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Bitcoin: a new way for money?

What is it?

The short answer is money.
Well, there are several ways to make money: earning it, finding it, counterfeiting it, stealing it. All of them requiring some skills. But, if you’re Satoshi Nakamoto, you can also invent it! On the evening of January 3rd 2009, he pressed a button on his keyboard and created a new currency called Bitcoin: all bit and no coin, made of thirty-one thousand lines of code and an announcement on the Internet. Nakamoto created a currency immune to the predations of bankers and politicians and entirely controlled by software. He claimed to be a 36-year-old Japanese male. He disappeared entirely from the net in April 2011, saying that he was moving on to other things. A Pulitzer prize awaits the journalist who unmasks him.
In reality, bitcoin has been defined in many ways and it is now a bit difficult to frame it into existing patterns. The original paper from the elusive Satoshi Nakamoto tends to describe it as a secure peer-to-peer electronic payment facility that does not require the intervention of a financial institution.
If it were limited to that, it would be a notable progress – actually with a prosperous future and brilliant destiny – but it wouldn’t necessarily attract the attention of most people – not after credit cards and PayPal. Nor the fact that it defines yet another currency can make it strong enough to attract attention – not after the latest experiment with the Euro….
The fundamental characteristic that makes bitcoin unique, interesting, attractive, volatile, somehow dangerous, somehow cathartic is that it is new money, created out the blue by an individual – not an accredited financial institution!
Whatever aspect we look at, it’s worth taking a closer look, because there are fascinating implications regarding on our existing patterns for value and trust.

The payment facilitation

The free electronic payment capability is both the way bitcoins are first explained and the first benefit that is claimed.
The fundamental approach is that it is fully decentralised: no central clearing house to execute payments. Encryption plays a major role in its very strong security and a special design guarantees unicity of transactions. Payments are also anonymous, because there is no need of knowing the sender’s identity for the system to work. Moreover, the mechanism is such that once you send them, they’re sent. From the other end, if someone sends you bitcoins, you know for sure that you own them because the whole system guarantees that: there’s no need to know or trust the sender  – just that they are in your wallet!
Though it needs to be recognised that it addresses the security topic in an innovative way and it removes the dependency on a usually profit-making third-party controller, electronic payments have been in service for a few decades now and this is not enough to justify the passion on this phenomenon.

Mining bitcoins

How can bitcoins be obtained? One can purchase existing bitcoins but other alternatives are available: you can mine bitcoins.
As if they were gold or diamonds, mining bitcoins means that you need to spend work for that: you’ll need to run a program that tentatively tries billions and billions of combinations before it can generate a block of bitcoins. The reason for that is in the mathematical properties and the supporting technology.
As it stands now, bitcoins behave like diamonds: no central issuing authority, a very large but not infinite base. The amount of bitcoins that can be mined is 21 millions. Currently, each valid combination generates a block worth 25 bitcoins. With the people doing it worldwide, this occurs approximately every ten minutes. This amount will be halved to 12.5 bitcoins within the year 2017 and again roughly every 4 years thereafter, until 2140, when the hard-limit of 21 million bitcoins is expected to be reached.

New money?

Bitcoins present characteristics of a commodity and of a currency.
Like gold or diamonds, they are not the property of any Government; they are not issued by any Central or Reserve Bank, and they certainly won’t be subject to inflation, since the global supply cannot exceed 21 millions. But the comparison with precious commodities stops here: there is no big seam to be explored and discovered because, as explained, mining for bitcoins requires a significant amount of computer work, pretty much no luck, and the average rate at which new bitcoins are generated is both known and decreasing.
They are also a currency. If I have a ten-dollars banknote and I gave it to you, it is a monetary transaction which is both anonymous and untraceable. It only requires us to be physically in the same place. Nobody sees any threat here. With bitcoins, it’s the same, with the clause that we need an Internet connection and the advantage that we don’t need to be in the same place.
The big difference with the “standard” currencies is not that bitcoins are made out of thin air: this is what the “standard” currencies are made of, whereas bitcoins are made of (computer) labour! The big difference is the legal aspect. Every Government in the world reserves for itself the right to give legal course to the currency of its choice (not necessarily to have its own) by law and, more importantly, forbids anybody else to do so. But this approach has been heavily influenced by the perception that money was primarily paper money: what does that really mean when private (though regulated) financial institutions can issue electronic money backed by nothing?
The matter is not as clear as someone would like it to be. There is formal evidence of pretty much anything. For example, on July 30 2013, the Foreign Exchange Administration and Policy Department in Thailand stated that bitcoin lacks any legal framework and would therefore be illegal in the country. But Germany’s Finance Ministry subsumed bitcoins under the term unit of account—a financial instrument—though not as e-money or a functional currency, a classification nonetheless having legal and tax implications. In March 2013, In the US, the Financial Crimes Enforcement Network (FinCEN) established regulatory guidelines for decentralised virtual currencies such as Bitcoin, classifying American “bitcoin miners” who sell their generated bitcoins as Money Service Businesses (or MSBs), that may be subject to registration and other legal obligations. In an on-going case brought by the US Securities and Exchange Commission, Federal Judge Amos Mazzant of the Eastern District of Texas of the Fifth Circuit ruled that bitcoins are a currency or a form of money (specifically securities as defined by Federal Securities Laws), and as such were subject to the court’s jurisdiction.
A clear legal determination by a credible Authority would settle the matter once and for all, but it’s not happening….

