The problem with Bitcoin

I’ll admit to being sneaky with the title of this article. The argument I’m making is really to do with the discussions taking place surrounding Bitcoin, and what I believe will happen when the next economic crisis comes. The ‘problem’ I refer to is with the current behaviour of Bitcoin investors and the confusion this has created in terms of the broader value of Bitcoin and other currencies like it. Many discussions about Bitcoin in the media have been misinformed and almost all that I’ve witnessed have missed a crucial point.

I’m writing this, in part, because I was asked for my opinion on Twitter and didn’t feel I could craft a suitable answer in 140 characters. As it turns out, I’ve needed about 10894. I’ve also been meaning to revisit the subject for some time, so I appreciate the prompt ;)

In short, I hear a lot of criticism of Bitcoin based on the volatility in value of the currency and bred from a misunderstanding — or just ignorance — of what Bitcoin is and how it works. What the value argument ignores is that volatility brought on by flawed investment tactics doesn’t negate the long-term usefulness of the currency itself, although it may limit it right now. It’s important for us to clarify what Bitcoin really is, and what it isn’t, and how it compares to traditional “fiat” money.

In the extreme, some have labeled Bitcoin a ponzi scheme, which is a ridiculous assertion. While the debate surrounding Bitcoin’s validity as “money” is mildly interesting, much of the criticism from misinformed critics can be boiled down to, “It’s new and has no historic value.” I don’t see that as a problem. I see that as an opportunity for disruption in an industry that is ripe for it. It might not be Bitcoin itself that finally tips the scales, but something like it will.

If you spend time engaging with the Bitcoin Foundation and the community of users online or if you just simply understand what the system is and how it works then claims of it being a scam are even more ludicrous. People may commit scams using Bitcoin, just as criminals have and do with the US dollar — but so what?

The value of Bitcoin
I use the word ‘usefulness’ instead of ‘value’ above because the latter term has a different meaning in the financial world. We think of the “value of Bitcoin” in terms of the exchange rate one is able to secure via places like MtGox — the world’s most active exchange for Bitcoin. When we talk about the “value of money” we think of numbers. What I’m talking about is its potential to reshape the way we transact with each other and to place the control of money where it belongs and already practically is: with everyone and no one. I think that would be pretty useful.

For the purposes of this article we must distinguish between the value of Bitcoin in exchange and the usefulness of Bitcoin as a viable currency.

The current volatility in value is derived from the actions of traders on currency exchanges that are third-party in nature. The exchanges facilitate a transaction between a buyer and seller. Nothing more.

Of course we can’t ignore the value of the currency as per current exchanges, but we also can’t suggest that there’s no future for Bitcoin because current values are volatile or because the currency has little historical value to speak of. That’s an incredibly short-sighted argument.

The same mistake has been made throughout history when new disruptive technologies enter the fray. Anything new has no track record and naysayers use this to debase its prospects.

In the case of money, we’ve been fooled into thinking that economists can predict the future based on the past. If you’re still afflicted with that kind of thinking I suggest reading Nassim Nicholas Taleb’s Antifragile for an effective cure. Or just stick around and watch the fireworks, because the one thing we can predict is that something unexpected will inevitably happen.

I want to continue the discussion of time and potential, but let’s first look at what Bitcoin is and what it isn’t. Understanding the currency is vital in any discussion of its validity.

Bitcoin is a currency supported by peer-to-peer technology and cryptography. It is decentralised in terms of the network that facilitates transactions made in Bitcoin and in that there is no central governance of Bitcoin.

The technology of Bitcoin makes it fundamentally unlike anything we’ve tried to transact with before. Except, perhaps, chickens. But more about that later.

It’s important to understand the distributed and uncontrollable nature of Bitcoin. Unfortunately these facts about it are usually sprinkled into many discussions on the topic as an aside. They should be central.

While some investors may own enough bitcoins to impact the value of currency exchange, no one authority controls the currency itself. There is no government, regulator or private corporation behind Bitcoin. It exists as a network — in this way it is like the internet itself.

We also do not know who “invented” — I prefer “developed” — Bitcoin. All we know is that whoever did has been called Satoshi Nakamoto and is super crazy smart. This entity is unlikely to be one person given the genius and complexity of Bitcoin and is more likely a group of people. We just don’t know, despite what you may have read or heard. Whoever it is has no control over the system anyway.

Bitcoin is not a good investment. No currency is. Forex trading is nothing short of outright gambling. It’s a bad idea with relatively stable currencies like the UK Pound and even worse with a new currency that is still finding its place, like Bitcoin. I suspect this opinion will attract fierce criticism from avid forex traders, so let’s get this out the way: it’s OK to trade forex if you want to. My opinion, however, is that the risk of forex trading makes it a bad bet. We can argue about my opinion, but the risk is down to facts that I doubt anyone would sanely disagree with.

If you invented a perfectly good bread knife and someone used it to stab their wife’s cousin in the neck, well then the problem would be with the person committing the action, not the bread knife itself. Bread knives don’t stab people. People stab people. And forex investors mostly stab themselves.

Bitcoin also shares some traits with traditional currencies despite its fundamental differences.

The dollar, like the pound, South African rand, euro or other ‘fiat’ currencies is regulated and managed by a central authority, such as the Federal Reserve System in the USA or the European Central Bank.

This central banking authority usually also prints the physical money we use every day. In most cases, money comes from the regulator of that money itself. This is an obvious problem.

Imagine if regulators of telecommunications networks also operated our cellular and fixed-line networks. It would be a disaster for communications. An effective regulator must be truly independant of government and also the industry. Money regulators are neither, in practice.

