Bitcoin: Good or Bad?
There's been quite a bit of hype and controversy lately about the popular digital currency, Bitcoin. What exactly are Bitcoins and why do they have people so excited? How does this monetary concept work and is it really economically and technically feasible?
Bitcoin is an open-source, software-based online payment system designed by an unknown person(s) under the pseudonym "Satoshi Nakamoto" in 2008. This payment system uses a peer-to-peer system with no central repository or administrator, making it the first large-scale decentralized "virtual" currency. It is often referred to as a "cryptocurrency" due to its heavy usage of cryptography.
How Does Bitcoin Work?
Those who haven't already informed themselves about this new currency may be wondering how such a thing could possibly work. The process is actually quite complex.
In reality, there is actually no such thing as a Bitcoin, at least not in any tangible form anyway. Bitcoin transactions are stored permanently on a distributed, public ledger called the block chain. The name comes from the fact that transactions are gathered together into a grouping called a block. Roughly six times per hour (or every ten minutes), this block is added to the public ledger and published to the nodes in the network, forming a chain of transaction blocks. A person's account does not actually contain any Bitcoins, only an address. The person's account balance is calculated by summing the transactions to and from that address from the block chain.
Bitcoin uses public-key cryptography, so each user has a public key and a private key. A user owns a wallet which basically contains the user's credentials. The public key is basically the equivalent of an account number and the private key serves as the ownership credentials (similar to a password or PIN). Bitcoin addresses are 160-bit hashes of the public portion of the public/private keypair. The transaction data is then cryptographically signed with the private key and anyone knowing the public key can verify that the signature is valid. Simply put, the digital signature is a piece of data that allows members of the Bitcoin network to mathematically prove that you possess the correct private key without directly revealing the private key, and since this signature is dependent on the content of the transaction, it will be unique for each transaction. This also means that the content of the transaction cannot be modified because it would invalidate the signature.
But how does all this work? There must be someone processing all these transactions and checking all this signed data, but we already stated that there is no central authority. The answer is Bitcoin miners. Miners can potentially be anyone. These are people or organizations which donate their computers' processing power to verify the legitimacy of the transactions. When a new transaction is made, it is broadcasted to the entire network. These miners then verify the transactions and additionally work to solve a particular type of math puzzle (i.e. brute forcing a SHA256 hash) which typically takes a long time for an individual, but roughly ten minutes for the network. Whichever miner or collection of miners working together (referred to as a mining pool) manages to solve the puzzle first will have his version of the current transaction block added to the block chain, and as a reward will receive 25 Bitcoins. This is the method by which Bitcoins are generated and added to the network, and serves as a motivation to mine.
The mining and transaction process is quite complex, and rather than go further in depth I recommend watching this video which explains it pretty well:
One key aspect of Bitcoin is anonymity. You don't need any form of ID or paperwork or citizenship to open an account. With all your personal information hidden, you are less vulnerable to identity theft. You don't need to worry about credit card numbers which can be stolen since with online credit card payments you actually give the seller everything needed to use the credit card, but with Bitcoin your private key is protected and a new address can be generated for each transaction.
Probably the most important feature of Bitcoin is that it has no central authority; it's a totally community-regulated currency which grows and functions mostly independently of governments and industry. This means that you have complete control of your money. Your money is completely without national borders, bank holidays, and currency conversions since Bitcoin is international.
Due to the public and peer-to-peer nature of the Bitcoin network, it is naturally protected from corrupt and oppressive governments. For example, in Argentina, recently there has been extreme inflation and strict capital controls; to protect their savings against this inflation and the possibility of confiscation, many Argentineans have turned to Bitcoin as an alternative currency. It has also been suggested that there was a rise in the purchase of Bitcoins in connection to a financial crisis in the Republic of Cyprus in 2012-2013.
Bitcoin has extremely complex but effective security mechanisms. Since all transactions are public record and are verified by many miners, it is incredibly difficult to cheat or manipulate the block chain. Additionally, Bitcoin transactions are irreversible, making fraud very unlikely. With these points in mind, it makes it easier for merchants to do business in high-crime areas since they don't need to worry about the possibility of being cheated. In addition to that, it's impossible to steal Bitcoins, so robberies would likely decrease.
If those benefits had you convinced of Bitcoin's awesomeness, don't make up your mind just yet. Unfortunately all of the points listed above as benefits are double-edged swords. Each of those advantages creates new disadvantages in the currency which we'll discuss next and add a few extra points.
