In the few days since I published my last article on parallel currencies, Bitcoin did not stop catching the headlines. Apparently, the “cryptocurrency” easily digested the disruptions caused by hack attacks on MTGox which had resulted in a temporary drop in value of one Bitcoin from over $140 to about $120. (Remember that when Bitcoin first started in January 2009, it was trading under one penny.) But, after a short respite, market turmoil started again.
See, for example, this note from Zerohedge from a turbulent night:
“Think the great BitCoin drama is over? After plunging by over 60% intraday, touching $100 from an all time high of $265 earlier, BitCoin was just getting started, posting a just as epic rebound to $200 in mere hours… before tumbling once more to $125… before rebounding again to $180… before sliding to $140… and so on.”
Or, to cite Joseph Weisenthal (@TheStalwart) on Twitter in the heat of a moment:
“Bitcoin is totally forked. (No, really, seeing prices of $90, $170, and $225 at different sites)”
Events like these fuel discussions about the nature of the currency, and I would like to draw your attention to some exciting new contributions.
Izabella Kaminska continued her higly readable BitcoinMania series on FT Alphaville. Her latest article on A Cybernetic Ledger starts with an observation by Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis. He said that money may qualify as unit of exchange, store-of-value or unit of account, but “at its heart it is nothing more than the technological equivalent of a collective memory function” (I. Kaminska). In analogy, Bitcoin, which is “made up of pure computer code”, may be regarded as a cybernetic ledger:
“A publicly available deal sheet – forged, monitored and policed by its users and propagators, and encrypted in such a way that encourages best practice amongst its community members, consistent with the principles of game theory.”
The system’s major flaw which has become apparent again during the recent turbulences is an inherent fundamental asymmetry between demand and supply. Peter Svensson of Associated Press writes:
“ … the supply of bitcoins increases only slowly, at a rate that’s coded into the system.
That’s a contrast to a regular paper currency like the dollar, whose supply is managed by a central bank like the Federal Reserve. The Fed engineers the dollar supply to increase slightly faster than the growth of the economy, which means that the value of the dollar falls slightly every year, in the phenomenon known as inflation.
New bitcoins are “mined” or generated by computers. They get harder to generate all the time, which means the inflow of fresh bitcoins keeps falling. There are about 8 million bitcoins in circulation today, and the maximum that can be generated is 21 million. By 2032, 99 percent of those will have been created.
Since the supply of bitcoins grows so slowly, any increase in demand leads to higher prices. That’s known as deflation, and it’s widely seen as a disaster when it happens to a real-world currency. As money becomes more valuable, our incentive is to hold onto the money instead of spending it — slowing down the economy.”
Deflation may not be a bad thing, as Jon Matonis argues in Forbes (more about this later). However, the current, more urgent problem is low market volume in an endless series of speculative waves which may be typical for a market in its infancy, but which in the absence of major players or market makers, or an intervening ‘Bitcoin Central Bank’ (Christopher Vecchio), causes large price swings and extreme volatility.
A lot has been written about how bitcoins are created and how the system works, which all seems very complicated. Matt Baxter-Reynolds has tested how it is done. In How to Buy and Sell Bitcoins he describes his experiences. The article comes in two parts. Part 1 is about some of the theory behind Bitcoin and Part 2 shows in detail how he actually bought and sold bitcoins, which to me appears a rather time-consuming and cumbersome process although the author concludes: “Once you get your head around it and set-up, working with Bitcoins is actually very easy.”
There are complaints that the system is not “idiot-proof”. But comparisons to other technologies indicate that procedures may become simpler and safer as soon as larger numbers of users get involved and incentives rise to work on easier solutions. One example is computers. To cite Timothy Lee in Forbes:
“The Bitcoin economy today looks a lot like the PC market circa 1978. Most people today look at Bitcoin and see an impractical curiosity. They’re happy with the banking services they’ve already got and can’t imagine why anyone would want to use an alternative currency”.
It is hard to imagine that in ten years from now the Bitcoin technology, or its successor, would look the same as today’s.
Imagination plays an important role in many respects. To some observers, Bitcoin is only a speculative hype that will end in tears. Others see beyond the excesses of this new experimental market and think of it as a longer-term alternative to a failed monetary regime with morally doubtful and incapable institutions.
Many observers think of Bitcoin as “anarcho money”. Anonymous and unregulated financial markets tend to attract criminals. Bitcoin is no exception to the rule.
