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Bitcoin: Such a good idea that it will probably fail

|Includes:American Express Company (AXP), MA, V

Bitcoin?

If you have never heard of bitcion you are not alone! But if you had heard about it a year ago - and if at that time you had the courage to invest $100 your investment would now be worth about $16,600 (at the current price for one bitcoin of about $10). In other words, bitcoin (BTC) was far and away the best performing currency this past year returning more than 16000%. Not a bad investment return at all.

Sound too good to be true? Must be some kind of Ponzi scheme, right?

No - not right.

 

What is bitcoin?
 Bitcoin logoClick to enlarge

Bitcoin  is a cryptographic, digital, internet-based (peer-to-peer) currency. There is nothing "backing" it. There is no government or central bank controlling its issuance. There are (and can be) no individuals or companies controlling BTC from behind-the-scenes . This is because the rules governing the issuance and exchange of BTC are completely transparent as they are open source for anyone to read.

What makes BTC worth anything?

Scarcity - just like regular "paper" currencies:

There are only so many BTC available (at present just over 7 million BTC ) at any given time, but unlike regular paper currencies which pose unknown inflation risks the future supply of BTC is completely deterministic as it's issuance is built into the system. In other words: You, I or anybody else already know today, exactly how many BTC circulate today, tomorrow and on e.g. March 15th 2017. This is hardly true for USD, EUR, "special drawing rights", gold or anything else!

Figure 1: Plot of total BTC in circulation as a function of time. By the end of 2033 all 21 million BTC will have been issued and there can never be added more BTC into circulation since all BTC are unique.Click to enlarge

Figure 1: Plot of total BTC in circulation as a function of time. By the end of 2033 all 21 million BTC will have been issued and there can never be added more BTC into circulation since all BTC are unique.
 

Bitcoins, like all other currencies, are just a medium of exchange and a unit of account, but BTCs are much better for serving these purposes than any traditional "paper" currency, as I will explain.

Based on asymmetric encryption any transaction of BTC from one place (wallet) to another is digitally encrypted and added to the so-called block-chain (transaction history). In this process, the network automatically confirms the validity of the transfer. This means that BTC transactions are not completely instant (it takes some minutes between block-chain updates), but it also means that there is no way any attacker can spend/transfer BTC the they don't have, nor cause the same bitcoin to be two places at the same time - unless that attacker has considerably more hashing power (computer power) than the entire BTC network - currently 170 petaFLOLPs/s. This compares to the World's largest supercomputer, called "K" running at “only” 8 petaFLOPs/s . The encryption algorithms used are industry standard SHA256 and ECDSA

Bitcoins are divisible up to 100,000,000 times. In other words, the smallest "amount" of BTC that can be transferred is 0.000,000,01 BTC (10 nBTC = 10 "nano bitcoins"). Being the smallest unit, this amount is the functional equivalent of 1 cent in the USD currency (although 10 nBTC is currently worth much, much less than 0.01 USD). This divisibility is the reason why the "hard" upper limit of 21 million BTC in circulation is not a problem - even if the entire World trade were carried out with those 21 million BTC the value of 10 nBTC would still only be about 0.2 cent in today's USD.

More general info on how BTC works may be found in the FAQ and a more technical presentation on how the system works may be seen here.
 

What makes it a great idea?

  • Bitcoins cannot be two places at the same time. Just like a bar of gold which it is either in my vault - or in some other vault - a bitcoin is either in my wallet or some other wallet. Therefore, BTC cannot be "multiplied" in the banking system like regular "paper" money which makes traditional fractional reserve banking impossible. Banks can create an infinite supply of "promise-to-pay BTC", but unlike regular "paper" money this "checkbook money/bank credit money" is clearly discernible from "real" BTC: If you lend some BTC to the bank - those BTC will disappear from your wallet (since they can't be multiple places at once) and will be replaced with "promise-to-pay BTC" issued by the bank. This will make the difference between real money and debt-money clear to everyone. This, IMO, is the single best feature of BTC.
  • Bitcoins can be stored by its owner on a computer, smartphone or any memory device - or by an online wallet provider. Thus I may choose an online wallet provider (like having an account with an online bank), but I may also be my own bank if I so choose. In the future, therefore, my employer could transfer my salary directly to my BTC wallet - not to a commercial bank.
  • Bitcoins can - unlike gold or other precious metals - be transferred electronically via the internet as easy, fast and inexpensive as email: No fees to banks for international transfers or fees to credit card companies for payments. No holds for days or weeks. Not closed on Sundays. No frozen accounts. -  Instead, essentially free, and almost instant, irreversible transfers to anywhere in the World. This makes international payments much, much cheaper than physical precious metals or present day "paper" money.
  • Bitcoins have an entirely predictable issuance and by the year 2034 essentially all BTC to ever exist will have been "mined" (issued) and thereafter the total number of BTC in circulation will be fixed at 21 million BTC. Unlike any paper currency, therefore, there is zero counter-party risk in that sense that no one has the power to just "print" more BTC and debase the value of BTC by inflation beyond the built-in issuance schedule seen in figure 1.
  • Unlike essentially all modern currencies, bitcoins are not issued against matching pledges of interest bearing debt. In short: BTC is not a debt-based currency. This is immensely important should the World enter a era where global economic growth is no longer sustained - since in that situation an (interest bearing) debt-based money system is bankrupt by design.
  • Much like cash transfers, BTC transfers are quasi-anonymous. Everyone in the bitcoin network can see transaction histories (when and also which wallets the money came from and went to), but the owners of those wallets can remain anonymous. 
     

