BitCoin: Anarchist's Payment System, Alternative Currency, Both, or Neither? - Granite Grok

BitCoin: Anarchist’s Payment System, Alternative Currency, Both, or Neither?

bitcoinsThere’s been a lot of sound and fury over BitCoin the last year or so, especially when the exchange rate for one ‘Coin broke into the hundreds of dollars, making some early adopters rich.

But is it REAL money?
But is it REAL money?
Cartoon by Mike Keefe – click to enlarge.
There have also been a couple of well publicized crashes in the value of BitCoin, and recent failures of established BitCoin Exchanges, with accompanying loss or theft of customers’ ‘wallets’.

Accompanying all this ‘Sturm und Drang’, there have been essays by respected sources claiming that BitCoin both is, and is not, Money. At National Review, well known economist Larry Kudlow wrote “BitCoin Is Not Real Money” and at American Thinker, Macroeconomics Professor Chriss Street wrote “BitCoin Is Not Going Away” – two well educated sources, two diametrically opposed viewpoints. Could they both be right?

Your scribe happens to think the answer is ‘yes’, and I’ll attempt to explain why I think BitCoin most closely resembles a speculative stock which also happens to be a payment medium. As an investment, it is exceedingly volatile, while as a payment medium, it aims to be as seamless as PayPal – all with little or no government visibility.

When you put money into BTC, you never know what you'll get out!
When you put money into BTC, you never know what you’ll get out!
Try to imagine settling transactions via PayPal, except that all transactions must be carried out in PayPal’s own stock – that means your recipient may receive a different amount of Dollars than the price you paid when you initiated the transaction. Unless the value of the exchange medium is MORE stable than the Dollar, merchants will demand a price premium or fee in order to accept digital payments.

The simplest phrase I can think of for this behavior is normally (appropriately) associated with car salesmen: “YMMV – Your Mileage Money May Vary”!

How does BitCoin work, and how did I form my opinion of it?

In order to be a reliable store of value, a substance needs to be desirable and scarce, and for that scarcity to be perpetuated by the level of difficulty in adding to it, IE mining silver, gold, or diamonds, where the expense and effort to mine more of a commodity helps to regulate the price.

Contrast that with fiat money, where, unless strictly backed by physical gold or silver, the natural temptation of governments is to print more and reduce the value.

249px-Mining_symbol.svgBitCoin attempts to emulate a physical store of value, and to avoid inflation, by having a strictly limited supply of unforgeable digital certificates (effectively the ‘Coins), which are ‘discovered’ and added to the ledger (called the BlockChain) through a computationally intensive process called “mining’, which it resembles.

In BitCoin mining, a bit like calculating larger and larger prime numbers, the first few are easy, and then it takes the poor old PC longer, and longer, and hours, and days, and weeks, to solve the equations. Now that more than half of the ‘Coin have been discovered and the equations are taking a long time to solve, ‘miners’ are investing thousands of dollars in high end PCs with special processing boards resembling a gamer’s graphics card, with a payback of a ‘Coin every few weeks, in return for the computing power which they bring to to bear on maintaining that crypto-ledger, the BlockChain. The increasing value of the ‘Coin justifies the hardware and electricity invested by the miners.

Server-CloudHaving explained the scarcity and the discovery process, now it is time to look at the transaction process. The very large numbers of users and miners form a giant peer-to-peer distributed accounting ledger, where the movement of every BitCoin, or fraction thereof, is tracked by adding new digital signatures to the “BlockChain”.

Because the BlockChain is widely dispersed and based on sound cryptograhpic principles, loss of, or attack on, any part of the network will not compromise its integrity. Transactions contain information about the prior chain of custody up to the current owner, the number or fraction of BitCoin being transferred, and the secure digital identity of the recipient. Within a few minutes of a transaction, it has been cryptographically embedded into the BlockChain, and the ‘money’ belongs to its new owner.

To sum up: There is a limited supply which becomes increasingly difficult to ‘mine’ (so cannot be inflated), there is a secure digital ledger of (anonymized) ownership and transfers, and it does not involve banks or government except where money is converted between BitCoin and other types of currency. What could go wrong?

