Bitcoin Part 1 – The Flaws

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tl;dr – Bitcoin will not survive long-term. The value of Bitcoins will ultimately go to ~0. However, the underlying technology and protocols are a testbed/prototype for future implementations of distributed, decentralised financial technologies.

Currency

When I return home from an overseas trip, I toss my left-over notes and coins into a drawer. Euros and US dollars obviously get used (as long as I remember to take them with me!) but the dirham, rubles, rupees, yuan, francs, and dollars from Hong Kong and New Zealand just sit there gathering dust – pieces of paper and metal that are effectively worthless here in London.

However, for all its faults, physical notes and coins remain the only way in which you can transfer currency in a decentralised fashion. Electronic money – the ones and zeroes in our bank accounts, the records of credit card transactions and inter-bank transfers – ultimately rely on central banks and mechanisms like CLS, which keep track of how much money each bank has.

Bitcoin is an effort to bring the advantages of physical currency – specifically the ability to transfer wealth with little-to-no cost and without needing to involve anyone else in the transaction – to the electronic medium.

(Many assume that Bitcoin transactions are anonymous. They’re not. All Bitcoin transactions are recorded publicly in the blockchain. At best, Bitcoin transactions are pseudonymous; at worst, network analysis – something that security and intelligence services are very good at – can provide major clues to participants’ identities.)

I first became aware of Bitcoin in 2010, when someone paid 10,000 bitcoins for a couple of pizzas. My instinctive gut reaction was that it was an interesting technology but, ultimately, would prove to be nothing more than a fad. Three years later, I have yet to be proven correct. Enough people have supported Bitcoin that an eco-system has built up around it. There are online exchanges where you can buy and sell bitcoins for dollars, euros or pounds; payment processors that allow merchants to accept bitcoins for goods or services; casinos where you can gamble your bitcoins; and online marketplaces where you can use bitcoins to buy drugs.

Bitcoinmania

The Bitcoin protocol has deflation built in, which created an expectation that bitcoins would increase in value over time. This has sparked speculation that the entire thing is a pump’n’dump scheme designed to enrich those who were able to mine lots of bitcoins during its early days. There are also rumours that the price increase has been stoked by direct market manipulation.

Bitcoin’s supporters have shrugged off such concerns. This year has seen the hype reach fever pitch, with the mainstream media quoting questionable claims that, in the aftermath of the Cypriot haircut, Italians and Spaniards are swapping their euros for bitcoins. The media attention has led to mainstream awareness and interest – you can now place bets on the price of bitcoins with financial spread-betting company IG Index.

The price of bitcoins has risen in line with the hype. The two charts below track the price of bitcoins (per blockchain.info) and the interest in Bitcoin (as an index of the number of  searches for the word “bitcoin”, from Google Trends), from January 2009 to the beginning of April (i.e. it doesn’t include the wild fluctuations that occurred yesterday).

Bitcoin-market-price

Bitcoin_Google_Trends

The correlation does nothing to disavow me of my suspicion that the price of bitcoins is primarily driven by hype (although I must admit that the correlation is likely to break down today, as news outlets report on the drop in price).

The meteoric rise in the price of bitcoins (and the deflation that’s built into the Bitcoin protocol) seems likely to lead people to “invest” in Bitcoins, in the expectation that the price will rise – a recipe for a bubble if I ever heard one – and hoard them, instead of using them as was originally intended – i.e. as currency.

Is Bitcoin really a currency?

I have no interest in arguing over semantics. From my perspctive, a currency only has value if you can spend it. A fiat currency’s value derives from its status as legal tender (or, as I like to say, your ability to use it to pay your taxes). Bitcoin evangelists argue that fiat currencies are susceptible to manipulation by governments – and they’re right. I agree that fiat currencies have flaws. However, I don’t care because a better solution has yet to present itself.

Bitcoins have no intrinsic value and they are not legal tender – anywhere. The value of a bitcoin in your virtual wallet is determined solely by whatever someone else is prepared to give you in exchange for it. Early yesterday afternoon, people were prepared to buy bitcoins for $260; a few hours later, their value had halved and the price of goods and services denominated in bitcoins had doubled. To me, that’s not a currency – it’s an instrument for speculation. The value of fiat currencies may erode over time due to inflation but those timescales are typically measured in months and basis points, not minutes and double-digit percentage points.

To my mind, bitcoins are more like a digital commodity. However, even commodities like precious metals have intrinsic value (gold’s resistance to corrosion and high conductivity mean that it is widely used in electronics; more than half of the platinum mined each year is used by the automotive industry for catalytic convertors). It can be argued that bitcoins actually have a negative intrinsic value, because of the CPU cycles required to mine them. (For more on Bitcoin’s inefficiency, I recommend reading Ben Laurie’s paper on the topic.)

Security and confidence

Even if you believe that bitcoins have value, your bitcoin-denominated wealth is at greater risk of theft or loss than real currency. In mid-2011, a Swiss developer and Bitcoin enthusiast named Stefan Thomas managed to accidentally destroy/lose bitcoins that were, at the time, valued at $128,000, and many bitcoins have been stolen by hackers. Online wallets offer an alternative to storing bitcoins on your laptop but even legitimate companies suffer from security, privacy and reliability issues.

