Thursday, April 11, 2013

What are Bitcoins, Bitshares, and Bitamids?

With all the speculation out there about Bitcoin, I just had to put in my two-bit-cents.  I fear that ultimately, Bitcoin is going to flop, and in this article I outline why.

Let's get started! What is Bitcoin, anyways?

Is it currency?
To be considered currency, or money, Bitcoin needs to satisfy three main criteria:

  1. Be a medium of exchange - here is the genius of Bitcoin, which created a safe, semi-anonymous medium of exchange without the need of a central authority.  
  2. Be a unit of account - this is also something that Bitcoin satisfies: it's divisible without loss of value, each Bitcoin is equivalent to any other, and it's definitely countable. 
  3. Store of Value - this is where I think is Bitcoin's major shortcoming.  While Bitcoins can be reliably stored and later retrieved, the value of of the Bitcoin is not stable over time.

Why is the stability of the value of Bitcoins important when judging it as a form of currency?
Historically, almost every currency had its moments of instability.  Unfortunately, those moments of instability also had very bad implications for the currency at that time.

Inflation is the most common threat to currencies.  During high inflation periods, what one can buy tomorrow with what one earned today is greatly diminished.  Imagine a situation in which today you sell a dozen eggs for some amount of money.  With great inflation, a few days later, when you want to buy eggs with the money you made, you find out that you can only get six eggs!  Clearly, in these situations, no one wants to sell anything.  Or at least, not store the money that one gets from such sales for very long.  During high inflation periods, the Store of Value property of money is diminished.

But that's not what we're seeing with Bitcoins.  With Bitcoins, we're seeing a process of hyper deflation.  Deflation is the opposite of inflation.  During high deflation periods, what one can buy tomorrow with what one eared today is greatly increased.  Continuing with the eggs example, if you sold a dozen eggs today, you may find out that in a week you can buy one-hundred eggs with the money you've made!  Initially, this sounds great!  So what's the problem?  In a strong deflation, no one will want to buy anything!  Why buy something today if one can get more tomorrow?  The person who bought that now famous pizza in early 2010 for 10,000 Bitcoins may be feeling buyer's remorse today.  Had that person, instead of buying the pizza, held on to the Bitcoins, he or she would have been able to sell them today for over two million dollars!  That must have been some pizza!  Clearly, if a currency is suffering from strong deflation, it's Store of Value property is hurt, and with it the motivation for buying things suffers.  Yet, enabling just those kind of transactions is the purpose of currency in the first place!

Another problem with hyper-deflation is that it invites speculators.  People can see that the buying power of the currency is increasing with time.  And who doesn't want to have more buying power?  So now, people who don't have anything that they would actually want to buy using Bitcoins still buy Bitcoins just so they can later sell them for more dollars than they paid for them today.  At least that's what they hope to do.  These people are called speculators, and having them around buying Bitcoins further contributes to its hyper-deflation.  A viscous cycle has begun!

Can the value of Bitcoins stabilize sometime in the future?
Perhaps today Bitcoins are suffering from hyper-deflation, but what about the future?  Will the value of Bitcoins stabilize?  Even if one removes all the speculators from the Bitcoin market, Bitcoins still have one fundamental flaw that is working against its stabilization.  As mentioned above, the Bitcoins are ingeniously designed to enable safe transactions without a central authority.   However, the very lack of a central authority is contributing to its instability.  In traditional currencies, the central authority can notice that there is a deflation going on, and print more money.  More money balances out the deflation, and the value of the money stabilizes.   With Bitcoins, no such central authority exists, and by its very design, the number of Bitcoins in circulation grows very slowly, until a pre-determined set amount is reached in the distant future.  This rate of growth is much too slow balance the growing desire of people wanting to use Bitcoins, and thus the hyper-deflation that we're seeing is happening.  Thus Bitcoins are by very design prone to deflation, and the instability that it carries.

Unfortunately, having a very weak capacity to store value prevents Bitcoins from being considered a viable currency.

