Why I Do Not Trust Bitcoin

| About: Winklevoss Bitcoin (COIN)


Bitcoin’s volatility makes it an unreliable medium for financial transactions.

A Bitcoin-generated free market system becomes an inherently adversarial process, pitting the best interests of the buyer against the best interests of the seller.

Rising concerns about the security of the Bitcoin software indicate that its economic system is vulnerable to externalities.

Bitcoin may actually violate the principles of the free market economy that it purports to establish.

There are two ways to look at Bitcoin: as an investment opportunity and as a virtual currency. As an investment, one is buying "shares" in a pecuniary transaction system - a software-driven enterprise developed to provide users with a regulation-free, totally "libertarian," economy. As a virtual economy, Bitcoin provides a currency (the bitcoin), the value of which is mediated by the marketplace, rather than by a government, and that is not subject to legislative control and political manipulation.1

The beautiful simplicity of the whole concept is that the two functions - investment and currency - are bound inextricably in the same instrumentality: the bitcoin. In this way, the value of a bitcoin is tied to the desirability of participating in the Bitcoin economic system; that the value of a bitcoin is tied to its desirability is essentially guaranteed by the fact that, ultimately, there will be only 21 million bitcoins in existence, and with constancy of supply, the only variable in the worth of the "commodity" (the bitcoin) is its desirability (or, its demand).2

I have a problem with Bitcoin. It would seem that one should be disinclined to place one's trust in a "currency" the value of which is fundamentally dependent upon the enthusiasm of its adherents. Because of the volatility in a bitcoin's value, it introduces a measure of unfairness into the marketplace. That unfairness, coupled with growing concerns about security issues within the Bitcoin system seems to make Bitcoin an inferior alternative to fiat currencies.

The Subjective Value of Bitcoins

Fiat currency (such as the U.S. dollar) derives its value from the fact that it has a government backing it up. The government establishes and guarantees the value of the currency it issues. It is the stability in its assigned objective value that enables the fiat currency to be used as a transactional medium.

The pecuniary worth of bitcoins is based on subjective value - that is, their value is dependent upon what the bitcoin purchaser is willing to pay for it, and that subjective value is a complex assemblage of personal attitudes that contribute to the deliberative process as one decides just what value one is willing to assign to the bitcoin.

The responsibility for the variability in the monetary value of bitcoins is the conflation of monetary value with investment price that occurs in Bitcoin. The resultant valuation of bitcoins, thus, tends to be subject to periods of volatility. Consider the following chart3, which traces bitcoin price from July 18, 2010 through March 5, 2014:

On July 18, 2010, a bitcoin was worth $0.09, and on December 4, 2013, that same bitcoin was worth $1,147.25 - a 1.25-million percent increase in value. Barely more than three months later, on March 5, 2014, that bitcoin was worth $661.79 - a 43% drop from the December high. Serious fluctuations in the value of bitcoins did not occur until early 2013.

Bitcoin Transactions

If all bitcoins had a standard value, there would be no question but that any transaction involving bitcoins would be fair and equitable. If, for instance, bitcoins were worth $500.00 (and set at that value), buying a bitcoin would be a matter of paying $500 to the bitcoin exchange and getting the one-bitcoin amount added to one's account. A person buying something for $100 would spend 20% of his bitcoin's value to do so, and the seller would receive 20% of a bitcoin's value in exchange for the item sold.

It should be noted that all bitcoin transactions take place in terms of the fiat currency in which the seller participates - to effect the transaction, the current value of a bitcoin must be determined, the amount needed to conduct the transaction is determined, that amount is transferred from the buyer's account to the seller's account, once in the seller's account it is registered as (a portion of) a bitcoin.4

Since all bitcoins (in the scenario) are of a standard value, all transactions would be like this - both buyer and seller would be conducting business under purely equitable currency valuations. In the kind of transaction described above, the bitcoin functions - for all intents and purposes - like a fiat currency.

Unfortunately, a transaction such as the one described can only occur in reality if (1) both buyer and seller acquired their bitcoins at the same price, and (2) the transaction takes place at a time when bitcoins are valued at the same price as that at which both buyer and seller acquired theirs.

