http://seekingalpha.com/article/1325271-bitcoin-buyer-beware-this-is-a-classic-bubble-and-possible-fraudHas anyone ever bothered to understand what a "bitcoin" is before buying into this concept? It has every marking of a fraud. Believe it or not, people don't even know who created the bitcoin, or who is behind it. The whole concept was created by a pseudonymous person or group named Satoshi Nakamoto. And it only gets worse from there.
History:
What is a "bitcoin"? A "bitcoin" is a "virtual currency" that people can use for transactions over the internet, and soon even ATMs. The inspiration seems to be the same thing driving gold higher; a complete distrust of Central Banks and the Fractional Reserve System. The bitcoin is a peer-to-peer transaction system that requires no bank and has no central authority. No, I did not just mistype that, there is no central authority for this monetary system, and it is over a $1 billion monetary system, all done by a "collective network."
It uses peer-to-peer technology with no central authority, in which "managing transactions and issuing bitcoins are carried out collectively by the network."
The whole theory behind the bitcoin is that inflation is bad, governments are bad, so they have designed a non-inflationary monetary system with no government involvement, essentially an effort to create a virtual quasi gold standard.
Each 10-minute portion or "block" of the transaction log has an assigned money supply. The amount per block depends on how long the network has been running. Currently, 25 bitcoins are generated with every 10-minute block. This will be halved to 12.5 BTC during the year 2017 and halved continuously every 4 years after until a hard limit of 21 million bitcoins is reached during the year 2140.
A Virtual Gold Standard It's Not:
Why anyone would want to return to a gold standard is beyond me, but the people buying into the bitcoin are likely going to find out the hard way why it has been abandoned across the globe. A gold standard is an "inelastic" currency, meaning that it doesn't expand and contract with the economy. Under a true gold standard, miners will dig up gold, take it to a mint and have the gold turned into coins. The money supply of a nation grows at the rate of new gold discoveries. If gold is discovered at a rate slower than the growth of the economy, the economy experiences deflation. If gold is discovered at a rate faster than the growth rate of the economy, the economy experiences inflation. Basically under a gold standard the tail wags the dog. The economy adjusts to the money supply, not vice versa like the "elastic" currency system we have today. It is no coincidence that the most vicious business cycles this country has ever had occurred under a gold standard. The gold standard dog doesn't only wag its tail, it bites.
The bitcoin however isn't a gold standard, in fact it isn't even close. Under a gold standard, gold in minted into a coin with a value printed on it. A $50 gold coin is worth $50. The price of gold is fixed by a central authority. That is why Article 1 Section 8 of the US Constitution grants the power to "coin money and regulate the value thereof" to the US Congress. There is no fixed value to a bitcoin, there is no $1 equivalent of a bitcoin. A bitcoin is like virtual gold, not a virtual gold standard. The value of a bitcoin varies widely from day to day and is based upon the greater fool theory, nothing more. Supporters of the bitcoin no doubt criticize the Fed for printing money "out of thin air," but the bitcoin does the same thing, only they don't even bother to print the money, it is backed by the full faith and credit of a shadowy group of collective computers and consists of electrons.
The Bitcoin Isn't a Currency:
As I stated above, the bitcoin is like virtual gold, a commodity, not a currency. It is more like a virtual ounce of gold, only made out of highly elastic electrons, not highly inelastic gold. Currencies typically have 4 characteristics. The bitcoin is challenged on 3 of the 4.
1) Unit of Value: Technically yes, but practically no. Menus would need to be changed hourly. The deflationary bitcoin is like the Weimar Republic in reverse. The first data I can find on the bitcoin had it trading at $0.05 on 07/17/2010.
2) Medium of Exchange: Yes, you can transact in bitcoins.
3) Standard of Deferred Payment: Theoretically yes, but practically no. I'll explain later.
4) Store of Value: Theoretically yes, but practically no. I'll explain later.
