created by the central bank or money is created by commercial and other banks.

Money created directly by the central bank is called the monetary base. It comprises currency in circulation (notes and coins) and deposits of monetary financial institutions (MFIs) at the central bank. The monetary base is also called high-powered money because an increase in the monetary base can multiply to a much larger increase in the total money supply. The central bank applies a number of measures when it wants to create additional money. Through open market operations the central bank grants loans to MFIs against collateral. The loan amount is credited to the MFI whereby the MFI increases the deposits it holds at the central bank.

Commercial banks create money through lending. When a person holds a deposit at a bank, the bank can take this money and lend it out to a borrower. The borrowed money in turn will be held as a deposit at a bank (unless it is converted to paper money) which again can lend this money out. Money creation from lending already existed in ancient societies where all money was represented by physical precious coins. Imagine someone takes one coin to buy a vase. The seller of the vase holds this coin as a deposit at his bank. The bank lends this coin out to a second person. This second person also buys a vase for this coin and the seller brings the coin to the bank again. This process could be continued endlessly, as long as the bank finds enough trustworthy borrowers. In this example, one physical coin bought two vases worth two coins in total.

When money is created through lending this is also called fractional reserve banking. That’s because central banks require commercial banks to hold a certain fraction of its client’s deposits as a reserve in a central bank account. The European Central Bank’s reserve ratio is currently 1%. So if a client holds a deposit of EUR 100 at a given bank, only EUR 99 can be lent out to borrowers. We can calculate the maximum amount of money created from fractional reserve banking with the money multiplier. The money multiplier equals 1 divided by the reserve ratio. With a reserve ratio of 1% the theoretical money multiplier is 100, therefore a deposit of EUR 100 can be lent out so often that in total EUR 10,000 have been created.  This also highlights why the monetary base is called high-powered money.

The money supply M1

The money supply of fiat currencies is clustered in three groups called M1, M2 and M3. The definitions of what counts as money and to which of the three groups it belongs varies. An overview is sufficient for our purposes.

M1 is also called narrow money. It includes notes and coins in circulation plus deposits of people and non-financial businesses (the public) held in current or checking accounts at MFIs. M2 includes M1 plus savings deposits and time deposits. M3 includes M2 plus money market instruments with a maturity of less than 2 years.

Let’s take a closer look at the components of M1 for the Euro zone. It is important to note that M1 contains both, money created by the central bank as well as money created by commercial banks. 75% of M1 were created from fractional reserve banking by commercial banks. Only 22% of M1 is comprised of the monetary base which was created by the central bank. The monetary base contains EUR 300 bn of MFI reserves held in central bank accounts. These EUR 300 bn are the basis for fractional reserve banking. Therefore the effective money multiplier in the Euro zone is currently somewhere at 14.

Caption: Euro area money supply M1 as of June 2013; data source: ECB statistical data warehouse

Creation of the Bitcoin monetary base

Now that we have introduced money supply and money creation for a fiat currency, we can look at these terms from a Bitcoin point of view.

Bitcoins are created through mining. Mining is comparable to the original endowment of the public with money that was created by the central bank. Therefore mined Bitcoins are part of the Bitcoin monetary base. However, there are significant differences between mining and money creation by the central bank. When the public is endowed with new money after a currency reform, money creation by the central bank does not stop. The central bank keeps increasing the monetary base further which can cause inflation. In the Bitcoin currency system nobody can increase the Bitcoin monetary base beyond the Bitcoins that are created from mining. There is no central bank in power. Mining is the only source for the Bitcoin monetary base. Thus, mined Bitcoins are the Bitcoin monetary base – and not just a part of it.

Also, we never know how much money will be created by a central bank in the future. The central bank doesn’t know it itself because monetary policy depends on economic variables that can change quickly. In contrast, Bitcoin mining is predictable. We know with high certainty how many Bitcoins will be mined over a specified time and therefore the growth rate of the Bitcoin monetary base is predictable. As we can see on the following chart the growth rate will decline dramatically in the near future.

Caption: Bitcoin monetary base and growth (actual 01-2009 until 08-2013 and projection until 2029); data source: blockchain.info, own calculations

Bitcoin money creation from lending

As we have seen with the fiat currency, the second way of money creation is lending by commercial banks. If lending activities existed in the Bitcoin currency as well, the total Bitcoin money supply would exceed the number of mined Bitcoins (the Bitcoin monetary base). Such Bitcoin lending operations already do exist. Such sites are listed under the lending section of the Bitcoin Wiki Trade page.

Some of these sites are based on a peer-to-peer lending model and some operate like a Bitcoin bank. In the latter case the site collects deposits and grants loans to Bitcoin borrowers directly. Both models have certain advantages and drawbacks. I won’t go into this here. The important point to note is that Bitcoin lending does take place.

This means Bitcoins are not only created from mining but also from lending. However, the number of Bitcoin lending sites is not large. Even though they do not publish any figures, it can be assumed that relative to mined Bitcoins, the number of Bitcoins created through lending is small. Since Bitcoin lending currently is not explicitly regulated, there is no fractional reserve requirement. One could argue, this means that the money multiplier is theoretically infinite. A Bitcoin bank could lend the deposits it holds ad infinitum. It will be interesting to see how this evolves. Anyhow there something like a natural cap just from the fact that those who are willing to lend will not find infinitely many borrowers with sufficient creditworthiness.

Bitcoin money supply

If we want to know the Bitcoin money supply we first need to look at the number of Bitcoins in circulation from mining. This figure is currently at about 11.7 million Bitcoins. It represents the Bitcoin monetary base. The calculation of the Bitcoin market capitalization is also based on this figure. They are the same thing, in one instance expressed in Bitcoins and in another instance expressed as the US dollar value. That means the Bitcoin market cap equals the monetary base, currently it is USD 1.3 bn. If we want to compare the Bitcoin money supply to the money supply of other currencies we have to compare this USD 1.3 bn to the monetary base of the respective currency. Sri Lanka for example has a monetary base of approximately USD 2.5 bn which means that the Bitcoin monetary base is slightly more than a half of Sri Lanka’s monetary base.