So what are Bitcoins?
In many ways, Bitcoins resemble a publicly-traded company.  But a company that doesn't require a central exchange, such as NASDAQ, to enable transactions in its stock.  Perhaps we can call such a company Bitco.  There is a fairly limited amount of Bitcoins, or perhaps more accurately, should be called Bitshares.  The more people want to buy these Bitshares, the more the value of these Bitshares grows.  At this point, speculators have come in buying Bitshares in hopes of selling these Bitshares later at a higher value.  These speculators give little thought to the fundamental value of Bitco, they just think that it will be worth more later than it is worth today.  They may argue that this whole talk of fundamental value is a bit "old fashioned" and isn't applicable in the modern age of Bitco and virtual currencies.  Perhaps.

Perhaps not.  I'm making the case that on the one hand Bitcoins are not viable currency, as they do not enable a viable store of value.  On the other hand, if viewed as a company, its fundamental value is zero.  Why so high? Well, if viewed from the perspective of a company, Bitcoins are not designed to generate profits.  They may end up doing just that due to the instability of it's value as form of currency, but if it was to gain stability somehow, it would not generate revenue for anyone.

Bitcoin's only means of generating revenue is the very instability in value that is undermining it as a viable currency.
This is why I believe that Bitcoins are fundamentally worthless: they're not a valid currency, and they're not a viable business.  Could Bitcoin turn out to be a pyramid scheme?  Perhaps the very first peer-to-peer, decentralized pyramid scheme of its kind?  If so, perhaps a better term for it is a Bitamid.

To be fair, I believe that the inventor of Bitcoin, whomever he or she may be, never intended it to become a pyramid scheme.  Judging from the published whitepaper, the inventor of Bitcoin truly wanted to create a new virtual currency.  I wouldn't be surprised if he or she is actually disappointed with how it has developed.

I wrote this article right at the peak of April 2013.
Note that this contains all historical data, a log scale (easier to judge appreciation/depreciation),
and volume in US dollars (almost nothing until 2013).
What's to come?

So what can be expected for the future of Bitcoins?
I'm no fortune-teller.  The current hyper-deflation that Bitcoins are going through cannot last forever.  Eventually, everyone that could buy Bitcoins would already have, and it's value would stop increasing over time.  The extreme optimists may claim that this will happen in the distant future, a future in which all the citizens of the world have stopped using centralized currencies and have converted to Bitcoins.  A lesser optimist may imagine this happening a lot sooner.

But no matter when this point will be reached, eventually, it will be reached.  At at that point, all the speculators would want to cash-in.  If the optimists are proven correct, then these speculators would be regarded as history's great investors, and they would "cash-in" not by selling Bitcoins for dollars, but by selling Bitcoins for houses, and cars, and land, and other tangible assets.  After all, in this scenario, Bitcoins have become the dominant currency in the world, and everyone is accepting them.  There will also be peace on earth and everyone will love each other as they love themselves.

However, if the lesser optimists are proved correct, then when these speculators will want to cash-in, they will want cash.  And by cash, they will mean dollars (or euros, or yens, etc.)  This will trigger a hyper-inflation for the Bitcoins.  Such an inflation will mean that one will be able to buy less with Bitcoins tomorrow than one can buy with them today.  Perhaps significantly less.  Perhaps so much less that it will pressure many speculators (and even "normal" users of Bitcoins) to get rid of their Bitcoins, and get rid of them ASAP.  Of course, now we're in another vicious cycle, but one that sees the value of Bitcoins rapidly drop.

How much can it drop?  Well, if nobody wants to buy bitcoins, then its value will instantly drop to zero.  Yes, zero.  But that's an unlikely scenario.  Most likely, it's value will drop, perhaps a lot, but not all the way to zero.  Then it may go up again a little, then drop more, then up again, and then down more.  We may witness a slow, over-dramatic death, 1940's Hollywood style.

Eventually, it's value may drop so low that whoever bough that pizza for 10,000 Bitcoins may end up feeling rather good about the purchase.

A bit sentimental
Personally, I'm both awed and saddened by this whole Bitcoin affair.  Awed at the ingenuity behind Bitcoin.  Before Bitcoin, I didn't imagine that such a decentralized means for transactions is possible.  Saddened, because I fear that this experiment will end up a flop.  And if enough people lose money here, it may discourage people from using a future virtual currency, one that is both decentralized and stable.

Then again, people have short memories, so perhaps I shouldn't be worried about this.

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