Security Tip: Spam, Bitcoin and Wallets
In writing this blog, I encounter a lot of different spam comments every single day. None of this spam reaches the comment area of any blog article because of moderation and spam filtering. However, every once in a while I see a spam message that catches my eye and I feel the need to write about such traps. Let’s explore.
Today’s Spam
Today, I found this spam message and it spurred me to write this blog article:
Invest $ 5,000 in Bitcoin mining once and get $ 7,000 passive income per month
This sounds like a great deal, doesn’t it? Of course, this spam message arrived complete with a link to a website. I’ve redacted that part of this spam. The text is the most important part (or rather, the sleaziest part) and what I intend to discuss in this article.
Let’s dispel this one right away. You cannot invest $5,000 into a Bitcoin mining rig and get $7,000 a month in passive income. This is not possible. First off, Bitcoin is entirely volatile so values vary every minute. Second, you have to place your mined Bitcoin into a wallet somewhere. Third, a compute rig requires electric power, air conditioning and internet services requiring you to pay bills every month. Fourth, the maximum you could mine per month is a fraction of a Bitcoin.
Most mining rigs are lucky to make any money at all considering the electric bill cost alone. You must also pay your Internet service as Bitcoin mining requires regular check-ins with its sites to transfer the data processed during mining and download new data. Both the electric and internet bills are not at all inexpensive to own and will substantially reduce the value of any Bitcoin you might mine. There are also exchange fees to convert your Bitcoin into US Dollars (or vice versa), which will eat into the profits of your mined Bitcoin.
Mining
Bitcoin mining seems like a great thing. In reality, it is far from it. As I mentioned above, you need to not only invest in a specialty computer rig designed for Bitcoin mining, you also need to supply it with electrical power, heat dissipation (A/C or a fan) and internet service. In exchange for “mining”, you will occasionally receive tiny fractions of Bitcoin (when the bits align just right). When Bitcoin first began, the amount and frequency of Bitcoin given during mining was much higher than it is today. Worse, mining of Bitcoin will see less and less Bitcoin issued as time progresses. Why?
Bitcoin is a finite currency with a limit on the maximum number of coins ever. Once the coins are gone, the only way to get a coin is by getting it from someone who already has one. Even then, there’s a problem with that. That problem is called ‘end of life’ and, yes, even Bitcoin has an expiration date.
But… what exactly is “mining” and why is it a problem for Bitcoin? Mining is not what you think it is. This word imparts an image of men in hardhats with pickaxes. In reality, mining isn’t mining at all. It is a collective of computers designed to compute the general ledger of transactions for Bitcoin. Basically, each “mining” computer takes a small amount of potential ledger data given to it by an “authority” and then solves for the equations given. This information is handed back to the “authority”. The “authority” then compares that against all other results from other computers given the same data. If a consensus is reached, then the transaction is considered “valid” and it goes into the ledger as legitimate. This is the way the currency ferrets out legitimate transactions from someone trying to inject fake transactions.
There’s a lot more to it, but this is gist of how “mining” works. In effect, when you set up a mining computer (or rig), your computer is actually performing transaction validation for Bitcoin’s general ledger. In return for this calculation work, your computer is “paid” a very tiny fraction of Bitcoin… but not nearly enough to cover the real world money needed for the 24/7 constant computing. A Bitcoin payment is only issued during mining IF the calculation solves to a very specific (and rare) answer. And so begins Bitcoin’s dilemma…
Basically, if you take all of the fractions of Bitcoin you receive over a year’s worth of 24/7 general ledger computing, you might be lucky to break even once you take your electric and internet bills into account. However, you are more likely to lose money due to the rare incidence of solving the equation for payment.
Additionally, to store those fractions of Bitcoin from your mining activities, you’re going to need a wallet. If your wallet is stolen, well that’s a whole separate problem.
Bitcoin Logistics
Unless you’ve been living under a rock, many crypto wallets and companies that store wallets are entirely insecure. They “think” they are secure, but they’re not. They’re simply living on borrowed time. Too many wallet companies (and wallet technologies) have been hacked and have lost Bitcoin for many people. Because of the almost trivial vulnerability nature of a crypto wallet, owning Bitcoin is almost not even worth the risk. We’re not talking small amounts of Bitcoin lost. We’re talking tens of thousands of dollars “worth” of Bitcoin gone *poof* because the companies / wallets were hacked and Bitcoin emptied.
While there might be some reputable and secure wallet storage companies, you have no idea how secure they really are. Because it’s cryptocurrency, once the Bitcoin has left the wallet, there’s no way to get it back. It’s the same as if someone stole your wallet out of your pocket or purse. Once it’s gone, it’s gone.
