Everything I asked about Bitcoin

bitcoin

The econ-blogosphere has been Bitcoin crazy for a while now. I haven’t quite understood what all the fuss is about, and knowing the personalities involved in much of the hype, I was afraid to ask too many detailed questions.

But I did anyway.

I finally put together my views following Rabee Tourky’s post at Core Economics, and a recent note by CommSec’s Craig James earlier in the week.

So what are the big questions about Bitcoin that need answering? There are two: What is its purpose? And, how will it maintain value and avoid volatility?

To answer the first question it is worth starting with Bitcoin founder Satoshi Nakamoto’s paper about a peer-to-peer electronic cash system. He repeatedly remarks that the benefit of electronic cash is being able to avoid intermediary financial institutions, thus cutting down transaction costs, and that the reversibility of such facilitated transitions is an inherent weakness. I quote from the paper at length.

While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non- reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

Here’s where the circularity of arguments about trust comes in, and where my first question about the purpose of Bitcoin becomes rather confusing. What sort of transaction would buyers be willing to undertake without a trusted intermediary? Twitter was not much help either…

But even in the case of ‘dodgy anonymous transaction’ as one of my mates suggested on Facebook, the whole point of Bitcoin is a record of transactions or ‘money as memory’. A court could order Bitcoin’s miners, online waller suppliers or others involved in the network to disclose knowledge of transaction details and wallet identities in any case. Not only that, US officials have shut down digital currency operations in the past.

Authorities have also been looking into the criminal aspects of virtual currencies. Wolf Richter’s exposition of Bitcoin examines some of their discussions.

Officials from the Secret Service, the Treasury’s Financial Crimes Enforcement Network, and the Justice Department bragged to the committee about successful investigations of crimes where bitcoin or other virtual currencies were used, including the busts of Silk Road, eGold, and Liberty Reserve. They were confident that they knew how to tamp down on criminal use of virtual currencies. No one expressed outright alarm about the new world of bit coin.

Since every transaction of every bitcoin is forever recorded and part of the system, Mythili Raman, acting assistant attorney general at the Justice Department’s criminal division, pointed out that “cash is still probably the best medium for laundering money.” And she admitted that “many virtual currency systems offer legitimate financial services and have the potential to promote more efficient global commerce.”

At the word legitimate, bitcoin soared. And I mean, SOARED.

My line of thinking about potential benefits of Bitcoins is to consider what sort of transaction I would like to be unable to reverse. Would I ever purchase items on eBay with irreversible electronic cash, assuming that eBay itself did not provide any other intermediary role apart from advertising? Nakamoto seems to suggest that the cost of financial intermediaries excludes very small transactions, yet facilities like Flatter seems to overcome this problem through batching transactions.

The success of Paypal as an online payment system is partly due to the insurance it buys for both buyer and seller for the transaction. Anyone who refused payment from Paypal would be signalling their untrustworthiness or unwillingness to meet conditions of any mediated dispute. The point being, rather than creating a payment system that doesn’t rely on trust, using Bitcoin over other payment methods will itself signal a lack of trust. All transactions require some trust. There is no escaping that. Online that is even more important. For example, you pay me with Bitcoins, then I don’t post your goods, what recourse do you have?

So far there is no reasonable answer to my first question about the purpose of Bitcoins.

My second question unfortunately reveals similar unsatisfactory answers. If Bitcoins really are limited by constraints on ‘mining’, then that will mean that in a situation where they are in demand as a medium of exchange, they will also be increasing in value and be a means of investment. As more people prefer to hold Bitcoins as investments rather than exchange them, this will push their value higher still. If you can’t see it coming, the end result is a massive bubble followed by a crash when the herd realises that their investment value was purely based on herd mentality, without any fundamental resources backing it, and that the system is no longer being used as a medium of exchange. This view has been put forward previously by Eric Posner.

It’s not like alternative payment methods have not been tried many times before. Bartercard springs to mind as one system that survives in its business-to-business niche.

So let’s summarise. Bitcoins have been severely hyped online yet almost no one can suggest scenarios for both buyers and sellers in which they are actually a more useful medium of exchange than current costly reversible transactions. Furthermore, the ability for Bitcoins to hold there value is severely hampered by the nature of their technically limited supply. To top it off the only people I know of who have owned Bitcoins were speculating and never used them to transact. I can only conclude that this episode will go down in history as a lesson about the nature of money and trust in facilitating trade.