The reason a bitcoin isn't a viable currency is because of its volatility. A currency needs to be stable. The bitcoin has increased 360% over the last month. It recently has traded as high as $147, and just 2 years ago it traded under $1. The chart and data set linked above has it trading at $0.05 in late 2010.
Two years ago, one bitcoin was worth less than $1. Two months ago, the price for one unit surged above $20 on a proliferation of cyber-exchanges from Tokyo to Moscow. A sudden burst of new interest sent its value soaring to a record $147 on Wednesday.
Because contracts are tied to currency stability, not astronomical investment returns, are required for a currency. Supporters of gold and bitcoins as currency seem unwilling to accept this concept, or understand its consequences. Currencies aren't investments, they are mediums of exchange. Currencies are used to make investments, and pay off debts, they aren't intended to be them. Imagine signing a $200,000 30 year mortgage when a bitcoin was under $1, promising to pay back 200,000 bitcoins. Today you would owe the bank around $28 million. The risks of signing a contract based on a bitcoin and settled in US dollars are astronomical. Something that increases 360% in a month isn't a "store of value," it is a highly speculative investment. Imagine an employer signing a labor contract in bitcoins two years ago. The exponential increase in their labor costs would surely have driven them into bankruptcy by now. Debts written in bitcoins would have seen their monthly interest payments make the ARMs of the mortgage crisis look laughable.
Cracks in the Facade:
I'm about as much a small-government conservative as they come, but like the military, legal system and public services, there are legitimate roles for the government, and managing the monetary system is one of them. We may have a flawed system, but it is better than all the rest. With the bitcoin trading above $140, the inevitable was sure to happen. Hackers hit this "collective network" sending the bitcoin plunging 20% from over $140 to $115 in less than a night. Imagine going to bed and waking up to find that your savings account which holds your life savings down 20%. It has since settled back above $140 in some locations, but that is little comfort to those who sold out at $115. Love it or not, the US dollar has never shown that kind of volatility. Imagine trying to manage a budget with those kinds of currency swings. The spreads also seem to be extremely wide between servers or "nodes." Current data has a bitcoin trading at $149.93 in Columbus Ohio, and $139.96 76 miles away in Mason Ohio.
What's Wrong With That?
The bitcoin went from under $1 to over $140 and I have a problem with that? Yep. If you bought a bitcoin over 2 years ago when it was under $1, and held it to today you made a great investment, no doubt about it, but the bitcoin is supposed to be a virtual currency, not an investment. If you buy a bitcoin today you pay $140 or more. How much is a bitcoin worth then? About $140. How much can you buy with it? About $140 worth of goods and services. What will the bitcoin ATM dispense for 1 bitcoin? About $140. What will that bitcoin be worth in the future? No one knows, and that is why a bitcoin is a speculative investment, not a virtual currency. Sure it is great to be the one that bought in at $0.05, and held to $140, but people today are paying $140 for something someone recently only paid $0.05 for. Why? So they can avoid using a US dollar. My $1 bill bought the same McDonald's (MCD) sausage biscuit 4 years ago as it does today. In late 2010 it would have taken 20 bitcoins to buy that sausage biscuit, today a bitcoin will buy 140 biscuits. Does that even remotely make sense? People will only stick with the bitcoin as long as it keeps going higher. The bitcoin is like a repeat of the great tulip bubble, and once it pops, no one will stick with the bitcoin, why would they? What real value does it offer? Once it starts falling, the whole foundation on which it is based collapses. If bitcoin owners don't run for the US dollar, they will likely run to gold or bitcoin 2.0. Nothing prevents someone from creating a competing currency and offering it at $0.05 instead of $140. Move along, move along, nothing to see here, pay no attention to the fact that the $0.05 bitcoin 2.0 will buy $0.05 worth of goods and services, and the $140 bitcoin 1.0 will buy $140 worth of goods and services, and everything keeps coming back to the bitcoin being a US dollar based derivative currency.