All possible opinions on bitcoin!

Browsing the Internet in search of information on bitcoins exposes you to any type of commentary on any aspect, leading to all possible conclusions. If you already have an opinion on what bitcoin should be or will be, you can find at least two articles from two different writers that support it!
And the timing of these commentaries follows the actuality: a drop in value due to a (fixed) bug in the system (like in March 2013) and a stream of articles and posts on the “whys” and the “hows”; a surge in value and another stream; the FBI seizing some unauthorised gambler and another stream again….
There are some recurrent themes, though.
Organised crime using and mining bitcoins is shown as a fundamental issue – as if organised crime didn’t use traditional money at all or was never involved in credit card fraud! To be honest, if organised crime dedicates resources to something, there must be value in it: these are not people that waste their time or money…. On a more serious note, the involvement of organised crime worries because of alleged security issues. There have been a few episodes, indeed, where some incidents occurred: one need to have in mind that the source code for the bitcoin platform is open, which means that just about every hacker and cryptographer in the world has had a crack at it. And there is consensus on the conclusion: it really works. From a formal perspective, these episodes are not different from the criminal attempts to print paper money or perpetrate a credit card fraud: it has happened, it’s happening and it’ll happen; and all of this doesn’t stop us from using paper money or credit cards.
The undesired price volatility is a less laughable concern. But this is a consequence of being both a commodity and a currency: supply and demand regulate the process and bitcoins are subject to speculative attacks, especially now that the mass is small. People forget too easily that similar effects happened on the major currencies in the XX century – and not just once. Volatility will decrease with the increase of confidence – which is not necessarily boosted by the confusion and the dust that multiple divergent opinions of so-called experts generate.
But, ultimately, the fact that it is not controlled by anybody scares financial institutions and Governments. But they don’t realise that was the main purpose of such an invention: removing the control and interference of these bodies! Fundamentally, bitcoins were born out of mistrust in the existing financial world. Nobody can explain it better than its inventor:
The root problem with conventional currency is all the trust that’s required to make it work. The Central Bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.
Sceptical people should compare this with what Warren Buffet (the chairman, CEO and largest shareholder of Berkshire Hathaway and consistently ranked among the world’s wealthiest people) wrote in his 2012 letter to his shareholders:
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets.
Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. (….) Systemic forces will sometimes cause [Governments] to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the US, where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time.
It is also true that, in bitcoin, technology is trusted instead: a technology which is managed in distributed manner by unknowns….
The most serious concern, though, is deflation. The fixed amount of money will definitely makes us forget about inflation but the risk of something potentially bigger is just round the corner. Keeping your money because you know that what you could buy today is going to be cheaper tomorrow is certainly a showstopper for the Keynesian economy as we know it. However, macro-economic theories based on indefinite growth may actually be our fundamental issue; maybe it’s time to move towards sustainability, accepting that eternal growth is just not achievable in a large but finite world. And what if it required a totally invented tool like bitcoin to realise and achieve that? Ultimately the world has survived for centuries on a stable and sustainable economy where gold was the privileged currency….

So where do we from here?

Nobody has a crystal ball to give a definitive answer and the fact that all of this happening for the first time ever doesn’t help. Proposing forecasts is not helpful but observing facts is.
The keyword is trust: it gives value to our current currencies and the lack of trust in the financial world – largely justified by the Global Financial Crisis – is at the birth of bitcoin. And trust is as irrational as one can think: after the first crash in June 2011, there was panic because one web site was hacked; and the immediate conclusion was that bitcoin was a failure!
Like any other human achievement, imperfection is the only certainty and bitcoin is no exception: issues are expected. These will cause temporary crises of confidence, as they are resolved. There are good chances that bitcoin will evolve and move past them.
The stereotype of bitcoin users as long-haired anarchists, libertarians, and weirdos who would do away with government entirely is fundamentally a romantic picture. As Mike Caldwell had this to say:
I am not an anarchist; I believe in the rule of law and a civilised society. But I also believe that unchecked power is a threat to the common good, and that anything that the public can do to challenge that power is a benefit to society. As an individual, if you accept bitcoin in exchange for your goods or your work, that is a vote for economic fairness.
Does it mean that bitcoin could prevent another Global Financial Crisis? I would leave it to Gavin Andresen’s wiser suggestion:
I still tell people that bitcoin is an experiment: only invest time or money you can afford to lose, because bitcoin is still an experiment. The longer it keeps going in the face of volatility and technical glitches happening, the more we’ll know.
In other words: trust takes time.