Further, because Bitcoin’s wallet technologies are so hackable and because it holds real world value into convertible fiat currencies, like the US Dollar (and other currencies), there’s a real and solid motivation for hackers to find ways to get into and pilfer Bitcoin wallets from unsuspecting owners.
The Downsides of Bitcoin
As a miner, you’re paid in Bitcoin. Bitcoin has limited uses in the real world. There are some places that accept Bitcoin, but they’re few and far apart. Most places still only accept the local currency, such as the US Dollar in the United States. For Bitcoin to become a functional currency, it would need to be heavily adopted by stores and businesses. Instead, today most places require you to convert Bitcoin into the local currency. This is called exchanging currency and usually incurs fees for the exchange. You can’t put Bitcoin into a traditional bank. You can’t use it to pay most bills. Any business wanting to remain in business would need to convert any Bitcoin received into USD or similar. The conversion fee could be 1%, 2% or up to 10% of the transaction. There might even be a separate fixed transaction fee. These fees begin to add up.
All of this reduces the value of Bitcoin. If one Bitcoin is worth $1000 (simply used as illustration), you could lose up to $100 of converting that single Bitcoin to $1000… making it worth $900. Because Bitcoin is entirely volatile, a Bitcoin worth $1000 today could be worth $100 tomorrow. For this volatility reason and because of electric and internet bills, the idea of making $7000 in passive income in a month is not even a reality. If you could receive one Bitcoin per month via mining (hint: you can’t), you might clear $7000 (assuming one Bitcoin is worth $7000 when you go to convert). Chances are, you’re likely to get far, far less than one Bitcoin per month. More likely, you’ll get maybe 1/10th (or less) of a Bitcoin in a month’s worth of computing … barely enough to cover the cost of your electric bill… assuming you immediately cash out of your Bitcoin and use that money to pay your bills.
Insurance and Fraud
The US government insures bank and savings accounts from loss via the FDIC (Federal Deposit Insurance Corporation). No such governmental insurance programs cover Bitcoin (or any other cryptocurrency). Until or unless the US government issues its own digital currency and extends similar protections of the FDIC to banks storing those digital currencies, today’s decentralized cryptocurrencies are simply the “Wild West” of currency.
What “Wild West” means is that anyone who owns cryptocurrency is at risk of loss no matter what means is used to store your Bitcoin. Your coins are as secure as the weakest link… and the weakest link (among many) appears to be the wallet.
Cryptography and Security
Many crypto “banks” (though I hesitate to even call them a bank) claim high levels of security over your Bitcoin wallet. Unfortunately, your wallet is always at risk no matter where you store it. If it’s on a self-contained card on your person, that can be hacked. If it’s at a currency exchange service, like Coinbase, it can still be hacked (in a number of ways).
The problem with crypto “anything” is that (and this is the key bit of information that everyone needs to take away from cryptography) is that cryptography was designed and intended to offer transient “short term” security.
What I mean by “short term” is that it was designed to secure data for only as long as a transaction requires (usually a few seconds). An example is using an app on your phone to perform a transaction with your bank. Your logged-in session might last 5-10 minutes at most. Even then, a single communication might last only a few seconds. Cryptography is designed to protect your short burst transmissions. It would take a hacker well longer than that short transmission period to hack the security of your connection. By the time a hacker had gained access, your transaction is long over and you’re gone. There’s no way they could change or alter what you’re asking your bank to do (unless, of course, your device is compromised… a completely separate problem).
Bitcoin, on the other hand, is required to be secured in a wallet for months, years or potentially even decades. Cryptography is not designed for that duration of storage and protection. In fact, cryptographic algorithms become weaker every single day. As computers and phones and devices get faster and can compute more data, these algorithms lose their protections slowly. It’s like when rains erode soil on a mountain. Inevitably, with enough soil eroded, you’ll have a landslide.
With crypto, eventually the computers will become fast enough so as to be able to decrypt Bitcoin’s security in a matter of weeks, then days, then hours, then minutes and finally in real-time. Once computers are fast enough to hack through a wallet’s security in real-time, nothing can protect Bitcoin.
This is the vulnerability of Bitcoin and other cryptocurrencies. Once computers hit the threshold to instantly decrypt Bitcoin’s security (or, more likely, Bitcoin’s wallet security), then Bitcoin is all over. You can’t store something when computers can gain unauthorized access in a few minutes. This law of diminishing cryptography returns is the security fallacy of Bitcoin.