To be fair, physical currency can be stolen or destroyed, and phishing attacks have resulted in electronic thefts from bank accounts but I would judge that money in my wallet or bank account is far safer than bitcoins stored anywhere (although depositors with more than €100,000 in a Cypriot bank account might disagree).

Bitcoin also suffers from systemic risk. Absent intrinsic value, the price of bitcoins is highly susceptible to loss of confidence, as demonstrated by the price fluctuations that have resulted from DDoS attacks on MtGox (the largest bitcoin exchange) and last month’s blockchain fork.

In my opinion, the single largest current threat to Bitcoin is a malware-fuelled attack on a large mining pool that attempts to fork the blockchain, with the goal of sparking a loss of confidence which allows the perpetrators to profit by effectively shorting bitcoins.

(Ironically, there are already already botnets devoted to mining Bitcoins.)

So, there’s no good news?

I may sound like a doom’n’gloom merchant but I actually believe that a lot of good will come from Bitcoin. I’ll write about why in  Part 2!

Written by jackgavigan

April 11, 2013 at 12:54 pm

One Response

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  1. I have to admit i was introduced a few weeks ago to bitcoin and in my feverish excitement (read….dollar signs in my eyes) i jumped on the bitcoin bandwagon and bought a bunch.

    after a few weeks of intelligent more pragmatic conversations between friends i developed a more secure sense of the future value of bitcoin or some other crypto currency. so much of its potential makes sense and i still believe a crypro currency is in the future (near future) of mankind but i no longer believe it to be bitcoin.

    after more reserved individual examination i’m starting to realize theres a huge fundamental flaw with bitcoin as a currency. i began searching to see if others had noticed the same and interestingly i came across very few.

    most forums seem to be filled with people locked in a mindset that is filled with ideals and hopes not pragmatic honesty. i was one of these people because i re-read an article this morning i read several weeks ago that explained the pitfalls of bitcoin but i did not get the point back then. now i’m listening and it made sense. your article above touches upon the one HUGE dilemma i have with bitcoin, and that is….it is NOT a currency…it is a commodity.

    Gold is a commodity. it was once used as a currency because it was the best option available at times. its advantage over bitcoin is its rarity as an earth born substance. this is why gold continues to be of some value as a commodity. bitcoin does not hold this value. gold as a commodity was used as a currency but was imperfect so men evolved and created fiat currencies. for all their faults (and please remember its faults are not born from the currency but from the minds of men) it is the solution we adopted, the best solution so far as a means of facilitating the exchange of goods and services.

    the value of (most) fiat currencies is their inherent stability. of course they fluctuate in value but it is slow and measured. a man can expect to receive a wage and pay his rent and not see the value of his wages halved in a day or two.

    currencies have stable price fluctuations…stocks and commodities do not. could you imagine the panic and outcry one could invoke if tomorrow the president said that the price of the US dollar was going to be determined and pegged to the daily price of the Dow Industrial Index? people would be rioting in the streets once they realized the ramifications of this.

    The Dow Industrial index trades hundreds of millions of shares a day but over the course of a couple months can drop by 20% or more. it has in the past. my point being even such a hugely liquid vehicles (investments) as the big Dow can fluctuate wildly.

    My greater point being even if bitcoin ever even reaches the point where hundreds of million of bitcoins are traded daily its still going to be subject to wild price swings because its price is pegged to its trading.

    the recent fall of bitcoin after the silkroads seizure really drives this home in a big way and may have unknowingly been the reason for my change of heart.

    lets say i work and get paid in bitcoin. to keep it simple lets say i earn and get paid 10 bitcoin per week (or $1000 US dollars). my rent is 20 bitcoin per month ($2000). after paying all my other bills for the month i have 23 bitcoin left over ($2300). the price of bitcoin suddenly drops by half. my 23 bitcoin is now only worth ($1150). not enough to pay my rent. this is insanity…no retailer can survive long term in this environment using only bitcoin UNLESS his price of his goods and services is pegged to a local fiat currency. in other words bitcoin needs local/ stable fiat currencies to determine fair value for goods and services. in other words bitcoin couldn’t survive on its own as a currency because value to price fluctuates to wildly.

    in the above rent example we are not paying rent with a currency model but rather a commodity model. we own a commodity that we swap in exchange for goods and services. some days we get more for our bitcoin commodity…some days less.

    so in my opinion bitcoin is truly a commodity and always will be UNLESS someone changes the way bitcoins price fluctuates in relation to a retail environment. in other words…if we could seperate bitcoins daily retail value ( its price used to buy goods and services) from its traded value maybe then and only then would it be a viable currency. i’m not even sure if this is possible but only then will i have faith in bitcoin long term. as for now….i’m treating it as a short term investment in a commodity and as soon as i reach a profit i will be selling my bitcoin with no regrets.

    ER

    October 7, 2013 at 5:15 pm


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