Bitcoin is dead. Long live cryptocurrency.

Bitcoin, in case you've been off grid, is all the rage. From rising public usage, to growing daily trade volumes, to rapidly increasing institutional investments, this relatively new form of currency as been billed as the game changer for just about every aspect of global monetary policy. But does this “cash killer” really live up to its billing? The thesis of this post is a resounding no.

In brief, bitcoin is a form of virtual peer-to-peer currency that is not issued or controlled by an authority, such as a central bank or massive online player game company.  It derives value in that it is difficult (ie. computationally expensive) to mine (ie. create) new bitcoins and that there are a finite number of bitcoins that can be eventually mined.  Given this decentralization and built-in scarcity coupled with the public-private cryptographic scheme that keeps bitcoin transactions secure, it is clear why bitcoin would appear to be such an attractive alternative to the standard currency we all grew up with.  A more elaborate explanation of the mechanics of bitcoin is given here.

Commodities and Currencies, Physics- and Sovereign-based Scarcity

The ingenious scarcity manufactured into bitcoin (21 million total can be mined), makes it behave like a commodity from a value perspective. Just like bitcoins, there is a finite amount of gold and platinum near the surface of the earth and a relatively prescribed cost per rate of mining.  The price, in turn, reflects the scarcity and the discount on the future availability of the commodity (there is inherent value in these metals, e.g. in manufacturing, but let's assume this contributes negligibly to their current valuations). When the value of bitcoins and gold rises there is increased incentive to mine faster. (The Ludwig von Mises regression theorem would suggest that since bitcoins do not derive from a commodity then they should have no value).

However, bitcoins are not like commodities in a fundamental way: since there is no central authority, we could all just create our own bitcoin clone with the exact same prescription for transactions, mining etc. Unlike the finite number of elements in the periodic table (central authority = Physics) which gives value to helium, copper, gold and platinum, there are virtually an infinite number of bitcoin clones possible. If any of these clones (I'll call mine Bloomcoins™) takes off then we've just eaten into the value of bitcoins (more on this later).  That is, the value of a commodity derives not just from the scarcity of that commodity but from the scarcity of the number of commodities as well. There is nothing in the fundamental way bitcoin works to stop or forbid the creation of other clones.

Bitcoins are obviously more than commodities in that they are easy to trade (derivatives of commodities are also easy to trade but not the actual goods themselves). And so despite the fairly low volumes now for bitcoins (or the tiny fractions of bitcoins called satoshis) the bitcoin market has the potential to act like a truly liquid currency. But, in the same way that there are fundamental limitations to the number of commodities which can be ascribed value, there are effectively a finite number of countries on the face of the earth that can and do issue currency. Say what you will about the appetite and willingness for individual countries to print money at rates which undermine trust and the implicit contracts of maintained scarcity of supply, but there are still a finite number of country-backed currencies. As with commodities, some of the intrinsic value of sovereign-generated currencies is that there are a finite number of them.

Bitcoin ≈ MySpace

I suggested above that the cloning of a bitcoin system could undermine bitcoin's value. This would be easy to do but hard to get traction with given the popularity of bitcoin itself. But why would we clone bitcoin when could instead produce an evolved version? Indeed, the way in which bitcoin exists and operates in the world was fixed at the time they were envisioned and created — that is, how transactions are recorded, how they are mined, how trust in the system is built in, etc. And we know that [some of the detailed mechanics of how bitcoins work are broken and susceptible to major undermining of trust](http://crypto.stanford.edu/ xb/fc12/bitcoin.pdf). For example, on March 11, 2013 the famous block chain fork almost ruined bitcoin. Ironically, for what is suppose to be a highly decentralized currency, the collapse was avoided because the system was “controlled by the will of a very small number of people – particularly, the operators of mining pools” who effectively agreed which block chain to support.

For such reasons alone, I think we might consider bitcoin as an alpha version of a minimally viable product (MVP) in the burgeoning cryptocurrency ecosystem. Ian Steadman at Ars Technica wrote about some of the known shortcomings with bitcoin and possible solutions. Adding proof-of-stake to proof-of-work seems like a good start.

If cryptocurrencies are the new social network, then I argue that Bitcoins are MySpace. That is, they are acting like a 1st mover in a new market and they are enjoying first mover advantage: popularity, network effect, investment, and trust. But, like MySpace, they are susceptible to being disrupted from a later entrant or entrants.  I do not profess to know what the startup-stage version of the Facebook equivalent is for cryptocurrencies but there are plenty of possibilities. To name a few with interesting prospects: YACoin, Litecoin, PPCoin, Freicoin.