Of course, Bitcoin developers will say, “Well, we’ll upgrade the Bitcoin cryptography to last longer than the then-current processing power”. It is possible for developers to say and potentially do this. But, that could still leave YOUR wallet vulnerable. If your wallet happens to be stored in an older cryptographic format that is vulnerable, then what? You may not even know your wallet is being stored in this vulnerable way if it’s stored at an exchange like Coinbase. That could leave yours and many other’s wallets hanging out to dry. Unless the currency exchange shows you exactly the format your wallet is being stored in and exactly the strength of cryptography being used, your wallet could very well be vulnerable.
Note that even the strongest encryption available today could still contain vulnerabilities that allow it to be decrypted unintentionally.
Bitcoin Uses
Probably the only single use of Bitcoin is as part of a balanced portfolio of assets. Diversifying your portfolio among different investment strategies is the only real way to ensure your portfolio will continue to grow at a reasonable rate. This is probably one of the only reasons to legitimately invest in Bitcoin. However, you don’t need to outlay for a mining rig to do it. Some investment firms today now allow for investment into cryptocurrencies as part of its investment portfolio offerings.
Still, you’ll have to be careful with investing in cryptocurrencies because there can be hidden transaction fees and conversion fees involved. These are called “loads” in the investing world. This means that you might invest $50, but only receive $40 in Bitcoin. That $10 lost represents the “load”. If you sell out of Bitcoin, you may also receive yet another “load” and again lose some of your money in the exchange. You have to take into account these “loads” when you choose to invest in certain funds. “Load” funds are not limited to Bitcoin. These exist when investing in all sorts of funds including mutual funds and ETFs.
However, Bitcoin (and other cryptocurrencies) can be valuable as part of a balanced portfolio. Of course, Bitcoin would be considered a Risky type of investment because of its volatility. Depending on how your portfolio is balanced, you may not want to invest in something as risky as Bitcoin. Not all portfolio management companies (i.e., Schwab, E*Trade, Ameritrade, etc) may offer cryptocurrency as an investment strategy. You’ll need to check with your specific company to determine if Bitcoin is available.
End of Bitcoin
Because Bitcoin is finite in total numbers of coins, eventually computing the general ledger will no longer pay dividends. What I mean is, once the Bitcoins run out, there will be no way to pay the miners. Bitcoin currently pays miners from the remaining ever diminishing pool of Bitcoin. Once there’s no more Bitcoins in the pool, there’s no more payments to the miners. This means that Bitcoin is dead. No one is going to continue to spend their expensive electric and internet bills on computing a general ledger that offers no dividends. No general ledger computations, no transactions.
This means that eventually, miners will stop mining. Once a critical mass of general ledger computation stops, computing Bitcoin transactions may become impossible. This will be the death of Bitcoin (and any other cryptocurrencies that adopt the same mining payment model). You can’t spend a Bitcoin as liquid currency if there’s no way to validate a transaction.
Some people think that it might require Bitcoin to completely hit zero, but it doesn’t. Once the remaining pool gets small enough, the algorithm gives out ever smaller amounts of payment in return for computing. At some point, spending thousands of dollars on a rig to gain a few pennies worth of Bitcoin every month won’t be worth it. Miners will shut off their mining activities. As more and more miners realize the futility of their mining efforts, fewer and fewer will mine.
When a compute (or lack thereof) critical mass is reached, Bitcoin will be in a crisis. This is the point at which the value of Bitcoin will plummet, taking with it many “paper Bitcoin millionaires”.
If you own Bitcoin, you need to watch and listen carefully to this part of the Bitcoin world. In fact, we are likely already on the downward slope of the bell curve for Bitcoin computing. How far down the bell curve is unknown. Unfortunately, as with most investment products, many people hold on far too long and get wiped out. It’s best to sell out while you know the currency holds value. Don’t wait and hold thinking it will infinitely go up. It won’t.
Eventually, Bitcoin will die because of its finite number of coins and its heavy reliance on “mining”… which “mining” relies on offering dividends. When the dividends stop being of value, so will end the mining and, by extension, so Bitcoin will end.
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Can Bitcoin’s bubble burst the economy?
Yes! Let’s explore.
Housing Bubble
Back in 2007, what drove the home mortgage collapse was a combination of factors, but one of the biggest factors that tipped the scale was speculative home buying. That is, people who would double or triple mortgage their homes to pay for secondary homes. When the home mortgage market unraveled, all of those multiple homeowners lost everything. Not only did they lose their secondary homes, but they also lost their primary residence and they ended up bankrupted to boot. I’ve heard tales of people who had taken out 3 or even 4 different mortgages on their home to pay off secondary homes. When those ARMs came due, it all came tumbling down. I know one person who, at their height, owned up to 4 homes and ended up living out of an RV when the home mortgage collapse was over. Do you want to end up being that person?
