Bitcoin mania has now reached such worrying heights that some people are even putting all of their savings into it. Unfortunately, Bitcoin is fundamentally flawed and by the time you finish reading this article, I hope you will agree with me.
For those of you not familiar with Bitcoin, it is often described as a “peer-to-peer currency”. This geeky video is sorta informative:
There are a lot of good reasons to be excited about the design behind Bitcoin — it enables secure transactions in a transparent manner and doesn't require centralised authorities. It really is genius and I look forward to seeing it used in other domains.
However, this does not make Bitcoin a suitable currency system.
Why?
Because, by design, there will never be more than 21 million Bitcoins in existence. And thanks to hoarding and attrition, we can be sure that it will eventually serve as nothing more than as a collector's item.
Bitcoin Hoarding
First, let's take a look at why Bitcoin encourages hoarding. As I write this, the current total of Bitcoins mined so far is just short of 6.5 million:
>>> bitcoin.currentTotal()
6459900
That is, nearly a third of all Bitcoins that could ever exist are already sitting on people's computers. Now let's assume for a moment that Bitcoin really is useful and in the next decade grows to an economy the size of Mexico, i.e. a trillion dollars.
In this context, if you had 50 Bitcoins they would be worth:
>>> (50. / 21000000) * 1000000000000
2380952.3809523806
That is, 50 Bitcoins would be worth over 2 million dollars!! Knowing this, unless you were super desperate, would you really spend those Bitcoins today?
In the early days, when Bitcoin was just a fun experiment, it might have made sense to spend it. But given that people are now willing to accept it as a currency, you would be an idiot not to hoard it.
And, unlike currencies backed by gold or oil, where there is always the chance of someone discovering new gold mines or oil fields, you know for certain that no-one will ever be able to dilute your share of the total Bitcoin.
Now, despite the hoarders, there will still be an initial spike in the demand for Bitcoins due to:
- Non-hoarders experimenting with the system and unwittingly increasing the value of the Bitcoins held by the hoarders.
- Greedy hoarders trying to buy up as much Bitcoins as they can so as to increase the size of their potential future wealth.
- Scammers manipulating the market with trades so as to make a quick buck from greater fools before it all comes crashing down.
Unfortunately it won't last long. For starters, the non-hoarders (the actual spenders) will gradually discover that hoarding is the best strategy for maximising the value of their Bitcoins — causing them to either abandon the system or start hoarding themselves.
It would also become increasingly apparent that the majority are hoarding and that only a fraction of Bitcoins are in actual circulation. At this point, it is effectively game over for Bitcoin as a currency. An economy really can't function if nobody spends any money!!
Since there will be a slow trickle of new users and cautious hoarders gradually dumping some of their Bitcoins, I doubt the Bitcoin economy will come to a total standstill anytime soon. But there is no doubt that the majority of the activity will be driven by speculation.
It should hopefully now be obvious that Bitcoin is simply a store of speculative value. In some ways, it's a lot like publicly traded shares. But it's worse, because at least with most shares you get a share of the underlying corporate assets and profits.
Also, unlike shares, where you can generally expect recurring speculative bubbles, Bitcoin is not impacted in positive ways by underlying conditions, e.g. corporate acquisitions, new share issues, growing profits, etc. Thus the capacity for multiple Bitcoin bubbles is extremely low.
If anything, potential changes in external factors pretty much all lead to a negative impact for Bitcoin speculators, e.g. financial regulation, technological breakthroughs, forked block chains, etc.
Bitcoin Attrition
The effect of hoarding is made worse by the inevitable attrition of the number of available Bitcoins. That is, as time goes by, there will be fewer Bitcoins available in proportion to the total number of Bitcoins.
This happens for a variety of reasons:
- Many users, especially early-adopters, having experimented with Bitcoin and generated some coins, have then just forgotten about it.
- You can't access your Bitcoins unless you have your private keys backed up somewhere. Hundreds of people have failed to backup their wallets and have lost these keys permanently.
- Technical issues in how the client generated keys has led to users losing Bitcoins even when they tried to backup properly, e.g. these two have each lost what would today be worth about $130k and $160k due to technical glitches. Ouch!
If it were possible to determine it, I would be willing to bet that over a sixth of the Bitcoins mined thus far are already not accessible. In our hypothetical scenario above, that would translate to over 50 billion dollars worth that has simply been “lost”.
As time goes by, this figure is only guaranteed to increase. And since we can safely assume that hoarders will be a lot more careful than the experimenters, most of the attrition will likely come from the actual spenders in the economy.
Thus, limiting the actual number of Bitcoins in active circulation even further! I could go on, but I hope the point is relatively clear. Hoarding and attrition make Bitcoin unsuitable as a currency. Now, let's look at some counter-arguments.
What about creating new block chains without the 21 million coin limit?
Yes, you could create new block chains, EuroCoin, ChinaCoin, etc. However, this would be not be fixing the problem with Bitcoin in any way. You would simply be introducing competing alternative systems which may or may not fix the fundamental issue.
What about extending the Bitcoin client to keep on issuing new Bitcoins?
I don't think you could keep on calling this Bitcoin. For starters, it violates what most people understand as Bitcoin — that it is totally decentralised and cannot be controlled by any one party.
By imposing such a fundamental change, you would be violating the core assumptions made by those who have invested in Bitcoins. I doubt most of the anti-gov folk who seem to have taken to Bitcoin would be interested in having such changes dictated to them.
What about using consensus to change the protocol?
This is super easy to say and almost impossible to achieve. How would you achieve this consensus? Would it be majority/mob rule? By lottery? What about those who disagree with the result? Who decides on the process?
I fear that the opportunity to fix this has long since gone. If anything, future decentralised currency designers should take this as a lesson to specify, ahead of time, a process to use in order to make protocol changes.
That way, beneficial changes can be made without violating any implicit assumptions that people might have made.
Conclusion
Bitcoin is not a viable currency. It is a store of speculative value — much like investing in stamps, comic books and vintage shoes. The fixed limit of the number of Bitcoins is subject to attrition and encourages hoarding which will inevitably lead to mainly speculative activity.
Whilst Bitcoin is a perfectly viable speculative instrument, it will be far too volatile to serve as a medium of exchange. I would like to call upon the Bitcoin community to stop referring to it as a digital currency. This is misleading and harmful.
Finally, forgive me if I haven't been clear enough with any of the explanations and do let me know what you think.
— Thanks, tav