What should not be done is to compare the Bitcoin monetary base to the M1 money supply of fiat currencies. As long as there are no figures on the total outstanding Bitcoin loan volume available, we won’t know what Bitcoin M1 is. We would need to sum up mined Bitcoins and outstanding Bitcoin loan volume in order to get Bitcoin M1. As we have seen on the Euro zone example, the larger part of M1 is created from lending. A comparison of the Bitcoin monetary base with M1 of other currencies would try to compare two incomparable figures.

Bitcoin has the potential to preserve long-term purchasing power

When we sum this post up, two things become clear. One, Bitcoins are not only created from mining but also from lending. Two, in order to measure the total Bitcoin money supply we need to add lending volume to the number of mined Bitcoins. What is the conclusion from this regarding the growth of Bitcoin money supply?

The Bitcoin monetary base grows at a predictable rate and the growth rate goes to much lower levels from 2014. That’s when the 2013 reduction to 25 Bitcoins per block jumps in. This means the Bitcoin monetary base is not of concern. Bitcoin lending deserves more attention as it is only at the beginning and could evolve to become more significant.

As a first estimate about the impact of Bitcoin lending two things can be noted. Currently a high Bitcoin volatility poses an exchange rate risk on both, borrowers and lenders. We can expect lending to increase with declining volatility. The second thing is that Bitcoin will remain in deflation as long as the user base keeps growing faster than the Bitcoin money supply. A deflationary currency increases incentives to build savings instead of borrowing money. Therefore we can expect the Bitcoin lending volume relative to the monetary base to be low. Probably much lower than we have seen it in the Euro zone example.

Since the Bitcoin monetary base growth will decline and Bitcoin lending is less significant than for a fiat currency, Bitcoin can be expected to remain deflationary for the years to come. This is a good message. It means that Bitcoin is not just an instant and cost effective payment network but also a stable currency that preserves purchasing power. Inflation is not fully eliminated because the money supply can grow significantly from lending. But as we have seen this is quite unlikely.

Written by Radoslav Albrecht

___________________________________________

Radoslav Albrecht studied economics and finance in Germany and Great Britain. He worked in investment banking and strategy consulting before he became a Bitcoin entrepreneur. At the beginning of 2013 Radoslav cofounded the peer-to-peer Bitcoin lending site Bitbond.net. He also runs the German website bitcoins21 which explains brick and mortar shops how they can integrate and accept Bitcoin as a means of payment.

After series of Bitcoin businesses being dropped  by their banking partners earlier this year, the Internet Archive Federal Credit Union (IAFCU)  came to the rescue. The New Jersey based credit union, run by the Internet Archive, has been very friendly to the Bitcoin industry and has worked with a number of businesses who have had trouble establishing relationships with banks.

One of the businesses the credit union partnered with was the US based TradeHill  exchange. Late last week Jered Kenna, Tradehill’s founder and CEO, confirmed via Reddit that the exchange had suspended trading due to “operational and regulatory issues” faced by its bank.

IAFCU posted its own statement on the matter , but was not clear on the nature of the regulatory issues.

• As the rupee continues to struggle, Indian officials continue their attempts to curb demand for gold.

Via Reuters…

India is considering a radical plan to direct commercial banks to buy gold from ordinary citizens and divert it to precious metal refiners in an attempt to curb imports and take some heat off the plunging currency.

The RBI will ask the banks to buy back jewelry, bars and coins for rupees. Lenders will have to offer better rates than pawn shops and jewelers to lure sellers.

“We will start a pilot project among some banks where we will allow them to buy back gold from individual households,” the source, an official familiar with the central bank’s plan, said. “This will start soon, we have discussed (it) with banks.”

• From New York to Germany, check out a timeline of August events affecting the crypto-currency community here.

• For those following the Bitcoin Foundation’s board elections Bitcoin Magazine has posted transcripts from Let’s Talk Bitcoin’s interviews with the Individual Seat Candidates

Two new seats are being added to the Board of Directors. One representing Individual Members and the other is representing Industry (business) Members. In order to be eligible to vote in this election, you must be a current member of the Bitcoin Foundation.

But what exactly does the designation of “Rechnungseinheiten” mean for German Bitcoin users and businesses?

Via Pymnts.com …

The German parliament stopped short of granting bitcoin full currency status on August 19, but recognized bitcoins as “units of account” when it formally issued regulations for the popular virtual currency.

The ruling means bitcoin will be legal for use in private transactions, PC World reported. German commercial entities that want to conduct business with bitcoin will first need to obtain permission from the Federal Financial Supervisory Authority. 

The announcement comes at a time when global governments are looking for direction on how best to regulate bitcoin, and commentators told PYMNTS.com that the development can be seen as a win for both bitcoin users and business owners and investors.

Likewise, the ruling is likely to have reverberations in the international community, where it could serve as a template for lawmakers in countries where the regulatory environment for bitcoin remains unclear.

Additional Implications For Germany

German lawmakers also issued directives on key issues, determining if bitcoin would be subject to capital gains tax and sales tax, how bitcoin mining – the process by which additional bitcoins are generated – should be addressed and whether payment processors could avoid taxation.

Legislators decided commercial activities that use bitcoins should not be tax exempt, TechCrunch reported. Still, there is some confusion regarding this point. The media outlet noted that it was not clear how the sales tax would be implemented, and whether it would affect individuals who only occasionally sell items through third-party businesses such as eBay.

German lawmakers recommended bitcoin mining be governed as private money creation, and that payment processors be exempt from sales tax when dealing with German customers.

Further, notable German lawmakers made the philosophical case for bitcoin.

“We should have competition in the production of money,” said Frank Schaeffler, a member of the German parliament’s Finance Committee, according to CNBC. “I have long been a proponent of Friedrich August von Hayek scheme to denationalize money. Bitcoins are a first step in this direction.”

The statement made it clear that Bitcoin is not e-money and not subject to the EU’s e-money regulations.  Also bitcoins held for 12+ months are still free from capital gains tax.

However, there still seems to be some confusion for Bitcoin businesses over whether or not they need to register with Germany’s financial regulator BaFin. There are reports that BaFin classified Bitcoin (and other digital currencies) as “financial instruments“. This would require licensing and other challenging requirements such as €730,000 of capital.

Recently the German exchange bitcoin.de has collaborated with German based Fidor Bank which has pre-emptively applied for a license from BaFin. The outcome of their application may shed some light on the situation.

