Random Thoughts – Randocity!

Note, if you’re not really into philosophical discussions about economics, money and technology, this is probably not the post you’re looking for.  Also, if you’re looking for technical details on exactly how Bitcoin is implemented, I suggest you seek your research elsewhere.

[Update for 3/1/2014] — Mt. Gox files for Bankruptcy

Mt. Gox, a bitcoin exchange located in Japan, has filed for bankruptcy stating the loss of around 744,000 bitcoins from its exchange wallet. More info in this Reuters article. How this loss occurred is up for speculation. Mt. Gox claims its loss stems from a known flaw in the Bitcoin protocol. Bitcoin protocol advocates claim the wallet that Mt. Gox used was designed so that it exacerbated the known but usually rarely occurring flaw, which ultimately led to the massive loss of the Bitcoin from Mt. Gox exchange. Because of the massive amount of debt incurred as a result of its loss (among other debts), the exchange has ceased operations and anyone who had Bitcoin (or any other currency) deposited there may be out of luck.

What this says is that is several things. The Achilles heel of Bitcoin is its decentralization and the lack of properly protected wallet systems. The fact that there is no authority to advocate for depositors when companies like Mt. Gox go bankrupt leaves Bitcoin in a majorly problematic state. This situation also advocates for using personal wallets stored locally over using third party companies where situations like Mt. Gox can arise.

Because of the decentralized currency, there is no one to turn to when your Bitcoin goes missing from a large privately run exchange. Situations like Mt. Gox are exactly the type of setbacks that prevent Bitcoin from really becoming a solid workable useful currency.

If you had Bitcoin deposited in Mt. Gox, I’d like to hear your experience. Please leave a comment below describing your experiences with Mt. Gox or any other exchanges.

Disclaimer

This article is written with the sole intent to discuss whether Bitcoin can succeed as a currency at all or whether it’s a scam.  This article is not here to discuss the technical merits of Bitcoin, how a Bitcoin is specifically implemented technically or whether those technical details are a valid.  Once again, this article is here to discuss if a Bitcoin has any value in the marketplace or is merely a scam.

If you really want to know how Bitcoin is implemented, there are many many technical white papers that discuss this in great detail and that are available from the below mentioned Wikipedia article and through Google searching.  This article’s author leaves it up to the reader to do the technical research on the Bitcoin implementation details if you are interested.  If you’re looking for that level of detail, you’re not going to find it here.

What is Bitcoin?

Bitcoin alleges itself to be a, more or less, a digital / electronic currency that uses decentralized electronic ‘banking’ techniques involving digital signatures to validate each coin and approve transactions (to validate authenticity of said coin).  As Wikipedia states about Bitcoin,

Bitcoin (abbrv: BTC) is a decentralized digital currency based on the open source protocol created by a pseudonymous developer named Satoshi Nakamoto.^[1] It is subdivided into 100-million smaller units called satoshis.

This technical implementation was designed to solve the problem of exact digital copies when in the digital form. Therefore, the way each Bitcoin is created means that it is unique, individual and can’t be double spent by the same person.  So, when you own a Bitcoin, only you owns that unique coin and no one else (until you spend it).

Want more details? Follow the Wikipedia link on Bitcoin or search Google.

What is a currency?

Bear with me as some of this may seem very simplistic, but we need to start simple and at the beginning to understand the issues involving Bitcoin. Currency is, simply, any object or thing that takes on a given value.  More specifically, it becomes a currency when many of these objects are mass produced that all look and feel identical.  For most currencies, we equate the value with these tangible objects by ‘size’ or ‘denomination’ of the object.  Most of the currencies in play today work with two types of duplicated objects: paper ‘bills’ and flat metal cylinders called ‘coins’.  These are tangible physical duplicated but unique objects. The denomination is then a specifier of that specific duplicated object.  In the US, the currency is named ‘dollar’.  But, it could be just as easily named ‘fred’ or ‘mxyzptlk’ (except that that word is probably trademarked by DC comics).  So, as in the US Dollar, it’s a piece of paper marked with the number 1 and the words ‘one dollar’ or a coin struck and marked with the words ‘one dollar’.   These unique objects are then the basis of a piece of currency or ‘money’. So, while these are the fundamentals to begin a currency, it doesn’t establish it as valid currency until other criteria have been met.

Simply striking out objects labeled with this information doesn’t make it become currency.  For example, you can mint any coin you like, but the simple act of minting a coin doesn’t make it worth money.  After all, you can go buy child’s play money or grab some of Hasbro’s Monopoly game ‘money’, but these are mere pieces of paper with ink and hold no value in a currency market.  For casinos, they have chips and metal coins, but again these hold no value until exchanged within the casino back to US Dollars (or whatever currency that that casino provides).  For example, while a casino will accept their own tokens and coins to play their games, these tokens and coins hold no value outside of the casino (except in the case as a collectible or because of they contain rare earth metals as discussed below).