Bitcoin and the Crypto Bubble
Behaviors don’t change. The fastest way to get a pile of cash is taking out a new mortgage on your home. Today, my belief is that what’s driving up Bitcoin and Ethereum is speculative buying from people who don’t have money to spend. People who are using credit cards and second or third mortgages to buy into these markets thinking they can make a quick buck. The real danger is, of course, when Bitcoin collapses and these folks cannot pay off those loans.
Will Bitcoin collapse? Upward rises on investment products at the unprecedented level that has come to Bitcoin is not sustainable. In fact, Bitcoin’s actual value is no where near the sky high prices that it’s currently seeing. There will be a correction. How deep that correction goes is up for debate. However, it doesn’t really matter how deep it ends up. It only needs to be deep enough to put speculators underwater on their loans forcing them to fail to repay their additional mortgage(s) they used to buy into the Bitcoin market.
It would only take a small correction to wipe out speculators using risky loan vehicles as money sources. It only takes a limited number of speculators to fail to start the dominoes falling.
Economic Danger
The red flags are here and they’re waving boldly. Yet, of course, no one is looking at them. If a Bitcoin correction begins to collapse those speculator’s second and third mortgages, it will take with it first mortgages and the home mortgage market may face yet another collapse. What tertiary triggers fail after that is unknown. Does AIG still sell derivatives? Do other insurance companies? Are there other risky investment vehicles tied to these second and third mortgages that could topple Wall Street yet again? Are there risky investments tied to Bitcoin?
We don’t know. What we do know is that Bitcoin (and the rise of the secondary crypto currencies) could easily knock over the first few dominoes after a correction and start the economic decline. The danger is here and it’s very real.
Word to Speculators
Unless you invested in Bitcoin back in 2011 or so, you’re too late for this party. If you’ve recently taken out loans (no matter the source) to fund a Bitcoin investment, you need to get out of it as rapidly as you possibly can and pay off that loan. Holding onto Bitcoin hoping for long term millions is most assuredly going to backfire on you and ruin your financial world.
My best guess is that you have about 5 months before the whole thing topples. Yes, it could take a little longer or it could be sooner. What starts that topple is anyone’s guess, but it will happen. Having Bitcoin go from $1700 to $17000 to $21000 in less than a year is insane. Anyone in their right mind knows that investments don’t grow that fast. Something nasty is afoot. Do you want to find out the hard way? If so, invest more, but don’t say I didn’t warn you when your world collapses.
Economy and Investment Ties
Unfortunately, economic markets are tied together in very loose, but established ways. When a collapse of any single investment vehicle begins, it takes with it all kinds of other unrelated investments and markets. This means that even your IRA which is investing in vehicles unrelated to Bitcoin will take a hit when Bitcoin collapses. Why? because institutional investors who’ve just lost a pile of cash on Bitcoin will sell out of their holdings in their other investments (which your IRA may be investing in) to make up for their Bitcoin losses and/or to pay off speculative loans they lost money on. This will drive down those unrelated markets and cause IRAs and other similar investment accounts to lose significant value.
If we could see into the future, it would be easy to tell you when to sell out of your holdings in your IRA and wait for the wrath to end. Unfortunately, there is no such crystal ball available. You will need to use your best judgement when you feel is the best time. No one can predict that for you.
There is simply no way to know just how deep this cut will go when the correction occurs. It all very much depends on where the money is coming from that’s driving up Bitcoin (and other crypto). Right now, that information is not transparent at all. But, it is nearly guaranteed that some of the money is coming from Wall Street institutional investors, investment funds and possibly even banks and insurance companies. And… this is the biggest danger to unrelated investment vehicles.
Even if you don’t have a single dime invested in Bitcoin, that won’t necessarily protect your finances and investments from exposure to a crypto bubble burst.
How do I protect my finances?
The short answer is, it’s not easy. Because the markets are so closely tied and there’s so much institutional investing made all over, you can’t know who’s exposed to Bitcoin. The only real way to protect your financial future is to sell out of the markets and wait it out. But, no one can tell you when is the best time to sell. You just need to watch Bitcoin and other cryptocurrencies closely and then wait to see what happens. However, by the time you realize that it’s time to sell, it may be too late. Earlier, in these cases, is always safer. However, too early also means you may lose gains you could have realized if you left your investments in place. So, it’s ultimately your call when to choose the best time to protect your financial future.
Bitcoin: Scam or Currency?
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.
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