Is the cryptocurrency Bitcoin a good idea?
http://www.bitcoin.org
If Bitcoin did not offer substantial advantages to alternative digital currencies, it would not be seeing increases in market share.
In 2008, Paypal daily transaction volume was approximately $164 million dollars. On peak days, the Bitcoin network processes over $25 million in transactions. The largest online payment process, Alipay, does $300 million per day in transaction volume. (Update: bitcoin daily transaction volumes has increased 100% from when I wrote this article and now exceeds 50 million per day in transactions).
Update: March 2013
Bitcoin market cap now exceeds 500 million. Daily volume is 75 million. BTC is trading at over $50 BTC/USD.
Advantages of Bitcoin
Bitcoin is very similar to PayPal, but with several advantages and differences.
Advantages of Bitcoin:
- Bitcoin has lower transaction fees (zero)
- Bitcoin does not subject merchants to chargeback risk.
- Bitcoin has stronger privacy protections than PayPal. Accounts are numbered, but have no personally identifiable information, similar to a Swiss numbered account.
- Your bitcoin account cannot be frozen or seized. PayPal often freezes accounts used to sell virtual goods and stored value cards because of the high fraud and chargeback risks. Bitcoin is more suited for these applications.
- Bitcoin transactions do not incur currency exchange fees. Capital controls in many countries and central bank fixed exchange rates which are below black market exchange rates create an incentive for bitcoin adoption. Bitcoin serves as a digital alternative to existing hawala networks.
- Not everyone in the world has access to traditional banking services, but everyone in world who has a cell phone can use Bitcoin.
Differences from PayPal:
- Bitcoin is decentralized.
- Bitcoin is floated and not tied to the dollar. PayPal is pegged to the dollar (like the Yuan). Bitcoin exchange rates are established by markets.
- PayPal's behavior is backed by a contractual relationship with a corporation. The Bitcoin protocol's behavior is backed military grade cryptography, not by contracts.
- Bitcoin's design reduces the counter party risk inherent in legacy payment systems such as eGold and PayPal.
Many feel that the level of privacy that bitcoin offers is immoral or dangerous. Regardless, there is an extremely large demand for the superior banking privacy that bitcoin offers.
The weight of the advantages of bitcoin make it extremely appealing to a diverse range of people for a diverse range of transactions.
Most Arguments Against Bitcoin are Grounded in Misunderstanding:
- Bitcoin is not a ponzi scheme. Bitcoin does not pay interest on deposits. Adam seems to be using a "very unique definition" of ponzi scheme, which includes any asset which is appreciating in value. "Facebook stock is a ponzi scheme because the people who bought stock first made more money!"
- Adam describes a bank run scenario on Bitcoin. Bitcoin does not have a bank or any counterparty.
What is Bitcoin:
Bitcoin is open source software.
Bitcoin is a protocol for online payments, similar to PayPal but has several advantages over legacy payment systems for online transactions.
Bitcoin tokens have currency-like properties, but Bitcoin is not a "currency". It's something new. Calling Bitcoin a currency is like calling a PayPal account a "merchant account" simply because you can use it to receive credit card payments. They are conceptually similar because they are used for the same purpose, but they differ significantly in the details.
The vast majority of criticisms against Bitcoin attack the differences between Bitcoin and existing payment systems. However, it is exactly these differences which are driving Bitcoin adoption. If Bitcoin did not offer substantial advantages, it would not be seeing increases in market share.
1> Factors Driving Bitcoin Adoption
- Bitcoin only needs to be better than alternative payment systems for specific applications.
- Bitcoin will be adopted where it has advantages over alternative payment systems
- PayPal became the dominant payment processor for eBay but has not seen much success at displacing credit cards for general online payments. PayPal adoption for instance was driven by the need of eBay merchants to transact payments digitally. PayPal had a niche to fill because most eBay merchants did not have the transaction volume required for a traditional merchant account.