The best known example is Silk Road, where, as Gary Bryan writes, you can buy, and pay with bitcoins,
“anything from LSD to a custom-made Australian electricity bill (in case you ever need to, you know, fake proof of residency in Australia). There are even listings for trained assassins (which goes against Silk Road’s policy, but still).”
Or, to cite Jeremy Liew:
“The biggest six hacking, theft and fraud incidents involving Bitcoin exchanges, wallets, or investment vehicles have resulted in a total 1.2 million coins being stolen. This means that more than 10% of all Bitcoin in circulation has been stolen, and this does not include many smaller thefts and losses from individual wallets. There has been a great deal of malware in the wild, targeting individual wallets held on computers, and even hijacking computers into botnets to “mine” Bitcoin on the behalf of hackers.”
Criminal activities, an increasing awareness that there is a fast-growing market circumventing banks and regulatory control, and the idea of a currency “that can’t be debased to political order” (John Naughton) did not escape the attention of governments and monetary auhorities. In my annotated list I already mentioned Jeffrey Sparshott’s article on the U.S. applying money-laundering rules to virtual currencies. There is another text by Evan Soltas of Bloomberg on the same subject titled Bitcoin Really Is an Existential Threat to the Modern Liberal State. He writes:
“The Financial Crimes Enforcement Network, the wing of the U.S. Treasury Department that investigates money laundering, said last month that it has the authority to regulate transactions involving both Bitcoin and U.S. dollars under the Bank Secrecy Act. These inter-currency exchanges appear to be the best foothold for regulation. Governments could require records of all purchases and sales of Bitcoin, for instance. But this approach has severe limits … (T)he usual mechanisms for detection and enforcement are very weak against Bitcoin.”
Some observers see the danger that Bitcoin exchanges are taken down by a patent lawsuit. On Twitter, Carta (@carta_) drew the attention to an article by Max Keiser who argues that
“as Bitcoin and the exchanges become more prevalent we’ll see Wall St. and the central banks challenge the exchanges on intellectual property grounds. They will argue the technology for trading in virtual securities with a virtual currency is a patented technology owned by Wall St. and that virtual market making is violating this patent (US pat. no. 5950176).“
Felix Salmon writes:
“… it’s far from clear that bitcoins are even legal. The FBI is on the record as saying that “it is a violation of federal law for individuals… to create private coin or currency systems to compete with the official coinage and currency of the United States”. And laws against operating an unlicensed money-transmitting business have been used against electronic currencies in the past, and would seem to apply equally to bitcoin.”
For all those who want to know more about Bitcoin’s legal status, Noam Cohen from the New York Times drew the attention to an academic paper by Reuben Grinberg on Bitcoin: An Innovative Alternative Digital Currency.
Kim-Mai Cutler of TechCrunch describes how Bitcoin is increasingly attracting venture firms. In Why I Take Bitcoin Seriously as a Venture Capitalist Jeremy Liew lists what, in his view, are the core attractions of Bitcoin:
Its value cannot be changed by the fiat of any single government or entity (unlike “fiat” currencies like the U.S. dollar controlled by the Federal Reserve Board)
It is nominally anonymous (or more accurately, pseudonymous) in that transactions are tied to wallets (essentially numbered accounts with passwords), not to people
It should be a “deflationary currency,” meaning that its buying power should theoretically always go up over time
Its transaction costs are zero (or close to zero)
Its transactions are irreversible (which is attractive to merchants)
Some of these advantages are real, others are part of the myths surrounding the cryptocurrency (as Jeremy Liew’s cautious formulations indicate, too). From what I have read so far, Bitcoin appears NOT, or at least not much longer, to be
– anonymous. There is widespread agreement that Bitcoin does not provide cash-like anonymity. As Jon Matonis argues,
“it is better described as user-defined anonymity because the decision to reveal identity and usage patterns resides solely with the bitcoin user. This is far superior to a situation where users of a currency are relegated to seeking permission for their financial privacy which is typically denied by the monetary and financial overlords.”
But, this may change. As Jeremy Liew writes:
“the “anonymity” of Bitcoin appears to be phantom as more research is done to tie Bitcoin wallets to individuals. This is anticipated to reduce the overall level of shady Bitcoin activity.”
See also Blogger Matthew Green about recent efforts and the resulting limits of privacy through pseudonymity offered by Bitcoin.