All new entrants to the crytocurrency game will certainly have to fight for the same things that make bitcoins so valuable now (primarily growth and widespread trust) but the new crop will be viewed as a beta version with some important patches applied. And with a better product will come dissatisfaction with the older product and widespread adoption of the better product (and unlike MySpace and Yahoo!, bitcoins cannot reinvent themselves to keep up with disruptive foes). It's ironic: the very liquidity and ease of use of bitcoins will make them so very not sticky, hastening the abandonment. If I were an investor in a new bitcoin-centric company, I'd be getting pretty worried as one of the newer cryptocurrencies started to rise significantly in volume trading.

Tomorrow is always better, and so today is worthless

The case against bitcoin might be even worse than suggesting it's merely an alpha version. This software or company analogy would suggest that there will be an eventual winner, some sort of lasting incumbent (or perhaps set of incumbents) that come to dominant the cryptocurrency market. But I would suggest that the reliance upon cryptography for value fundamentally undermines the value of any cryptocurrency. Why? Because cryptography is always improving. Bitcoin is based upon the SHA-256 cryptographic hash function. What if, even after the major shortcomings are deemed fixed in the mechanics of the bitcoin ecosystem, I start a bitcoin-like system with a SHA-512 hash function? Can I interest you in a bit more security for your assets? What happens when someone invents a new cryptographic protocol that is deemed better than the public-private key system currently used? What happens when quantum computing becomes ubiquitous? (The bitcoin FAQ on myths suggests that the security could be updated but I do not see how this can be done in practice without a central authority).

It is uncertain when the current cryptographic scheme will be deemed less safe than a viable alternative but I think there is no uncertainty that this will happen. If this is a generally true statement at any moment in time, then the currently popular cryptocurrency will always be seen as less attractive than one which is bound to come later.

A set of post-beta version cryptocurrencies may one day emerge that are deemed good enough for the moment even if this undermining principle serves as downward pressure on their valuations. But bitcoin will be long gone by then.

If You Want Privacy, Trade Wampum

I've not really touched on issues of usability, maintainability, eco-friendliness, and the value relative to other currencies. But one thing to touch on that is often discussed with decentralized, bank-less currencies is privacy. It's important to note that bitcoin transactions and their owners public keys are not anonymous, but instead part of a public ledger like the size and timing of stock trades. To be sure, no names are associated with public keys. But disassembly of the ledger has shown that individuals may be tied directly to transactions, much like anonymous metadata about a few phone records can efficiently predict the person behind those records.

Given the decentralized nature of cryptocurrencies, its temping to view them positively from a libertarian lens. But decentralization itself coupled with the growing need for volume essentially means that the vibrancy and growth of any cryptocurrency will require remote electronic transactions. This means each transaction is susceptible to eavesdropping and tracking.  Physical goods, like cash and gold are much harder to transact because they require truly a physical connection (at least in space, usually in time as well) between both parties. But physical currencies and commodities are much harder to track in bulk because they can be truly off grid. Given the recent NSA PRISM scandal, its clear that the collection and storage of public of electronic records are also all the rage, so those looking for true anonymity might reconsider the good ole greenback (or wampum).

So What's it worth?

I'm clearly not enthusiastic about bitcoin's long-term valuation prospects. It's possible that all bitcoin holders already thought of these concerns and that the current price has such considerations already taken into account. But I've been reading about bitcoin for awhile now (albeit at the popular and trade press level) and not really seen these arguments laid out.  (It's also very possible that I'm flawed in some of my arguments.) Josh Seims (@jseims) recently suggested that even if there is a 10% chance of bitcoin succeeding in the long run (i.e. value not going to zero) and it captures 30% of the now-valued gold market, then bitcoins are undervalued by a factor of 100 currently. Another read of this is that the market, however inflated and hyped up as it seems to be now, still only gives bitcoin an 0.1% (=10%/100) chance of not being worthless. We'll see…

I'd like to thank my friends and colleagues, especially Ryan, Wayne, and Kevin, for stimulating discussions about this topic over the past few months. The views expressed herein are entirely my own and do not necessarily represent the views of my employer. I hold no financial stake in any cryptocurrency, long or short.