In their 2014 appropriations bill, the subcommittee directs the FBI to report on Bitcoin, specifically what the FBI is doing to address the “challenge” that they see from the “ersatz currency“.

Page 45 of the bill…

From the wording of the bill, particularly in describing digital currencies as “ersatz” (inferior substitute – merriam-webster.com) we can guess that the members of the United States House Appropriations Subcommittee on Commerce, Justice, Science, and Related Agencies are not big Bitcoin fans.

LetsTalkBitcoin, which broke the story on Monday, sees this fear from Congress as quite predictable.

The cash-like nature of Cryptocurrencies such as Bitcoin seem to be fundamentally at odds with the identity-based financial systems we’ve used since the advent of the internet.  What the bitcoin-using community sees as the advantages of Bitcoin; trustless and irrevocable transactions divorced of official identity.  In another light this can be seen as enabling money laundering, consumer fraud and terrorism.

“It is natural for established industries and their representatives in the Senate to fear new and disruptive technologies.” explained Andreas M. Antopoulos, Expert on decentralized networks  “As with the early Internet, there are those who only look at the empowering effects on criminals, rather than on the vast majority of people who can benefit enormously. It just takes time for the lawmakers and laws to catch up to the technology and adapt”

The ECB is not worried at the moment because the volume of virtual currencies is still low. Therefore it does not see them as a threat to financial stability. But the ECB notes that such virtual currencies could have a negative impact on the reputation of central banks.

Moreover, the ECB points out that the high degree of anonymity of virtual currencies poses a challenge to public authorities because virtual currencies could be used as means of payment for illegal activities and money laundering.

Virtual currencies are not regulated per definition used by the ECB. Therefore electronic money, which is regulated in the EU since the first E-Money-Directive of 2000, cannot be a virtual currency. Analyzing the impact of virtual currency schemes, a proper definition and categorization between virtual money and e-money, which is compliant with EU-regulation, is crucial. Let´s have a closer look to the genesis of these new currencies and their domestication by regulation before discussing the definitional misunderstandings of the ECB.

Genuine digital currencies like Bitcoin are decentralized digital bearer instruments stored in an electronic device (PC, chip card etc.). Such instruments are not a new phenomenon. The first wave of pioneers of this digital cash-equivalent, like Mondex and DigiCash, entered the monetary world in the mid-90-ies. Unfortunately, they did not survive. Similarly, the e-purses schemes that were meant to replace cash in the physical world did not gain much of the market and were discontinued in most European countries (except Germany where banks still ride an expensive, but almost dead horse called “GeldKarte”).

In spite of the limited success of the early attempts to implement digital cash in the market, central banks and other oversight authorities in Europe introduced a wave of (premature) regulation of these digital currencies. In 2000 the first E-Money Directive (2000/46/EC) was passed – long before any relevance of these e-money products could be detected.

Indeed, with the closure of most schemes, there was hardly anything that fell under the new regulation. But rather than having an empty regulatory box regulators started to widen the definition of e-money to include all kinds of other new payment instruments. Later on, this regulatory practice found its way into the definition of e-money in the second E-Money Directive in 2009 (2009/110/EC).

As a consequence, today most of the e-money schemes which fall under the scope of the e-money-regulation have nothing to do with genuine e-money in the sense of digital cash (digital bearer certificates).

Most of today’s e-money consists of balances held in special “prepaid” accounts, centrally administered by the issuing institutions. These accounts are like limited purpose accounts comparable to a current account at a bank that has a restricted functionality. PayPal is the well-known market leader of this kind of e-money.

So, in the EU, we have had regulations in place for genuine e-money and other prepaid products for more than 10 years. As far as we can see, most “virtual currencies” would simply be treated as “e-money” if they were issued in the EU. However, notwithstanding the existing regulations, the ECB Report makes a comparison between “E-Money” (regulated) and “Virtual Currencies” (not regulated). It identifies two types of virtual currency schemes,

• closed schemes and
• schemes with a monetary inflow via currency exchanges (traditional exchange: currency versus virtual currency).

In contrast to e-money, the unit of account of virtual currencies is an invented unit (like Bitcoins). Moreover, as stated by the ECB-report, there is no guaranteed redeemability of virtual currency funds into traditional currency.

The analysis of the ECB is striking for a number of reasons:

First, it is remarkable to see that the ECB is using an outdated definition of e-money (of the invalid EMD I) which not complying with the current e-money definition of the EMD II and the regulation within the EU.

Second, no matter whether the EMD I (not relevant since 2009) is used or EMD II, the core characteristic of e-money has remained the same: issuance on receipt of funds (= prepaid). This implies that every virtual currency which is issued (not traded!) in exchange for traditional money is legally defined as e-money (if the other requirements are fulfilled too).

Thus, the equation “virtual currency = unregulated” applies only in special cases like Bitcoin. Otherwise, those currencies defined by the ECB as “virtual currencies”, which are issued via an inflow of traditional currency, are subject to e-money regulation in the EU! Linden Dollars or Liberty Reserve Dollars (both “prepaid”) would be subject to e-money-regulation if issued within the EU-jurisdiction. All of these schemes would have to be redeemable at par. This is a regulatory requirement (Article 11 of EMD II) and cannot be part of a definition or a criterion for categorization, as in the ECB report. (By the way, when the EMD I was drafted in 1999, the ECB itself insisted on this requirement).

Third, the report states that e-money is (in contrast to virtual currencies) always issued in units of account of existing legal tender currencies. This is also not correct. Regulated e-money can be issued in fantasy units but the exchange rate vis-à-vis the legal tender currencies must be fixed (“issuers issue electronic money at par value on the receipt of funds”, “issuers redeem, at any moment and at par value”). The denomination is not essential! The ECB is missing the point by stating: “lastly, the fact that the currency is denominated differently (i.e. not euro, US dollar, etc.) means that complete control of the virtual currency is given to its issuer, who governs the scheme and manages the supply of money at will.”^[3]

Fourth, another criterion of categorization used by the ECB is the acceptance of the currency: only virtual or also real goods and services. A good or service is virtual, if it is offered within a virtual community and cannot be traded outside the community (ECB-definition). From a monetary and regulatory point of view the kind of goods and services which can be bought with a particular currency has no relevance, at all. Relevant could be the level of acceptance at third-parties (besides the issuer) whether in a virtual or real world.