LiliCartoons-20140228-Robbery

There was a reason why the Nation’s founders specified gold and silver as money, and tasked Congress with minting coins and regulating the value thereof – Gold and silver have always had value as jewelery, art, and more recently in electronics, which explains the steady demand to counterbalance supply. The only sudden drops in the value of Gold vs commercial goods have been caused by human stupidity, such as the Conquistadores dumping the spoils from their plunder into circulation on their return to Spain, or the Federal Reserve leasing out ‘fractional gold’ to deliberately suppress price signals.

Help! I'm shrinking!  (Graphic: Global Fund Exchange Blog)
Help! I’m shrinking! (Graphic: Global Fund Exchange Blog)
Fiat money is rightly despised by lovers of economic freedom because, unless strictly backed by gold, silver, etc., it is subject to inflation at the whims of the central bankers and governments, a hidden tax which impoverishes the majority and enriches the few. The reason the dollar remains desirable is that it’s value cannot fall too quickly unless the printing becomes infinite, AND because it is the medium for investing in the worlds largest economy with a vast bounty of natural resources and businesses continually creating value.

hThe founders and software community behind BitCoin have solved the inflation issue by the engineered scarcity and effort involved in ‘mining’: What they have NOT solved is the desirability issue – remember that I said a medium of exchange (currency) should be both scarce AND desirable.

BitCoin proponents will say I am wrong, because BitCoin has advantages for those wanting to trade beneath the government’s radar, and is thus desirable for that reason. My counter to that is to ask how safe BitCoin is as a long term investment? Can you keep your (ill-gotten?) gains from your transactions in BitCoin, as BitCoin in your Wallet, and be sure that, say, the $1M you just got from selling art or real-estate will be able to buy similar art or real-estate tomorrow, or next week?

As an example of what I mean, consider a tale of two businesses:

FactoryLet’s say I’ve got an old fashioned factory with some metalworking machinery, a stock of raw material, office furniture, IT gear, maybe some company trucks, and the land it stands on. If demand for my finished product vanishes, some value remains to be recovered in liquidation, and the creditors and stockholders will get something back.

WorthlessStockNow lets say I have a whizbang software company in a rented building, with leased furniture and computers, and the fanciest social media system since ‘faceplant’ or ‘tweeter’. My stock price is held aloft by the slim (but growing) advertising revenue, and the faith that my user base will soon outpace those other fuddy-duddies.
Then one day, I have a major security incident, the users flee in droves, the advertisers have no reason to stay, and the business runs out of cash as the stock price is cratering. There’s nothing to liquidate, nothing for another investor to buy out, and nothing stopping those stock certificates from becoming toilet paper.

The Dollar (with the US economy behind it) mostly resembles the former scenario, while Bitcoin most closely resembles the latter scenario, because, regardless of its inherent non-inflationary nature, it has no underlying value except for its desirability as a medium of exchange – cause doubt in its reliability, and the users will flee in droves, the miners will take their computing power elsewhere, and the blockchain (ledger) will lose first its speed and then its integrity.

What could cast doubt on the stability of BitCoin as a store of value? (Not disputing its utility as a medium of exchange.) Let me count the ways…..

MtGox-CoinA BitCoin exchange could fail, resulting in the loss of customers’ funds, though incompetence, software bugs, or malfeasance. Last month’s failure of Mt Gox could be a combination of all three, and caused a major reduction in the value of BitCoin.

HackerSecurity problems or hacking could result in funds being withdrawn or spent twice, such as the lingering “Transaction Malleability” bug, whereby a small change in the transaction identification could result in a subtle difference in the signature added to the BlockChain. If the exchange’s ‘wallet’ software did not incorporate appropriate checks, the payee could claim they did not receive the ‘Coin, and request a resend. Several Bitcoin handlers have asserted they were victimized as a result of the bug, but it’s hard to verify whether they were careless or complicit.

Governments could restrict trading in BitCoin, investigate exchanges, or generally harass users.

BankSquidCentral banks could take advantage of the limited liquidity to play games with BitCoin’s value. Large trading firms are now getting into the market, and High Frequency Trading is likely to increase volatility.

Tending to confirm my assertion that BitCoin is more like a volatile stock than anything else, the IRS just ruled that “BitCoin is property, not currency”, meaning that gains and losses in the value of your holdings are subject to Capital Gains Tax rules.

In conclusion, if you use BitCoin as an investment, buckle your seatbelt, and if you use it as a payment medium, ensure that transactions are completed quickly, to avoid having to “top up” the payment. Like I said, YMMV!

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