Bitcoin is an absolutely brilliant idea, combining cryptography, finance, economics, and computer science concepts to create a virtual medium of exchange. It is intended to address aspects of traditional currencies that some find objectionable, such as arbitrary inflation, centralized control and oversight, and counterfeiting. However, bitcoin as set up has some fatal flaws that will relegate it to the shadow economy and a nothing more than minor player in the global economy.
What Is Bitcoin?
There are detailed guides on what it is all over the web, so here I will just say that it is a digital construct with many of the features of what the creators consider to be an ideal medium of exchange. It only exists as a string of encrypted bits on a computer. An account number, or "wallet," can be used to "hold" bitcoins (these terms are holdovers from physical currency use and are only metaphorical, to help people understand).
I am not going to go too deeply into the technical details here, because it will be over the head of almost everyone in the world except those with both technical and financial expertise (part of why bitcoin has such a mystique is that very few people actually understand bitcoin - financial and economic professionals don't understand the technology, and technology professionals don't fully understand the economics and finance). Suffice it to say for now that bitcoin's structure relies on solutions to absurdly difficult math problems that can only be solved by brute force with heavy computing power.
Instead, I will discuss the fundamental properties of bitcoin:
- There is a hard maximum of 21 million bitcoins. After that there will be no more bitcoins ever created. Currently there are just over 12 million in existence, and more bitcoins will be created ("mined") until the last bitcoin is created around the year 2040. The schedule of creation is constructed so that the rate of creation will decline, despite increases in computing power over time.
- Bitcoin is mostly, but not completely, anonymous. I say mostly anonymous because while it is currently impossible to discover what individual owns a particular wallet until those bitcoins are exchanged into a currency governed by controls and disclosure laws, the entire record of bitcoin transactions is public, so you can trace transfers across wallets quite easily. You just have no idea whose wallet it is in the real world.
- Transactions are impossible to forge. In order to do that, someone would have to forge the next bitcoin block chains in 6 different instances within 10 minutes before anyone else in the entire rest of the world did once. This is not possible unless someone creates a quantum computer.
- Transactions are the same as cash and are irreversible. If someone steals your password and liquidates your account, you have absolutely no recourse, because there is no governing body.
- Physical bitcoins are simply tokens with the private key of the bitcoins embedded inside. While these can be physically secured offline, in order to be spent the transaction must occur over the internet in the public record of transactions.
- There is no issuer of bitcoins, no governing body (this is where the oft-repeated term "decentralized currency" comes from), and thus no arbiter of disputes or guarantor of value.
This structure makes for a currency with some very interesting properties, but also fatal flaws that will relegate Bitcoin to the shadow economy and to its treatment by the financial world of bitcoin as more like a commodity than a currency.
1) Unlike a currency, bitcoin has no issuer. Because no entity is contractually backing up the currency with their domestic production, the intrinsic value of bitcoin is exactly zero. This makes bitcoin more like a commodity than a currency - just a commodity with no intrinsic value or use.
Proponents will say that the population of the world that will accept bitcoins as payment is backing up the value of bitcoin with their production. This may be true, but as nobody is contractually obligated to do so, the entire population is free to stop accepting bitcoins as payment at any time with no restrictions. If the world stops accepting them as payment, they are worthless.
2) A finite number of bitcoins means that there will never be any inflation for bitcoins. This means theoretically they are great as a hedge against inflation. However, no inflation means a deflationary bias which encourages hoarding. As the ratio of total world goods and services value to number of bitcoins in existence increases over time, there will be more and more incentive not to spend them.
3) Lack of consumer protections will make bitcoin unusable for most legitimate and day to day transactions.
a. User passwords are notoriously bad and bitcoins being stolen will be a frequent occurrence.
b. Once stolen, the bitcoins are gone and cannot be recovered. Bitcoin's anonymity ensures that you will only know the wallet account number of where the bitcoins went - you will not know who actually stole them - so there will be no target to sue or prosecute. Particularly if they are stolen by someone from another country.
As an example, close to $200 million worth of bitcoins was recently stolen from an online bitcoin marketplace for illegal drugs called Sheep Marketplace (see http://www.reddit.com/r/SheepMarketplace/comments/1rvlft/i_just_chased_him_through_a_bitcoin_tumbler_and/ and motherboard.vice.com/blog/did-one-of-the...). Someone was willing to risk having organized drug cartels searching for him (and drug cartel enforcers aren't exactly known to abide by the Geneva Convention), trusting only in the anonymity inherent in the bitcoin system for his protection.
c. The only way to physically secure bitcoins is to hold them in a computer that is not connected to the internet, or to write down the private keys of your bitcoins and store them somewhere. Commercial physical bitcoin tokens are risky because the manufacturer of the physical coins had access to the private keys in order to make them, and there are several instances of exchanges stealing bitcoins from users.
4) Most governments will be antagonistic towards bitcoins
a. No government entity will ever issue debt in bitcoins in order to avoid the situation where their own debt burden becomes unsustainable and the debt cannot be inflated away because they can't issue any more of the currency in which the debt is denominated (think Greece with the Euro). In this situation the entire government becomes beholden to external state debt holders who may be hostile and the sovereign risk becomes too great. Imagine replacing Greece owing Germany Euros that it cannot pay back with Israel owing Iran bitcoins that it cannot pay back. No government will take that risk.
b. Because of the sovereign risk, if virtual currencies do become widespread, governments will use their spy agency resources to use virtual currencies for strategic warfare, which will further reduce bitcoins' viability as a currency.
c. Bitcoins can be used to avoid capital controls (think China), sanctions (think Iran), and official inflation (think Argentina), undermining political power and control.
d. Bitcoins can be used to avoid paying taxes in standard currencies, and as identities are not traceable if the individual doesn't want to be identified, can be used to avoid government oversight entirely. Nearly every government in the world will want to prevent this.
e. The anonymity inherent in bitcoins makes it impossible to know who in real life is paying the money, if the individual wants to remain anonymous. This means that any government accepting bitcoins in payment could be accepting money from a foreign entity. Recently a US court decided that campaign contributions cannot be accepted in bitcoins for this very reason.
(Ed. Note: China just forbade the PBoC from transacting in bitcoins and then forbade third-party processing of bitcoins, cutting the price of bitcoins in half.)
5) The anonymity and government antipathy will relegate bitcoin transactions to sectors where there are already no consumer protections and no government oversight. This typically means criminal activity such as drug trafficking, human trafficking, child pornography, and other illicit activities such as rhino horn poaching. We are already seeing this (Silk Road, Sheep Marketplace). This will lead to a public antipathy towards bitcoins and to bitcoin having a reputation as "criminal money." This will further reduce its viability and sideline it to the shadow economy.
6) There is no barrier to entry for creation of a crypto-currency, and I found a list of 54 currently in existence. Bitcoin is the first, but it will be replaced by another with fewer flaws.
Bitcoin is a brilliant idea, but has fatal flaws as a currency that will relegate it to the shadow economy or to be treated more like a speculative commodity. New digital currencies will be created, however, that will solve these issues and will gain more widespread acceptance. In particular, I believe that governments will eventually issue their own crypto-currencies with consumer protections, full tracking, and better controls. Imagine if dollars went virtual and were all labeled with serial numbers - they could be tracked individually around the world in real time. There would be no hidden transactions (at least not to the NSA). Fraud would be much harder. This in my opinion is the endgame of digital currencies.
Final note to commenters: There is a lot of irrationality surrounding bitcoin discussions on the web so feel free to offer reasoned and rational counter-arguments, and definitely feel free to keep emotional and irrational responses to a minimum.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.