– Unregulated and uncontrollable. Timothy B. Lee gives an example (ignore the technicalities, the argument will become clear in a moment):
“A few weeks ago, a node that had upgraded to version 0.8 of the client software generated a block that nodes running version 0.7 and earlier didn’t recognize as valid. This produced a “fork” in the network, with each half generating blocks the other half viewed as illegitimate. …
A core part of Bitcoin’s appeal is that it’s not under anyone’s control. Supposedly, nobody has the authority to change the Bitcoin money supply, cancel or reverse transactions, or otherwise change the attributes of the protocol. But in practice that’s not really true. In the wake of last month’s fork, the elites in the Bitcoin community effectively changed the rules in a matter of hours. In principle, there’s no reason those same elites couldn’t make other changes to the Bitcoin protocol.”
– A market without institutional players, “completely outside the professional traders and hedgies of Wall St. and City of London” (Max Keiser). This is already changing. As Nikolay Gertchev of the Ludwig von Mises Institute writes:
“The growing investment demand … spurred the development of intermediary dealers in bitcoins. There are a number of exchanges where bitcoins can be bought and sold against currencies. Specialized online storage, presumably with increased security, has also been made available. Intermediation, though open to free entry, is likely to remain rather monopolistic, given the very low margins associated with transacting in and with bitcoins.”
In addition, there are newly-forming markets for leveraging and shorting. Tim Worstall of Forbes reports about a soon-to-launch New York-based “leveraged forex trading platform” for Bitcoin, called Coinsetter. New ventures and players emerge. Cyrus Farivar of Ars Technica gives the example of ICBIT, currently “in process of incorporating in an offshore jurisdiction”, where investors can engage in a futures market, effectively betting on the upcoming exchange rate from bitcoins to dollars. And he draws the attention to a firm called Exante:
“Exante is likely the most bona fide of these operations as it is an official, licensed, Malta-based brokerage company with a real office, real employees, and the power of European Union regulators behind it. Earlier this year, its “Bitcoin Fund” became the world’s first bitcoin-based hedge fund and is based in Bermuda, a notorious offshore tax haven.”
A crucial question is: Are bitcoins money?
Cullen Roche stresses:
“After all, anyone can create money, but the trouble is in getting others to accept it. And since money’s primary purpose is in the means of exchange, just about anything can serve as money as long as it meets that primary purpose. The thing is, there aren’t all that many things that meet that need on a broad level. For instance, lots of people like to claim that gold is money (which it is), but gold isn’t accepted for payment in many places. Therefore, … gold has a low level of moneyness … Gold is money, but it’s just not a very good kind of money. Bitcoin is actually very similar. If you have Bitcoins you can buy certain things online that only a Bitcoin merchant will allow you to buy. These merchants accept Bitcoins as a form of final payment. To them, it’s a form of money with a very high level of moneyness. But to a company like Wal-Mart a Bitcoin is like a gold bar. It doesn’t give you access to anything in their store therefore its moneyness is virtually nil in a Wal-Mart. Most retailers around the world view Bitcoins similarly.”
Timothy B. Lee writes in Forbes:
“What gives money its value? One popular theory says that modern fiat currencies get their value by “government fiat”: the government declares a currency to be the official one, requires that currency be used to compute and pay taxes, and thereby confers value on what would otherwise be worthless slips of paper. Bitcoin is a clear challenge to that view. It has no “backing” from any government or other large institution, yet the stock of outstanding bitcoins is now worth more than $1 billion.”
Izabella Kaminska uses the term fiat above all
“to differentiate a faith-based non-collateral-backed currency system from a collateral-backed currency system. Bitcoin … is described as the “fiat of all fiats” due to its decentralised fiat nature and because its value lies in the mutual interests of its users rather than a collateral pool. It is, in that sense, a fiat that supersedes all other fiats, because it depends on an algorithmic self-dictated “law” for authority.”
But, she further argues:
“With Bitcoin … it’s the fact that the system cannot be mistaken for a credit system that classifies it as some form of fiat. There is, after all, no known reputable entity backing or guaranteeing any of the financial claims issued in its name. On the contrary, there is only a system of code. A memory. An arbitrary and faceless entity which glues the whole thing together.
Unlike government fiat, Bitcoin’s value doesn’t even represent a share in the collective equity of a nation.”
Lord Keynes has a similar argument:
“Bitcoins were obviously created to be “decentralized digital currency,” a type of money to be used as a medium of exchange and store of value. That is how the Bitcoin software was “advertised,” if you like. But a Bitcoin is not tied to some real commodity like gold at a fixed conversion rate. One wonders why any libertarian would get excited about it (as it turns out, most do not!).