- When Visa, Mastercard and Paypal froze the accounts of Wikilieaks, they were able to raise millions in donations through Bitcoin. Bitcoin is rapidly filling the cracks between legacy internet payment systems.
- Bitcoin will be most successful in those niches (and geographic regions) where there are not already satisfactory alternatives.
- People do not use Bitcoin because of its flaws, people use Bitcoin because of what it is good for.
2.5> Testing Adam's "Bitcoin Collapse Prophesy"
The June 21st. 2011 Bitcoin Flash Crash
"something will happen" has happened several times and it has not killed bitcoin. Both of Adam's predictions were tested and proved was wrong.
A hacker compromised an account controlling approximately 7% total bitcoin and sold all of them. The market collapsed to 0.01 BTC/USD. Within seconds bitcoin rebounded to $15. Its beyond credulity to imagine a greater test of the resilience of bitcoin.
Negligible Market Reaction to Crash:
The bitcoin apocalypse has happened twice already and the market just shrugged it off. Bitcoin's resilience against crisis and market collapse has been tested multiple times.
0> Long Term Trends
I have highlighted the trend line in red. Click the graphs for larger version.
A straight line on a log plot means constant exponential growth.
Let me highlight the "bubble".
Long term weekly BTC/USD price. Notice the price plateaus and jumps in price.
A straight line on a log plot means constant exponential growth. The growth rate of Bitcoin market capitilization appears to be nearly constant. Individual events and news coverage have not had much of an effect on the underlying trend line.
4> Myth: Bitcoin will become the single digital currency
Online currency exchanges already offer exchangeability between Bitcoin and
- USD
- the Euro
- Swish Francs
- the Yuan
- gold, silver
- WoW Gold
- ISK
- Linden Dollar
- There are multiple currencies and they are exchangeable and interoperable.
- Bitcoin is increasingly offered in parallel with existing payment processing services such as PayPal, eGold, ePassporte.
- Competition between currencies gives consumers and investors the largest array of choices. Competition allows people to vote with their feet.
6> Bitcoin Disruption in the 3rd World
Bitcoin has more potential to be disruptive in the 3rd world, where satisfactory alternatives for online payments and banking do not exist.
PayPal froze the accounts of 3rd world Kava farmers, who discovered that they could sell their crops directly to consumers over the Internet. If the Kava farmers were using bitcoin, this could not have happened. The 3rd world Kava farmers need Bitcoin more than people living in affluent countries who already have adequate banking and payment processing services.
There are already several precedents for the need for Bitcoin in Asia and Africa. Zynga and Blizzard have experienced pains to sell digital goods in Asia where there are not well developed credit card networks. The problem is even greater for companies without the scale to distribute prepaid cards through these countries.
In Africa, many homes do not have electricity but increasingly everyone has a cell phone. Prepaid cell phone minutes have become a defacto currency in many African countries. Africans are in many ways more acclimated with using privately issued digital currencies (such as M-PESA) than Americans.
M-PESA is very similar to Bitcoin in functionality and already has widespread adoption http://en.wikipedia.org/w
Bitcoin has the potential to become universal in a way that regionalized payment systems subject to government regulation cannot. Regional payment processing firms lobby governments for regulations to protect them against foreign competition, resulting in a fragmented payment processing market and protectionist transaction fees.
For example, see the recent actions of the government of India against Paypal. As Paypal's usage in India for international payments is restricted, economic incentives to circumvent capital controls will drive adoption of alternatives such as Bitcoin.
Bitcoin is more resilient against government regulation because it has no central corporation and therefore is similar to other P2P systems such as hawala. Enforcement costs for government regulation are prohibitive when transactions are between individuals (example: Bit-torrent vs Napster).
Bitcoin is the only existing payment system with the potential to become universal internationally.
Summary:
If Bitcoin were a bad idea, it would not be gaining uses. The proof is in the user statistics.
Bitcoin is a theoretical and practical breakthrough that makes it possible to decentralize services we previously weren't able to decentralize.