So, as rule of thumb: if a virtual currency is prepaid, it is e-money with the regulatory requirement of redeemability at par value. Only non-prepaid currencies in closed systems (like Bitcoin or some in-game currencies) could be considered as non-regulated virtual currencies in the EU.

Central banks are monopolist providers of cash. So, they may be forgiven when they do not spend an awful lot of time observing and analyzing competitors. But central banks are also regulators and as such they should – at least after 10 years of experience – understand what they are regulating and what the regulations are.

Dr. Hugo Godschalk

Managing Director

PaySys Consultancy GmbH – Frankfurt/Germany

Unfortunately these bridges which make up the exchange market are concentrated and often broken.  This leads to concerns over reliability and security, which can cause market panic and extreme volatility. As Bitcoin enters the mainstream a wave of new businesses, services and software developers have recently dedicated their efforts to solving this problem. Their task will not be easy, and the while the exchange rate has seen some recent stability, there is a long way to go before obtaining bitcoins can be called user friendly and reliable.

This is an especially big problem for the expansion of Bitcoin. Attempting to purchase bitcoins is a frustratingly slow, nervous and difficult process for a consumer who is used to the convenience of internet shopping.  The usual reversible and/or disputable payment methods of credit cards, PayPal, etc. are rarely available in the purchase of non-reversible bitcoins. Generally consumers are required to use slow and expensive bank wires. This situation is an example of the difficult task facing exchanges as they attempt to integrate two very different systems.

Bitcoin was not designed for compatibility with traditional banking.  There is no Bitcoin protocol for ID verification. There are no accounts to freeze or confiscate.  As such exchanges have the unenviable task of attempting to shove Bitcoin transactions into the current banking regulatory mould.  While Bitcoin’s recent gains in popularity have brought about new entrants to the exchange market, it has also brought the scrutiny of regulators. Compliance with financial regulation, particularly in the states, is costly, time consuming and no small barrier to entry.

The Bitcoin exchange market is in the midst of a rapid evolution which will be critical for Bitcoin’s continued adoption. Here we will attempt to provide an overview of the current market and developments on the horizon. This is a tricky task as it is an attempt to take a snap shot of a rapidly moving target.

What are the current options in the Bitcoin exchange market?

While there are a number of different ways to obtain bitcoin, however, the large online exchanges are currently the dominant players in the exchange world.

Online Exchange Markets

By far the most popular option is a large online exchange such as the market leader Mt.Gox. Exchanges such as these operate entirely online. Customers must first open an account which now usually requires sending in copies of ID and waiting for verification in accordance with anti-money laundering polices. Once an account is set up a money wire or another form of irreversible payment is sent in to fund the account. After those steps, which are likely to take days if not weeks, bitcoins can be purchased. While this method requires some patience, the advantage is that it can be done entirely online.

At some exchanges there are faster funding options such as Dwolla or cash deposits, however, these options are often suspended or shut down due to banking and regulatory issues.

Over the Counter Alternatives

For those looking to avoid common delays from online exchanges, or perhaps looking for greater privacy, a common option is a local Bitcoin exchanger.  Services such as LocalBitcoins.com match local Bitcoin traders with those looking to buy or sell. Exchanges can be arranged entirely online using options such as bank wires and the site offers an escrow service. However, many transactions that originate via the site happen in person and with cash. Another OTC option is services such as Bitcoin-OTC.com which helps to match buyers and sellers via an IRC channel.

New Software Options

On the horizon are projects that aim to provide peer-to-peer exchange solutions. MetaLair is an open-source project designed to create a decentralized exchange network. The network created would allow for both crypto-currency to crypto-currency via an automated escrow service with plans for fiat to crypto capabilities. While still very much in development, a solution such as this technology would provide a quick, peer-to-peer exchange solution.

The Expanding Market

Earlier this year Bitcoin’s USD exchange rate hit all-time highs at near $260. This happened as Europe was experiencing a new round of financial trouble in Cyprus and Bitcoin hit the mainstream press.

What was once considered to be only the play thing of computer nerds or conspiracy theorists was now seen by the mainstream press as a possible opportunity. Perhaps still a very risky and out-there opportunity, but Bitcoin got quite of lot of attention.  And it sparked a rush to invest in the new currency and related businesses.

Many Bitcoin start-ups went from being small operations run by one programmer in his/her spare time, to potential big businesses being courted by major venture capitalists. This is especially true for the exchange market as many realize that Mt.Gox’s huge market share can be chipped away at, and the race to do so is on. As Bitcoin exchange support service Bex.io’s co-founder Yurii Rashkovskii put it, the current situation “is a land grab.”

The many new exchanges entering the market is exciting news for the Bitcoin economy which has suffered from extreme market concentration.  The oldest and by far the largest Bitcoin exchange is the Japan based Mt.Gox. While its market share is starting to slip, for years the exchange enjoyed an over 80% market share for USD/BTC exchange.

This extreme concentration has been an ironic problem for the brilliantly decentralized Bitcoin as it leaves one very large point of failure in the exchange market. The trouble this can cause was shown earlier this year during Bitcoin’s run up in price. Mt.Gox is such a dominant force in the market that it’s posted BTC/USD exchange rate is the defacto ‘Bitcoin price’.

In April, as Bitcoin’s price was soaring over $200, Mt.Gox was hit by a series of DDoS attacks that delayed and briefly blocked access to the site. Market speculators panicked and the price plummeted to near $60.

This exchange volatility makes accepting Bitcoin payments a risky business for merchants, often undermines the currencies legitimacy and holds back those considering investing in the Bitcoin world.

However, as the Bitcoin economy continues to expand, new entrants in the exchange market not only stand a chance of making quite a lot of money, but also will wind up solving some of the currencies biggest problems in the process; exchange market concentration and price volatility.

The Race is on

The new businesses entering the market are numerous and varied and any list or figure given here would likely be out-dated by the time it reached the reader. However, some idea of the activity in the area can be gained by looking at new investments in Bitcoin exchanges and exchange related businesses.

Many investors go about their business quietly and solid numbers are unavailable, however, there have been a number of well publicized investments in the Bitcoin exchange space in the past few months.