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{ 7 comments… add one }
  • Maddy 31-Oct-2013, 13:09

    This is a rather interesting take on money.
    It is something we all need some, want more and desire the most.

    Whether or not Bitcoin is a solution for our “need” for money is something which only time can tell. An interesting though.

    Cheers,
    Maddy

  • Moiz Mehmood 04-Nov-2013, 11:53

    Thanks for the enlightening post. I guess we’ll just have to wait and see if bitcoins ever gain the trust of the general community. It is completely uncharted territory for everyone so any prediction is as good as the other. If it ever becomes a medium of exchange used by everyone, it would be a seriously disruptive change for the world of finance as we know it today.

  • Despre 04-Nov-2013, 21:38

    It would be interesting to see a hyper-inflationist economy having an exchange rate against bitcoin.

    There was quite a lot of inflation in Brazil, in 1990 reaching 6821.31% and getting as low as 1.65% in December 1998 [1], and the stabilization came by a monetary reform ([2]) which involved a non-monetary currency, or URV [3], having an exchange rate with the old hyper-inflationary currency. From sources which I cannot remember in order to quote, I remember the mass of URV was considered fixed, and prices were displayed by economic agents, in particular retailers, in both the hyper-inflationary currency and also in URV. This plan actually achieved the monetary stabilization, which was followed by the introduction of the BRL (Brazilian Real). I see now 1 EUR is 3 BRL, not bad after 6k% inflation 13 years ago, isn’t it?

    [1] http://www.tradingeconomics.com/brazil/inflation-cpi
    [2] http://en.wikipedia.org/wiki/Brazilian_real
    [3] http://en.wikipedia.org/wiki/Plano_Real

    • Armando Gherardi 04-Nov-2013, 23:46

      Hello,

      What you say confirms that, as far as we may understand the dynamics, bitcoin will not generate inflation but deflation.
      Experts say that deflation is worse. Their main argument is that, if money increases its value, it’s more convenient to keep and buy just what’s necessary, instead of putting it back in the economy. As a result, less consumption, less jobs and recession.
      My personal comment to this is twofold:
      (1) the final result doesn’t sound that different from what we are seeing now – maybe the amplitude would be different; this means to me that something fundamentally wrong is happening now and nobody is putting any action into it;
      (2) the Keynesian continuous growth is not sustainable in the long term; and we need to measure successful economies with other and different parameters.
      Sustainability is the next challenge for humanity and the sooner we act on it, the better. For all of us.
      Maybe I should start posting on that…. On a dedicated category….

      • Despre 05-Nov-2013, 18:46

        I think we would ignore a few factors if we consider deflation as the only outcome of bitcoin having an exchange rate with a fiat currency. We are ignoring the overnight interest rate, the fractional reserve system and the capacity of central banks to buy ‘new’ debt. The monetary mass non-scriptural is a direct measure of the reserve percentage, therefore keeping overnight interest rate constant, not buying any new gov’t bonds, and pegging the fiat currency to bitcoin but decreasing the mandatory percentage of reserve is yet another way of stimulating credit while stability in CPI and PPI is brought by reference to bitcoin. So I rather disagree in conclusion with the idea that the only outcome is deflation. I think inflation weakens purchasing power and favors asset owners who don’t [need to] invest, and forces economic agents take higher and higher risks to accumulate in current economy. Yet another example is the original Greenback which was a finite quantity and created an unprecedented wealth for the American nation.

        • Armando Gherardi 10-Nov-2013, 16:44

          I understand your point.
          However, my comments were more towards “what happens if bitcoin replaces existing currencies” as opposed to “what happens if bitcoin coexists with today’s currencies”. The example of the XIX centuries “greenbacks” is closer to the latter….
          The fundamental objection partitioners have on bitcoins is related to deflation, though. I’m still unsure of why deflation will necessarily be catastrophic; and, if it’s not, there would be no reasons to fear bitcoins!
          It might be time to abandon the idea of everlasting growth and tolerance of a “small” inflation….

  • Ray Mcloskey 02-Dec-2013, 04:37

    Why is there no talk of other crypto markets? BitCoin value is DOWN 5% today… don’t leave your investments there, instead trade your BTCs for an upcoming crypto market (via cryptsy)…. Smaller markets are going up by 1000% in a day (coinmarketcap.com). I bought Zetacoins (ZET) at $0.02 per coin via cryptsy yesterday and the value today has doubled making me $10k… I’m buying more today due to no sign of slow down and no press for Zetacoins yet so potential for huge returns is sky high, I see them at least $.40 next week. I’d advise you to get some now, or really regret it next week