To elaborate: Bitcoin isn't just a currency but an elegant universal solution to the Byzantine Generals' Problem[1] in computing, one of the core challenges in reaching consensus in distributed systems. Until recently the problem was thought not to be solvable at all, much less on a global scale. Regardless of its currency aspects, many experts believe Bitcoin is brilliant, in that it technically makes possible what was previously thought to be impossible.
The Byzantine Generals' Problem goes roughly as follows: N Generals have their armies camped outside a city they want to invade. They know their numbers are strong enough that if at least half of them attack at the same time, they'll be victorious. But if they don't coordinate the time of attack, they'll be spread too thin and will all die. They also suspect that some of the Generals might be disloyal and will send fake messages. Since they can only communicate by messenger, they have no means to verify the authenticity of a message. How, then, can such a large group reach consensus on the time of attack without mutual trust or a central authority, especially when faced with adversaries intent on confusing them?
Bitcoin's solution is this: All of the Generals start working on a mathematical problem that statistically should take 10 minutes to solve if all of them work on it. Once one of them finds the solution, she broadcasts that solution to all the other Generals. This solution then becomes the next problem. Everyone then stops to work on the previous problem, and proceeds to use the previous solution as the next problem—which again should take another 10 minutes. Every General always starts building upon (using as the problem) the longest chain of solutions he's seen. After a solution has been built upon (extended) 12 times, every General can be certain that no attacker controlling less than half the computational resources could have created another chain of similar length, because it took a lot of computational resources to extend the chain 12 times. The existence of the 12-block chain of solutions is proof that a majority of Generals have participated in its creation. This is called a proof-of-work scheme.
If this sounds confusing, don't worry. What it means is simply that consensus is reached because computational resources are scarce. You vote with work. So to rig the vote, an attacker would need to control more computational power than the honest participants have. Also, to ensure that it's more expensive for an attacker to purchase the computational power needed to attack the system, Bitcoin adds an incentive scheme. Users who contribute computational power get rewarded for their work. Thus, if the value of a Bitcoin rises and attacking the system becomes more profitable, it also becomes more profitable for honest users to add computational resources. Here's an example of how this works: At any given point, one would expect miners to invest as many resources into mining as is profitable for them. Bitcoin then also is a currency, because it needs incentives to protect the consensus process from attackers. This computational process ("mining") is not wasteful, but an incredibly efficient way to make attacks economically unprofitable. Bitcoin never uses more computational resources than necessary to protect the integrity of its interactions.
Now let's return to discussing the value provided by Bitcoin. Essentially it's a means to make consensus in highly distributed large-scale systems that would otherwise never be able to accomplish that. The value of this is, that it's now possible to build applications in a decentralized fashion that we previously thought could not be built without a central authority. The most obvious example is of Bitcoin as a medium of exchange for goods and services that can't be easily bought or sold using cash issued by a central authority. But there's more. Bitcoin also makes it possible to fully decentralize the DNS (Domain Name System). Every Bitcoin Domain Name comes with a cryptographic key pair, which also allows us to solve the PKI (Public Key Infrastructure) problem: every name you connect to, has an encryption key associated with it that can be verified without having to trust a central authority. Moreover, in case network traffic monitoring prevents people from accessing information either at all or anonymously, Bitcoin makes it feasible to pay for internet relays that anonymize or reroute traffic—that is, it makes it easier to remove central control and fight censorship. The list of benefits goes on, and I've been hard-pressed to find any decentralization schemes that would not benefit from Bitcoin integration.
The pattern here is that almost all of these applications can already be built in centralized form. But often the centralized solution comes with many weaknesses. In the PKI case, you have to trust over 300 Certificate Authorities every time you make an https:// connection, many of which are located in countries with repressive governments. If any of those 300 entities are compromised, malevolent attackers will be able to read your email, access your bank account, and violate your privacy. DNS is being censored by governments simply because they can do it. And every time you store value in currency, you're trusting a central authority to ensure that it isn't mismanaged and won't depreciate in value.