In April Coinsetter, a Bitcoin trading platform offering margin trading, raised $500k from a number of investors including the Bitcoin Opportunity Fund run by SecondMarket founder Barry Silbert.

Coinbase, a Bitcoin wallet service that can be used to purchase BTC, announced in May this year that they had raised $6 million from a number of big investors including Fred Wilson, Ribbit Capital, SV Angel, and Fundersclub.

Also in May BitInstant, a Bitcoin exchange funding service, raised $1.5 million in a seed funding round led by Winklevoss Capital.

There has also been a number of venture capital funds created for investing in startup Bitcoin businesses. These include Liberty City Venture’s Digital Currency Fund and BitAngels.

The race for market share is such that new businesses providing support to exchanges are springing up; specifically BTCGlobal and Bex.io.  These new businesses provide technical support for new exchanges. “We do the tech. You do the rest” reads the Bex.io website. Or as co-founder Yurii puts it they are “Mt.Gox in a box”.

“Looking at the eco system as a whole there is definitely a need for more access points into and out of the Bitcoin economy and it makes no sense for everyone to be reinventing the same wheel” explains Bex co-founder Jessie Heaslip. ”We are inventing one wheel that we are going to license out.”

The start-up has the goal of making opening an exchange a less capital intensive and technically challenging endeavour.  Bex will focus on developing “the most repeatable parts of this business” and then link together the exchanges using their platform in a “global liquidity pool.” This liquidity pool would allow small exchanges in various locations to operate reliably without a large amount of start-up capital. Instead they would be able to access liquidity from other Bex based exchanges.

Support businesses such as Bex could dramatically lower technical and capital barriers to entry for new exchanges. But Bex is not aiming to capture any of the very large US market share, that would be too resource intensive and risky.

Also looking to create an exchange network is the new Ripple system. Operated by OpenCoin Inc., which received a round of venture capital funding in April, Ripple is looking to create a network of small and large exchanges which are ‘Gateways’ to the Ripple network. With Gateways in many locations Ripple users will be able to exchange a wide variety of currencies. Leading Bitcoin exchange BitStamp is already setup as a Ripple Gateway.

What is the online exchange market doing?

For years Mt. Gox has been the undisputed market leader with a USD exchange market share of 80%+. Mt. Gox came to be in this position largely by getting in first and managing to be the last man standing as the Bitcoin economy grew and became the subject of many theft attempts.  Mt. Gox simply survived the growing pains that killed many others.

Since April, Mt. Gox has slowly been losing its market dominance.  And now sits at just below 50% of the USD exchange market.

*Via BitcoinCharts.com

 *Compiled from data obtained via BitcoinCharts.com. Shows total BTC volume including trades in USD and other currencies, using 7day averages.

Mt. Gox’s decline in market share, as can be seen from the above chart, is due largely to a loss in its own volume rather than being over taken by a competitor.

With all of the issues Mt. Gox has expirenced this year, law suites, bank account closures and issues with USD withdrawals,  it’s not terribly surprising that it has lost volume. But where has the volume gone? Perhaps there has been a reduction in speculator trading. Perhaps Bitcoin users are moving to exchange alternatives.

Unfortunately there are not easily available numbers on the use of exchange alternatives, but as all Bitcoin transactions are public, we can have a look at the Bitcoin transaction numbers in general.

*Chart taken from BlockChain.info 180 day USD major exchange volume using 7 day averages.

The above chart shows USD volume on the major exchanges. It is clear that USD exchange volume in general has been on the decline, particularly in the last month.

However, USD transaction volume on the Bitcoin network has seen a rise in the last few months. This shows that while exchanges have been losing some volume, the Bitcoin network has not.

*Chart taken from BlockChain.info 180 day USD transaction volume using 7 day averages.

It would be very interesting to look at a comparison of trade volume of various exchanges vs. total transactions on the Bitcoin, however, due to a number of technical factors this is quite difficult. However, BlockChain.info provides an estimate of Bitcoin transaction volume and produces a Trade vs. Transaction ratio chart.

The chart was created to examine speculation in the Bitcoin economy. It compares Bitcoin ‘Trade’ volume, volume of exchange between BTC and fiat, to Bitcoin ‘Transaction’ volume, number of transactions which likely represent transactions between users or for purchases of goods and services.  The charts tracks the ratio of transactions to trades; transactions/trades. A higher ratio means less speculation. 

*Via BitcoinCharts.com

The US Dollar remains the dominant national currency in the Bitcoin economy.

Regulation

While Bitcoin’s recent explosion in value and mainstream attention has brought many new entrants to the exchange business, it also brought about the attention of regulators and the scrutiny of banking partners.  Just as the Bitcoin economy is moving into the mainstream regulators and bankers are applying the brakes.

Serious regulation entered the Bitcoin economy earlier this year with US financial regulator, FinCEN, releasing a guidance paper on ‘virtual currencies’.  The guidance made it clear that any entity which buys and sells virtual currencies, such as an exchange, is considered to be a money transmitter.  This is a heavy burden to bear. Not only does it require strict adherence to anti-money laundering policies but also lengthy and costly licensing hurdles. To legally operate as a money transmitter in the States, a business needs to obtain money transmitter licenses from 48 different states. Estimates vary on the time and cost of this compliance but it is certainly a significant hurdle for a start-up business to clear.

One US based exchange start-up, Vaurum, has experienced interest from investors and has raised a seed round, but also faces an uphill battle with compliance. Avish Bhama, Vaurum founder, sees compliance as being a barrier to entry and one which has been very costly for his business. “Complying will cost us ~100k+ / year.  It is expensive and time consuming and is a big barrier to entry. … It’s hard to put a number on it, but lately more than half of my time has been spent on regulatory stuff.”

CampBX, an established US based exchange, also puts a significant amount of resources into staying compliant. “Bitcoin regulation is evolving at a fast clip, and we actively revise our compliance program every quarter to remain fully compliant.”

One could assume that friction with US regulators would simply move Bitcoin businesses off shore. However, this did not save Japanese based Mt. Gox from a run-in with US authorities. Shortly after the release of their guidance regulators seized the Dwolla account of Mt.Gox’s  US subsidiary, Mutum Sigillum LLC. The subsidiary also had its Wells Fargo bank account closed as regulators accused the business of operating in the US as an unlicensed money transmitter. Nearly two years prior while opening the Well Fargo account the businesses CEO, Mark Karpeles, signed a form declaring that the business was not a money transmitter.