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Comments

  1. Agree with that and for HnH’s comment on this too that only gvt’s have the toughest sanctions to protect the currency. This is hype and also partly anti-CB and anti-gvt nonsense that is fuels it’s own demented sense of significance. Speculators can make loads of money but that is far short of what is claimed.

    • not true – speculators like me have made more in a short time on BTCs than i ever made on any equivalently priced asset except leveraged real estate

      it’s easier to buy and sell than gold and it’s in a bigger and faster pattern of appreciation than gold at even it’s most volatile times

      p

      • JG> “Speculators can make loads of money but that is far short of what is claimed.”

        TPOP> “not true – speculators like me have made more in a short time on BTCs than i ever made on any equivalently priced asset except leveraged real estate”

        You are both in agreement here so I assume BTCs are just another bubble for speculators. Will virtual pain feel real I wonder when it pops?

      • What! you have made 80x gains in leveraged real estate?

        remember, it not a profit till the momey is in your wallet.

  2. I’ve used Bitcoins to make donations to open source projects as well as pay for web hosting, VPN access and MP3s from three different bands. I have had absolutely no problems and wouldn’t hesitate to use them more in the future.

    I’m not sure what world you live in where you always needs to rely on an intermediary for purchasing all your goods and services.

    It’s easy enough for a physical store to accept bitcoins – would you trust a cafe enough to pay for your breakfast with Bitcoins?

    Price stability is a different matter but to suggest that there are no useless scenarios for Bitcoin transactions is ridiculous.

    “A court could order Bitcoin’s administrators to disclose transaction details in any case.”

    Pray tell who are “Bitcoin’s administrators” and under which jurisdiction they fall?

    “If you can’t see it coming, the end result is a massive bubble followed by a crash when the herd realises that their investment value was purely based on herd mentality, without any fundamental resources backing it, and that the system is no longer being used as a medium of exchange”

    Perhaps a bubble is inevitable (and we may well already be in one) but I don’t see how a crash will mean that Bitcoins lose their inherent usefulness.

    • Try thinking a little differently – what if you would like to buy from a online retailer but don’t want to give them your credit card details?

      You may trust them for the transaction but what about the risk of them being hacked and having your credit card number exposed?

      Or perhaps you’re buying something digital online but don’t think the retailer needs to know who you are or what your address is (needed for credit card verification)?

      Or perhaps you’re running a popular blog and don’t want advertising but would like an easy way for your readers to show their appreciation for what you’re doing. With 10 seconds’ work you can add a Bitcoin address for them to send money to with no transaction cost for you or them.

      The possibilities are great…perhaps you’re just lacking imagination?

    • i think their usefulness is limited

      if they became very popular then the number of transactions would grow exponentially

      if that happened the number of blocks to process would grow at a rate faster than any system to process them

      the block chain would become enormous – too big for anything but a top of the line block-chain miner to process

      then everything reverts to what we have now – a few “banks” (miners) that we have to trust

      as well the lack of anonymity of bitcoin is problematic

      unless you take significant steps to prevent a wallet being linked to you all of your transactions are embedded in history forever

      your great great grandchildren and enjoy the fact that your wikipedia entry includes reference to your purchases of, say, porn or whatever in the future we might frown upon

      p

      • “unless you take significant steps to prevent a wallet being linked to you all of your transactions are embedded in history forever

        your great great grandchildren and enjoy the fact that your wikipedia entry includes reference to your purchases of, say, porn or whatever in the future we might frown upon”

        If that’s a worry, then it’s simple to use a different wallet for every transaction.

        And there’s plenty of work going on to figure out how to completely anonymise Bitcoins – http://zerocoin.org/ for example.

      • ok what about this – b = bank, w = wallet

        b1 -> w1 -> w2 -> w… -> b2

        each transaction is on record

        the only trx that might be hard to track down is if the last point in the chain is to say a drug dealer who used tor to set up his point of sale

        if all transactions were only in BTC then you can have anonymity

        maybe

        i can use tor see things but i can’t isolate my eventual receipt of funds from some scrutiny

        unless i live my life on BTCs

        and only BTCs

        and i never purchase from anyone except as in a cash trx – ie i never buy something that is sent to me in the mail

        i think that is why government agencies are not so terrified of bitcoin

        every trx is recorded forever – such trails can probably always be analysed

        p

    • “It’s easy enough for a physical store to accept bitcoins – would you trust a cafe enough to pay for your breakfast with Bitcoins?”