So, what makes a currency become legitimate legal tender? 

Basically, it requires an ‘authority’ to decree that the currency exists, issue the currency and usually a government to back the currency.  By ‘backing’, I don’t mean that there’s something tangible backing up the currency (like gold or land), I mean that the government has a gun-wielding military force at its disposal.  Having such force at someone’s disposal gives that someone power.  With power comes the ability to enforce rules.  And then, rules establish policy, policy establishes currency, currency establishes an economy along with such things as capitalism and that establishes the ability to buy and sell things.  Keep in mind that buying and selling will happen with or without currency.  It’s just that currency makes it easier and more standardized.  So, instead of having to hand over a  bushel of apples in trade for a bail of hay for your horse (i.e., random bartering), you can hand over 25 dollars instead.  And because many people have all handed over around 25 dollars for a bail of hay, that establishes that a bail of hay is ‘worth’ around 25 dollars.  That also establishes at once, the value of 25 dollars and the value of a bail of hay.  It doesn’t necessarily establish the value of a bushel of apples until the apples are ‘sold’ multiple times at or close to a certain price.

That means people have to ‘buy into’ that that piece of currency paper (or coin) has a ‘value’ and that that ‘value’ is established by the words printed on it, along with the issuing body’s ability to enforce that this piece of paper is now considered ‘legal tender’.   That value is then further established by how much it can buy.  Remember that policy establishes what is ‘legal’ and the power to enforce that policy is what puts the power behind that piece of paper which is then considered ‘legal tender’.  The government and the issuing body (not necessarily the same thing) lend legitimacy to the currency by power, policy and the ability to enforce policy.  Note that tangible currency created by decree and enforced by power is called ‘fiat currency’.

Of course, ‘the people’ have to allow that government to wield the power.  The reason the people give the government power is in exchange for protections. So, in exchange for allowing the government to remain in power, the government will provide protections for the people in the form of such things as a police force, a fire department, a military and some types of health services.  Of course, these protections aren’t without costs (i.e., read taxes or payments using, of course, the decreed currency).  But, the protections are established by the government.

One additional thing is that not only does the government and the issuing body have to recognize the currency as valid, but so do other worldly governmental bodies.  So, a currency must be recognized as valid by other governments to be useful in those other locales. It’s not an absolute requirement, but unless other governmental bodies recognize the currency as valid, it cannot be used in exchange for other currencies.  Without being recognized by other countries, this then makes it hard to, for example, buy things from other countries with our currency. Once recognized, however, the currency can then be exchanged to other forms of currency around the world and purchases can be made.  And with that, foreign currency exchange is born, which is a much more lengthy discussion than is required here.

The bottom line is that ‘the people’ give their trust to the government to both decree and ‘back’ the currency as valid.  So then we all have to agree that the ‘dollar’ has value, what that value is and how much it will ‘buy’.

Digital vs Real World currency

Bitcoin does not have a governmental power behind it.  It does not have a governmental sanctioned entity issuing the currency.  It is not recognized by any governmental force as a legitimate or legal currency.  It was developed by a technical engineer with an open standard protocol and is backed by nothing other than a relatively strong encryption algorithm and a set of established exchanges (where to buy Bitcoin).  So, as long as the encryption algorithm cannot be cracked, each issued Bitcoin is a unique and individual entity.  If it ever is cracked, the whole Bitcoin system falls apart.

Let’s compare the difference between a tangible ‘dollar’ and a Bitcoin.  A tangible dollar is a physical unique piece of fiat currency.  That is, it’s a tangible thing you can put in your pocket, it has a unique serial number (at least the bills have these) and are so stamped by the issuing authority. Ignoring for the moment that these tangible ‘dollars’ can be reproduced (read counterfeit) by unauthorized entities, each ‘dollar’ is its own unique entity.  Counterfeit bills are usually identifiable because the ‘original’ issuer uses anti-counterfeit techniques that establish parts of the bill which cannot be duplicate easily.  However, counterfeiting is a problem with any currency.  Or, at least, in real world currency.  That’s why bills and coins are redesigned periodically.

So, when you have ten tangible dollars, they are real physical bills.  In a digital world, these rules can’t apply.  In a digital world, it’s all 1’s and 0’s.  These can be duplicated infinitely and freely without knowing that that digital file was ever duplicated.  So, for example, attaching and emailing a photo of your dog to your friend makes a copy of that photo.  And that photo is the exact same as the photo on your computer and the exact same as the one you posted on Flickr.