A Bitcoin is backed by no commodity whatsoever: just like a stock or share, whose value is subjective and whose price is just determined by supply and demand on a stock market. The value of Bitcoins in goods or other currencies might crash tomorrow (and so might gold, but at least we have industrial uses for gold and uses in jewellery, etc.).”
Izabella Kaminska compares Bitcoin with other parallel currencies or free-banking initiatives stating that
“Bitcoin’s defining feature lies in the fact that it is redeemable against nothing. It is, as they say, completely uncollateralised.”
Lack of redeemability and backing by a real commodity is one of the key arguments brought forward against Bitcoin referring to the arbitrariness of the money creation process. But, as Paul Ford argues in Business Week: “Bitcoin is no more arbitrary than derivatives or credit default swaps”.
Actually, bitcoin is no more arbitrary than any other currency. Money is a convention based on trust – in its value, in the sincereness of its creator, the soundness of intermediaries, the authority of rulers, the existence of a lender of last resort, the safety of deposit accounts or whatever.
To counter a common argument with an extreme example: If people, who are both currency users and voters, stop accepting the US dollar or the euro whenever possible, policymakers in need to win elections may soon decide to include acceptance of tax payments in bitcoins in their election programmes.
In what do holders of Bitcoin trust? Given the risks involved in this new experimental currency there is certainly a greater preparedness to lose money than in other monetary regimes. But this does not mean that users are willing to throw their money away for sentimental reasons. Kim-Mai Cutler reports that
“Jered Kenna, who just re-launched TradeHill, a Bitcoin exchange targeted at accredited investors and high-net worth individuals … says he’s had investors open accounts and individually send in more than $1 million to buy Bitcoin.”
Probably, these are not all nerds and dreamers. Bitcoin investors can be assumed to trust in the basic functioning of the system and, like any investor in any currency or other financial instrument, in their ability to cope with the risks. In the case of Bitcoin, this may be called overoptimistic or naïve, but users’ willingness to hold bitcoins, and engage in transactions using them, makes bitcoins money.
People in Europe just learn anew what a currency representing “a share in the collective equity of a nation” is worth if the latter is deleted by a stroke of the pen. People in other parts of the world have made this experience, too. As Kim-Mai Cutler notes:
“Some Bitcoin founders are driven less by ideological passion and more by personal experience — especially if they grew up in countries with unstable currencies. They are keenly aware of how fragile faith in a government’s ability to repay its debts can be.”
In my view, what matters – in analogy to national currencies which are valued by their purchasing power – is the range or basket of goods and services bitcoins can buy, and of economic activity they may serve to finance. 50 years after the Euromarkets rang in the era of financial globalisation, Bitcoin became the first truly global monetary phenomenon not tied to a national or regional jurisdiction. And just as the value of the Eurodollar, and later of other Eurocurrencies, was determined by developments in and outside national territories, bitcoins must be valued accordingly. Noam Cohen from the New York Times mentions a similar idea:
“Some observers and investors also make the case that bitcoins are in fact undervalued. Their argument goes like this. The total value of the world’s economic activity is enormous. There are certain transactions that are ideal for bitcoins because the currency is relatively anonymous and does not need to be processed by a financial organization or a government.
If bitcoins become the dominant currency in some small niche of the world economy — that is, those people who do not want their transactions easily tracked or who want to send money back home from abroad — then they will become quite valuable indeed.”
Eventually, the range of bitcoin uses determines its value.
The second key argument against Bitcoin already mentioned is limited supply.
The Unconventionial Economist describes how the algorithm behind Bitcoin is restricting currency supply. Starting from 2009 the number of Bitcoins generated every 10 minutes was roughly 50. Every 210,000 generations (approximately 4 years) the creation rate drops in half (50, 25, 12.5, etc), until the said limit of 21 million bitcoins is reached.
According to some commentators, the consequences may be devastating. To cite Felix Salmon once again:
“The biggest problem with bitcoins … is conceptual: if they succeed, they fail.
If millions of people started using bitcoins on a regular basis, the soaring value of bitcoins would actually be disastrous. You’ve heard of hyperinflation: this would be hyperdeflation. Take a gold bar valued at $600,000. At $60 per bitcoin, the value of that bar is 10,000 BTC. But then assume that bitcoins rise in value to $600 apiece, and then to $6,000, and then to $60,000 — as would have to happen if the fixed number of bitcoins was being used to store hundreds of billions of dollars in value. Then the value of the gold bar would plunge, in bitcoin terms — to 1,000 BTC and then 100 BTC and finally just 10 BTC. The same thing would happen to all other goods and services in the world, including your own salary. Everything would be constantly going down in price, if you thought in bitcoin terms.
