http://ftalphaville.ft.com/2013/04/03/1446692/when-memory-becomes-money-the-story-of-bitcoin-so-far/I was wrong, It seems we haven't moved on; the last FT article must have created a tsunami of WTF so they are back with
another what is bitcoin post.
Okay…
Requests have been made, so here is a quick “story so far” on Bitcoin. Consider this a perfect dinner party cheat.
First off, Bitcoin is best described as a virtual crypto/digital parallel currency that is completely decentralised and unregulated (for now) by the current powers that be. It is understood to be the brainchild of one Satoshi Nakamoto, whose identity is alleged to be an alias in its own right. Many people believe the paper behind the Bitcoin system to be some anarchic manifesto purposefully designed to disrupt and destabilise the current economic status quo.
The ferocious and vocal advocates of Bitcoin — who tend towards the Austrian Liberatrian side of the political spectrum — pitch the system as a viable alternative to the current monetary system due to its free-market roots and general freedom from government intervention. No potential for Bernanke debasement here. Unlike other independent non-government based fiat systems, which have historically proved fragile and volatile, as well as vulnerable to collapse time and time again due to lack of intervention, Bitcoin advocates claim that the genius of their system lies in its self-regulatory mechanism.
So how does Bitcoin self-regulate?
Unless you are a computer geek, an MIT grad or an algorithmic genius, it’s unlikely you will ever really understand. Generally speaking, however, it’s fair to say that the regulatory system is related to the two ways you can acquire Bitcoins.
The first way is to create or “mine” Bitcoins for yourself, but the downside here is that it takes a lot of computer power (and know-how) to do this effectively*. The amount of CPU dedicated to Bitcoin creation is in a sense directly proportional to the number of Bitcoins in circulation. The more Bitcoins exist, the greater the CPU power needed to mine new coins — meaning there is only an incentive to mine new coins if and when the Bitcoin price is high enough to cover your computer costs.
There is theoretically also a possibility to hack, replicate or steal existing independent Bitcoin warehouses. However, there is a bit of game theory involved in the programme which encourages everyone to play the rules. The game theory works on the basis that if a major hacking did take place, this would only knock confidence in the system, crashing the price of all units, including the stolen ones, rendering the efforts to steal them pointless in the first place. All in all, there should always a greater incentive to mine new coins and play by the rules — especially, if you have the tech know-how to hack stuff in the first place — than to steal existing units.
That’s not to say hackings have never happened. The last time Bitcoin prices went bubbly in 2011, prices crashed rather dramatically as soon as it transpired there was a lot more coin in circulation than there should be due to one of the main internet depositories being hacked.
The other way to acquire Bitcoins, of course, is to buy existing units in the secondary market. The process is very similar to any over-the-counter market, and in many ways entirely identical to how FX itself trades. The market is open, and features many competing platforms. You can buy them to invest, or you can buy them for transaction purposes. At the end of the day, you put your trust in the platform which holds your digital record of account. Much like anyone does when they transact with an FX platform, or any other third-party payment provider like Paypal.
If the provider of the digital warehouse collapses, is hacked, or simply operates insecure networks, you stand to lose the wealth you have digitally stored there just like at any other private institution — which believe it or not, are also hacked all the time.
The store-of-value therefore lies in the account, and the fact that a trusted third party can corroborate your ownership of that particular account.
Bitcoin thus represents in many ways the ultimate fiat of all fiat currencies, since the system is entirely trust-based. What’s more, if the system collapses or fails to create enough coins to prevent deflation, or fails to regulate supply causing inflation — there is no third party obligated to intervene to hold up the currency’s value.
If you believe a currency’s value lies in its stability, Bitcoin represents the polar opposite of that sort of system.
It’s worth mentioning that the use of Bitcoin was first popularised in the murky underground universe of Silk Road – an online marketplace for illicit goods and services — where identity protection and non-traceability were key. Because Bitcoins are totally independent and not regulated by monitored authorities, it proved the perfect monetary instrument for an anonymous community which had a mutual interest in maintaining anonymity as well as an alternative underground store of value.
The Bitcoin flaw
In that sense Bitcoins can be described as the black-market dollars of the communist era.
But remember, whilst these “eurodollars” proved a bit of a headache for US monetary authorities (that’s the reason why you have to declare how many dollars you are bringing in from abroad every time you enter the US), they didn’t really compromise the existing system, because the central bank was always able to adjust and regulate supply to meet its intended target.