With a digital currency, this is a problem.  Enter Bitcoin.

Why Bitcoin?

Bitcoin creates each coin uniquely through a computer algorithm that generates guaranteed unique coin entities and to prevent counterfeiting.  So, each Bitcoin represents one unique digital coin that stands on its own.  Each coin was created by an issuing authority using that algorithm and each coin is then registered in a decentralized database of outstanding coins.  So, whenever you spend that unique Bitcoin, the decentralized database will log that coin’s ‘transaction’.  However, like any currency, the transaction does not need to be recorded. In reality, to verify the legitimacy of any digital Bitcoin(s) when spent, it should be cleared with one of the transaction databases.  Otherwise, you risk that it may be counterfeit or double spent.  Because the coin was created using a basically un-crackable bitsize combined with each being unique and because each coin is officially registered with the decentralized transaction registry, that coin in theory can only be spent once per transaction.  So, even if you manage to copy the coin and attempt to give it away to someone else, it’s still only one coin no matter who owns or spends it.  In other words, duplicating the coin file into multiple files still only yields one coin to spend.  So, duplicating the coin’s file does not duplicate the number of coins that it is.  It’s still only one coin and is valued at whatever one coin is worth.  If you give away a copy of the coin to someone else, you’ve effectively just given them one Bitcoin and you’ve lost it.  Or, you will have lost it if they spend it first.  Again, if you want exacting details on how all of this is implemented technically, please read the Bitcoin Whitepaper.

Suffice it to say that the coins are allegedly unique and the transaction service prevents double spending.  So, it effectively makes it useable currency in the sense that each coin is unique like paper money.  Which, of course, is the sole goal of the whole technical implementation.. to mimick real world money in a digital way.

Before I get into the spending of Bitcoins, let’s step back and ask, “What legitimizes this currency?”  The answer is, not much.  The ‘currency’ is not yet recognized by any governments that I know of.  Therefore, it is not listed on exchanges with the dollar.  In other words, to exchange any other currency, such as the dollar for Bitcoin, you have to go to a Bitcoin exchange.  Bitcoins are not openly exchanged at regular exchanges.  So, you’re handing over dollars (or other legal tender) to a Bitcoin controlled exchange in trade for Bitcoins.

Think of this like going to a casino.  To get a chip to use in the casino, you have to go to that casino’s cashier and exchange your dollars for casino chips.  Therefore, you’re at the mercy of that casino to 1) remain in business while you play and 2) to retain the value of the chips while you’re playing.  So, if the casino goes out of business and kicks you out of the casino with chips in hand, those chips are worthless.  If the casino refuses to exchange the chips back to dollars, again, they are worthless.  If the casino decides that a ‘one dollar’ chip is now worth ‘one cent’, again, you’re at the mercy of the casino.  This is effectively Bitcoin.

Scam? You decide!

So, this is the place where some people see Bitcoins as a scam.  If you don’t personally recognize the currency as legitimate yourself, then you will only ever see it as a scam.  The fact that you have to go to a Bitcoin controlled exchange (regardless of being ‘decentralized’, read peer-to-peer) to change dollars (or any other currency) to Bitcoins is suspect.  Let’s get to the heart of the matter.  Exchanging real money for Bitcoin may simply make the originators of Bitcoin rich with ‘legal tender’ at the expense of people buying into the ‘Bitcoin’ idea as currency, but in reality is destined to fail and become worthless digital files. Where do those dollars go when handed over to that exchange?  How is the exchange rate determined?  These are all questions not easily answered.  Oh, I’m sure the people running the Bitcoin exchange will come up with some colorful answers, but the reality is that who really knows?  Unless Bitcoins become traded at a national exchange level and through exchanges not controlled by Bitcoin exclusive exchanges, then we really don’t fully know where the dollars or euros or whatever went after becoming Bitcoins.  Of course, the flip side of this is that you effectively ‘bought’ Bitcoins with your ‘real’ currency.  By purchasing a Bitcoin, that comes to another issue regarding collectibility, but that’s discussed below.

So, on the one hand you have legal tender which is established, recognized and sanctioned that you can really spend for real world items. You are taking that money and exchanging it for Bitcoin which has extremely limited uses cases, limited spend venues, questionable exchange rates, limited denominations coupled with low supply, no governmental backing, not being recognized by governments and other authorities and the high probability that it will be used for less than legitimate purposes, and this is presently what Bitcoin is.  Looking at all of this coupled with giving some random entity real money in exchange for ‘Bitcoin’ can be easily seen as a highly speculative scam.  It has a high probability to be or become a scam and, at the same time, make someone (or a few someones) very rich with real legal tender in the process… possibly your supplied legal tender funding violence or other unsavory uses.

