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I've written various articles on Bitcoin mostly defining the bad and the ugly:

Bitcoin: Buyer Beware, This Is A Classic Bubble And Possible Fraud

Bitcoin: I Hate To Say I Told You So... But I Told You So

Bitcoin Fails As A Currency And The Bubble Will Eventually Pop

My thesis is consistent with most economists, that Bitcoin is a bad idea. The main problem economists have with Bitcoin is that it is specifically designed to be perfectly inelastic. An inelastic currency in a dynamic economy is certain to create price instability. The extreme price instability of both the products purchased and the value of Bitcoin simply outweigh its benefits.

After my previous articles generated so many comments, I felt obligated to try to make the case for Bitcoin. I wanted to find the good in Bitcoin to balance the bad and the ugly.

While I still hold to my main thesis that Bitcoin will eventually fail, and that it will fail because it is either intentionally or accidentally designed to fail, the inherent volatility of Bitcoin will simply make it impractical to be used for anything other than a speculative investment.

There are benefits to Bitcoin however, and venture capitalist Marc Andreessen does a great job highlighting them in his article "Why Bitcoin Matters." Unlike me, who just writes about Bitcoin, Mr. Andreessen has invested $50 million into Bitcoin start-ups. It should be noted that Marc invests in companies related to Bitcoin; he does not invest in Bitcoin. He is kind of like a modern day Sears and Roebuck supplying the gold miners with picks, coffee and jeans, but never actually getting into the high risk gold mining business.

Marc Andreessen's venture capital firm, Andreessen Horowitz, has invested just under $50 million in Bitcoin-related start-ups. The firm is actively searching for more Bitcoin-based investment opportunities. He does not personally own more than a de minimis amount of Bitcoin.

I will use Mr. Andreessen's article as the foundation of this article, and try to address its key point as to "why Bitcoin matters."

One of the first points made in defense of Bitcoin is that it is a technological revolution representing the culmination of decades of work done by computer scientists.

In this post, I will explain why Bitcoin has so many Silicon Valley programmers and entrepreneurs all lathered up, and what I think Bitcoin's future potential is.

First, Bitcoin at its most fundamental level is a breakthrough in computer science - one that builds on 20 years of research into cryptographic currency, and 40 years of research in cryptography, by thousands of researchers around the world.

Bitcoin is the first practical solution to a longstanding problem in computer science called the Byzantine Generals Problem.

The key point is that this was a computer science problem, and solved by computer scientists apparently far removed from the economics departments. A secure way to make anonymous transfers and facilitate commerce across international borders for little or no fee is an absolutely wonderful achievement. There is no doubt about that, Bitcoin is truly a monumental computer science achievement. The problem is, Bitcoin concept doesn't fit in reality. In order to be an acceptable currency, it has to have a stable value, and Bitcoin is anything but stable. Its design is inherently unstable, and its price history proves that beyond any reasonable doubt.

As this quote highlights, the ability to transfer assets across the internet in a secure manner "are hard to overstate."

The practical consequence of solving this problem is that Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.

I don't disagree for one moment about what a wonderful technological advancement a means to securely transfer assets over the internet is, but that isn't Bitcoin. If I have something of value that I want to transfer to another over the internet, the most important aspect is that if I bought it for the equivalent of $100, then the item holds that $100 value from the start of the transaction to the end of the transaction. Bitcoin simply doesn't do that, nor will it ever do that. Imagine buying a house using Bitcoin when the closing process may take months. Imagine writing a labor contract in Bitcoins, and Bitcoin goes from $50 to $1,000. The creators of Bitcoin either deliberately or accidentally designed it to be volatile, and that is its fatal flaw that will prevent it from reaching its objective as a global currency.

This quote highlights all the wonderful things that can be transferred using this technology, and I don't disagree, it is a wonderful computer science advancement, but transferring the title of a house, stock, bond or other is totally different than transferring money that is highly volatile. If I transfer you the tile of my house, the house isn't likely to drop or appreciate by 50% during the transaction. If I transfer you ownership of a stock or bond, you get the market price valued in local currency. With Bitcoin you never really know what you are getting from minute to minute.