The 800lb Gorilla:
Reading about this bitcoin, I noticed that no reporters were asking the most important question, who gets the money for the newly issued bitcoins? There are 25 bitcoins generated every 10 minutes, or about $35,000 currently. In the articles I read, no one bothered ask who gets that money. Under our current monetary system, there is zero personal incentive for Ben Bernanke to print money, zip. Ben prints the money and gives it to some bond holder; the bond holder gets US dollars for their bond, the bond then gets deposited at the Fed. No one personally benefits from the newly printed money. Ben didn't print the money and run off and build a mansion, he simply transformed an illiquid asset into a liquid asset, that is it. The bond was purchased in the open market at market rates. The interest from the bond gets returned to Congress. Ben has absolutely no financial incentive whatsoever to print money. His incentive is keeping his job by following the monetary guidelines defined in the Fed's charter (for more info read about the Fed's duel mandate of low inflation and full employment.) Under the bitcoin system, there is a huge incentive to cheat and print money, and when those bitcoins are printed, we have no idea where the money goes, and that isn't a joke. It could be some guy paying for his mansion in the Canary Islands, or Kim Jung Um funding a new missile program for all we know.
The way bitcoin explains the system in their Wiki is similar to the way the gold standard was implemented back in the 1800s, they even use similar language. Sorry about the linking to a Wiki, but because of the secrecy of this bitcoin, there aren't a lot of credible sources. This Wiki however is linked on the front page of the bitcoin website as a source for more information. I take that as a sign of confidence/endorsement from whoever is behind bitcoin.
Bitcoins are awarded to Bitcoin nodes known as "miners" for the solution to a difficult proof-of-work problem which confirms transactions and prevents double-spending. This incentive, as the Nakamoto white paper describes it, encourages "nodes to support the network, and provides a way to initially distribute coins into circulation, since no central authority issues them."
Note how they use the term "incentive" to print bitcoins. Two years ago, the incentive was under $1 to create a bitcoin, now it is over $140. That is an incentive to print money out of thin air if I've ever seen one (more on this topic below). Also the miner analogy is way off. Miners in 1849 had to work long hard hours to discover an ounce of gold and have it minted into coins. Gold is called a precious metal for a reason; it is of very limited supply. There is no shortage of electrons and pushing a button on a keyboard doesn't count as hard work. As the hackers recently proved, all it takes is a push of a button and the bitcoins evaporate. This literally could be the ultimate Ponzi scheme, only this time Ponzi is hidden behind a collective network of computers. Gold can work as a currency because it is inelastic. You simply can't print gold out of thin air. That is not true for a bitcoin. A hacker can "print" as many bitcoins as there are electrons in a blink of an eye.
Major Warning Sign:
The bitcoin website proudly publishes the research paper done to support the bitcoin. They use persuasive language to get the reader to distrust the current system, and to "trust" the bitcoin because of its superiority in offering "non-reversible" transactions. Non-reversible is a good thing? Are you kidding me? They convince the buyer to "trust" a system of "non-reversible" transactions. I just had to return two defective Xoom Tablets, how is irreversible a good thing in commerce? That is the perfect system to sucker people in, then dump a supply of new bitcoins on the market and quickly shut the whole system down and vanish before anyone can say Bernie Madoff three times. The following quotes are from the "research" report linked above.
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes.
Mediating disputes is a bad thing? Irreversible transactions make fraud easier, not more difficult. If I'm trying to defraud someone, I want the money transaction irreversible so the person I suckered can't get it back. Notice the crafty way it breeds distrust in the current banking system, and leads the reader to "trust" the bitcoin. What is the message? Those evil third parties that ensure delivery, returns and exchanges are not to be trusted. Does that even remotely make sense?