Transactional Dilemma, Part I: Let the Buyer Beware

In the "real" world of the virtual currency, however, the value of a bitcoin changes - literally from one minute to the next. A person ("X") buys a bitcoin at the rate of $550.00 per bitcoin. Later that day, X visits a local electronics store that transacts in bitcoin, and finds an excellent Tablet PC for $275.00. A quick calculation informs him that that is one-half bitcoin at the rate at which he made his recent purchase.

Transaction 1: As X informs the seller ("Y") that he wants to buy the tablet using bitcoin, Y begins the transaction. It is discovered that at the time of the transaction, the bitcoin is worth only $500.00 - an approximately 9% loss of value in terms of dollars. This being the case, the tablet will cost X 55% of his bitcoin, essentially a 10% increase in price compared to the original purchase price of the bitcoin (55% of the original bitcoin value is $302.50).

Transaction 2: Of course, things could work out differently for X. Suppose, as the transaction is taking place, the value of a bitcoin is $600.00 - a 9% increase in bitcoin value. In this case, X pays just over 45% of a bitcoin, and since 45% of the original bitcoin value equals $247.50, X gets what amounts to a 10% discount on the tablet.

Based on the above considerations, we can generalize: The Buyer should always prefer to transact when his bitcoins are worth more than he paid for them (i.e., when bitcoins have appreciated in value).

Transactional Dilemma, Part II: Seller's Remorse

Things work quite differently for the seller in our example. Y does business in U.S. currency, so for him, there is no preference in terms of the bitcoin rate at the time of the transaction with X (at least, on the face of it).5 We may suppose that Y has a profit margin of 5% on his electronic equipment, so that the sale of the tablet represents a profit of $13.75; the remaining $261.25 represents fixed costs (his cost for the tablet, plus overheads).

Transaction 1a: According to the above scenario for transaction 1, Y receives .55 bitcoin. At some point, Y will want to exchange his bitcoin for fiat currency, either for his own use or to use for business expenses. Suppose that when he goes to exchange the .55 bitcoin he received from X the exchange rate has dropped to $475.00. In this case, Y's bitcoin is worth $261.25 - the 5% drop in the bitcoin rate has effectively eliminated Y's profit for the tablet.6

Transaction 1b: Suppose that the exchange rate for Y has gone up since the sale, and bitcoins are valued at $525.00. Y's .55 bitcoin is now worth $288.75. After accounting for his fixed costs, Y is left with a profit of $27.50, or double his usual profit.

Transaction 2a: In transaction 2, above, Y receives .45 bitcoin. If the exchange rate is $475.00 when Y seeks to collect his dollars, he realizes only $213.75 - not only costing him his profit, but also causing him an additional loss of $47.50, or 18% of his fixed costs.

Transaction 2b: Now suppose that the exchange rate for the bitcoin is $525.00. Y's .45 bitcoin is worth $236.25 - certainly more than he realizes in 2a, but he still loses not only his profit, but comes up $25.00 short in covering his fixed expenses (an almost 10% loss).

Generalizing on these considerations: It is always in the Seller's interest to seek the greatest amount of bitcoin in any transaction (i.e., transact when bitcoins have depreciated in value).

The Adversarial Economy

It is a principle of free markets that buyer and seller meet and come to a mutually agreed-upon basis for exchange. Fundamental to the concept of such an exchange is that there is some way that the needs of the seller and the needs of the buyer can be made compatible. If that compatibility cannot be achieved, the transaction does not take place (at least, in principle).

In light of the set of examples I've just presented and the two generalizations that were drawn therefrom, it would seem to follow that Bitcoin, as it is currently conceived, may not produce a truly free market wherein both buyer and seller can come to agreement as to the conditions of a transaction. It will always be in the interest of the buyer to transact with the highest valuation achievable of the transactional medium (the bitcoin), and it will always be in the interest of the seller to transact with the lowest valuation achievable of that same medium.

In short, it would seem that a Bitcoin economy would be - as it is currently conceived - an adversarial economy, where buyer and seller are both committed to strategies that are mutually incompatible and would inhibit the possibility of reaching the agreement that characterizes a free market.

I believe that the reason Bitcoin economics reaches this fundamental standoff is because it seems not to acknowledge an important aspect of investment: cost basis. Any rational investor is bound to consider the costs involved in making an investment. That cost basis is the measure against which capital gains (and losses) are determined, and - ultimately - what determines whether the investment was worth the undertaking. And since Bitcoin is both an investment and a system of currency, it needs to be mindful of the expectations people have both as investors and as participants.