Is it really money?

Why do you accept USD, EUR or any other fiat currency for your work or assets? After all, you know that their intrinsic value is the same as BTC: Precisely ZERO.

You accept them only because experience tells you, that someone else will accept them when you want to spend them. Money (any money) is really just a confidence game, but also a unit of account, a store of value - portable power!

Given bitcoin's extreme convenience for transfers and storage, predictable supply with built-in scarcity, inherent decentralized and debt-free nature, bitcoins strike me as much more credible money than any government decree (fiat), debt-based currencies.
 

What is the current status and should you invest?

There are a number of web-based sites for trading bitcoins to and from various other currencies. A list including current exchange rates my be found at bitcoinwatch.com There are also websites providing advanced plotting tools for the technical traders. One place to start is bitcoincharts.com/markets.
Figure 2: Google trends for "bitcoin" over the past 12 months. Clearly, hardly anyone had heard about bitcoin before April.Click to enlarge
Figure 2: Google trends for "bitcoin" over the past 12 months. Clearly, hardly anyone had heard about bitcoin before April.

As evidenced by Google trends (figure 2) general interest in bitcoin has risen from almost zero during the past half year or so. Concurrently, the options for spending bitcoins on "real" things have been getting better all the time as the bitcoin economy has grown rapidly.
 

A place to get an overview is this list of traders accepting bitcoins. You can buy real things and services like books, computer hardware, clothes, internet hosting and even gold and silver.

Other sites to explore include:spendbitcoins.com, forbitcoin.com and weusecoins.com

So should you invest in bitcoins?

Clearly, if the bitcoin economy were to become comparable in size to even the smallest "paper" currency economies the value of 1 BTC would be substantially higher than it is today (about 10 USD/1 BTC) since the money supply would remain limited to 21 million BTC.This translates to an almost astronomical upside.

On the other hand, should bitcoin fail (see below) the investment would of course be lost. At this stage I think it is too risky to go long BTC in a big way, but it makes sense to create a wallet, buy a few BTC and check it out - perhaps try paying with bitcoin next time you buy something online to get an understanding of the system.
 

Why will it probably fail?

Because, while the average person would be better off with bitcoin then debt-money, powerful interests would stand to lose if BTC became a success.

Clearly, banks would loose on multiple fronts:

First and foremost,the practice of "fractional reserve lending" where banks lend out money at interest with a leverage of 10 times or more - in effect lending out and collecting interest on money they don't have - would probably cease or at least people would learn the distinction between real money and checkbook-money. Good for you and me; very bad for the banks!

Secondly, fees on transfers (particularly) international wire-transfers and on currency exchange would go down tremendously.

In reality - banks would have to revert their business to what most people think is the core business: Connecting people with surplus money with people in need of money and charging a small commission therefore. Such a reversion to pre-fractional reserve banking practices would cut the banking sector from being >15% of the total economy down to perhaps 3% - great for everyone, except of course the banks.
 

Credit card companies such as American Express Co. ($25.500 billion in revenue in 2010), VISA inc. ($8.000 billion in revenue in 2010), MasterCard ($5.500 billion in revenue in 2010) would become essentially irrelevant since BTC payments could be made on the spot using a smartphone. Because of this I have no doubt, that the financial industry will use their enormous power and influence to stop initiatives like bitcoin before they get any real traction. Not doing so would simply be too dangerous to their business.

If you decide to try out bitcoins and wish to test how easy transfers are, feel to do so by donating to me:
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I have a small position in BTC.
Stocks: AXP, V, MA