While they have now registered with FinCEN, Mt.Gox had failed to register immediately after FinCEN’s guidance which categorized exchanges as money transmitters.

US regulators willingness to enforce their rules on any digital currency based service with US customers was demonstrated in their dealing with Mt. Gox and in the recent shut down of Costa Rican based digital currency provider Liberty Reserve. Statements after the May shutdown of the business make it clear that US regulators intend to enforce their anti-money laundering standards on foreign companies. Under Secretary for Terrorism and Financial Intelligence, David S. Cohen, clarified that the US would pursue illicit financial actors wherever they may be, in the US or overseas.

“We are prepared to target and disrupt illicit financial activity wherever it occurs – domestically, at the far reaches of the globe or across the internet.” 

Any exchange which hopes to share in the very large US market will have to keep US financial regulators in mind. However, the ever resilient Bitcoin economy is developing services designed to ease compliance issues for exchanges.  BTCGlobal, a Uruguayan based support service for Bitcoin businesses, has launched a “Massive Parallel Licensing” program which aims to create a network which will allow members to leverage each other’s regulatory infrastructure and resources.

Via the BTCGlobal Site: “The highest hurdle for entrepreneurs interested in launching a Bitcoin exchange business is the significant international and local regulatory requirements. It is estimated that an investment of over $10 million would be required to reach total legal compliance in all the U.S. 50 states alone. The BTC Global Massive Parallel Licensing program addresses this hurdle with a package that includes comprehensive regulatory support and a full suite of Bitcoin products and services.”

However, increasingly Bitcoin businesses are simply choosing to block US customers as they see entering the US market as too risky and/or costly and focus on other jurisdictions which have been comparably much friendlier.

Regulation outside the US

Many countries have not directly addressed digital currency regulatory issues, however, some countries have stated that they are not requiring any regulatory compliance at this time. Both British and Canadian regulators have issued letters to exchanges stating that they are not required to register with financial authorities.

In Canada a letter from regulator FINTRAC was sent to a number of exchanges confirming that the exchanges were not money service businesses and were therefore exempt from laws governing those businesses.

The UK’s financial regulator HM Revenue & Customs (HMRC) sent a letter to at least one exchange start up making it clear that the business was not required to register with HMRC under money laundering regulations.

In Europe ‘e-money’ is regulated, however, for the moment the European central bank does not view Bitcoin as money or e-money and does not require compliance for Bitcoin businesses.

While regulators may change their policies, it’s clear that some locations are far more lenient than others. However, lenient regulation does not necessarily translate to co-operative banking partners.

Nervous Banks

Recent moves by regulators, particularly in the States, have scared many banks out of the Bitcoin arena and their caution is understandable. Commercial banks cannot exist in their current form without accounting rules and national currencies that are created and supported by national legal structures. They cannot afford to be on the wrong side of these legalities.  Bitcoin should be a concern for them; it was not built to fit the regulatory mould and it seems that banks are frightened of inadvertently enabling violations of financial regulations via the Bitcoin network.

There have been numerous examples of banks, often abruptly, ending their relationships with Bitcoin exchange businesses. Earlier this year US based exchange BitFloor ceased trading after CapitalOne closed their bank account, and this is just one of many examples from the US.

In Germany Bitcoin exchange Bitcoin-24 had its bank account closed by authorities in April who were concerned that the site was being used for fraudulent transactions. More recently, LibertyBit, a Canadian based exchange, halted operations as a result of bank account closures and alleged fraudulent account activity.

While start-up Vaurum has managed to build banking relationships, it took some convincing. “The hard part is that banks won’t even talk to Bitcoin exchanges because their compliance teams are scared of the regulatory issues that come along with banking a Bitcoin exchange. …  The mechanics of the partnership are pretty straight forward – it’s just that banks don’t want to get in trouble with regulators and are quite conservative by nature. … It took some time to educate banks on our business.”

The Other Options

While some are putting their effort into making the Bitcoin/banking partnership work, others are busy finding ways around it. For the moment it would seem that there is only a small percentage of Bitcoin trade happening outside the large exchanges and most exchanges do not view these options as competitors. However, the alternative exchange market is experiencing rapid growth of its own.

As Fiat currencies in their digital form exist only on the servers of banking institutions, Bitcoin to fiat exchange cannot take place without the co-operation of a banking institution.  Many who are looking to bypass the regulatory and banking relationship hurdles are attempting to fly under bank’s radar with small transactions.  This means peer-to-peer transactions rather than a large intermediary such as an exchange.

There are a number of options that aim to connect individual Bitcoin users for trades. Two examples are LocalBitcoins.com and MetaLair.

MetaLair is an open source software project that aims to create a decentralised exchange mechanism which would facilitate peer-to-peer exchanges between crypto-currencies and in the future fiat to crypto exchanges.

The project will begin by building a network to enable peer-to-peer, crypto-currency to crypto-currency exchanges. In this scenario the MetaLair software acts as an automated escrow agent which makes for a very low trust system; but of course fiat to crypto exchanges would be more complicated.

Due to the nature of the banking system, the project’s crypto to fiat exchange plans would necessarily involve fiat funds being held by a third party escrow service. MetaLair plans to provide an open protocol to allow anyone to set up as an escrow service and to build a reputation via a rating system. As lead architect Johnathan Turrall explains, “what we are creating is an open system. The details of how the fiat to fiat transactions occur between the entities are effectively between them, we are just providing an interface by which they can do that.”

While MetaLair aims to create online exchange, LocalBitcoins.com has been in operation for years offering primarily in person exchanges.  The service matches local Bitcoin traders with those looking to buy or sell. The site is known for finding exchange agents for in-person trades, however, exchanges can be arranged entirely online. These trades use options such as bank wires and the site offers an escrow service for added user security. Via a local trader it is possible to purchase bitcoins quickly, privately, in person, and with cash in over 2,200 cities worldwide.

Earlier this month the sites founder Jeremias Kangas said his site has been gaining roughly 300 new users each day and has over 50k users overall. The site currently employs 4 people and is looking to hire more as they continue to improve their service.

