Just another day in Bitcoin

As I am finishing writing this post, Bitcoin (BTC) is in the middle of a crash, or what some people call in technical terms, going completely bonkers. I have been unhealthily interested in bitcoins for more than a year, and I have been following it closely. This includes reading papers, visiting websites, reading forums, monitoring its subreddit, and generally trying to keep in touch with what is happening in the BTC world. While I have been vocally negative about Bitcoin during all that time, I am not writing this as a “told you so”, my guess is that Bitcoin will bounce back at some point, so there is no need to gloat. My criticism and interest stems from frustration, the digital currency is so tantalizingly close to what we need that I cannot help but try to urge it forward in the right direction. The world is in dire need of a decentralized payment system like Bitcoin. Anyone who values decentralization and openness would be immediately drawn to BTC, but once you start looking at the details, it is easy to find the problems, many of which have been too evident in the last couple of days.

I would like to write about these problems right in the middle of the crash because some of the optimist BTC proponents who have been dazzled by its previous growth may have been ignoring any criticisms, and now they might actually read and think of why this is taking place. My hope is that we will get past Bitcoin and that at some point a better cryptocurrency will emerge, one that has learned from the many problems with this first experiment. I will being by explaining what is Bitcoin, and then will state some reasons why I think it has some serious problems.

What is Bitcoin?

This is a modified and updated primer taken from this article.

Bitcoin is a non-fiat cryptographic electronic payment system (cryptocurrency). In other words, it is a peer-to-peer, client-based, completely distributed unit of value that does not depend on centralised issuing bodies to operate, the value is created by the users, and the operation is distributed using an open source client that can be installed in any computer (and many mobile devices).

Bitcoins are created by computer operations, therefore, their value arise from computing power, that is, the only way to create new coins is by allocating distributed CPU power through computer programs named “miners”; the miners create a block after a period of time that is worth 25 bitcoins, and each bitcoin consists of 100 million smaller units, called a satoshi. The operations performed to mine are precisely to authenticate other transactions, so the system both creates value and authenticates itself, an elegant and simple solution that is one of the appealing aspects of the currency. Once created, each Bitcoin (or 100 million satoshis) exists as a cryptographic address that is part of the block that gave birth to it. The person who mined the coin owns the address, and can transfer it by sending value to a another address, which is a “wallet” file stored in a computer. The blockchain is the public record of all transactions.

A key feature of Bitcoin is that they are deflationary in nature, and that it has scarcity built-into the system. Mining for coins becomes more difficult as time goes by and the market grows. The algorithms that produce new coins increase the amount of processing power necessary to create each new block, so producing new money is more difficult as time goes by, and this difficulty is built into the system to try to keep the total amount of bitcoins at a maximum of 21 million. So, the first block “mined” was done at difficulty 1, at the time of writing there were 230,418 blocks, making a total BTC of just over 11 million, and a difficulty of 7,673,000. That means that making a new block will be more than 7 million times more difficult than it was for the initial block. This difficulty will only go up, so an individual cannot hope to have the processing power to develop new coins, and this can only be done currently through pool mining CPU resources. Or by operating a large botnet… but we’ll get to that.

Transparency

One of the main selling points of Bitcoin is its transparency. The client itself is open source, and all the transactions are open to scrutiny because all transactions must be verified by the whole, so it is possible to look at each individual transaction in the public blockchain to scrutinise the outgoing and incoming wallet addresses. The addresses do not identify the person, only the possessor of the key that unlocks the address. This makes it both anonymous and transparent at the same time, another neat feature that explains Bitcoins popularity with the technical elites (although the anonymity aspect is disputed by some studies).

