Bitcoin – Don’t Believe The Hype

It is anonymous, so you can buy and sell whatever you want without leaving a trace…drugs, weapons, stolen credit cards, assassination contracts…

Bitcoin, the new decentralized digital currency that’s rapidly gaining popularity, was invented in 2008 by a mysterious hacker named Satoshi Nakamoto. He published the original paper describing the protocol, developed the initial implementation, and remained active on the mailing lists until mid-2010, but then vanished. He was presumed to be an individual from Japan, but nobody by that name actually exists, so many now assume Nakamoto is a pseudonym for an individual or group that wished to remain secret. So what did this mysterious person/group/ghost create, and why is it taking the world by storm?

Bitcoin is essentially a new form of money, purely digital and stored on your computer. It can be treated like cash, and payments in any denomination can be made securely and instantly around the world. It is managed and operated by a peer-to-peer network, so no central authorities or banks are involved in these transactions. It is anonymous, so you can buy and sell whatever you want without leaving a trace. This has led to its popularity in underground markets such as Silk Road, where bitcoins are used to buy drugs, weapons, stolen credit cards, assassination contracts, basically whatever you can think of. Because of this anonymity, bitcoin transactions are not generally reported to tax authorities, making them tax-free (at least for now). Transactions are secured by strong public-key cryptography, a very secure mechanism, although it does ultimately depend on the security of your individual computer. If someone hacks your computer, your bitcoins can be stolen, in the same way that someone can steal cash out of a safe if your house is not properly secured.

These are the features of the currency from a user perspective, but what about from a systemic perspective? The primary feature that bitcoin advocates are excited about is the absence of any central authority. There is no central bank managing the currency, as opposed to virtually every government currency, where a national or regional bank, such as the Federal Reserve or European Central Bank, controls the amount of money in circulation. Proponents are excited by this because of perceived mismanagement of U.S. dollars by the Federal Reserve, in conjunction with out-of-control government spending that has led to unprecedented levels of “printing” in recent years. Fears that the government will be unable to control its spending, leading to high rates of inflation, make a deflationary currency scheme like bitcoin seem very attractive.

So how do bitcoins get created? The technical details of the money creation process are a little too arcane to describe quickly or easily, but if you’re technically minded, the protocol is open source and available online. Bitcoins are created in a controlled fashion, at a predictable rate, essentially as a reward for the computational work required to keep the system running. Since this is a peer-to-peer network, it requires a large number of computers running at the same time to keep things running smoothly. This means capital and electricity costs for the participants, so as a reward, new bitcoins are given on a somewhat random basis to those doing the work. 

This is what puts bitcoins into the system. This process is called “bitcoin mining,” due to its similarity to gold mining—work is done to produce something of value and put it in circulation.

Bitcoin mining is one of the primary drivers of the hype behind bitcoin. Unsuspecting newcomers are led to believe that all they have to do is run a computer program 24/7, and it will essentially print money. There are numerous sites and blogs describing “mining rigs” — people building out elaborate specialized computers and networks for the purpose of capturing this money as it is created. Now, before you go out and waste your money, I should tell you that the facts do not support the hype. There is so much computational power in the network at this stage that the likelihood of capturing any new coins is very low unless you have an enormous pool of computers at your disposal, and the costs of building and operating such a network will likely outpace your return. If you want to use bitcoin, do it for its utility, not out of hope of getting “free” coins.

The other way to get bitcoins is to trade national currencies for them. There are several online currency exchanges available, such as Mt. Gox, that allow you to trade dollars for bitcoins and vice-versa. This is another driver of the hype behind bitcoin — speculators that are essentially investing in bitcoins, hoping the value will go up, as it has been. The value is extremely volatile, and traders are capitalizing on that, but overall the value has been going up as more people buy into the hype. As of the time of this writing, one bitcoin is worth $22.76.