Inflation is bad, but deflation is worse. The reason is that in a deflationary environment, no one spends money — because whatever you want to buy is sure to become cheaper in a few days or weeks. People hoard their cash, and spend it only begrudgingly, on absolute necessities. And they certainly don’t spend it on hiring people — no matter how productive their employees might be, they’d still be better off just holding on to that money and not paying anybody anything.
The result is an economy which would simply grind to a halt, with massive unemployment and almost no economic activity. In a word, it would be a Depression. In order to have economic growth, you need monetary growth as well — and that’s something which is impossible to achieve in a bitcoin-based system. Currencies such as the dollar, with a central bank which can print money at will, have succeeded for a reason. As economies grow, the money supply has to be able to grow with them. And that’s why bitcoin can never really succeed over the long term.”
“Deflation is actually a good thing, because in a deflation prices drop and money becomes more valuable, so deflation encourages people to save money. Deflation rewards the prudent saver and punishes the profligate borrower. The way a society, like an individual, becomes wealthy is by producing more than it consumes. In other words, by saving, not borrowing. And during a deflation, when money becomes more valuable, everybody wants money. They want to save. Whereas during an inflation, you want to get rid of the money. You want to consume. You want to spend. But you don’t become wealthy by spending and consuming; you become wealthy by producing and saving.”
As so often in economics, the expected outcome depends on the assumptions made. In a highly developed, saturated economy, for instance, sinking prices may well result in higher savings as described. In an economy in an earlier stage of development, in deep recession or enduring austerity, however, the propensity to spend may not decline to the same extent as prices. Similar arguments hold for the answer to the question whether investment will rise or fall under a Bitcoin regime.
Another question is whether bitcoin supply is indeed limited.
On closer inspection, the 21 million may turn out to be one of the myths Bitcoin proponents nourish. In his article on Bitcoin’s Collusion Problem Timothy B Lee argues that the promise that the number of Bitcoins issued will never exceed 21 million is not credible. To follow his argument would require delving deeply into the process of bitcoin creation. But the following excerpt may give you an idea and provide an incentive to read the whole article:
“(T)he question is whether it would be possible for a critical mass of nodes [of the network running Bitcoin] to collude to change the rules. And I think the obvious answer to this question is yes, for two reasons. First, the Bitcoin software itself offers a convenient collusion mechanism. If the Bitcoin protocol is anything like other network protocols, a handful of clients is likely to account for the overwhelming majority of nodes at any given time. That means that convincing the creators of the top two or three Bitcoin clients to change their implementations would be enough to effectively change the protocol.
Second, collusion will grow easier as the network grows and becomes more professionalized. Bitcoin supporters are quick to point out that their system wouldn’t require ordinary consumers to run their own Bitcoin nodes. They predict that as the network grew and the resources required to run a node increased, that nodes would increasingly be run by commercialized entities who made money by providing “eWallet” services to ordinary Bitcoin users.
We might call organizations that are in the business of running Bitcoin nodes and processing Bitcoin transactions “banks.” And we could imagine these banks forming a membership organization whose primary function is to control the size of the Bitcoin money supply. It would announce changes to the Bitcoin protocol that expand the supply of Bitcoins at the desired rate. Member banks would agree to change their software accordingly. We could call this entity a “central bank.””
The history of money and finance shows that there is always a loophole to overcome obstacles and circumvent restrictions, and Bitcoin may be no exception.
Furthermore, change may also come from outside. As Prof. Steve Hanke (@steve_hanke) wrote on Twitter:
“#Bitcoin is vulnerable 2 currency competition (like all others). Just bc Nakamoto came up w/ a great algorithm doesnt mean someone else cant”
There are already alternatives. As the Economist writes: “Bitcoin is not the only digital currency, nor the only successful one.” There are variants which to some observers already appear more attractive. Felix Salmon’s article about The Promise of Ripple is one example
Eventually, Bitcoin’s fate will be decided by how it fares in this competition. coɴsτ∀ɴτιɴε (@kkoolook) is right remarking on Twitter amid the highest turmoil:
“The real value of #Bitcoin is not its price but its technology.”