But this transparency is limited because the actual originator of the scheme remains anonymous. Bitcoin was created in 2009 by a member of a cryptography mailing list who goes under the pseudonym of Satoshi Nakamoto (paper here). This mysterious origin does not seem to bother some proponents, but to me is indicative of the almost religious nature with which some developers treat the subject. It seems like a strange thing for someone to come up with such an amazing idea, and yet remain in the dark. This has made some people suspect that Bitcoin operates in a manner similar to a Ponzi scheme, where those early adopters at the top amassed large BTC stocks, so that the resulting coins can be easily manipulated. The barrier-to-entry is not only physically high (difficulty increases with time), but also it is a psychological investment for anyone who understands just how easy it would be to maliciously manipulate the market if you had a large share of the same.

Just look at this transaction performed during the crash. Yes, that is one single person selling transferring 69k bitcoins, at the highest point of the trading at around $250, that would have been worth a staggering $17,250,000 USD (ETA: see the comments section for a further explanation about this transaction).

This lack of transparency is a serious concern for anyone who would think of investing in the scheme.

Lack of failsafes

As already mentioned, bitcoins exist only as files in a computer or mobile device, these files have access to the private key used to secure the money. This creates one of the biggest issues with Bitcoin to date, which is the ease of losing one. If the wallet file is lost, then the bitcoins it contains are lost forever. Sure, the file can be backed up, but people rarely do that, so if anything happens to the computer, or if you just inadvertently delete the file, then the Bitcoin is gone. The public address still exists, but this can only be accessed by the private key, which has been deleted, so unless one breaks the very secure encryption built into the system, then it would not be possible to recover the lost coins.

I read somewhere that there may be as many as 5 million lost bitcoins out of the 11 million ever mined. This may seem like an exaggeration, but  a study looked at very old “dormant” addresses in the blockchain, and assumed that these were probably lost coins from the time when people were testing the technology and deleted their wallets. The authors calculated the number of lost old coins to be 1,657,480 bitcoins. Considering the certainty of later losses, it would be fair to assume that the value of lost coins could very well double that number. This has not been seen as a problem for enthusiasts, as they point out that each BTC is divisible up to 8 decimal points. It is also assumed that the fewer BTCs there are, the higher the value. Defenders of Bitcoin also point out that it is possible to lose real money as well.

Hogwash, the finality of Bitcoin loss is absolute. People tend to know where their wallet is, but are less conscious about files in their computer. Similarly, normal consumers do not keep all their money stashed in one location, that is why we have banks. The lack of a failsafe when things inevitably go wrong is a serious issue with the scheme.

The solution to this concern is to keep wallets online, but that is a centralized solution that has its own problems, chiefly the fact that one has to rely on unregulated intermediaries holding the wallet. Some online wallets have had problems with security and lost coins, not to mention the real possibility of fraud.

Regulation

Bitcoin has not really been the subject of much regulatory scrutiny so far. There were quite a lot of comments in the BTC forums recently when new guidelines from the Financial Crimes Enforcement Network (FinCEN) in the US specified that decentralized currencies should comply with money laundering regulations. This was met with both glee and worry from bitcoiners. On the one hand, it proved to many that Bitcoin was big enough to warrant official notice. On the other hand, most enthusiasts distrust any sort of regulation, and thought that this was the first step towards the much-feared government crackdown on Bitcoin.

I have the suspicion that regulators were well aware of the Bitcoin phenomenon, and simply decided to ignore it for the time being, given the fact that it seemed to be headed for disaster.

The truth is that today many thousands of Bitcoin users are learning the hard way why financial markets and currencies are heavily regulated areas. Deposit taking, the keeping of accounts, management of payment transactions, the keeping of balances… all of these are functions of financial institutions that are of the utmost importance to businesses and consumers. The economy relies on financial intermediaries to operate, and while things sometimes go spectacularly wrong, regulation is precisely there to prevent more damage to consumers. The notion that we should forego centuries of banking experience and regulation to favour a system where no accountability is either expected or desired speaks volumes of why Bitcoin is so unreliable.

In the end, the fact that many in the BTC community are precisely shouting for the exchanges to do something makes a strong point in favour of some sort of regulation. Would regulation kill the decentralized nature of the currency? Not necessarily, a future cryptocurrency could be decentralized, and the exchanges and other intermediaries could be subject to the same forms of regulation as every other financial institution.