On the other hand, you have a possible new digital currency that could succeed if it gains enough traction in various marketplaces.  However, the risk vs reward for Bitcoin is clearly too high for real currency use.  So, that leaves speculation and collectability almost the entire reason to buy into the idea of Bitcoin, if that’s a reason at all.

Ignoring the fact that each coin is unique and can’t be easily counterfeit, you have to consider what things you can currently buy with Bitcoins.  Since it’s not recognized as legal tender or even valid currency other than in very limited uses and by limited ‘businesses’, this currency is ripe for scam artists.  That means, legitimate businesses (especially banking) shy away from things that are not considered ‘legal’ or that reside in the fringe of ‘legality’. Any such legitimate businesses will opt for ‘legal tender’, such as the US Dollar.  So, adoption by legitimate business is a huge hurdle for Bitcoin.  Especially in the banking sector.

In addition, because Bitcoins are now being considered as the standard for online gambling uses (to thwart restrictions on the US dollar in online gambling), this further reduces the legitimacy of this ‘currency’.  That is, you can’t run to your local supermarket and buy a loaf of bread with a Bitcoin, but you can place an online poker bet with it.  You can’t run to your local car dealership and buy a new car with Bitcoin, but you likely can buy some drugs with it.  You can’t buy school supplies with your Bitcoin, but you probably can buy a handgun with it in an underground market.  This doesn’t spell good things for Bitcoin’s success or legitimacy as a currency. Because online gambling is one of the biggest scams out there right now, this use case doesn’t make Bitcoin look better.  Considering that most of the online casinos reside outside the US, US laws don’t apply to wagers made at those casinos.  So, even if you win big, there’s no protection from simply losing all of your Bitcoin when they choose not to give you your winnings (the most likely outcome) or the exchange rate has changed so much as to have lost any gains you may have won.  When you invest in Bitcoin to use at a casino, you’re effectively gambling twice: Once at the casino with your wager and again when you go to exchange your Bitcoin back to legal tender.

The fact that you were using Bitcoin, which have few protections anyway and which is then used to place a bet at an online casino leaves you ripe for losing everything you’ve given to the casino.  Meaning, you’ve lost your dollars to the exchange and you’ve lost your Bitcoins to the scam casino who’s just bilked you.  If you do manage to get anything out of the casino, you have to try your luck at the exchange and hope you can get legal tender back out at any kind of a decent rate.

Is Bitcoin Legitimate Currency?

None of these uses cases, no matter how technically well designed that this currency is, validates or legitimizes Bitcoin as a useful or legal currency.  Sure, it might be able to protect you from counterfeiting, but it will never protect you from being scammed.  And, if you are scammed, there is no one you can turn to to get your Bitcoin back, let alone get your US dollars back.  With the US Dollar, you can turn to your bank or your police both.  If you know who the other party is, you can sue.  With Bitcoin, all that is likely off the table.  In the  digital wild west, there’s no Sheriff in town here.  So, you lose your Bitcoins and they’re gone.  Neither the cops, nor the feds nor the banks will help as Bitcoin is not recognized as legal tender.  And, this is one of many hurdles involving the use of Bitcoin.

Of course, you might be able to sue the exchange where you gave your dollars for Bitcoin, but if there is a transaction record that can be produced that proves you were handed Bitcoin, then any lawsuits will be fruitless.  If you exchange money for any other good or service (digital or otherwise) and delivery can be proven through a transaction record, there is really nothing that can be done there legally.  That you gambled with your Bitcoin and lost is your problem.

Worse, what of the exchanges?  How are they managed or audited?  Who runs them?  Are they even audited?  In this case, who watches the watcher?  I’ve read a rather disturbing blog article at Nerdr.com about how at least one of the Bitcoin exchanges is manually altering the Bitcoin price to their own whim.  So, what does that say of the other exchanges?

Collectible Commodity vs Currency

Bitcoin faces another serious adoption problem: supply.  Built into the algorithm at the decentralized exchange is managing how much Bitcoin is in circulation at any one time.  So, if you want to obtain Bitcoins, you probably can’t get them from an Exchange until they are issuing new Bitcoin.  And since new Bitcoin isn’t issue often, that leaves you to find someone with Bitcoin willing to sell it to you outside of the exchange and likely at collectible prices (which brings up collectibility of Bitcoin). If you do manage to get it, you’re likely to pay the ‘collectible’ price for the Bitcoin.  Basically, as of this writing, $10-15 might get you one Bitcoin assuming you can even find someone willing to sell you coin.  And, that’s the problem, supply.