What it costs the individual to partake in a particular investment is part and parcel of the ultimate rationality of pursuing that investment. To ignore the relevance of cost basis is to neglect the very fundamental principle upon which the acceptability of free market economics is dependent: it is always rational for an individual to be motivated to seek the maximum gains for the minimum costs. Like it or not, in its current form, Bitcoin is fundamentally anchored to fiat currencies inasmuch as those currencies are the means by which Bitcoin acquires its users and conducts transactions.

Summary and Addendum about Security

The considerations I have presented are products of my thinking. I may be wrong on some things, but I think not. In any event, it is important that potential and current investors in Bitcoin have access to all information available, and that they be exposed to various perspectives of the Bitcoin enterprise. It is not my intention to discourage anyone from participating in the Bitcoin enterprise.

Since the fiasco of Mt. Gox, it has become clear that there are serious security issues to be had with the software that serves as the foundation for Bitcoin. One such issue is transaction malleability, which involves the manipulation of the digital signatures that are used to generate the IDs that identify each transaction occurring on the Bitcoin network. By doing so, transactions can be "lost," with a resultant loss of bitcoin. Bitcoin programmers have known about malleability issues since 2011, but have not been able to completely eradicate the problem as yet.7

On March 5, 2014, it was reported that two bitcoin sites suffered significant losses of digital currency by flooding accounts with transfers between users' accounts before the accounts could be updated; the thieves would then close out their own account (loaded with the transferred coins). Canadian bitcoin bank, Flexcoin suffered the loss of all of its digital currency with a total value approaching $600,000.00; Flexcoin has gone out of business. Poloniex, another bitcoin exchange, lost 12.3% of its digital currency; Poloniex plans to devalue all users' accounts by 12.3%, since precise records indicating which accounts actually lost coinage have not been found.8

Given the security issues that seem to be becoming rife with the open-source software, it seems to some degree irresponsible to attempt to continue doing business. Further, given the fact that open-source software can be altered by users, it would seem to be difficult, if not impossible, to guarantee that all users in the system can be made secure - at least, until standardized software is developed that addresses the security issues and is made mandatory for all users.

It is no wonder that it is now possible to "short" bitcoin, just as one could short any currency.9

1 I follow the convention of using the word "Bitcoin" (capital "B") to refer to the system, and the word "bitcoin" (small "b") to refer to the currency.

2 Alternatively, it is considered a serious flaw of Bitcoin by Anthony Alfidi here that constancy of supply will result in a stagnant economy, because Bitcoin would be unable to generate new capital for growth. I think it is not as limited as some might argue. If the value of a bitcoin is dependent upon its desirability, even if the number of bitcoins is constant, their value should be variable according to the elasticity of demand.

3 The data used in constructing the chart is from CoinDesk, here.

4 This is admittedly a rough characterization. The bitcoin transactions I refer to are according to bitpay.com, a company that provides merchants with the software and data needed to conduct bitcoin transactions. The price is what bitpay.com calls its "Bitcoin Best Bid" ("BBB") - the best rate available from exchanges with "adequate liquidity" and withdrawal capability in the U.S. and eurozone. Rates are updated every minute.

5 A quick survey of some of the websites that will accept bitcoin as payment shows that they list their prices in dollars, relying on a transaction facilitator (such as bitpay.com) to manage bitcoin transactions for them.

6 Please note that in all of these transactions, I do not include transaction fees. While the absence of fees is often used as a selling point for Bitcoin, it is understood that exchanges and other intermediaries are free to charge for their services. A quick review showed that most agencies do charge a small service fee for at least some services.

7 Danny Bradbury, for instance, discusses this issue for CoinDesk, here; it has also been acknowledged by Gavin Andresen of the Bitcoin Foundation in his blog, here.

8 Information about the "withdrawal vulnerabilities" at the facilities is described by Lucian Constantin for PCWorld, here; details of Poloniex's recovery strategy are outlined by Cyrus Farivar for ars technica, here.

9 The process must be undertaken using an exchange that will transfer between bitcoins and other currencies, and the process is described here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.