Deflation

As explained above, Bitcoin is built with scarcity in mind, that is, the maximum number of Bitcoins that will ever be mined is fixed at 21 million. This entirely arbitrary figure is one of the reasons many BTC advocates equate it with gold and other commodities. The idea is that the scarcity will ensure upward valuation of the currency because there is no central bank that can print more money as the economy requires it. This seems like a good idea if one looks at the economy in very simplistic terms. Inflation is bad because the currency loses value, and therefore people lose acquiring power, so deflation must be good, right? Not really, the problem with deflation is that it encourages hoarding, in which case the currency is not being used as intended, namely to exchange it for goods and services. If everyone kept their money and hid it under the mattress, then the economy would enter into a downward spiral as businesses would have no revenue, so they could not employ people. Moderate inflation is desired in a healthy economy because it encourages investment and spending.

When Bitcoin was experiencing its amazing upward trend, many commentators correctly noted that a rise in the price of Bitcoin meant that it had entered a hyperdeflationary spiral which made it uniquely unsuitable as a currency because there was no reason to spend BTCs if the price would continue to rise. Just look at the early days of Bitcoin, when a poor person spent 10,000 Bitcoins to buy a pizza. In a deflationary economy, this person feels that they lost greatly as valuation goes up, so they would be less willing to part with their currency  in the future.

If one wants a stable medium of exchange, then the deflationary element has to go, otherwise what you have is something more akin to stocks or commodities.

Centrality

During its short history, the Bitcoin economy has relied too heavily on one intermediary, a Tokyo-based company called Mt.Gox. Bitcoin relies on exchanges to operate, these are intermediaries that will accept your “normal” currency and exchange it into Bitcoins, and vice versa. There have been dozens of exchanges, as in theory literally anyone could setup their own firm. Mt.Gox is famous for having started out as an outfit to trade “Magic the Gathering” cards, but then evolved to be the largest exchange by far. How large? A study found that Mt.Gox had intervened in 90% of all Bitcoin transactions ever recorded. As of today, Mt.Gox accounted for 58% of all volume transaction in the last 30 days for the top 10 exchanges. This is a remarkable market share when one considers that Mt.Gox stopped trading yesterday to try to alleviate the crash.

This is a level of centrality that is not good for a supposedly decentralized currency. Many blips in price prior to the crash were caused precisely by DDoS attacks against Mt.Gox. Similarly, such reliance makes the entire system less resilient and prone to catastrophic failures.

Instability

Bitcoin has been tremendously unstable throughout its trading history. While as of today the overall trend has been upward, the currency has crashed several times before, just take a look at this excellent illustrated history of crashes. This is not the picture of a healthy currency, such instability is one of the reasons why it is very unlikely to be a viable currency.

Imagine that you are a merchant who decides to accept BTC, and agree with the buyer to sell at the trading rate when the transaction was initiated. The first problem you would encounter is that the transaction needs to be verified, and as there are more verifications taking place all the time, the process takes longer (about an hour). With wild variations in price, it is possible that you could lose money even before the transaction has been completed. Moreover, even a minor downward swing like those which were common in the days before the crash could wipe away any profit margin, leaving them wondering why they are even bothering accepting the pesky things in the first place.

However, the instability may not kill Bitcoin. In one of the best pieces that I’ve read about the instability of Bitcoin, Matthew Yglesias argues that it is possible that it will continue to go up and down in price forever. He says:

“Bitcoins are deliberately designed to represent a finite supply. So if over time more and more people want to use Bitcoins to conduct transactions of various kinds, then the price of bitcoins is going to have to rise and rise. The problem is that if the price of a bitcoin is on a steady upward trajectory, then nobody’s actually going to want to spend a Bitcoin on anything. And if everyone’s hoarding their Bitcoins, then the network is actually useless. Then, since it turns out to be useless, you get a crash. The funny thing is that once the upward spiral comes to an end, then the technological virtues of the Bitcoin platform come to the fore again.”