The word ‘fiat’ is Latin and means, “let it be done” or “it shall be”. It is used as an authoritative statement. Traditional currencies, like the dollar, are referred to as ‘fiat money’ because they are declared by a government as legal tender.

Until not too long ago the value of money was based on a physical commodity — gold. Almost all the money in the world was based on the Gold Standard at some point, albeit indirectly. As of 2013, however, there are no currencies based on gold anymore. Fiat currency is now based on the willingness of a citizenry to use that currency, the sentiment of the global market as to what that currency is worth compared to others, and the ability of a central authority to regulate it. It’s historical value is also a factor, but there are many who don’t think it should be.

For an extreme case of what happens to a currency that falls foul of global sentiment, consider the Zimbabwean dollar. To cut a long story short, the Zimbabwean dollar doesn’t exist anymore. Zimbabwe was forced to adopt the currencies of other countries. Who do you think really made that decision? Go into any store in Zimbabwe and ask the owner for an answer. Yes, the Reserve Bank of Zimbabwe ratified the use of other currencies in their country but it was a largely meaningless statement. The market — the people — had already decided.

Think about that. If everyone in the USA decided to stop using the US dollar tomorrow, what would happen? I’ll withhold my own answer to that question in the interests of strengthening the thought experiment.

Bitcoin, like regulated currencies, also derives its value from the willingness of buyers and sellers to use it. Its value, like everything else, is decided on by the market.

A government supports a currency as legal tender, but can not force people to use it in transactions. If I agree to buy your chickens with my shoelaces then that is between you and me. The value of the shoelaces in terms of chickens is something we will have to agree on.

Right now the value of Bitcoin in exchange for other currencies is volatile, changing drastically on an almost daily basis. This is predictable behaviour. Bitcoin is new and highly disruptive. People are treating the currency itself as an investment, hoping to cash in on fluctuations. Those of us tracking Bitcoin since the beginning knew this would happen if indeed it gained any form of initial adoption. Incidentally, you can actually buy a chicken with Bitcoin in Brazil. So I’m told.

Bitcoin does not come from a central authority. There is no central reserve that can decide to “print more money” or adjust prime lending rates in order to impact on the value of the currency.

No government has declared Bitcoin as legal tender and doing so would be pretty meaningless in any modern, democratic society anyway. It would be as pointless as the Zimbabwean government’s agreement to allow the official use of other currencies, which the people of Zimbabwe had already decided to do.

Governments also do not have the power to make Bitcoin illegal. Sure, they can attempt to limit investment in the currency, as perhaps they should and as China has. They could stop banks from accepting it. However, they can’t stop individuals from passing bitcoins to each other in exchange for goods and services. That’s really up to the people. I’d love to see any authority try to arrest someone who agreed to sell their chickens for Bitcoin. It would also be amusing to see them try and technically block transactions.

Pirating films is outright illegal, but there is nothing anyone can do about it. Not technically, anyway. Why? Distributed, peer-to-peer technology, and encryption. Same as Bitcoin.

No one can control the creation of bitcoins either. Bitcoins are generated by a decentralised network of computers that are following complex algorithms. Every time one block of an algorithm is solved, more bitcoins are generated, and the next blocks become more difficult to solve. This is a finite process too. The system will not just carry on generating bitcoins forever. This, perhaps above all else, is testament to the abject genius of whoever created the system.

The next downturn
Having a group of human beings with the power to decide to print more money is where we get our fiat currencies from — and it’s turned out to be a pretty bad idea.

With Bitcoin there is no deliberation. No committees or interfering politicians, etcetera. The network as a system generates the units of the currency. This, combined with the peer-to-peer, decentralised nature of the currency makes it inherently more stable as a transfer of value than fiat money.

Again — don’t confuse the stability and usefulness of the currency itself with its exchange value. Yes, the two are components of the same system, but the latter is a temporary phenomenon while the former is an element of Bitcoin itself.

What we’re really talking about is time. Right now Bitcoin is a crapshoot. Its value is volatile and its future uncertain, although perhaps not as uncertain as you may think. I believe that with a better way for everyday consumers to utilise the currency, and supporting systems for sellers, we would already have substantially greater adoption.

Bitcoin is not going to go away unless everyone using it right now decides to stop doing so — and quite the opposite is happening. I’m not talking about the foolish investors that are essentially forex-trading with Bitcoin, but about buyers and sellers of actual goods and services. Every day more and more people are agreeing to accept Bitcoin in transactions.

The trend is on the up. If you study disruption then you know where this is going. The good people at Andreessen Horowitz make a living from disruptive technologies and have bet millions on the future of Bitcoin.

I also believe that Bitcoin adoption will increase drastically in the next three to five years as the financial crisis of 2008 comes back to haunt us. The measures taken by governments to bail out banks and ease the pain post 2008 have essentially delayed the inevitable — and they know it. There’s just nothing they can do about it.

If the world economy was a cancer patient, all we did in 2009 was give it some aspirin. It may have felt a bit better, but the cancer is still there.

When the next downturn comes our current currency systems will be turned on their heads. We have already seen the beginnings of this in Cyprus and Russia. Where did people in those countries put their money when governments started helping themselves from personal bank accounts last year? A lot of them turned to Bitcoin. In Cyprus you can now even pay for university tuition in bitcoins.

The next big downturn is likely to fuel en masse adoption, if not of Bitcoin then of something like it. Perhaps a new global, digital currency. Then again, we’ve already got a perfectly good one.

Also posted on Medium

I'm a writer and broadcaster who also designs apps and strategies for disruptive startups in the financial world. Find out more on my about page.