What kinds of digital property might be transferred in this way? Think about digital signatures, digital contracts, digital keys (to physical locks, or to online lockers), digital ownership of physical assets such as cars and houses, digital stocks and bonds … and digital money.

This next statement is where I have a lot of disagreement with Bitcoin supporters, and highlights why Bitcoin was designed with what I consider a fatal flaw. Bitcoin must have been created by people that grew up in the depression or have watched "It's a Wonderful Life" too many times. Bitcoin is based upon a distrust of banks and financial institutions, chief among them being the Federal Reserve that "prints all this money out of thin air." In the world of Bitcoin, "trust" or I would say blind faith is completely placed on a network of anonymous computers. There are no local offices of Bitcoin Bank of the Internet. Bitcoin functions much like a Ponzi scheme, with a lot of people not asking the correct questions because they are making money by ignoring obvious problems. There is no "Full Faith and Credit of the United States of America" backing Bitcoin, there is nothing but faith in an anonymous network.

All these are exchanged through a distributed network of trust that does not require or rely upon a central intermediary like a bank or broker. And all in a way where only the owner of an asset can send it, only the intended recipient can receive it, the asset can only exist in one place at a time, and everyone can validate transactions and ownership of all assets anytime they want.

This following quote highlights the real strength on Bitcoin concept, a global currency that has low or no fees to use. That is a wonderful, even utopian, system, but that isn't a Bitcoin. Bitcoin can lose 10, 15, 20% or more in a day. The 2 or 3% fee is insignificant when your entire Bitcoin account can lose 10% while waiting in line to buy a coffee at the local coffee shop. Bitcoin's volatility negates any benefits one can get from lowering transaction fees. Sure you saved 2%, but your Bitcoin lost 10% in the transaction. That 2% fee guarantees that if you owe $10, you only pay $10, and if you don't like it you can take it up with the bank manager.

Bitcoin ledger is a new kind of payment system. Anyone in the world can pay anyone else in the world any amount of value of Bitcoin by simply transferring ownership of the corresponding slot in the ledger. Put value in, transfer it, the recipient gets value out, no authorization required, and in many cases, no fees.

That last part is enormously important. Bitcoin is the first Internetwide payment system where transactions either happen with no fees or very low fees (down to fractions of pennies). Existing payment systems charge fees of about 2 to 3 percent - and that's in the developed world. In lots of other places, there either are no modern payment systems or the rates are significantly higher.

This quote highlights how Bitcoin economy is an "as is" economy. It is much like a global going out of business sale. "All Sales Final," is marketed as a benefit of Bitcoin. Even reputable merchants won't allow returns, and if they do, it will be for an adjusted Bitcoin price. Imagine buying something at the local store for 1 Bitcoin when it was trading at $50. A week later you want to return the item and Bitcoin is now trading at $200. People could make fortunes simply by returning items to the store if the store returned the same amount of Bitcoins as was used to purchase the item. Stores make money by charging shoppers, not by giving them money. Additionally, once that Bitcoin is transferred, there are no stop payment orders or reversing transactions. Remember, that untrustworthy bank used to handle those issues, and they were intentionally cut out of the loop.

Bitcoin is a digital bearer instrument. It is a way to exchange money or assets between parties with no pre-existing trust: A string of numbers is sent over email or text message in the simplest case. The sender doesn't need to know or trust the receiver or vice versa. Related, there are no chargebacks - this is the part that is literally like cash - if you have the money or the asset, you can pay with it; if you don't, you can't. This is brand new. This has never existed in digital form before.

This quote highlights where there is a disconnect between economists and Bitcoin believers. There is no doubt that Bitcoin has value, but bubbles can create value simply due to herd behavior, not due to any real intrinsic value. That is what defines a bubble. Bitcoin could have value simply because people are hoarding it, expecting it to be more valuable in the future. Under normal circumstances one could figure out where the value is coming from by using MV=PQ, but because there are no macroeconomic monetary data on Bitcoin, we are simply left to speculate.