This is going to be the biggest challenge for future cryptocurrencies. Fiat money is kept stable by all sorts of means, from fiscal policies to centralized decisions about interest rates. It is even possible that stability can only be achieved through some form of centralization.

Security

Bitcoin itself is based on sound and tremendously strong cryptography, so the chance of someone hacking it are very small (for now). However, throughout its history BTC has been riddled with serious security incidents that place a large question mark above the implementation of the technology. The issue is that while Bitcoin itself is secure, intermediaries and consumers are not always so resilient. In early days, wallet files were unencrypted, which meant that any person who gained access to the computer holding it could simply transfer out all of the money, as happened to an early adopter who had 25,000 BTC stolen from his machine. Unencrypted wallet files were also to blame for an exchange losing 24,000 BTC.

Needless to say, when the price was going up there was a great incentive for hackers to create botnets that would mine bitcoins, or to engineer malware that would steal BTCs, these would be propagated by installing fake clients or by visiting infected sites. At some point there was also an increase in phishing sites trying to pass-off as Mt.Gox.

It is not necessary to detail all of the incidents, a simple web search will show a large number of them. Bitcoin prides itself in being an unregulated technical currency, which makes it a prime target for hackers looking for an easy way to steal money that is not likely to be prosecuted. This is because involving law enforcement would be a double-edged sword for the BTC community. If they want the police to pursue theft just like they do with fiat currency, then they would be welcoming regulation. On the other hand, if the currency remains unregulated, then police will be likely to treat it as the theft of WoW gold or Linden dollars.

And remember, once stolen, you cannot get the coins back. Ever.

Political underpinnings

From very early on, Bitcoin has been extremely popular in libertarian circles. Any visit to a Bitcoin discussion forum is evidence enough that an important core of the BTC community consists of libertarian types of all stripes, from those who want to see the end of all fiat currencies, to slightly more moderate and pragmatic Ron Paul-type supporters. To be called a statist is the worst insult, and anything that smells of regulation and/or government is immediately dismissed.

The depth of hatred against fiat currencies is staggering, a small group really think that Bitcoin will be so successful that everyone will be using it eventually after the much prophesied collapse of all government-backed money. However, most seem to accept that coexistence will be prevalent.

Lately, a growing number of Anonymous outlets have been  coming out in favour of Bitcoin. The politics of Anonymous are more difficult to pinpoint, there are some left-leaning positions in many issues, but I have always classed Anonymous more as an anarchic movement. The leftist anarchic fear and loathing of government is shared by the Randian libertarian branches on the right. The common denominator is distrust of any regulatory solution and the wish to see the end of the tools of power.

I have no problem whatsoever with people becoming involved in something out of ideology. However, I have a big problem when that ideology is taken as fact with the flimsiest of evidence to support it. Ideally, a decentralized currency should be politically neutral, it should strive to be efficient, not to overthrow governments. Any revolutionary effects would be caused by its success, not as part of a big plan to bring about a libertarian utopia.

Concluding

One of my favourite tweets of the last few days states:

Money is: 1. A unit of account 2. A store of value 3. A medium of exchange Right now, Bitcoin is none of those things (in any serious sense)

A good cryptocurrency must strive to fulfil these three requirements. It is not my remit to point out how this is to be achieved, I am not a developer. I just know that Bitcoin has too many problems to be the solution that we are looking for. An anonymous and decentralized payment system could indeed revolutionise the economy, it could help to end the disproportionate power of fat-cat banking systems, and would democratise monetary exchange. A system created by an anonymous cryptographer with a pseudonym that sounds like an anime character is not the way of the future, we need true openness for the next experiment to be successful.

Having said that, I do not blame the crash on early adopters selling-off huge amounts of BTCs. Just hours before everything went south, this article was published in the New York Times detailing how the Winklevoss twins (them of Facebook infamy) now owned about 1% of all Bitcoins in existence. The Bitcoin shark had been jumped. Panic ensued.

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