The future of Bitcoin in a volatile world

Hardly a day passes when I am not asked what I think about Bitcoin — as a technology, as an investment, as a currency for transactions, perhaps even as the coolest thing to talk about over this year’s turn at holiday cocktail parties.

But, as news comedian Jon Stewart once pointed out to over-the-top TV stock-picker Jim Cramer after listing his failures and statistical losses: “It’s not a game.” At least, not to the newbies now piling into Bitcoins with just as much chance of understanding what they own, or what to expect, as if they were purchasing shares of neutrinos.

As for pseudonymous founder Satoshi Nakamoto (Satoshi is also the name given to 1/100,000th of a Bitcoin), the chance that he is a real Japanese male person is, let’s say it, less than the value of a Satoshi. More likely, his name represents a small collaborative group of programmers, with at least one or two British members. As an entity, he appears to have bowed out in 2010, after writing the first paper on Bitcoin system design in 2008 and launching the first coins in 2009.

You might say Satoshi has just evaporated.

Just before he did, though, he passed along the magic key to the kingdom to Gavin Andresen, now chief scientist at the Seattle-based Bitcoin Foundation. He subsequently told Forbes: “Bitcoin is designed to bring us back to a decentralized currency of the people… this is like better gold than gold.” His dream: creating “cash for the Internet.”

But should you buy into that dream?

Benefits of a Digital Currency

Digital currencies are more common than we realize, and there is nothing to keep you and your mom from inventing the next one tonight. Even the world's fiat currencies, like dollars and pounds, may be considered digital, since virtually none are backed by gold or other physical assets. Their only existence is as bits and bytes in a computer somewhere. (Now that is faith.)

So why bother with the increased risk of a non-country currency like Bitcoin? Well, we could start with politics: People from the libertarian persuasion love the idea of an anonymous digital currency, which they can get and spend without government approval or intervention.

So, of course, do drug dealers and cartels, thieves of all kinds, terrorists and a long list of people who prefer to keep their financial lives outside the law. The recent FBI takedown of the criminal website Silk Road included the seizure of $28M in Bitcoins from its founder. In fact, Silk Road seems to have been the largest Bitcoin transaction site on the planet, until its demise.

If you are looking to avoid government scrutiny, you can consider using this cryptographic messaging system, but you should also be aware that you, too, just like the nice fellow running Silk Road, may be shocked to find out that “they” have found your name and address.

And this brings out the most important aspect of Bitcoins, which we’ll come back to later: As brilliant as this crypto system seems to be, it is run by computers. It’s just cool IT.

Are there other benefits? Sure:

1. They are useful. First and foremost, there are a growing number of uses, places, and vendors where Bitcoins can be used. Every Sunday paper seems to have stories about some poor reporter who was asked to go buy dog food, deep-dish pizza, or a birthday card with Bitcoins.

Sir Richard Branson, never one to shy away from publicity, even accepts Bitcoins for passage on Virgin Airlines. And the first Bitcoin ATM opened in Vancouver, BC, not too long ago.

2. They are cool. All you have to do to be the center of attention is to quietly announce that you just bought another Bitcoin this morning.

3. Wealth potential. If nothing goes wrong (see below for examples of the things that could go wrong), you may get rich, or richer. After all, the Winkelvoss twins (the guys who really did invent Facebook) are in it. Of course, when most sane people see words like “If nothing goes wrong,” they properly head for the nearest exit.

Or, you could throw caution to the wind and remind yourself that the non-existent Satoshi is rumored to hold about a million Bitcoins, worth up to a billion dollars today — oh wait, that was yesterday. We’ll cover volatility in a moment.

4. It's an ecosystem. Bitcoin seems to be on its way to becoming a serious platform, with a fast-growing community of support technologies surrounding it, adding to its crypto strength, its geographic availability and its availability for use by any and all. Well, at least by any.

Are there any dangers? I’m so glad you asked.

Dangers of a Digital Currency

Last month I was in Park City, Utah, launching the new Park City Institute / SNS “Future in Review” Speaker Series, where I had the chance to visit a high-school class in finance and economics. Most of the students asked smart, pragmatic questions about Amazon, Microsoft and future investment choices and techniques. And then it came:

“What do you think about Bitcoin? And, specifically, what do you think about its volatility?”

1. Volatility. Bitcoin has the volatility of hot C4 plastique sitting over an open flame. Its value moves faster than you can, and the size of these price moves makes heroin street pricing look like cotton on the commodities exchange.

2. Security. The whole idea is that this is a secure technology for store and forward use, but history has already shown this to be a fallible assumption. Those interested in this issue (and who would not be?) might want to take an Internet stroll over to www.Bitcointalk.org, where you will find a partial list of past frauds, including, but not limited to:

   Rank      Name Time Severity 1 Bitcoin Savings and Trust 2011-2012 est. 263,024'ꀯBTC 2 Silk Road Seizure October 2013 171,955.09292687'ꀯBTC 3 MyBitcoin Theft   July 2012 78,739.58205388'ꀯBTC 4 Linode Hacks March 2012 46,653.46630495'ꀯBTC 5 July 2012 Bitcoinica Theft July 2012 40,000.00000000'ꀯBTC 6 May 2012 Bitcoinica Hack May 2012; unresolved as of December 2012 18547.66867623'ꀯBTC
   39000'ꀯBTC total impact 7 Allinvain Theft June 2011 25,000.01000000'ꀯBTC 8 Tony Silk Road Scam April 2012 est. 30,000'ꀯBTC 9 Bitfloor Theft September 2012 24,086.17219307'ꀯBTC 10 Bitomat.pl Loss August 2011 est. 17,000'ꀯBTC 11 Bitcoin7 Hack October 2011 est. 11000'ꀯBTC  15000'ꀯBTC  
   

   I’ll note that the value, for instance, of the Bitcoin Savings and Trust fraud was 263,024 Bitcoins. If each were worth $1,000 (they are currently worth less, but have reached this value in the past), this fraud would amount to $263M.