So is there really value in Bitcoin? The answer depends entirely on your perspective. Let me ask a counter question: Is decentralization valuable? If you think we'll increasingly lose trust in the central authorities that manage the infrastructure we rely on, you might expect Bitcoins to rise a lot in value. If, however, you believe that authorities will be able to tackle the challenges of the future better in centralized form, then from your perspective Bitcoins don't add value. Time will tell which viewpoint is correct.
[1] Re: Bitcoin P2P e-cash paper
Originally written 2011. Updated 5/25/2015: Re-Edited version for grammar and improved reading flow.
Fortunately, it's such an obviously flawed system that it will probably never grow to a point where it causes any ill-effects,or even impact, to world economies.
Still, I feel like it's worth pointing this out.
Bitcoin, described most generously, is a system that makes digital transactions more like cash transactions. That's...fine. The problem is it does this not by offering dollar-denominated digital cash-transfers, but by bootstrapping an entirely new currency. The question to ask is why this would be at all desirable. Maybe you hate the US government, or all governments. Maybe you want to avoid bank interchange fees, or perhaps avoid tracking altogether because your payment is for something illegal, or because you're a particular private person. Or perhaps you just think that the world currency regime is going to collapse and you see Bitcoin as a technological salvation.
No matter what your reasoning, Bitcoin is a ridiculous idea that will not accomplish what you want.
Severe Problem Number 1: Seeding Initial Wealth
When the federal reserve "prints money", it doesn't just mail million-dollar checks to random Americans. It does one of two things. It either (a) purchases some other asset [generally US treasury bonds] on the free market, thereby injecting more cash into the system than there had been before, or (b), loans money to a bank, who will then loan it to other people who will then spend it.
Importantly, the people on the other end of those transactions did not just get free money. They either sold an asset for cash, or they borrowed cash that they will eventually repay (with interest).
Bitcoin does not have a central bank capable of printing and lending bitcoins; it has an "algorithm" which through some convoluted mechanism allows bitcoins to be "mined". Essentially it randomly allocates bitcoins to early adopters. This is a very good system for early adopters (free money!) It is a nonsensical system for a real currency, not to mention being obviously unscalable (what happens when everyone tries to mine bitcoins all day long?). To solve this second problem, the supply of bitcoins is algorithmically limited, which is again good for early adopters. But that brings us to...
Severe Problem Number 2: Built in Deflation
Econ lesson time! Deflation is the phenomenon where cash grows in value relative to everything around it (that is, prices go down). More specifically, deflation occurs when people expect the value of cash to grow in relative value to everything around it, and prices trend down consistently.
Question: if your money is getting predictably more valuable, why would you want to spend it? Answer: marginally speaking, you wouldn't.
The supply of bitcoins is programmed to grow at a known but decreasing rate over time, topping out relatively quickly at about 21M. The graph looks like this:
Or at least have constant rate of growth? Yes, of course you would, because that's the only way to actually accommodate more people using it.
But Bitcoin is not designed to be a functioning currency, it's designed to enrich early adopters. Again, that is why it is a scam. Period.
As a quick thought experiment, let's say demand for bitcoins grew as more people found out about them. Well, you'd expect the price of Bitcoin in dollars to grow rapidly. Now assume I own one bitcoin. I also have a dollar bill. I would like to purchase a Pepsi. Which one of those will I spend? Obviously the devaluing dollar gets spent before the skyrocketing bitcoin.
In the best case scenario [the one where it becomes popular] the limited supply of bitcoins will cause crippling deflation, drying up most Bitcoin-denominated commerce save whatever speculative buying and selling happens on exchanges. Some new world order. All that transparency and all those low interchange fees aren't going to do you much good if you don't ever want to spend these things and no one wants to give them to you anyway.