Because Bitcoin has undergone such a rapid increase in value, one would have to conclude that V isn't keeping pace with Q, or M in circulation is falling. Both those would point to people not transacting with Bitcoins, but holding them in expectation of future gain. That implies Bitcoin is a speculative investment, not a frequently used currency. Remember, there are only $12.25 million Bitcoins in circulation. With Bitcoin trading near $950, Bitcoin Monetary Base is about $11.6 billion. Unless the velocity is real high, one would have to assume that Bitcoin economy is relatively small given the attention it has been getting. If that is the case, I would imagine most of the value of Bitcoin is speculative, and not generated from the demand for transactions. Why would anyone want to use a coin with such volatility for transactions? I wouldn't.

Bitcoin is a digital currency, whose value is based directly on two things: use of the payment system today - volume and velocity of payments running through the ledger - and speculation on future use of the payment system. This is one part that is confusing people. It's not as much that Bitcoin currency has some arbitrary value and then people are trading with it; it's more that people can trade with Bitcoin (anywhere, everywhere, with no fraud and no or very low fees) and as a result it has value.

The above analysis appears to be supported by the article as well, but I disagree with its conclusion. Yes, as MV=PQ proves, an adequate monetary base is needed for Bitcoin to be accepted as a transactional currency, but that monetary base needs to be stable, and reliable. A monetary base whose value is based upon pure speculation isn't the solid foundation needed to support a transactional currency. In fact the speculative value of Bitcoin decreases its appeal as a transactional currency. Unless someone can define a smooth transition process from Bitcoin's value being based upon speculation to transactional needs, it is hard to make the case for Bitcoin as a transactional currency. As long as the inherent volatility exists, its value as a transactional currency will be limited.

It is perhaps true right at this moment that the value of Bitcoin currency is based more on speculation than actual payment volume, but it is equally true that that speculation is establishing a sufficiently high price for the currency that payments have become practically possible. Bitcoin currency had to be worth something before it could bear any amount of real-world payment volume.

I find the argument that Bitcoin is like the PC and Internet totally unconvincing. The PC and Internet greatly improved the lives of people, whereas the benefits of Bitcoin have to be weighted against the risks. Owning a PC or surfing the Internet doesn't put the participant at extreme financial risk. Using Bitcoin does. Bitcoin is off over 20% from its peak set just last month, and at one time it was down over 50%.

Critics of Bitcoin point to limited usage by ordinary consumers and merchants, but that same criticism was leveled against PCs and the Internet at the same stage. Every day, more and more consumers and merchants are buying, using and selling Bitcoin, all around the world. The overall numbers are still small, but they are growing quickly. And ease of use for all participants is rapidly increasing as Bitcoin tools and technologies are improved. Remember, it used to be technically challenging to even get on the Internet. Now it's not.

Ironically, the article appears to support my arguments, and fails to provide a real solution, or highlight the benefits of Bitcoins to merchants. While disagreeing with my analysis, they are actually agreeing with it. Merchants would be put at astronomical risk for accepting Bitcoin. As pointed out above, Bitcoin lost more than 50% of its value in less than a month. Not many merchants can survive losing 50% of their value in a matter of weeks. Merchants aren't in the business of currency speculation, and Bitcoin takes currency speculation to a whole new level. Bitcoin creates huge hassles for merchants. Prices have to be updated in real time, returns if allowed at all have to be adjusted in value and once a Bitcoin is accepted it has to be immediately converted to local currency or risk a loss. And for what? To avoid a credit card transaction charge? Why not just ask the customer to convert their Bitcoins to local currency and demand cash? If they do that, we are then back to expecting the customer to risk losing 50% of their Bitcoin value in a month, and I just don't think many customers are willing to take that risk. I know no prudent merchant will.

The criticism that merchants will not accept Bitcoin because of its volatility is also incorrect. Bitcoin can be used entirely as a payment system; merchants do not need to hold any Bitcoin currency or be exposed to Bitcoin volatility at any time. Any consumer or merchant can trade in and out of Bitcoin and other currencies any time they want.