3. There's no such thing as security. The largest problem, to my mind, is that any digital currency represents a radar detector / radar trap kind of world, with each side in a race to improve security or hacking tools in order to defeat the other. This is, after all, why we have the fraud table above. What users of Bitcoins are assuming, which is provably untrue, is that their currency value does not depend on flawless IT — a level of software perfection that literally does not exist. There will always be some kind of hack that can allow the theft of Bitcoins.

4. It’s a Machine World. Bitcoins are created by “mining,” or solving increasingly complex problems. Ingeniously, the solving of these problems also helps to secure the system and track all transactions. However, this opens the system to an entirely new kind of fraud, which, at least theoretically, has already been perpetrated: Someone with a large data center can solve Bitcoin mining problems, but hold out on submitting the solutions. This puts their competitors, who still assume those problems are unsolved, at a disadvantage: They're wasting their time on old, already solved problems while the fraudsters move on to new problems. Eventually, the fraudsters will submit a large chunk of solutions all together. In this way, the perpetrators can reserve a larger fraction of the coins for themselves, since once-solved problems are no longer available to others.

5. The “Oops” Factor. Recently, some poor fellow realized that he had long ago purchased Bitcoins (when they were really cheap) and stored them on his hard drive. Years later, he threw the hard drive away, and last month he remembered that the coins, now worth real money, were sitting in a digital funk at the bottom of a municipal garbage pit. The accidental loss or deletion of bits and bytes can literally cost users huge amounts of money, as this is all that Bitcoins are.

6. National Hostility. The greatest fear Bitcoin owners should have is of the politics of digital currencies. A nation, or group of nations, may decide to make Bitcoins illegal, or to restrict their trade, and suddenly — poof. This happened in December, as China took a second step against Bitcoins, announcing it would prohibit the trade of yuan into the digital currency. Bitcoins lost something like 60 percent of their value for a short time, and 30 percent for a longer time. How’s your stomach?

7. Networks Are Not Nations. The really important thing about currencies, particularly in this era of faith-based fiat money, is that the “full faith and credit” of a country stands behind its money. This means, to users, that the government will not let its currency fail if it has any control over the issue. What if Bitcoin fails? Well, it just fails — as have many prior digital currencies. When it goes out of business, so do its holders.

 
The Country View: What Is a Currency For?

All of this discussion begs the larger question of exactly what constituents want from a currency. Certainly there are myriad responses, including those of countries.

Given China’s antipathy to Bitcoin, we might extrapolate and suggest that governments that insist on top-down control of their economies (dictatorships, communist countries, etc.) will hate Bitcoin.

We might take an even deeper look, in this case, at the two great opposing national business models of this century: Inventing Nations and InfoMercantilists. The U.S. (an inventing nation) recently gave Bitcoins a tacit blessing, which provided lift to the system before China made its move. Since the InfoMercantilist model presumes currency intervention and manipulation, how will these countries (Japan and South Korea being the largest) view Bitcoins? Will they follow China’s lead, fearful that they will lose the ability to provide illegal lift to their export companies?

I would assume so, in one way or another. (Indeed, further inspection reveals that this may be a real pattern: South Korea has already made Bitcoins illegal.)

This does not bode well for Bitcoins. If the Asian lead economies all come out against it, this could be a major problem.

 
The Valley Goes Bitcoin

If there were ever a place on earth where Bitcoin would be adopted with crowd-driven passion and no sense of risk, it would be today’s venture players on Silicon Valley's Sand Hill Road. Indeed, they have opened the spigot recently and let ‘‘er rip.

From this perspective, Bitcoin is a dream come true — libertarian, technical and free by nature and an investor’s King Solomon’s mine.

Given the above caveats, however, I suspect that there is a more moderate approach that investors and users alike might take, also driven by earlier experience with gold mining: Levi Strauss & Co., which made its money serving the miners instead of the gold.

Companies such as Coinbase are being formed at a furious pace in order to provide services in the Bitcoin market, attacking issues such as transaction latency, transparency, fraud prevention, merchant support, consumer ease of use and security. These firms may well do better, and be less volatile in their pricing, than the digital currency they service.

Back in Park City, during the Q&A period following my Park City Institute talk, the Bitcoin question came up again.

I warned the audience about the effects a single country’s service shutdown could have on the price. That was Friday night. On the following Wednesday, BTC China — the nation’s largest Bitcoin exchange — was forced to stop accepting deposits in Chinese currency. The next day, Bitcoin prices dropped 60 percent.

A version of this story was originally posted on the Strategic News Service blog.