Ask any financial reporter about Bitcoin and they'll tell you it's all the rage these days. "Cryptocurrency," previously a term that had never graced the ears of the general public, now permeates the radio and television waves, and of course, the internet, on a daily basis. Last month, there were two back-to-back hearings in the United States Senate Homeland Security and Banking Committees to help legislators learn more about the emerging and exciting phenomenon of digital cash. Yet, as is the case with most things in life, Bitcoin is far more complex than its many advocates would have us believe. Consequently, the understanding held by most, including those in government charged with regulating virtual currency, appears to be lacking. And that's a serious problem.
To be fair, there's a lot to understand and much of it is fairly nuanced. Even as someone who has spent considerable time learning about computer software, with a specialty in digital financial systems and occasional forays into security and public policy, I don't think I grasped Bitcoin's implications until recently, when I actually took the time to sit down and read the original 2008 research paper authored by the ever-mysterious and reportedly pseudonymous Satoshi Nakamoto. It's possible that I don't grasp all of the technology's implications still. There is no doubt that Bitcoin is a brilliant academic thought experiment. But the media hype has carried the paper's tenets far from the academic realm, which raises more than a few questions.
Question 1: Why don't we just barter with water?
Water is a scarce resource with obvious value: life depends on it and the supply on this planet is fixed. We are all used to paying for water. So why not use it as a medium of exchange?
For one thing, water is not easy to transport. If you had to pay for your groceries with water, you might have to carry a rather heavy kiddie pool with you at all times just in case your bill was particularly large. Paying for on-line purchases with water would be prohibitively expensive—imagine shipping even a gallon to Amazon.com in exchange for a book.
It's possible to sub-divide water into small units, but doing so requires a container and some way to measure amounts; you can't just eyeball 20 exact cups the way you can count out 20 identical pre-fabricated coins. It would also be a shame to allocate such a intrinsically valuable natural resource to a monetary system when there are people who die every day from their lack of ability to simply drink it.
The water question may seem like a complete tangent relative to Bitcoin, but it's actually quite instructive. At its core, Bitcoin is a proxy for another commodity we are all familiar with: electricity. Those who believe in Bitcoin (and given that a Bitcoin has no intrinsic value, it does require faith) necessarily believe that electricity is a scarce commodity that we should trade as a currency. Normally, this is difficult to do, because electricity isn't something you can hold in your hand in large quantities (at least not without seriously injuring yourself), and its ephemeral nature makes it impossible to sub-divide into physical units that one might pass over a merchant counter. That being said, it can readily be used to power machines, such as computers, that can do the laborious work of tracking who has used how much electricity, and when.
Here's where Bitcoin's peculiar nature begins to show through. No one has ever reasonably proposed that instead of using possession of water as a store of value that we should use consumption of water as proof of prior possession, which is then assigned value. The incentive to consume enormous, wasteful amounts of water would be too strong. Yet this is exactly how Bitcoin works: you are rewarded with new coins once your computer has consumed a certain amount of electricity (measured by the complexity of computing hashes of data, which takes time). Worse yet, the amount of electricity required to be wasted to earn a reward predictably increases, which means that the more Bitcoins one wants, the more one has to waste.
Electricity doesn't have the exact same transportation issues and sub-division issues as water. Electricity-via-Bitcoin allows greater control over sub-division than just about any currency ever known to man. Bitcoin wallets are also easily and freely transportable, provided that a computer infrastructure exists in the form of disks or networks, which is not an issue in the developed world. This last attribute is as much of a problem as it is a virtue, however. Bitcoin wallets are stolen with alarming frequency because they are so easy to move around, and unlike insured bank account deposits, once your wallet is gone, it's gone. There is no recourse. Whether on your own hard drive or on a server, so long as you have internet access, storing Bitcoins in a wallet, even at an exchange, is much like stashing your cash in a motel's mattress. You're definitely taking a chance, some motels have better security than others, over time the entire world might sleep on it, and not everyone who stays at (or operates) a motel is trustworthy.
Question 2: Is using Bitcoin worth it?