My analysis of bitcoin has led me to believe that the money creation process is flawed, and the system rewards early adopters to an unfair degree. It has some of the characteristics of a Ponzi scheme as a result. Early adopters have already captured about half of the total number of bitcoins that will ever be generated, and as the rest of us scramble, their value will increase. The deflationary aspect of this virtual currency is also troubling—it doesn’t account for the fact that, as the number of participants increase, the value of the overall economy also increases, but the money supply does not reflect that. Bitcoin is a very interesting experiment, but I believe it is the first of many, with much left to be desired.

I’d love to hear from you. Go to http://synthesisweekly.com and comment on this article, or email me.

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Matt Olson is a systems thinker, hacker, and social entrepreneur proud to call Chico home. He's a software engineer with a particular interest in using social business to address seemingly intractable problems. When it's time to relax, you'll find him on the roads and trails of the North State on his Homer Hilsen, playing bocce, or building robots with his boys.

Comments

  1. William Bell says:

    There are mistakes in your publication. Right from the start, Bitcoin is *not* anonymous at all. And the bigger of your misconception is to believe Bitcoin leaves no trace. It is the exact opposite, Bitcoin leave a permanent public trace of every transaction. That is quite a huge tool for police investigation. So Bitcoin is not the “money of criminals”. Also Silk Road does not sell assasination contracts or guns. o_O . And their anonymity rely on tor, not Bitcoin.

    “My analysis of bitcoin has led me to believe that the money creation process is flawed, and the system rewards early adopters to an unfair degree.”

    Early adopters get nothing but an unstable, volatile and under-developped economy. Sooner you buy Bitcoins, the more you take risks. If Bitcoin is worth 1000$ in 3 years, it might also have a legal status, be much less volatile and empower a stong and stable economy, have plenty of buyers and business accepting it. There is a price for this.

    Saying that this process is flawed is the same as saying that investing in high-risks startup (like Google and Apple once where) and making extreme profit is a bad thing. Yet the reason why you can make extreme profit is that there is a high risk that you won’t make a penny.

    So for that reason I agree with you on “Don’t believe the hype”. And that is why the main Bitcoin developpers makes it clear when he repeats “Don’t invest money in Bitcoin then what you can afford to lose”. That is no revolution, that is classic high risk investments.

    “Unsuspecting newcomers are led to believe that all they have to do is run a computer program 24/7, and it will essentially print money.”

    Money creation is indeed a hard and competitive process. And someone with no technical knowledge won’t be able to do the technical steps to start mining. So you need to read and understand it before you get started. There are probably more than 20 online calculator to evaluate potential profits. And any of them shows you deceiving (yet realistic) results. So I’m not quite sure how someone could believe this is that easy. Bitcoin mining is not publicized as a easy way to make money.

    “the value of the overall economy also increases, but the money supply does not reflect that”

    You are probably missing the point that Bitcoins are divisibles. That is how they handle scalability.

    You also forgot to mention the reasons why Bitcoin has a value. Namely that it has no or about no fee to use. That it works worlwide with about no delays. That it is the first money that is impossible to counterfeit, usurpate or reverse (making it the only online money that can reaches some countries with high fraud risks). And its interoperability, making it a money that works between many banks and software.

    Those are pretty huge features no other system can provide yet. And thus, the value of Bitcoin is actually also a representation of how the market want these properties. Just as any other good in this world..

    1. Matt says:

      While it’s true that bitcoin transactions are published to the entire network, if care is taken you can operate in an anonymous fashion. Using new addresses for each (or a particularly sensitive) transaction, not associated your personal identity with your bitcoin addresses, obtaining your bitcoins through mining or trading with individuals that don’t know your identity — these steps help ensure your anonymity. The tricky part is when using exchanges that retain personally identifiable information. But that is outside the realm of the bitcoin protocol, and it is widely acknowledged that introducing the trust of third party services reduces your privacy.