The anonymous nature of Bitcoin is of course a convenient thing for many people, but unfortunately it's also quite convenient for criminals and money launderers. It has been estimated that between 4.5% and 9% of all Bitcoin transactions were for drug trades on Silk Road (a online deep web black market service). And nearly half of all Bitcoin transactions were bets placed on a single online gambling site called Satoshi Dice. Bitcoins have even been used to get around gun control laws to sell guns without background checks.
Additionally this opens up problems with tax evasion. Since this currency is not government regulated, and since accounts are completely anonymous, it becomes extremely difficult for governments to tax individuals and businesses. And while we all hate taxes, they are a necessary evil, so their impediment could have drastic effects on society. Or, more likely, if Bitcoin is becomes a more widespread currency it will become government regulated (thereby removing the advantage of being decentralized).
Bitcoin's "anonymity" is also somewhat less anonymous than advertised. The fact that all transactions on the block chain are public means that, while still not identified by name, transactions can be linked to individuals and companies. Additionally, many Bitcoin exchanges collect personal information. It has been suggested that Bitcoin transactions should not be considered more anonymous than credit card payments.
Due to the fact that Bitcoin transactions are irreversible, and do not go through a central authority such as a bank (meaning you cannot cancel payments), you have no recourse if a payment is sent to a wrong address or a merchant cheats you. There is no insurance or liability protection for Bitcoins, so if you are a victim to fraud or your wallet is hacked then you likely have to deal with it alone. There was even a case in 2013 of a man accidentally losing 7500 Bitcoins when he threw away an old hard drive.
Additionally, many countries such as Bolivia and Ecuador ban the use of Bitcoins due to their inability to regulate it.
Bitcoin's many security mechanisms are the cause of a number of problems themselves. Not only is it impossible to reverse a transaction and not only is it easier for criminals to hide their activities, but when criminals are caught, their accounts cannot be seized. That money can't even be put back into circulation. It's lost forever (unless authorities also obtain the private key).
In addition to that, the fact that your private key is the only way to use your money, if you lose it (possibly due to any number of reasons such as your hard drive crashing) your money is lost forever, and since there is no central authority, there is no way to recover your key or unlock your account or receive any sort of compensation.
The fact that your private key is typically stored on your hard drive (rather than memorized like a PIN number) means that it's potentially easier for a hacker to obtain access to your money. There was a case in early 2014 of a virus called Pony which was reported to have stolen up to $220,000 in cryptocurrencies including 335 bitcoins from 85 wallets. In general, the more electronic money becomes, the more vulnerable it will be.
The block chain introduces some very innovative ideas for preventing double-spending as mentioned in the video linked earlier in this article. The video illustrates the following attack:
From bitcoin.it: The attacker submits to the merchant/network a transaction which pays the merchant, while privately mining a blockchain fork in which a double-spending transaction is included instead. After waiting for n confirmations, the merchant sends the product. If the attacker happened to find more than n blocks at this point, he releases his fork and regains his coins; otherwise, he can try to continue extending his fork with the hope of being able to catch up with the network. If he never manages to do this, the attack fails and the payment to the merchant will go through.
This attack typically has a very low probability of success (less than 0.1%), however, when combined with the >50% attack (a situation in which the attacker controls more than 50% of the entire network) the probability of success would become 100%. This is a situation which has precedent; in 2014, the mining pool GHash.IO reached 50% of the network share.
While Bitcoin continues to grow in popularity, it has still be labeled by many experts as a speculative bubble (a situation in which asset prices appear to be based on implausible or inconsistent views about the future). According to the former Federal Reserve Chairman, Alan Greenspan:
It's a bubble. It has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven't been able to do it. Maybe somebody else can.
The fact that this digital currency has no backing will lead it to become extremely volatile and, in the end, economically worthless. According to Mark T. Williams, former Federal Reserve Bank examiner and Boston University instructor, Bitcoin is over seven times as volatile as gold and over eight times as volatile as the S&P 500.
Due to this high volatility, it has been suggested that businesses accepting Bitcoin payments should establish a clear policy for returns and refunds which should be based on the item's original dollar price rather than the Bitcoin price to avoid exposure to Bitcoin's ever fluctuating value. The very fact that you have to base the price on dollars defeats the purpose of this currency since it clearly isn't capable of replacing other currencies.