Severe Problem Number 3: Lack of Convertibility
There is a common misconception among people that there is such a thing as an inherent value of money. There is no such thing. Paper assets are literally only valuable to the extent they can be exchanged for other paper assets. A dollar is worth a certain number of euro cents. A euro is worth a certain number of yen. A yen is worth a certain number of dollars. A dollar can be put in a bank for a certificate of deposit, which can then be exchanged for a dollar. It can be turned into a cashier's check or a personal check, and then converted back to cash or deposited. It can be converted to traveler's checks which can then be converted to yen on your vacation. Even if you spend your money and buy a sandwich, the sandwich stop only took that money because it was convertible to something else, such as a payroll check and then a bank account. Paper <--> Paper <--> Paper. All the same, all different. It's a beautiful circular equilibrium. Envision a tee-pee. Paper assets are the poles; they fall over by themselves, but leaning against each other they form an edifice.
The critical point here is that exchange rates might change, but they never go away completely. The term in economics is "convertibility". For Bitcoin to work as a currency, it would have to act as a predictable store of value, which means it needs to be easily convertible to all other stores of value depending on an individual's needs or wants. It needs to be a part of that tee-pee. It isn't.
The problem here is that because Bitcoin is completely decentralized, no one is completely invested in the long-term success of the system. No one is literally making the market, saying "no matter what happens, I'll buy Bitcoins from you at some price". I understand that there are "exchanges" floating around. Their commitment to this market is (in my opinion) not credible. Anyone and everyone can just pick up their ball and leave.
As a result, my ability to turn a bitcoin into a dollar or a euro or a yen is no greater than my ability to sell my laptop on eBay. I can probably do it, but that doesn't mean I'm going to start measuring my bank account in MacBook Pros, because one day I might not be able to find a buyer, and then what?
Because of this, Bitcoin is not really a currency, it's an asset [and a particularly useless one at that]. It is being marketed as a currency to appeal to people who are crazy, idealistic, or afraid, and it is a scam.
Severe Problem Number 4: When Something Goes Wrong, It Will Die
In the early days of the great depression, some Americans started to worry that if their bank closed, they would lose all of their money. They then tried to take money out of banks all at the same time, which actually caused some banks to fail. That made even more people nervous, which caused even more banks to fail. That's called a bank run, and for obvious reasons we want to avoid them.
After that happened, the US government started explicitly guaranteeing savings deposits (as well as implicitly guaranteeing other forms of financing, see Bush, Obama et al, "Bailouts", 2008). Despite everyone's frustration with this state of affairs, it turns out to be vastly preferable to a complete collapse of our banking system, so it continues on.
Now, fast forward five years. The Bitcoin economy is roaring! Everybody owns these things. Life is great. But then...something goes wrong. Maybe it's a slight hardware glitch. Maybe there's a rogue node somewhere in the system that causes transaction delays. Maybe some people were storing their bitcoins on Amazon Web Services and they lost it when it crashed again. It doesn't really matter what: something will eventually go wrong, and Bitcoin will be tested.
Will it pass this test? People will get nervous. Some will panic. Few will run for the exits. The exchange rates will dip. Others will get nervous. Some will realize they never really had faith in the system to begin with. That will make them really nervous. Who is going to step in to backstop this system?
More importantly, is there anyone that even CAN do that? When a bank collapses, the federal reserve can honor deposits by quite literally printing money and giving people their cash back if need be. That slight increase in expected inflation (maybe) is a small price to pay for avoiding a financial meltdown. In the Bitcoin economy, that's literally impossible. It's decentralized; it's a published algorithm. No one can change it, and even if they could, it's no one's job to do so. Anyone with a large stake in Bitcoin will be too busy trying to get their own money out to worry about systemic risk.
Bitcoin (and really, any e-currency) is inherently unstable. And with currency, stability is everything.
In Conclusion
So, do I think Bitcoin is a good idea? The cryptography system seems to have technical merit although I'm not a cryptologist. If it were thoughtfully integrated into a legitimate banking product it might be a good idea. But this is not a good idea, this is a scam. Someone out there is trying to become very rich off of this system, and anyone who participates will be playing hot-potato until the inevitable collapse.