      As for your statement about treating bitcoin as a high risk investment, you have a valid point. Treated as such, with resources you are willing to lose, this is classic speculation. But that is not what I was referring to with my statement that the money creation process is flawed. If I had more space available to me, I would have elaborated more on that. I was referring mainly to the cap on the total number of bitcoins and the deflationary pressure going forward as a result. Early miners are rewarded with a larger share (due to the higher probability of collecting) of a fixed pie. Not only that, but the value of bitcoins is tied directly to their artificial scarcity. I would advocate for a different approach where the currency is tied to real value in the economy.

      With my statement that the currency doesn’t reflect the overall value of the economy, I mean to say that it is based on artificial scarcity. I’m aware that bitcoins are divisible, this is how users will handle the inevitable deflationary pressure, but that will also have its own negative consequences — a desire to hold the currency due to its increasing value.

      I would advocate for a decentralized mutual credit clearing system that would have a lot of the benefits of bitcoin while removing the incentive for speculation and avoiding the inevitable deflationary pressure that exists in the bitcoin market.

      There’s a lot to love about bitcoin, don’t get me wrong. I like its decentralized nature, its underpinnings in public key cryptography, its irreversible nature and ability to avoid fraud allowing for instant worldwide transactions. But my opinion is that the hype right now is based more on speculation than a strong foundation, and a lot of people are going to get crushed when the bubble bursts.

      I would treat bitcoin as the first of many digital currency experiments. We will learn a lot from this and create something stronger and more durable.

      1. William Bell says:

        Yet.. classic cash is more anonymous than Bitcoin and is certainly the #1 money for criminals. So to me while it seems absolutely genuine to question if Bitcoin can be associated to illegal things, I think that it can become pretty reductive and not representative of what it is as a whole.

        I don’t understand how you come to the conclusion that “early miners are rewarded with a larger share (due to the higher probability of collecting)”. It think there is a misunderstanding here. No matter how long someone is mining Bitcoin does not increase its chances to fix hashes. And oppositely, old miners have to upgrade their equipments unless it becomes not enough productive against new technologies.

        I am interested to know what is your definition of a “real value in the economy” and how Bitcoin is does not have this property. The value of any currency works actually exactly in the same way than Bitcoin. Except that Bitcoin is a perfect representation of its value in the market. As opposed to traditionnal currencies that have the value that central banks artifically gives them with money printing VS money destruction. From that perspective, if find the value of the later much more artificial than the first one.

        I would also be interested to see alternatives rising. I do not believe that much in mutual credit clearing because I tend to believe that an economy must rely on something stronger like math. Which is why I find Bitcoin amazing. However, I would be very pleased to be wrong. All of these ideas are actually very exciting.

        Bitcoin is indeed a very young thing. I share your skepticism on speculation. That is definitively something that might turn against Bitcoin. Even if it seems very resilient to massive drops, it is something that will be interesting to follow.

        1. Matt says:

          Point taken, William. I didn’t intend for bitcoin’s potential use in illegal activities to be the focal point of the article. I think if you read the entire article, you’ll see that is a relatively minor point, but it was called out by the editors for the pullquote.

          My point about early miners being rewarded more than later ones comes from the fact that the pool of miners is smaller, therefore the chances of claiming the reward is greater than later periods where you are competing against a larger pool. There is now a relatively low chance of succeeding on any meaningful level, whereas in the early days there was a greater chance.

          My point about the currency reflecting real value in the economy is somewhat philosophical. Fiat currencies don’t necessarily do this either, as they are subject to the whims of central banks and government spending. The Austrian school of economics would advocate for a return to the gold standard, which is essentially what bitcoin aims to reproduce in the digital realm. I would advocate for a third way — a decentralized currency that is driven directly by economic activity rather than centralized decisions by central banks, namely the mutual credit clearing system, which is based on community trust, but implemented as a digital currency. The currency in the system adapts to economic activity and is not influenced by policy makers, only the needs of the market. Unfortunately, it’s difficult to get into these topics in an 800 word essay. 🙂