I remember reading an article in Science News years ago about a promising virtual currency that operated using open source software and cryptographic principles. Of course, this currency turned out to be the now buzzy Bitcoin (BITCN) and I'm kicking myself for not stashing a few thousand dollars in it before everyone else started finding out about it.
I'd now be a Bitcoin millionaire with the crazy price appreciation the cryptocurrency has shown as it has started to enter the mainstream. This regret manifested itself again today as I read a well-reasoned and enticing article by legendary tech inventor turned investor Marc Andressen entitled "Why Bitcoin Matters", which laid out some extremely promising uses for bitcoin in outlining why the currency could gain widespread acceptance in the future.
And while this article may sound like gripes over sour grapes, I'm hung up on what I believe may be a fatal flaw of the Bitcoin system. One of its breakthroughs was verifying transactions through a process called "mining", where payment processors receive bitcoins for solving difficult problems to verify a transaction and add it to the public record of all transactions, called a "block chain".
This lucrative activity has set off an arms race of ever greater computing power that is sometimes pooled together to reduce the amount of time it takes to verify a transaction. This works well now since it incentivizes verifiers to more quickly bless a transaction. However, Bitcoin has a built in feature that reduces the amount of bitcoins that are rewarded for performing this work, reducing it from 25 per block to 12.5 in 2017, and then continuing to halve it again approximately every four years thereafter.
This will result in diminishing returns for ever increasing computing power, discouraging people from performing this important verification step unless the value of bitcoins they receive keeps pace with the effort required to get it. But with the number of bitcoins automatically being halved this would require a corresponding doubling of the value of each to result the same reward. Here we see the Bitcoin system begin to show the hallmark of a Ponzi scheme, where ever increasing values for the money that is flowing into the system is required to keep the current participants satisfied.
This could be subverted by an increase in fees, which are also sometimes attached to payments by the sender to encourage faster execution. However, with presumably fewer miners participating due to lower rewards, this might result in transactions with no or low fees to remain unsolved, which would threaten to sabotage the whole system. Fees would have to begin to increase at similarly steep rates to keep the payment verifiers satisfied, undermining one of the strengths of the Bitcoin system.
Therefore, while I admire its ingenious technical aspects and am certainly impressed with how quickly it is becoming an accepted method of transaction, I fear that due to this limiting flaw it will suddenly collapse someday. The very mechanism that is supposed to guarantee that Bitcoin remains a deflationary currency could actually manifest itself in rampant inflation someday when payment processors demand ever higher values or fees for performing the critical step of payment verification that holds the whole system together.
While this might not happen until years in the future, the same could be said for any Ponzi scheme, so you probably don't want to be a part of it even if you get in early, since you never know when it will end. With Bitcoin, it could end badly when any of a number of things happen, such as government intervention or just a general lack of faith in the system. I believe I have exposed a particular flaw of the currency with this article, but I encourage readers with more technical knowledge or insight than me to engage in an intelligence discourse on what could become the downfall of this promising alternative to fiat money.
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.