Do. Not. Buy. These.
===
Update 6/2: For those of you also on Hacker News, I made a couple of clarifying points, which included an apology for glibly using the word scam. Read more here.
http://news.ycombinator.c
This is similar to asking "Is the optical telegraph a good idea?"
If this were 1685, shortly after the optical telegraph was invented (see Telegraphy), we would probably be saying Maybe, it's too early to tell. Fast forward to 1840, several years after the first commercial electrical telegraphs were invented, we would probably saying Yes, of course - it's obvious. Today, most of us take E-mail for granted, not realizing that its roots spanned centuries of innovation.
The original proof of concept clearly signified a technological breakthrough (transmit messages efficiently over long distances with the telegraph; synchronize two databases without a trusted intermediary with Bitcoin). While the functional implications will continue forward, the actual version of the technology that gets widely adopted for real commercial and consumer applications will likely look very very very different than the original.
Right now, Bitcoin looks a bit like the optical telegraph did shortly after it was introduced.
One of the Bitcoin founders was already "invited" to Central Intelligence Agency headquarters (http://news.ycombinator.
I personally don't know enough about the Bitcoin system to make an independent judgment of its worth as a currency and long term viability. I liked this video criticizing Bitcoin:
Nielsio make a similar point to mine -- evading legal tender law for any sorts of significant business transactions in the US will have inevitable negative consequences. I'm personally indifferent to the assurances of Bitcoin and other techno-currency startups to the contrary. Any sort of barter or "time-trading" transaction is taxable.
Even if you can find some kind of brilliant legal loophole, the government will change the law and throw you in jail anyway.
The fear and risk of going to jail or losing capital far outweighs the potential benefit of using Bitcoin. The Internal Revenue Service can do all kinds of terrible things to monitor your financial behavior. Having significant capital tied up in a semi-liquid, complex security that relatively few people demand with huge legal implications is mistaken.
While it may be technically more challenging to shut down Bitcoin, it's certainly possible to sic the IRS on the community that trades it with astounding ferocity.
Any currency requires a massive marketing effort or a government monopoly to become successful.
That being said, I think that Bitcoin may wind up thriving. The ideological impetus behind it is admirable. The technological achievement is impressive. I like that it was motivated by science fiction, like most great technologies. I think that it should be free to compete with other currencies.
Adam Cohen wrote a good answer, but I disagree with many of his points.
Deflation (economics) in prices isn't a bad thing at all. Deflation in monetary terms (decrease of the money supply) isn't what happens with Bitcoin, apparently; only a slowing of the rate of inflation.
Stuff can "work" as a currency for limited periods of time. The Hungarian forint became worthless in 1946, but it served as a semi-functional fiat currency like most others have in history.
Bitcoin sucks as a currency because you need to take on legal risk to transact in it, at least in the US.
It's tough for me to comprehend the debate although I've spent years studying these sorts of issues. I have the intuitive sense that many Bitcoin defenders talk their books aggressively, although I could be held guilty of that too.
The price chart of Bitcoin looks like that of a pumped penny stock, which reflects the tremendous risk involved in buying, holding, and transacting in it.
Prices are information. Bitcoins are extraordinarily complicated securities with built-in encryption. There are never such 1000%+ gains in a short period of time without accompanying gigantic downside risk.
I have no proof that Bitcoin is a "scam," either for or against.
Also, since Bitcoin is managed by software, I have an instinct that it's vulnerable to corruption. There have been corruption scandals over far smaller amounts of currency within companies. The temptation to embezzle or counterfeit is large in this case.
This is why even free-banking types like me, who do want to see a bevy of competing currencies, tend to gravitate towards supporting commodity money. I have zero moral qualms with Bitcoin and would be happy to see it succeed, but would not buy any at this time.