      Sure. They accept many other payment methods too. So what is the value of another? Would I trust an online store in China that accepts only Bitcoins? Probably not. But I might buy from them using Paypal.

      “Pray tell who are “Bitcoin’s administrators” and under which jurisdiction they fall?”

      Anyone with an interest in ensuring the encryption in the system is robust and the time-stamping etc is valid and the system is not subject to hacking. My understanding is that any Bitcoin miner would fall into this category (correct me if I’m wrong). The point about revealing identities is more relevant to the identity of an owner of a Bitcoin wallet. Essentially the system appears to have a decentralised validation scheme rather than a centralised one.

      “Perhaps a bubble is inevitable (and we may well already be in one) but I don’t see how a crash will mean that Bitcoins lose their inherent usefulness.”

      Well, with government sanctioned currencies we have a long history of hyperinflation leading to an almost useless currency. A popping Bitcoin bubble would mean that prices in Bitcoin terms will be skyrocketing. Who would accept payments in Bitcoins while there value is plummeting and government-backed currency is not?

      • “Sure. They accept many other payment methods too. So what is the value of another? Would I trust an online store in China that accepts only Bitcoins? Probably not. But I might buy from them using Paypal. ”

        The cafe is an extreme example of a presumably trusted seller – you gave some examples of the other extreme. Surely you can admit there may be some in between (I have several examples in my post)?

  3. to your first question – Satoshi suggested escrow and i note that escrow was built into silk road

    so the issue of trust is not one to be addressed against bitcoin but about the way people do their transactions – transact without escrow and wear some risk or transact with escrow and pay a small charge to the escrow service – how much of a charge depends on the level of service of escrow but competition and statistics would allow for competition

    as to your second question – eventually the market will iron that out

    right now they are not an investment but appear to be a vehicle for speculation – and that happens everywhere humans get the idea that something might be worth more than the rest of the world realises

    their real value is how they might shake up the system and force other payment mediums to improve their services and lower their fees

    in the mean time it’s very very easy to trade BTCs on line

    that makes it fun – so it’s a form of entertainment

    one you can engage it at levels according to what you are prepared to risk

    pop

  4. Great article.

    For me, John Quiggin nails my sceptism about bitcoins.

    http://johnquiggin.com/2013/04/17/the-bitcoin-bubble-and-a-bad-hypothesis/

    “… Bitcoin is perhaps the finest example of a pure bubble.”

    “… because Bitcoins are the most demonstrably valueless financial asset ever created, they represent the sharpest ever refutation of the efficient-markets hypothesis.”

    So they have some value as a lesson on the nature of money.

    Perhaps also the ideas/technology behind them will go on to inspire some radical shakeup in future payments systems and I’m all for reducing the power of intermediaries (banks) to gouge out their profits from a system we’re all forced to use.

    • I’m more sceptical of the EMH than I am of Bitcoin.

      The problem I have with all these economists bagging Bitcoin is that they are looking at it from a purely theoretical point of view and ignoring the practical side of just how easy and convenient it makes electronic transactions.

      No currency conversions, no charge-backs (having previously been involved in online retail, I see this as a positive from a retailer’s point of view, not a negative as Rumplestatskin does), very low transaction costs, no need to trust a merchant with my credit card number or name and address (unless shipping is required)…I could go one.

      I believe that ease and convenience has a massive inherent value and if Bitcoin does disappear, then some other electronic currency will take its place.

      I have no idea what that value is but I’m not using Bitcoins for speculation or investment – just for online transactions.

  5. Your 3 questions:
    What is its purpose?
    How will it maintain value and avoid volatility?

    It’s a peer to peer electronic cash system. Its purpose is to cut out the middlemen and their fees.

    It will maintain value because people will trust in an all-hours functioning and transparent peer to peer electronic cash system over an opaque and wasteful government system that is inextricably linked to bad regulation of banks.

    Volatility will be part of the picture for a while but will eventually get less as more people get involved.

  6. I believe that what the Japan’s monetary easing policy is doing to push the YEN downwards healthily is an appropriate action for the Australian government to consider. In a layman term, just print more money to make the currency move downwards peacefully.

    Since the YEN is much cheaper than before, the export and tourism businesses from Japan are active again. This is exactly what we want to see.

    Also, if the A$ depreciate, it will show an improvement of our government’s overseas investments which are usually calculated in foreign currencies.

    Before A$ starts to depreciate, it should be a good idea for investors in Australia to rapidly purchase some overseas assets e.g. a supermarket chain in Hong Kong or some businesses in China or other parts of Asia.