BITCOINS: Boom and Coming Bust
Yesterday Dr. Jia Liu, AIER Research Fellow, and I attended a Bitcoin presentation at Boston University’s Center for Finance, Law & Policy. The lead speaker was Jeremy Allaire, founder and CEO of Circle Internet Financial. Circle will offer transactions software and systems for merchants to deal with bitcoins, as well as services for consumers to buy, sell, and store bitcoins. This makes Circle a major competitor with BitPay and Coinbase. So far the new venture has raised $9 million in venture capital from Jim Breyer, Accel Partners, and General Catalyst Partners.
Advocates like Allaire call bitcoins a form of digital currency. The currency is completely virtual—it exists only on the internet—and is independent of any government. Thus, they like to say, it is a global currency.
But is it a currency? Or is it a security? Or is it just PayPal with a weird back-story? There are really two separate aspects to bitcoins. First, advocates argue that bitcoins are more secure, stable, and private than government-issued currencies. Second, that the use of bitcoins facilitates transactions and transactions processing.
Currencies—money—work because people trust in them. One way to engender trust is to establish a high-demand commodity as the basis for the currency. Promising to exchange the currency on demand for a fixed measure of gold very quickly makes a currency viable. This is the basis of gold standards and similar commodity-based currencies. The other way to create trust is for the political entity to declare that, by law, the public has to accept the currency of the land in exchange for real goods and services. It helps a lot if the government has a track record of maintaining a stable currency, but weight is also provided by tax-levying power and a substantial tax base.
If you are one of those people who does not trust the government, bitcoins offer an alternative. But bitcoins offer neither commodity nor government backing. To believe in bitcoins, you have to believe in mathematical algorithms that release money into the bitcoin economy when and only when certain math problems are solved. You have to believe that the internet cannot be hacked. You also have to believe in the mysterious creator of the bitcoin, an untraceable, possibly nonexistent person or group of persons going by the invented name Satoshi Nakamoto. Are we feeling warm and fuzzy about this yet?
Of course, bitcoin accounts have been hacked. Often. Accounts have been wiped out. More generally, the system has been compromised. In fact, in the news yesterday was a story that researchers from Cornell University have demonstrated that a group of self-interested individuals could co-op the bitcoin system for profit, affecting the flow of bitcoins into the system. The system does not appear particularly safe.
Advocates also promote the idea that bitcoins are anonymous and untraceable. This has led to fairly widespread usage of bitcoins for illegal transactions and money laundering. Bitcoins seem the way to go for drug trafficking and online gambling. It is also a way to move money and make transactions so as to avoid taxation. Not surprising, the Department of Justice (DoJ) and the Department of the Treasury have jumped on this as fast as you can say “Nakamoto.”
This year, the FBI shut down Silk Road, a service using bitcoins to deal illegal drugs. Seizing their virtual assets, the FBI now owns about 1.5% of all bitcoins in circulation.
Oh, and that anonymity. It turns out that by tracing the trail of transactions, it appears that it is possible to track down the owners of bitcoins and identify their transactions. Put together DoJ and traceability, and it is starting to look like the bitcoin may not survive in its current form much longer. The federal government may just choose to make holding bitcoins illegal as a way of clamping down on illegal activity.
If bitcoins form a currency, is it a more stable currency than national currencies? The short answer is no.
The value of bitcoins has fluctuated wildly, leading many to criticize its use as a currency. The design of the bitcoin slows the growth of the bitcoin money supply and limits the number of bitcoins to 21 million. Thus, scarcity in the face of rising demand has increased the market value of bitcoins, encouraging hoarding as speculative vehicles. Moreover, there is nothing real underlying the currency. And the more people get involved in bitcoins, the higher their value, leading some to charge that it is a Ponzi scheme.
This makes bitcoins look like securities being promoted in a Ponzi scheme, something that raised the interest of the U.S. Securities and Exchange Commission.
Trading the coins is also problematic. In a study by computer scientists Tyler Moore at Southern Methodist University and Nicolas Christin at Carnegie Mellon University, 45 percent of Bitcoin exchanges end up closing, with their customers losing their money. Many close without warning, some suffering security breaches that forced them to close. Even so, speculation has reached such a frenzy that speculative bubbles have arisen and burst, most recently in April of this year.
To the extent that it is a currency, bitcoins should be, and will eventually be, regulated under banking laws. If being unregulated and anonymous is the big selling point for bitcoins, it appears that it will not last. Governments are moving aggressively to police and regulate the market, and prosecute tax evaders.
In fact, bitcoin companies are facing lawsuits, legal actions, and investigations by private interests and government agencies including the Secret Service, the Department of Justice, the Securities and Exchange Commission, and the Department of the Treasury, to name a few.
But what about bitcoins as a means to make transactions easier? This has promise, but appears to be separable from the “bitcoin as a currency” argument. In fact, this makes bitcoins remarkably similar in practice to PayPal—a wildly popular internet transactions system.
All in all, this leaves us with a notion that bitcoins may go the route of Napster. The elements that facilitate anonymity and illegal commerce will be removed by federal enforcement agencies, and the transactions payment system that remains will become a competitor to PayPal. Since bitcoin uses the currency activity to finance lower transactions costs for the payment system, this leaves bitcoin with no cost advantage over PayPal and similar services.
In other words, it may just all blow over.