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud
Things only get worse. The part of the research paper discussing the "minting" process makes absolutely no sense to me whatsoever if applied to today's monetary system. The problem identified and addressed is a problem unique to digital currency, but they work in an attack on the "central authority" and "bank" making it confusing to the reader. The key point however is that they acknowledge the fact that who's guarding the hen house is critical to this system. One wolf and the system is chaos.
A common solution is to introduce a trusted central authority, or mint, that checks every transaction for double spending. After each transaction, the coin must be returned to the mint to issue a new coin, and only coins issued directly from the mint are trusted not to be double-spent. The problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank.
Follow the Money:
In my opinion, the bitcoin is all about making money for some unknown individuals. In the following quote from the "research" paper, they don't even try to hide it. Printing money out of thin air and lining their pocket is called an "incentive." As discussed above and demonstrated in the quote below, the analogy to a "miner" is totally misleading. The deceptive language like "stay honest," "inflation free," "greedy attacker" implies that this is an honest system and the other system is corrupt. Most damning in the below quote is the admission of how easy it is to defraud this system. It is a classic "bird in the hand is worth two in the bush" conundrum. The person running the computer can rob everyone blind all at once and disappear to a Caribbean Island under an alias, or he/she can stick around and milk this system for its 'incentives." Human nature is human nature, sooner or later I would expect someone will take the bird in the hand and run for Mexico. Even if the founders are pure at heart, it doesn't mean everyone they invite into their "community" will be so honest; in fact I would expect its success to attract thieves.
Incentive
By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them. The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended. The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction. Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free. The incentive may help encourage nodes to stay honest. If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back his payments, or using it to generate new coins. He ought to find it more profitable to play by the rules, such rules that favour him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.
In conclusion, the bitcoin has all the markings of a bubble and fraud or at least potential fraud. The lack of transparency, the unknown wizard behind the curtain, the deceptive and politically loaded language used to build trust, the extensive effort to convince the public of its validity and trustworthiness and most of all it plays on people's rational or irrational fear of the banking system. People however seem willing to overlook these risks.
I've been involved with politics and am intimately aware of the political spectrum, and the marketing of this bitcoin uses all the right buzzwords to appeal to both the right and the left. On the right I like to say there are those with a healthy skepticism of government and those with a destructive paranoia of government. The bitcoin is red meat to the destructive paranoia wing. It attacks banks, central authority, inflation, claims to provide a solution to "printing money out of thin air," and would effectively "End the Fed." Ron Paul's revolution can claim victory. To the left it offers the "collective" nature of a community, touchy feely descriptions like "trust" and anti-capitalism terms like "greedy." What isn't to like about the bitcoin, it offers everything to everyone, regardless of political ideology?
Well, if something sounds too good to be true, it likely is. Facts are this is a house built on electronic cards, and the "research" paper is so "trustworthy" it doesn't even try to hide the inherent weakness and catastrophic flaw of the system. Even if the founders are pure at heart, that doesn't mean future members of the secret community will have such altruistic intentions. One only needs to read about the success of the 1960's communes or 1609 Jamestown to see where this is headed.
"Even a man who is pure at heart, and says his prayers by night, may become a wolf when the wolfbane blooms and the autumn moon is bright." The Wolfman 1941
In my opinion the people buying into the bitcoin are going to find out the hard way that our monetary system may have its flaws, but it is infinitely superior to the alternatives. When I lived in Hawaii, a craze called "POGs" was sweeping across the islands. A POG was literally the paper inside of a milk cap, but decorated POGs could go for $15 or more. Visiting a flea market and seeing all the venders of POGs inspired me to try to figure out a way to "sell-short" POGs. I remember thinking "in a few years, the buyers of these $15 POGs are going to be asking themselves 'what was I thinking, who in their right mind would pay $15 for a paper inside of a milk cap?'" I have a hunch buyers of bitcoins will be asking themselves the same question in a few years…or maybe sooner.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Electrons you say, money made out of electrons? Sorcery!
Classic piece of FUD, seems like every random idiot is allowed to post on SeekingAlpha nowadays.