Given the utterly wasteful process of generating Bitcoin, a question that does not get asked enough is whether using Bitcoins is actually worth it from a strictly financial standpoint. Whatever the price of a Bitcoin might be at any given point in time, it is guaranteed not to take into account the actual costs of mining, which in econo-speak would be referred to as negative externalities. The fact that more coal has to be burned, in turn sending more sulfur, carbon dioxide and carcinogens into the atmosphere wherever the power station happens to be located, is not factored into a Bitcoin's price. (Mining Bitcoins does not merely require one's computer to be on; it requires the maximum resources one's CPU has to offer—the kind of computational intensity that makes a laptop fan sound like a jet engine, non-stop.) If only a handful of individuals were interested in mining Bitcoins, these externalities would be negligible. But if even 1% of the population of the United States or China were to become interested, the externalities might have an incredibly serious impact on our already fragile environment.
At the end of the day, the environmental cleanup costs and health care costs directly attributable to Bitcoin mining might very well exceed the aggregate worth of the coins themselves.
Question 3: Are merchants likely to accept Bitcoin?
The answer here is clear: no. Merchants are not likely to accept Bitcoin.
Even though there has been a considerable amount of hype around Bitcoin lately, and consequently a few small, independent merchants have expressed interest in Bitcoin with the ultimate goal of avoiding interchange fees levied by payment card companies—or of getting rich quick as currency speculators—none of that changes reality. It's not necessary to use virtual currency at all to avoid interchange fees; FaceCash and other mobile payments initiatives have accomplished that using plain old USD. More importantly, though, Bitcoin transactions are not like typical transactions because they are in the public domain and contrary to popular belief, Bitcoin is not anonymous.
The myth that Bitcoin is anonymous can be traced back to an error in the Nakamoto paper. Under the heading of "Privacy," page 6 of the paper states, "The public can see that someone is sending an amount to someone else, but without information linking the transaction to anyone. This is similar to the level of information released by stock exchanges, where the time and size of individual trades, the 'tape', is made public, but without telling who the parties were." This comparison is incorrect and misleading. Stock exchanges do not publish the account numbers, directly or otherwise encoded, of individual traders placing orders for securities. NASDAQ Level II data will tell you the size of an order and the broker or trading company (called a "market maker") handling it, but never any information that could conceivably identify the actual account holder behind the transaction. Bitcoin is different: information capable of identifying the account holder is published forever as part of the public general ledger, also known as the "blockchain." The fact that Nakamoto made such a descriptive error suggests a lack of familiarity with actual markets, regardless of the sophistication of the mathematics in the paper.
Most companies will not accept Bitcoin simply because they will not be comfortable with a public record of who has paid them, when, and how much. This information is too valuable to competitors, government regulators, and the media. It might also reveal illegal activity, which could trigger Foreign Corrupt Practices Act (FCPA) criminal investigations in multi-national corporations. For the same reason, most companies would be extremely hesitant to pay others in Bitcoin. Not to mention that the tax implications are an absolute nightmare, and would likely cost companies more than they would save due to additional paperwork, accounting fees, legal costs to clarify regulations, penalties, and interest.
But other companies will not use Bitcoin because doing so might directly violate the law, even if all of their other activity were completely legal. For example, a hospital, doctor's office, or medical laboratory would likely be forbidden by law, namely HIPAA, from using Bitcoin. Doing so would have a much-greater-than-zero probability of revealing who had paid the hospital, when, and how much, which could then be correlated with available pricing data to derive protected health information. Using a third-party collections service would not alleviate the problem, so long as that service was known to interact with hospitals. Their ledger would be just as public.
Furthermore, as many have pointed out, Bitcoin is not a particularly user-friendly technology. The addresses are very long strings of gibberish that are effectively impossible for the average individual to memorize, unlike bank account numbers, which have around ten digits. Special software is required to access the network. Even those who understand the basics may not really understand the mathematics behind the technology, let alone the security implications. Banking is comparatively simple: the mathematics behind a checking account is limited to addition and subtraction, and security is handled by the banks, Federal Reserve regulations, and FDIC (or NCUA for credit unions) protection—not the account holder. Libertarians who do not trust government institutions might be comfortable with such an arrangement, but most people simply are not.
Of course, the fact that Bitcoin prices have been highly volatile of late does not help matters. Widely-accepted currencies tend to have relatively stable prices with minor swings. But even if the price of a Bitcoin stabilizes, these other fundamental issues built into its design will remain.
Question 4: What happens if Bitcoin is more widely accepted?