For a currency to succeed, it has to remain liquid.  That is, there has to be enough currency in circulation all of the time that people can get it when they need it.  If it cannot be obtained, it cannot be used as a currency.  Which then comes to the difference between Bitcoin being a collectible commodity and being currency.  Clearly, even the US Dollar has numismatists (or currency collectors).  And, here’s the problem.  Collectible value markets operate outside of the currency market.  So, for example, the face value of a one dollar bill is one dollar.  But, to a collector looking for specific markers, that ‘one dollar’ bill might be worth 1000 dollars as a collectible.  As collectors pull money out of circulation marked as a collectible commodity, it removes that liquid currency from the market and, thus, it cannot be spent as its face value.  This means that the issuing body has to make up for the currency pulled out of circulation as a collectible and replace that currency with new liquid currency.

Bitcoin faces this exact problem.  Speculation collectors are holding onto their Bitcoin as a collectible, not as currency.  They are speculating that the collectible value of the currency will rise and they will be able to sell it to another collector at a much higher value than the monetary face value of the Bitcoin.  Worse, because Bitcoin doesn’t have stamped monetary denominations, it makes it all the worse at determining the face value of a single Bitcoin, let alone the collectible value of it.

Basically, the speculative collectors are hording the Bitcoin as a commodity and preventing it from becoming and remaining liquid currency.  So, each time an exchange releases more Bitcoin into the wild, it’s immediately snapped up by collectors rather than going into liquid motion to be spent.  Speculative collectors are the biggest problem that Bitcoin faces today.  As there’s so little currency in motion, it really cannot be used as a currency.  So, it’s really become a collectible item for people to hold onto and not spend.  In fact, there’s so much more incentive to hold onto Bitcoin than spend it, it’s basically paralyzed as a currency.

Bitcoin’s future

The Bitcoin designer was so focused on making sure that Bitcoin was secure and, at the same time, scarce that he/she probably didn’t realize it would become paralyzed by speculative collectors.  The reality of low supply of anything only breeds one thing, collectors.  Collectors do not spend or trade.  They collect and hold with the intention of selling at a much much higher price much later.  The only way out of this paralysis is to release so much more Bitcoin into the wild that the collectors have no incentive to hold it any longer.  And this is exactly what Bitcoin must do to succeed as a currency.  This is also exactly what the US Treasury does to avoid the same paralysis of money movement with the dollar.  Note that the release of new Bitcoin has to be so much that it’s impossible for any one collector to afford to horde.  While it may ruin the market for collectibility of Bitcoin (and also kill any paper profits that collectors may perceive they have) and also lower the value of Bitcoin, it will force Bitcoin to become liquid again.  Until this happens, Bitcoin will never become a liquid currency that can be used for anything more than speculation and the occasional wager, assuming you can even find Bitcoin to buy or spend.

Personally, I wouldn’t invest in Bitcoin other than as a collectible at this point and even that is questionable due to the volatility of that market. Bitcoin has no real uses as a currency, other than perhaps at offshore casinos and other mostly unsavory purposes.  Even then, it may not protect you from the IRS or US authorities (if in the US) when you win at a casino.  Right now, it’s more or less a novelty investment and even then there are better investment vehicles that offer safer and higher returns.

Demise of the Bitcoin?

There is one other thing that could potentially destroy Bitcoin.  If the US Government (or any government) were to take the idea of Bitcoin and implement something similar (and easier) as a national digital currency sanctioned and issued by the Treasury department, this would likely destroy Bitcoin’s main objective, to become the defacto digital currency.  The one thing that a US digital coin cannot destroy in Bitcoin, however, is the anonymous nature of the currency, that Bitcoin is not issued by a government (it is outside of government control) and the peer-to-peer decentralized nature of it.  In the end, those pieces probably don’t really matter.  That the new digital currency works, that it is usable, that it can buy milk and eggs and pay rent, that’s what’s important.  Were the US to legitimize its own digital currency, businesses would adopt this en-masse and people and businesses wouldn’t look twice at Bitcoin thereafter.  A US digital coin would become the defacto standard for digital currency, at least in the US.  Bitcoin would then, as it is now, be relegated to a digital underground currency used for purchases where government sanctioned money cannot be used without penalties.

It’s just a matter of time before the US Treasury department wakes up.  As the saying goes, “Fight fire with fire”.  Creating a national digital currency solves a lot of problems.  It reduces the amount of paper and metal that it must mint saving money buying the supplies for the production of tangible money, it ushers in an even more solid digital economy and it gets rid of Bitcoin all at the same time.