In that sense it’s the target — in terms of the supply relationship to demand — that matters, and nothing else. If central banks work it’s because they allow for a fluid and responsive adjustment of supply. In that sense they create stability out of elasticity.
Bitcoin, on the other hand, lacks this regulatory shock absorber effect. Its supply is inelastic and volatile, even if it’s marketed as adjustable. Today’s frothy price speaks volumes for the obvious flaw in within its supply structure. It’s responsive, but not responsive enough.
Bitcoin advocates, of course, say that doesn’t matter, because at the end of the day the system represents a liberated “real” currency. While that may be true, they fail to appreciate that currency is not just about value, but about providing society with a stable wealth allocation system. Value itself lies in the eye of the collective beholder.
Of course, if it’s instability, volatility and speculation you’re after, Bitcoin is definitely the currency for you.
But remember the volatility associated with Bitcoin stems from its inherent inflexible supply problem (the same problem, which happens to be associated with gold). A supply system which adjusts fluidly and dynamically, on the other hand, will always allow for better stability, a better store of value and fairer allocation all round.
That said, it’s understandable why the darker elements in society might feel threatened by an economic system that’s trending towards a more equitable distribution of wealth by means of government-controlled fiat system. The threat is heightened further when governments are doing their best to counter the hoarding of wealth in concentrated pockets by means of “dilution” through processes such as quantitative easing.
These processes, after all, act as shock absorbers that dampen what would otherwise be inelastic monetary adjustment periods. Indeed, the greater the inflexibility, the greater the economic suffering.
Removing the inflexibility factor, however, inhibits market speculation, because speculators depend on inelastic environments to breed volatility and uncertainty from which they can profit.
So what does a market speculator do in a world that’s being de facto nationalised, and de-volatilised, by the ultimate financial shock absorber of all time, the Bernanke put?
How about creating or talking up an alternative inelastic system which no Bernanke can ever touch or stabilise?
The ultimate irony of Bitcoin (from a fiat-sceptic advocate point of view at least) is that when its supply eventually runs out — and there is allegedly a natural choke point at 21m units — the only course for Bitcoin wealth is either towards maximum wealth concentration –so a hugely deflationary “them and us” contractionary effect — or, alternatively, towards fractional reserve lending in the manner we are used to today.
Bitcoins being a “free market”, one would imagine this lending could not be prevented if the demand was there. All of which has the potential to create a credit system on top of a fiat system, which has no chance of ever being able to regulate itself (at least not without external or state intervention).
Hence why probably the best idea is for existing central banks to just start issuing digital currency directly instead.
Some remaining fast facts about Bitcoin:
The ECB has looked into the “threat” from Bitcoin and concluded: “It is mostly the holders of the currency that face risks, including the risk of a complete loss of the monetary value. At present, in Europe no wider risks exist, such as to financial stability or price stability, but this would change if a scheme would become significantly large. “
There is an easy way to short Bitcoins if you so wish.
There are hedge funds dedicated to trading Bitcoin.
Market speculation is rife.
David Birch thinks the system is very simlar to the stone currency that was found in the island of Yap.
Money is memory anyway, or as Narayana Kocherlakota wrote in Kocherlakota “Money is technologically equivalent to a primitive version of memory.
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*Update 2030 BST : Re. Bitcoin mining. Someone who is obviously much more informed on the programming side just got in touch to point out a misunderstanding in the piece regarding the actual mining mechanics (which doesn’t detract from the overall financial points being made).
From Stefan Loesch of Oditorium:
…if bitcoin mining becomes unprofitable because the bitcoin price goes down then the marginal miners will drop out. This means less aggregate computing power in the mining pool, and this means that it takes longer than than the 10-minute average target to create a mining fee worth of bitcoins. At the next rebalancing, the ‘difficulty’ is reduced, meaning that in average it will take less tries to mine a block, meaning that the cost goes down.In fact, (the amount of CPU dedicated to Bitcoin being proportional to Bitcoin supply as claimed) would be a desirable property of the system, because the aggregate operating cost of the mining pool is what protects the bitcoin system from an attack (it becomes vulnerable if someone controls >50% of mining resources). However, unfortunately this is not the case in the actual implementation, and this is a well known vulnerability of the system. Once the mining profits will drop significantly (in about 5-10 years) there will be less miners protecting the system, and it will be more vulnerable to attacks.
