January 28, 2018

Opinion on Bitcoin

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I have being hearing people talking about Bitcoin recently, and as the designated ‘techie’ some people ask me what it is (the subtext being “should I buy some?”). I am always hesitant to say much in such situations (no one has ever made money listening to my financial advice!). For the interested, there are many good descriptions of the fundamental technology online (most of my knowledge comes from this Coursera Cryptocurrency course). I also mined some cryptocurrencies (results detailed in this blog post), but stopped very quickly after calculating the profit vs cost. I have never owned any Bitcoin, and have no immediate plans to change that.

Basically, I probably know enough to be dangerous, but falling victim to the Dunning-Kruger effect seems appropriate for Dunning-Krugerrands. Take everything written here with that in mind.

Firstly, most conversations on the utility or value of Bitcoin need to separate the cryptocurrency (Bitcoin) from the underlying technology (Blockchain). Blockchain seems like a very clever solution to the problem of distributed trust (i.e. a system where you do not need to trust anyone involved in the system but are still able to trust the system itself), produced by assuming that no one can control over 50% of the system. Bitcoin is the proof-of-concept application of Blockchain, with the added benefit that the value of the cryptocurrency encourages people to join the trust system (by mining) and thus decreases the likelihood of anyone controlling over 50% (also clever!).

As just a technology, the value of Blockchain depends on where it has been applied. Sometimes it will be useful, and sometimes not. At the moment it is the hot new technology and everyone seems to be using wherever they can. As I’ve seen with previously hot technologies, I suspect it will greatly overused in areas it is not applicable – beware! Still I can easily imagine places it would be helpful – it would be great for tracking ownerships of items/land in corrupt countries (although I suspect those are the last places that would adopt such a system for the same reason!).

Right now, there are five main reasons I don’t like Bitcoin. However, each of those reasons is surmountable with time and the advancement of technology. So while I think the Bitcoin is currently flawed and not worth the hype, I can believe that it has future potential (or more likely a successor cryptocurrency does). I’m sure all of these problems are being worked upon actively (and know of a few such efforts). A cryptocurrency that solves them all will probably be worthwhile.

The problems:

  1. There is no use for the mining calculation, it just burns electricity (and a lot of it!). To be part of the Bitcoin system by mining means performing a useless computation just to act as “proof-of-work” and randomise who proposes the next block. It would be great if this calculation had inherent value (like for instance drug discovery). However, it is hard to find a useful calculation that has the required mathematical properties.
  2. Bitcoin has no intrinsic value, and therefore no floor price. Cryptocurrencies have no backing (other than perhaps Tether). There is nothing to say the price should not be 0 or millions. This makes it hard to act as a store of value – holding it is currently speculation. If it was widely used for purchases then that would be something, or if the mining calculation had value. For comparison, commodities (like gold) have value in the industrial uses of that commodity; national currencies have the backing of their government, and even if you don’t trust them, you can still pay your taxes in that currency.
  3. Bitcoin is deflationary due to a fixed total size. While the total amount of Bitcoin in circulation is currently growing, at a certain point in the future this will stop. The Bitcoin system has a maximum amount of coin built into it, and when reached no more will be added. A currency that doesn’t grow makes the economy based on that currency hard to grow. It encourages people not to spend it as it will likely be worth more in the future (thus deflationary).
  4. Slow transaction speed and thus high fees. Bitcoin can handle a maximum of 7 transactions per second – worldwide! Only 7 people can use Bitcoin in the same second! This is several orders of magnitude less than any serious online payment system or credit card. The low number of transactions means people have to pay fees to have miners to include their transactions at the front of the queue. Everyone else waits. As the demand for Bitcoin increases, so will the number of transactions and the size of the fees.
  5. Few to no legal protections. One of the touted benefits of Bitcoin is that is not controlled by anyone, and thus safe from government interference or devaluation. However, this also means it is not protected. Scams and thefts of Bitcoin or other cryptocurrencies are common with victims seeming to have little recourse. I don’t think the level of corruption in the countries I reside is a serious problem for their currencies (yet) and their central banks generally do more good than harm – so I am happy to provisionally trust my wealth to government currencies. I would struggle to say the same for any cryptocurrency.

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