If somehow the aforementioned issues were overcome and Bitcoin became widely accepted, the incentives for malicious actors to exploit flaws in Bitcoin's model would be much stronger than they are already—and they are already very strong. Bitcoin has been called a cryptocurrency, and those who understand cryptography understand probability. The Nakamoto paper very clearly outlines Bitcoin's greatest weakness: it only works so long as "honest" nodes (effectively, computers) control more than 50% of relevant CPU power, because those nodes can work to create the longest chain of hashed transactions, which is the chain assumed by the software to be valid. In today's world this seems like a reasonable gamble, but there is no guarantee that it will stay that way.
For example, in an instant, and for whatever reason, the Chinese government could issue a directive, publicly or secretly, making Bitcoin supremacy a top priority. Whether through legitimate means (encouraging businesses and citizens to install Bitcoin mining software) or illicit means (creating computer viruses and/or botnets that take over unsuspecting computers to mine Bitcoins in the background), China—or really any large malicious actor—could harness vast computing resources to effectively outcompete the computers working on the valid chain (again, at great environmental cost). Thanks to the internet, China could even harness vast American resources using botnets to use electricity resources in the United States for China's financial gain. Just because it has not happened yet does not mean that it could not. Were this to happen, Bitcoin would be completely worthless as currency, and in principle.
Bitcoin's popularity in China today is more likely the result of that country's various fiscal policies that make it very difficult for average citizens to save. Consequently, real estate, and now virtual currency, are the preferred alternatives to savings accounts that largely do not exist the way they do in the United States. But China is also known for its willingness to exploit technology for its own purposes no matter the costs, and given wide adoption, the incentives for outracing the valid chain (controlling more than 50% of the network's CPU power) would certainly be present.
Question 5: Is Bitcoin legal?
In the United States and most other countries so far, Bitcoin itself is legal. Such legality is misleading however, because in the United States, running a Bitcoin exchange is not legal without federal registration with the FinCEN division of the United States Department of the Treasury and roughly 47 state money transmission licenses. There is presently not one Bitcoin exchange that has met these criteria, and therefore, there is no Bitcoin exchange operating legally in the United States. Although users of these illegal exchanges are not breaking any laws as customers, the fact that they are storing value with illegal enterprises means that their funds could be seized by the government at any time without prior notice.
As a side note, the existence of "The Bitcoin Foundation" hardly does much good for Bitcoin's image. The Foundation has refused to get involved with serious legal issues surrounding the state money transmission regulatory structure because of its impact on its founder's independent, commercial, for-profit ventures—one of which recently filed for bankruptcy.
Question 6: Is Bitcoin a Ponzi scheme?
In some ways, Bitcoin does resemble a Ponzi scheme. Its early adopters stand to gain the most, with successively later adopters each gaining less and less from Bitcoin's planned depreciation due to its fixed supply of 21 million coins. Bitcoin differs from most Ponzi schemes, however, in that it does not necessarily pay returns to new users from existing capital contributed by prior users. Bitcoin also has a multi-lateral nature, as opposed to the traditional bi-lateral model where one invests some money with a single fraudulent entity and then waits for eventual riches. In other words, participants can sell their coins to others at any time. These differences are enough to make Bitcoin at least a new variation on a Ponzi scheme.
Even if Bitcoin is not technically a Ponzi scheme, that does not make it any less dangerous. In a worst case scenario, a holder of Bitcoins would lose everything, and there are presently several ways in which that can happen:
- The user's wallet file is stolen or deleted from the user's storage device.
- The user's wallet file is stolen or deleted from an exchange's storage device.
- The user's wallet file is seized by government regulators.
- The value of each Bitcoin drops to zero (where it began) if and when users recognize that it will never be widely accepted.
- The value of each Bitcoin drops to zero if and when increased government enforcement of money transmission and/or anti-narcotics laws makes the use of virtual currency impractical.
- The value of each Bitcoin drops to zero due to presently-unknown circumstances involving Nakamoto's true identity.
The first two ways of losing everything transpire on a daily basis; the third way has happened at least once. The fourth, fifth and sixth ways have not happened yet, but easily could. Therefore, generally speaking, investing in Bitcoin is about as risky as investing in a Ponzi scheme, even if it is not one.
For all of these reasons, I don't own any Bitcoins. I don't ever plan to. Even if the price of a Bitcoin hits $2,000, or even $10,000, the problems described here will still apply. Bitcoin may persist as a minor curiosity used by a small number of people for illegal activity, but if anything, I believe that it proves that our government institutions, broken though they may be, exist for a reason.