New local Bitcoin markets calling themselves Buttonwood have sprung up in a number of US cities. The name is a reference to the 1792 Buttonwood agreement that created the New York Stock Exchange and which took place at 68 Wall Street under a buttonwood tree.

Conclusion

While the exchange market is changing, things are still largely the same. Mt. Gox is currently the largest exchange and USD/BTC exchange is the largest market.

Venture capital backed start-ups are determined to capture the US market and they seem likely to succeed. Only those start-ups who can attract large investment funds will be able to calm nervous banks and clear the regulatory hurdles.  As such the exchange options in the States will become much more serious and will require verification from all clients, likely above the current law. Privacy will not survive in the US online exchange market.

As compliance in the States is a large and expensive hurdle to clear, many innovators who’s projects do not fit the regulatory mould will avoid the US and likely actively block US users. Bitcoin innovation may be driven out of the States.

The large online exchanges are the dominant exchange options and it is difficult to guess the percentage of the market for exchange alternatives such as local markets or OTC trades. These options would seem to be much more appealing to Bitcoin veterans, however there is no doubt that alternative exchange options are experiencing a boom of their own.

As the world of traditional banking collides with the new world of crypto-currencies there will continue to be friction. New exchanges will appear, bank accounts will be closed, regulators will take action, businesses will be shut, some will get rich, some will face prosecution and how the exchange rate reacts is anyone’s guess. But this weak point in the evolving Bitcoin economy is where the action will be. Watch this space!

FinCEN noted Liberty Reserve’s irrevocable transactions and lack of ID verification as evidence that “Liberty Reserve’s system is structured so as to facilitate money laundering and other criminal activity,” these comments worried the digital currency community and was likely what scarred off many of their banking partners.

On the 19th, the Bitcoin Foundation responded to FinCEN’s proposed special measure urging them to clarify that not all virtual currency transactions are inherently suspect.

From the letter…

“the Bitcoin Foundation does not take issue with the imposition of special measures against Liberty Reserve. Rather, the Bitcoin Foundation is filing these comments to urge FinCEN to clarify statements made in the Proposed Rule and the underlying Notice of Findings that could be misinterpreted to suggest that virtual currency transactions in general are inherently suspect.”

“the Bitcoin Foundation is concerned that the statements in question may be misinterpreted to suggest that all virtual currency operators are inherently suspect. In particular, the Bitcoin Foundation is concerned that the statements will be misread by the financial institutions implementing the final rule adopted in this proceeding (the “Final Rule”) to suggest that virtual currencies in general should be subject to a higher degree of scrutiny, and the chilling effect this could have on the still nascent bitcoin industry. “

The foundation asks for 3 specific statements from FinCEN…

• Any Final Rule Should Rely on Established Terms and Definitions
• Any Final Rule Should Emphasize Liberty Reserve’s Activity as the Sourceof Concern, Rather than any Particular Attribute of Virtual CurrencyGenerally
• Any Final Rule Should Clarify that Irrevocable Transactions May Serve Legitimate Purposes

Read the Foundation’s response in its entirety here.

Via CoinDesk…

The letter from HMRC reads as follows:

“With reference to your enquiry at this time there is no requirement to register with HMRC under the Money Laundering regulations, however HMRC recognise that the issuing of Bitcoins represent an emerging development.

We are currently in discussions with HM Treasury concerning this market and whether HMRC will be a Supervisor for this market. HMRC will be watching any developments relating to the Bitcoin market and may change our view, therefore I would suggest that you regularly check our news and update section on our website at www.hmrc.gov.uk/mlr and sign up for our e-mail alert system at www.uktradeinfo.com/AboutUs/Pages/EmailAlertServices.aspx.

If at any time HMRC recognise Bitcoins as a currency you would then have to register straight away without any prior correspondence from HMRC as this would be your responsibility to register should the ruling change regarding Bitcoins under the Money Laundering regulations.”

A network of small, peer-to-peer transactions would likely bypass many of these issues and would be a fitting solution for the brilliantly decentralized Bitcoin network. But is such a thing possible? The guys behind MetaLair, a UK based start-up, think so and are working hard to develop the software and find the investors to make it a reality.

Their vision is a decentralised exchange mechanism which will facilitate peer-to-peer exchanges between crypto-currencies and in the future fiat to crypto exchanges.  The MetaLair network would be similar in structure to the Bitcoin network featuring…

• No central servers
• Open-source software
• Incentives for all network operators
• A proof-of-work based system

If they are successful in achieving funding, MetaLair will develop both a free open-source version and a pay version with added features. The business intends to make money by charging for the client software with additional features that will include added security, trading and analysis tools. They hope that this could become the defacto standard wallet and trading platform for Bitcoin and other crypto-currencies.

MetaLair’s developers believe that the project will benefit the crypto-currency community as it is open-source and fully decentralized; this ensures that should MetaLair not be around the decentralised exchange will simply carry on.

“For me personally I’m only ever interested in a business if it has a primary social benefit” explains lead architect Johnathan Turrall who just returned from a trip to Cuba and South America. “The reason I went to Cuba was to look at communism and the impact that it had on financial systems, processes, business and industry. … I think potentially this system could be of great benefit to people in those areas so that is one of the motivations behind it.”

Johnathan and his business partner, Kerry Fraser-Robinson, will release their design papers whether or not the business obtains funding with the hopes that the project will eventually be developed even if they are unable to finish it themselves.

MetaLair will create and distribute the exchange software, but will not handle any funds or transfers. All transfers happen between users of the network.  The system uses an escrow service in all exchanges; however, all escrow actions are either automated, or are carried out by the human users of the system.

The projects development will be in two phases with initial development focusing on crypto-to-crypto exchange. Theoretically MetaLair can work with any crypto-currency that uses a blockchain and has M of N transaction capability. This allows the exchange software to act as the escrow agent for the transfer of both crypto-currencies in the exchange.

Explanation of M of N Transactions

An M of N transaction is essentially an escrow system built into the Bitcoin protocol that removes most of the need for trust that a traditional escrow would require. This capability allows a party to the transaction to act as an escrow without actually having access to the funds held.

The most common form of an m-of-n transaction is a 2 of 3 transaction. In this case there are three parties and three private keys, any two of which are needed to sign the transaction for it to be valid.

