This article appeared in the June 5-7, 2013 issue of Informilo. Read full magazine here.
Bitcoin, an open source peer-to-peer (P2P) digital currency based on a protocol and software that allows instant peer-to-peer transactions and worldwide payments with minimal associated costs, has recently had unprecedented media coverage, thanks to the digital currency’s rollercoaster markets rides of epic spikes followed by equally epic plunges.
This monetary instrument – the topic of a session at Le Web London 2013- merits our attention (?): one Bitcoin cost merely $20 in the beginning of this year but the currency has quickly risen from relative obscurity amongst a group of cryptographers to enjoying nearly $45 million of activity everyday.
The philosophy of Bitcoin is one of complete mistrust in any form of authority or control, of a perfectly stateless, decentralized currency where issuing and control has altogether devolved to the “market” in its purest sense, with no central bank intervention possible. It has laid bare and tried to rectify the failings of traditional flat currencies, including gold and silver.
Bitcoins are generated through a process known as “mining” . Mining involves adding transaction records to Bitcoin’s public ledger of past transactions. This ledger of past transactions is called the block chain, and as the name indicates, it is a chain of blocks. The block chain serves to confirm transactions to the rest of the network as having taken place. Bitcoin nodes use the block chain to distinguish legitimate Bitcoin transactions from attempts to respend coins that have already been spent elsewhere. Mining is intentionally designed to be resource-intensive and difficult so that the number of blocks found each day by miners remains steady. It is not dependent on hardware improvement. Litecoin, a next generation Bitcoin, has already solved this problem by using scrypt in its mining process to compensate for improving hardware by slowing down the process. In any case, individual blocks must contain a proof of work to be considered valid. This proof of work is verified by other Bitcoin nodes each time they receive a block.
Basically, in order to “mine” a Bitcoin, you have to solve a complex mathematical problem using significant computational power. There’s a two fold reason for this: it controls supply of Bitcoins and also incentivises people to maintain the underlying infrastructure that keeps Bitcoins in place.
A unique feature of Bitcoin design is that the number of new Bitcoins created is halved every four years, until the year 2140 when this number will wind down to zero. At that time no more Bitcoins will be added into circulation and the total number of Bitcoins will have reached a maximum of 21 million. This finite supply of Bitcoins is, in my opinion, one of its biggest shortcomings. It significantly impacts the value of Bitcoins, as money supply needs to always be expanding in order to prevent a currency from having a deflationary bias, which encourages hoarding and as economist John Quiggin argues, in Bitcoin’s case, has resulted in “the finest example of a pure bubble.” The fact that Bitcoins do not have any intrinsic value (unlike gold, silver or other instruments), means their value depends on the classic demand and supply economics, leading many to exasperatedly liken it to a Ponzi scheme.
Another interesting feature is that Bitcoins are a unique code, which once stolen cannot ever be brought back and there is no central agency to chase after thieves—the owners are solely responsible to their Bitcoins. But one would expect an entirely digital currency to be secure, right? Not so – Bitcoin’s security, like physical currency, depends on how safely it is stored. There have been numerous instances of Bitcoin wallets and exchanges being hacked including Mt. Gox, Bitomat, MyBitcoin, Bitcoinica, Bitfloor and Instawallet. In fact, it has been reported that the Winklevoss twins (of Facebook fame) have stored their Bitcoins (apparently worth in excess of $15m at the time) on pen drives in real physical vaults, which prevents hackers from gaining online access to them.
I don’t buy some of the commentary from people who say Bitcoin is unethical because it is used to buy drugs, run guns and other such illegal activities. Yes, by its very nature it is anonymous and therefore transactions are untreaceable, but then every single “mainstream” currency has been used for illegal purposes. Once the initial excitement has abated, these things tend to find favor in the mainstream; a typical case of the tail wagging the dog.
In a world burdened by the huge cost of moving money around, Bitcoin has successfully demonstrated a way to create a simple measure of value that allows extremely efficient, frictionless and anonymous transactions. One of the key impediments in the developing world is the inefficiency of money movement, which results in the lack of availability of capital to spur growth. Creating efficiency here is the holy grail of long term economic growth and Bitcoin has given us a great roadmap for this.
So in my mind, Bitcoin isnt just a success, it is the beginning of a revolution. I say revolution because historically revolutions have destabilized traditional institutions such as government and brought in new and better ways to do things (or indeed sometimes worse, but they herald a change, at the very least).
I’m sure the shortcomings of Bitcoin will be fixed in its next iteration. The issue of monetary supply needs to be reactive to prevent specualtion and bubbles. And while Bitcoin itself is highly secure and difficult if not impossible to counterfeit, security needs to be improved around the storage of such currencies.
The issue of intrinsic value is probably the most difficult to solve. One idea I have seen is some form of Bitcoin Bearer Bonds which essentially stores another source of value (gold, USD, etc) as underlying for a Bitcoin like instrument – this is not the gold standard as much as a highly flexible universal exchange mechanism that would allow easy interoperability of value.Indeed, if we could get a crypto-currency to work, I would tend to agree with the Winklevoss twins who said, “We have elected to put our money and faith in a mathematical framework that is free of politics and human error.”
In effect, we could be looking at the ultimate democratization of monetary policy, in much the same way the Internet has democratized information. And we all like freedom without interference, don’t we?