Bitcoin is sometimes referred to as a Ponzi (or pyramid) scheme. A pyramid scheme is defined as an "unsustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public". Let's take a look at how Bitcoin functions as a business now. As a new alternative currency, Bitcoins are worthless if they can't be used to buy stuff; therefore, it is in the best interest of users to get Bitcoin accepted as a legitimate currency, and to do this they need to convince more people to join the network. It is stated that the lack of a central operator, the lack of referral rewards, and the open-source nature of Bitcoin clearly proves it is not a pyramid scheme, however, it should be noted that the creator of Bitcoin, Satoshi Nakamoto, is believed to be in possession of roughly one million Bitcoins (about $1.1 billion), so clearly someone at the center of this system is profiting.
Many expert economists have made pretty harsh criticisms of the new currency. According to an article from Wired, "in the estimation of many leading economists, bitcoin is a fatally flawed idea shaped by people who don't really understand how money works". Economist John Quiggin argues that the cryptocurrency has no intrinsic value whatsoever and therefore "bitcoins will attain their true value of zero sooner or later, but it is impossible to say when". He states that due to their lack of intrinsic value, the instant businesses would cease to accept the currency, it would become completely worthless.
Not only does Bitcoin lack any intrinsic value, but it also eats up resources which do have intrinsic value; one important detail about Bitcoins is that they are produced and maintained by performing complex but useless algorithmic calculations. The computing power used to mine Bitcoins is gone once it has been used and cannot be reused for a more productive purpose. Due to the fact that every transaction must be kept forever, the amount of memory and computing power necessary to maintain the network as it grows will continually increase. To effectively mine, professional miners need to always have the most efficient, modern equipment, and so they are forced to continually reinvest profits into updating and maintaining their hardware multiple times per year. According to an article on Forbes in 2013, Bitcoin mining uses $15 million in electricity per day which accounts for 50% of the value of all Bitcoins mined so far. This is a pretty outstanding statistic, however an article in 2014 from Coindesk states only $70 million per year (possibly due to improvements in mining technology).
One more important point to consider is that Bitcoin transactions currently take up to ten minutes for verification (due to the frequency of blocks being added the block chain). That's totally fine for online transactions since you typically don't receive your goods instantly anyway, but how will this work if businesses start to accept Bitcoin? Businesses have the option of just accepting all transactions and skipping the verification and just hoping that the money is really there. This is basically how cheques work, however cheques come with some verification of identity (since businesses typically require a photo ID along with them). Additionally, many businesses already refuse to accept cheques as it is, and they're only a small percentage of the payments in countries which use them.
While Bitcoin might seem like a pretty nice, efficient way to handle payments, it comes with some risk. All transactions are totally network-dependent. Ever been to a fast food place and tried to order something during a power outage? They have enough difficulty just adding and subtracting on paper; now imagine them trying to figure out how to do Bitcoin transactions without any power. What would happen in the event of network downtime? Suddenly McDonalds would be vulnerable to DDoS attacks.
Network availability issues aside, it is also theoretically possible to obtain someone else's Bitcoins entirely by accident. Bitcoin keys are generated completely randomly and so it is possible for two people to have identical keys thereby leading to identical addresses. Most people will say that this is mathematically impossible, but the fact is that it merely improbable. The likelihood of this happening is one in 2128, which is less likely than getting hit by a meteorite, however in a perfect system the probability ought to be exactly zero.
After some pretty extensive research, I have to conclude that, while it is an interesting idea and would serve as a fascinating economic and engineering experiment, Bitcoin is not currently feasible as a real world currency. However, this concept is definitely worth further research as it addresses many issues with government-regulated currencies. I look forward to seeing how the topic develops.
- Coindesk: How Bitcoin Mining Works
- Coindesk: How Do Bitcoin Transactions Work?
- Coindesk: Under the Microscope: Economic and Environmental Costs of Bitcoin Mining
- Coinreport: Advantages and Disadvantages of Bitcoin
- Bitcoin: The Pros and Cons for Consumers and Merchants by Eric Adamowsky
- Wikipedia: Bitcoin
- Greenspan Says Bitcoin a Bubble Without Intrinsic Currency Value by Jeff Kearns
- Beware of Bitcoin by Mark T. Williams
- Wikipedia: Pyramid Scheme
- BitCoin, Pyramid Schemes and Alternate Currencies by David Klemke
- The Bitcoin Bubble and a Bad Hypothesis by John Quiggin
- Meet Patrick Byrne: Bitcoin Messiah, CEO of Overstock, Scourge of Wall Street by Cade Metz
- Fascinating Number: Bitcoin Mining Uses $15 Million's Worth Of Electricity Every Day by Tim Worstall