• All parties involved in the transaction can verify that the address belongs to the transaction they are participating in.
• All parties can view the funds in the destination address.
• Escrow requests must be signed first or second by the escrow in the chain of events.
• The escrow is able to grant access to the funds to sender or receiver.
• Escrow is unable to access the funds themselves.
• Sender and receiver can still cooperate so that one party receives the funds without the need to rely on the escrow.

Any crypto-currency using the Bitcoin source code will support this feature and can therefore be used on the decentralised MetaLair exchange.

For example a Bitcoin/Litecoin exchange would begin with two parties entering buy and sell orders via the MetaLair network. The system correlates the matching bid/ask and, using a 2 of 3 transaction, will act as an automated escrow agent for both the Bitcoin and the Litecoin transfer.

Bitcoins are transferred between the parties via the Bitcoin network and litecoins are transferred between the parites via the Litecoin network with MetaLair acting as the escrow agent for both transfers. If MetaLair’s decentralised exchange mechanism notices that double spending has occurred before the maximum specified number of transactions has been reached it reverses the transaction and refunds each party.

In the crypto-to-crypto scenario the MetaLair software is acting as the automated escrow agent, which makes for a very low trust system; but of course fiat to crypto exchanges would be more complicated.

Fiat currencies in their digital form exist only on the servers of banking institutions. As such, fiat to crypto exchanges require the services of those who have access to the banking system.  MetaLair sees a number of options for fiat exchange escrow agents. These options include very large and well respected businesses that may use their name and existing banking relationships to bring in a large volume of trades.  Of course this scenario might look at lot like existing Bitcoin exchanges that have to take many steps to comply with regulation to appease their banking partners as they cannot offer exchange services with access to traditional banking.

On the other end of the spectrum, there is the possibility of individuals offering escrow services in their spare time. For example you may have an exchange in India that would only involve a small amount of Rupees moving between local accounts and would likely not draw any attention from regulators.

Essentially what MetaLiar is providing is an open protocol to allow anyone to set up as an escrow to facilitate fiat to crypto transactions, complimented with an underlying trust based system.  The fiat exchange may simply be a small transaction between individuals or small businesses. “That’s an added benefit of this approach.”

As Johnathan explains, “what we are creating is an open system. The details of how the fiat to fiat transactions occur between the entities are effectively between them, we are just providing an interface by which they can do that.”

Fiat to crypto exchange also require an escrow service, however, due to the nature of the banking system, this escrow cannot be automated via the MetaLair software. Funds will have to be held by an intermediary individual or business acting as an escrow service. “The key innovation with our system is, because it’s fully decentralized, that it lets a lot of different escrows sign up from anywhere in the world and offer their services via an API.” There are many ways in which a fiat to crypto exchange could take place, but below is how possibility might work…

• Bob is looking to sell his bitcoins for Euros and enters a sell order (ask) via the MetaLair network.
• Alice is looking to buy bitcoins in exchange for her Euros and enters a buy order (bid).
• The MetaLair system connects Bob and Alice who both agree to use Ivan as the escrow agent.
• Ivan is a small time Europe based escrow agent who has a good trust rating via the MetaLair network.
• Ivan acts as the escrow agent for the fiat funds and holds Alice’s Euros in his bank account.
• Ivan therefore also acts as the escrow agent for the Bitcoin transfer which is done via the Bitcoin network using a 2 of 3 transaction. (or this may be automated)
• The Bitcoin transaction completes successfully.
• Ivan transfers the Euros to Bob’s bank account.
• Ivan receives a fee for his services.

MetaLair will leave regulatory compliance as a decision for the users of the network and they do not expect to deal with any financial regulation themselves as the business is not an exchange. “In the same way that Satoshi has provided Bitcoin we’re providing the decentralized exchange mechanism. You don’t pay Satoshi for any of the transactions you do on the network. It’s distributed; you pay the people who are working on the network.  It’s the same process with our decentralized exchange mechanism.”

This is an attempt at setting up a network in which anyone is free to join and offer their services or exchange currencies between themselves.  Should it succeed it could offer a wide variety of options in what is currently a concentrated and under pressure market.

As the big exchanges face regulatory scrutiny and continue to impose more and more conditions on their users, the network that MetaLair is attempting to create could offer much needed options for consumers.

The exchange market leader had a run-in with US regulators earlier in the year when their US subsidiary, Mutum Sigillum LLC, had its bank account and Dwolla account shut down due to a lack of licensing. Soon afterwards the site changed their policies requiring all customers wishing to perform any USD withdraws/deposits to first verify their identity. As the majority of Mt. Gox’s businesses is in USD/BTC trades, their decision to appease US regulators is unsurprising.

Via Bitcoin Magazine..

The license lists MtGox as intending to carry out money services business activities in sixty US territories including all fifty states, granting the company federal permission to carry out their Bitcoin exchange activities in all of those regions (although the exchange still needs money transmitter licenses from forty eight states just like all other exchanges in the US; these are much harder to obtain, although certainly not impossible. Notably, the license specifically lists MtGox, Inc and not Mutum Sigillum LLC; this is not a mistake, as MtGox set up a new Delaware corporation with that name on June 11, presumably intending to use it for all Bitcoin exchange-related activities in the United States in the near future.

Since MtGox has received the MSB license, it can be assumed that they are simultaneously working with the Department of Homeland Security to resolve that agency’s Dwolla complaint. However, there is still one major thorn in MtGox’s side that remains unresolved: the Coinlab deal. On February 27, MtGox announced a deal with Coinlab in which Coinlab would take over MtGox’s activities in the United States, but in the months that followed it appears that MtGox procrastinated on their side of the agreement, leading to Coinlab suing them for contract violation on May 2. Perhaps MtGox intends to make amends with Coinlab and follow through on the agreement, in which case MtGox would not need to bother with money transmitter licenses; that would be Coinlab’s respnsibility. Alternatively, MtGox may be setting itself up to forge ahead in the United States on its own; the decision to create a new Delaware corporation can certainly be interpreted as evidence pointing at least slightly toward that conclusion.

Although MtGox’s recent legal and banking debacles, culminating with their recent decision to suspend all USD withdrawals, have led to serious difficulties for the exchange, its market share is remaining surprisingly resilient at 65-70% – much lower than the 75-90% the exchange was used to before the sudden rise in Bitcoin price and popularity earlier this year