The article does highlight why merchants would want to accept Bitcoin, but what it really does is define the problems that need to be solved, and a highly volatile currency like Bitcoin isn't the answer. No matter how Bitcoin supporters want to spin it, the fact remains that either the consumer or the merchant must be willing to accept losing 50% or more of their value in a relatively short period of time for the benefit of using Bitcoin.

Why would any merchant...? My partner Chris Dixon recently gave this example:

"Let's say you sell electronics online. Profit margins in those businesses are usually under 5 percent, which means conventional 2.5 percent payment fees consume half the margin... Another challenge merchants have with payments is accepting international payments. ..In addition, merchants are highly attracted to Bitcoin because it eliminates the risk of credit card fraud...Since Bitcoin is a digital bearer instrument, the receiver of a payment does not get any information from the sender that can be used to steal money...
Credit card fraud is such a big deal for merchants, credit card processors and banks that online fraud detection systems are hair-trigger wired to stop transactions that look even slightly suspicious, whether or not they are actually fraudulent. As a result, many online merchants are forced to turn away 5 to 10 percent of incoming orders that they could take without fear if the customers were paying with Bitcoin, where such fraud would not be possible.

There is no doubt that a transaction free, easily convertible, fraud resistant currency would be a benefit to both the consumer and merchant. That is what I believe is Bitcoin's greatest contribution, it started the conversation. It took the first stab at a very complex problem and it created a solution that fell within the ball park. Problem is, this is Bitcoin 1.0 and we are doing the beta testing with real money. In my opinion, the only way to save Bitcoin is to make it elastic, and by making it elastic would violate the very principles on which it was founded. Making it elastic would greatly reduce the potential for speculative gains, and alienate the "End the Fed" "no money out of thin air" supporters. Bitcoin would effectively have to "sell-out," go commercial and abandon its libertarian anti-establishment roots.

Why I am so bearish on Bitcoin is because the solution is so obvious. Bitcoin has all the benefits a merchant and consumer wants, but it also has a huge negative, that being its high risk volatile nature. A stable value, secure, fraud free Bitcoin is the utopian currency. Once that is developed, any hope for the current inelastic Bitcoin to function as a viable transactional currency will evaporate, leaving only the speculative investors interested in Bitcoin. What I would expect to be Bitcoin killer is for an established bank or retailer to issue stable value virtual coins that have a value pegged to a basket of currencies or the US Dollar. They would effectively act as virtual gift cards that are safe, secure, no or low fee and have a relatively stable value.

For example Amazon (NASDAQ:AMZN) could issue Amacoins. They would be easy to buy, there would be a well established merchant base, AMZN would maintain the ledger, utilize all the security features built into the original Bitcoin and most importantly, make it convertible. Because the Amacoin is backed by the money that was used to purchase it, just like a gift card, the consumer doesn't have to worry about losing 50% of its value in a month. The Amacoin would be perfectly elastic. New Amacoins would be "printed out of thin air" each time someone buys one, but that new Amacoin would be backed by the currency used to purchase it. AMZN would earn interest holding the money for the consumer. The consumer in America could then use that Amacoin to purchase a product from a Chinese merchant on the AMZN Amacoin ecosystem. The currency translation happens through the pricing using the Amacoin and the conversion process.

In conclusion, there is no doubt many of the concepts behind Bitcoin have merit. The main problem Bitcoin has is that it was developed in the computer science department staffed by libertarians, not economists. The deliberate inelastic structure of Bitcoin guarantees that Bitcoin will be volatile. Most merchants and consumers try to avoid uncertainty and volatility, especially when it comes to money. I'm pretty sure that in the not so distant future, a major retailer or bank will develop a competitor to Bitcoin that offers all the benefits of Bitcoin, but without the risk. Once that happens the only appeal of Bitcoin will be for speculative value, and without the hope of ever becoming a viable currency, Bitcoin is almost certain to join the Dutch Tulips in the annals of market bubbles.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Full Disclaimer and Disclosure Click Here.

Source: Bitcoin - The Good, The Bad And The Ugly